Friday, April 30, 2010

"Banging the Close" and Other Urban Truths

The CFTC said Moore's fund portfolio manager tried to manipulate platinum and palladium futures from at least November 2007 through May 2008 by entering trades in the last 10 seconds of trading in a manner designed to exert upward pressure on the settlement prices. The practice is known as "banging the close." Reuters

"The timing of the SEC's filing of a civil securities fraud action against Goldman Sachs has created serious questions about the commission's independence and impartiality," said Darrell Issa, the top Republican on the House Oversight Committee, in a letter to the SEC on TuesdayReuters

I couldn't believe my eyes as I read the stories above. A Hedge Fund (and former employer), Moore Capital, caught manipulating closing prices and the SEC caught timing the release of GS fraud charges to further their agenda.

What's next? Will the experts soon assert, with somber gravitas, that life, in fact, exists....on Earth?

That is, the incredulous implication of the above articles (and many others these days) is to me, incredulous. Do we all really believe we take up no space? politicians and bureaucrats don't play politics? fund managers don't "window dress", "paint the tape" or "bang the close"?

Mr. Bacon of Moore Capital, for whom I have great respect as a trader, and from whom I learned a great deal during my short time there, is no fool. I'm sure he authorized the obligatory statement: Neither Moore Capital's principals nor its current management were involved in any improper trading, and none have been accused of any wrongdoing.

I'm just as sure he senses the absurdity therein.

Every big player in every market I've traded effects the price when they trade. Central Banks count on this effect when they "intervene"- a word that implies some deus ex machina instead of another institution with an ax to grind. Why should anyone care if a firm decides to make liberal use of the "Texas Hedge"- increasing exposure to push the price in their favor?

Ultimately, "Texas Hedging" requires a greater fool to relieve you of your position at the "manipulated" price, or the practice will generate losses. A Hedge Fund manager willing to give up 2% in the long run to get an extra 1% (and consequent (but temporary) increase in performance fee) at quarter's end is just making his job that much harder.

If "banging the close" is illegal how should we qualify the Fed and Treasury's decisions to buy hundreds of billions of dollars of non-performing mortgage debt and ring-fence other "toxic" assets from a dreaded mark-to-market?  Both aim to effect the market, and the state has a nasty habit of leaving the general public "holding the bag" on unwound Texas Hedges.

I'll take the former over the latter any day.

Where's the harm in the former? except to modern institutional myth belief. The myth to which I refer is the view that modern institutions both public and private are impartial and altruistic, peopled by angels, and not humans.

I've little doubt both the CFTC's and SEC's cases are "timed" for effect. The state is trying to dispel the mythic quality of finance- to change public perception thereof (the fines are mainly beside the point). After all, that is the game they play. Explicitly, politicians and bureaucrats through policy and media access aim to effect popular opinion. Are we next going to chastise judges who aim to "make an example" of someone? Isn't deterrence an aim of public policy?

Of course, the state takes a risk in their myth dispelling goal. Once myth-busting becomes a habit, who knows which myths are next to face apocalypse? If finance is revealed to be just a bunch of guys with axes to grind, so too, the public may soon learn, are politics.

The public might even learn the money in their pocket has no intrinsic value- Insha'Allah.

I hope this myth-busting leads, as it often does, to renewal. I'm aware, however, that the path of social myth-busting is often chaotic. Dashed dreams make for unhappy people. On the bright side, dashed dreams improve one's sense of reality, if one is strong enough to get over the disappointment.

In Hindu theology, Shiva, The Destroyer (of myths) leads Brahma, The Beginner. It is said nobody worships the Brahma phase of the Hindu Trinity, perhaps because worship requires the sense of awe destroyed by Shiva. After Brahma comes Vishnu, renewed worship and a period of institutional status quo. Old myths acquire new faces.

The cycle repeats.

Wednesday, April 28, 2010

Breaking Up Is Hard To Do: TBTF, the Euro and Gold

Perhaps this is one reason why Gold has not reacted in recently "normal" fashion to Greek crisis inspired Euro weakness. Perhaps, the new thinking may go: Monetary Union's loss (in its many forms) is Gold's gain. If the drive to a monolithic world currency has stalled and currency competition comes back into vogue, Gold's track record is tough to beat.

Recent news about Greece's financial travails reminded me of a conversation I had with Helmut Schlesinger as the Asian Crisis was unfolding in 1997. Over a few drinks at the Long Bar in Singapore's Raffles Hotel, Mr. Schlesinger regaled me with his views on inflation, monetary integration and "realignments" (devaluations).  I don't know whether it was the drinks, the ambiance of the historic Long Bar, or the impending realignment of Asian currencies to the US$, but Mr. Schlesinger was in a mood to talk, and I, to listen.

As President of the Bundesbank from 1991-93 Mr. Schlesinger had a wealth of experience on monetary integration (with East Germany), realignment within the ERM (European Exchange Rate Mechanism), and disintegration (as Britain left the ERM). On the side of the "economists" in the debates over EMU, he argued, presciently, as the Greek situation demonstrates, that the "monetarists'" view- monetary integration prior to complete political integration wouldn't be a problem- was not historically grounded. Nor was he sanguine about the German reunification of East with West- 13 years hence East Germany continues to lag the West.

For Mr. Schlesinger, "flexibility" was a key component of economic integration. Adjustments in the terms of trade between economic parts, he told me, would always be necessary. Thus integration which didn't maintain some potential for flexibility-which assumed the combined parts would always thereafter be a unified whole- risked disaster. Perhaps this explains, to some extent, his comments about potentially necessary ERM realignments in 1992 that acted as catalyst to the GBP (British Pound) and ITL (Italian Lira) devaluations, and withdrawal of the GBP from the ERM.

There seems to me a lesson to be learned from both the recent EU and TBTF problems on either side of the Atlantic- breaking up, in the sense of making necessary adjustments in the terms of trade (a phrase that usually refers to the relation between import and export prices between nations, but can more broadly refer to the agreed upon bases of exchanges (prices, credit access, etc.) between and amongst any and all economic units), is hard to do. Flexibility has been lost in the pursuit of economic monolithism (if you will).

Previously, situations like Greece, or the TBTF banks in the US, would have begged a period of disintegration and adjustment in the terms of trade, either via devaluation in the case of Greece, or disintegration (perhaps bankruptcy) of certain units of the TBTF banks, in the case of the US.

To wit, US financial sector reform, in my view, needs to, inter alia, restrict discount window borrowing privileges to commercial banking (i.e. adjust the terms of trade within finance), leaving derivatives and proprietary trading to stand or fall on their own merits.  This is virtually impossible within the current system of financial monolithism.

The cost of the new approach of economic monolithism, is increasing bailouts- dilution of the common currency- which distributes the losses system wide, and slows the necessary adjustments in the terms of trade.

It is not surprising to me that the Germans, where fears of a Weimar style inflation remain strong, are loathe to dilute the Euro to bail-out Greece. After Greece, who else will need a bail-out?

Perhaps what the EU needs is a divorce (perhaps temporary separation, might be more apt) clause- a means to make the necessary terms of trade adjustments. This, in a sense, is that US financial reform seeks- a procedure to disintegrate (temporarily, or permanently) the financial sector to make equally necessary terms of trade adjustments.

The issues noted above, Greece and the TBTF banks, combined with the broader issue of relations between sovereign states and the international whole suggest that the world has, for the time being at least, reached a point of diminishing returns on economic integration. We may need more currencies, and certainly greater economic flexibility between the parts than currently exists.

Perhaps this is one reason why Gold has not reacted in recently "normal" fashion to Greek crisis inspired Euro weakness. Perhaps, the new thinking may go: Monetary Union's loss (in its many forms) is Gold's gain. If the drive to a monolithic world currency has stalled and currency competition comes back into vogue, Gold's track record is tough to beat.

Monday, April 26, 2010

A Sophisticated, Glamorous Nation

Education is like drinking- the more you get the easier it is to forget who you were before you started. A. Burns

I have a confession to make. About 15 years ago, I was a well-educated ignoramus, from an Ivy League school of some renown. I don't blame the school for this. Had I spent my years there wisely I could have learned a great many things. What I learned instead was how to appear smart- how to fake it. Fortunately, I came to realize there were more benefits to "education" than appearance, like knowing what words really meant, how we got here (if not originally, at least historically), and how the world works.

I'm still, 15 years later, an ignoramus, but at least I'm aware of my condition.

It hasn't been, for me at least, an easy road, nor is my journey complete. As the Buddha said, there are two mistakes on the path of enlightenment- not starting and not going far enough. I've found many temptations to further enlightenment. Pride both tempts me to scorn those less well versed than I and forget that the only difference between me and them is the realization of my ignorance, good fortune in having the time to study, and the study itself. Pride of education is, for me, very self-defeating. It keeps me from being wonderstruck at the millions of others both now and in the past who know more (by making them invisible) and blinding me to my own past history of being ignorant of my own ignorance.

There are, it seems to me, two paradoxes at the heart of education that stymie the continuation thereof. 1) The more you learn, the more tempted you are to think you know, and the less likely you are to keep learning. 2) The more you learn, the more you realize you don't know. Paradox #1 is the "do loop" of ignorance (really a "don't loop") while Paradox #2 can be daunting, if you don't learn to love learning- heck, to get addicted to the process, not the result.

This rather long preamble was occasioned by a read of Don't ignore the Tea Party's Toxic Take on history. I was reminded of my own ignorance (and consequent misuse) of words like communism, socialism, tyrant and progressive. I was reminded of my own pride, after learning the meanings of those words, in arguing by anecdote: Take for instance the Tea Party demonization of "federal regulation" as the instrument of the tyranny that's been imposed on them. I would like every Tea Partier who has denounced federal regulation to write a letter to the widows and children of the coalminers in West Virginia who died because of the failure of "federal regulation" of mine safety. I was reminded of my own pride in seeing simple answers to complex issues: Historical fraudulence is like a disease, a contagious psychosis which can lead to mob hysteria and worse. Consider the role that fraudulent history played in Weimar Germany, where the "stab in the back" myth that the German Army had been cheated of victory in World War I by Jews and Socialists on the home front was used by the Nazis to justify their hatreds.

Tea Partiers who misuse words like communism, fascism and socialism fall into a trap I know all too well- assuming connotation (in this case, negative) equals meaning. It's a common error. To wit: sophistication has acquired a positive connotation. Not too long ago, I discovered its root referred to sophism, or the use of fallacious argument to win debate and previously had a negative connotation. Two wit: glamorous has acquired a positive connotation. Not too long ago I discovered its root referred to a magic spell- a glamour- which made things appear more desirable than they actually were. In years past, I've happily received the "compliment" of being sophisticated. And who knows, perhaps the speaker was equally ignorant of the meaning and meant to compliment? Ignorance all around, in that case, might have been bliss.

Language is a funny thing-both cause and effect, pushing and pulling, hiding and revealing.

Take the anti-anti-regulation argument above.  Tea Partiers, according to the author, should contact the families of recently deceased miners.  Makes sense, yes?  If you are against regulations you must be for the things that occur without?

Like traffic deaths.  Except that's a fairly well regulated area of human life. 

I suspect the issues of driving and mining are more nuanced that either the Tea Partiers, the author, or myself could mentally unravel, which is a far cry from enacting (or removing) policies that would "improve" the world, if such a term could be defined. 

Of course, faith in man's ability to impose macro improvement (instead of self-improvement) through political change seems strong in modern times, on both sides of the political aisle in the US.  Or has politics degenerated into another spectator sport where team victory is all.  Should I even use the term "degenerated"?

Perhaps education about our history is like peeling an onion, the more you peel, the more you cry.

I could argue; conflating Tea Partiers with nascent German National Socialists based on their ignorance might be an error. Ignorance is man's most common state, and given the amount of work required to have what is called good working knowledge of a subject, I'm not surprised.

The conflation basis of Tea Partiers with nascent German National Socialists of which I'm concerned is their (in both cases, justified) sense of getting "screwed" by some of those in power (and rather unfortunate belief that a new boss can set things right). Ignorance is common. Passion fueled by outrage about getting "screwed" is (thankfully) reasonably rare. The combination is almost always a disaster.

Thus, the key element of the Tea Partiers one shouldn't ignore is the outrage. Fortunately, this is, in a sense, an easier problem to fix. In systems of popularly elected government, the elite should work hard to not screw the common man.

Seems to make sense, to me.  So I try to deal with people on the up and up. 

Could such a view be made law and what would be the consequences thereof? 

Tough, for me at least, to reason clearly on the subject as I have little knowledge of serious political reforms (as opposed to the more naked power/wealth grabs) that weren't informed by crisis.  Law follows ethics, with greater or lesser lags.

I suspect the fix, if such were to manifest, will require us to first "touch the stove".  How hot that stove will need to be remains to be seen.

As Santayana said: we learn from history that we learn nothing from history.

Friday, April 23, 2010

TBTF Requires a Controlled Demolition

If shareholders realized they they are getting the same shaft as depositors a major impediment to true bank reform could be swept away. Senior bank employees are using complexity of operations (which is more myth than reality) to hobble shareholder control and progressive era legislation to hobble depositor control.

Let the senior financiers keep their salaries and bonuses, and let them do with their banks what they will. If, however, their bank fails, let the bankers themselves fail. Let the value of their houses, cars, yachts, paintings, etc. be assigned to the firm's creditors. James Grant: Let the Bankers Fail

As the news of Wall Street's underhanded dealings goes mainstream thanks to the SEC's case against Goldman Sachs, the idea of letting the bankers fail never seemed so sweet to so many in recent history. Yet, failure might have nasty consequences. Just as one wouldn't want a skyscraper to topple over in a crowded city, one wouldn't want the TBTF banks to collapse. Better, I think, to effect a controlled demolition.

While he has been opining about finance more wisely and for far longer than I, Mr. Grant's ire may be somewhat misdirected (although the effect of his proposed renewal of the fear of God seems a wise idea) at shareholders, when senior bank employees are those whose behavior must be modified. They take the least risk and benefit the most.

Explaining the problem's emergence, Mr. Grant draws our attention to the FDIC, an institution ostensibly designed to benefit the man on the street whose limited life savings might be lost in a bank failure. An additional effect, however, was to shield bank owners from liability, at state expense.

Another key effect, particularly when the lender of last resort (in the US, the Federal Reserve) supports banks rather than credit markets more generally, was to dampen depositors' desire and hamstring their capacity to demolish a bank. It is no surprise that the vigor with which Big Finance worked to repeal Glass Steagle was not directed at FDIC or Federal Reserve legislation.

Banking is a curious business, as Louis Brandeis noted in Other People's Money: The goose that lays golden eggs has been considered a most valuable possession. But even more profitable is the privilege of taking the golden eggs laid by someone else's goose. Bankers, by which he meant bank shareholders, combined their equity capital with deposits, in 1929 at a deposit to equity ratio of roughly 10 to 1 and kept a majority of the profits thereof.

Prior to Fed support of banks, depositors had a significant controlling interest (whether they were aware of this is another issue). A bank run was the means by which they exerted this control. As noted, this control was greatly diminished (but not lost), and obscured by the Fed and FDIC.

Of course, what is good for the goose is good for the gander. Bank shareholders had it good for a while, but lately they too have been getting the shaft from senior bank employees, who may not have any investment in the bank. As noted here, (full article here) at the Big 4 US Banks (BAC, C, JPM, WFC) depositors were paid $25B on their investment of $2.5T, shareholders were paid $18B on their investment of $660B and employees were paid $111B for their time.

If shareholders realized they they are getting the same shaft as depositors a major impediment to true bank reform could be swept away. Senior bank employees are using complexity of operations (which is more myth than reality) to hobble shareholder control and progressive era legislation to hobble depositor control. Simon Johnson and James Kwak should take note. Explaining that shareholders' interests are aligned with depositors' might ignite the controlled demolition of TBTF.

Why should senior bank employees with the least "skin in the game" reap the largest benefits?

A controlled demolition of TBTF might proceed something like this:

1) Depositors could begin to reassert their lost control by withdrawing money from the Big Banks (there already is such a movement underway).

2) Minimally, shareholders could begin to reassert their lost control by wiser appointments to the Boards of Directors with the view that cost control includes direction as well as magnitude (to wit, why should shareholders pay for lobbying which enriches employees and not them). Preferably, sell the shares and reinvest the capital in various smaller banks, presumably some of whom might be the recipients of moved depositor funds and none of whom have significant derivatives' exposure. In a controlled demolition of TBTF, the numerous banks left standing should benefit significantly.

3) Depositors and shareholders could understand that institution size dilutes control and allows employees to usurp control leaving you (or the state) to deal with the risk.

4) If an aligned group of depositors (aka voters) and shareholders (aka those funding the lobbying) demanded action, change would come. One key change: The Fed would need to stop supporting banks and instead support markets mitigating collateral damage from the demolition. They should open lines of communication with the hundreds of banks with assets between $1B and $100B. They will also need to deal with foreign depositors at the TBTF banks and begin to unravel the nightmare of derivatives (admittedly a task easier said than done).

Instead of a full frontal approach, TBTF should be imploded from within. Those with "skin in the game" need to take back control. 

It's your money, and only your wisdom (not the government's or bank employees') will keep it safe and perhaps allow it to grow.  Concentration of money occurs when investment is passive.  Move Your Money!

One might even consider moving one's money out of the banking system entirely during the renovation through the purchase of Gold.

Tuesday, April 20, 2010

IMF Power Play: Capital Controls or Failed States?

Coincidences abound these days. GS calls for derivatives clearinghouses, as does the IMF. GS, and in the not too distant future, presumably other TBTF institutions face civil suits enforced by national states from many parties. The IMF declares the debt load of these states the biggest risk to the financial system.

The global financial system and the world economy are slowly regaining their health, thanks in large part to unprecedented interventions by governments, but the sharp rise in government debt during the economic crisis from already elevated levels helped create what the IMF says is the newest threat to the financial system: growing sovereign risk. IMF (April 2010)

2. Yesterday, October 10, the G-7 met and agreed the following plan of action:

• "Take decisive action and use all available tools to support systemically important financial institutions and prevent their failure

3. Today the International Monetary and Financial Committee strongly endorsed the above commitments IMF (Oct. 2008)

On Christmas Day, 800 A.D., Pope Leo III crowned Charlemagne Emperor of the Romans. While scholars' views vary as to the Pope's intent, and Charlemagne's prior knowledge thereof, that the Vatican had thereafter a large effect on national politics in Christendom is without doubt. Concerns about the Vatican's continued influence almost 1000 years later, inter alia, led the framers of the US Declaration of Independence and Constitution to declare their sovereignty from, not only the mother country, but also such supra-national institutions.

Of course, that was then and this is now. The US Government, now hobbled by the debt load, incurred, in part, to support TBTF financial institutions- a policy urged by the IMF 2 years ago- is now being urged, by the same IMF, to reduce sovereign debt risks, which are the "newest threat to the financial system."

As the saying goes, with friends like these...

For decades, admittedly with varying intensity, the IMF has, in general, urged open capital markets- a policy at odds with the IMF's original mandate. Two years ago, the inevitable result of such national sovereignty abdicating policies in the absence of vigorous supra-national regulation brought the world's financial system to the brink of disaster.

With the benefit of hindsight, from one perspective, the IMF could be seen to have loudly urged national governments to "take as much (debt) rope as you'd like," and whispered, "to hang yourselves with."

How times have changed.

The dilemma which, in large part, led to the creation of the IMF- how to have the cake of international capital mobility and eat the cake of national sovereignty (yes, it's a stretch, but go with it), was, according to Louis Pauly, in his Who Elected the Bankers? confronted directly by Bretton Woods negotiators: They could see no way around the fact that states, if they valued economic stability as much as they valued their political independence, would have to maintain the capacity to deploy capital controls.

In the event, capital controls fell out of favor and thus capital sovereignty in the largest states was greatly diminished but the costs associated with supporting the banks profiting the most from the open environment have been shouldered by these same states. This seems, borrowing a term for yesterday's post, asymmetric.

Why should the state pay for what it cannot control?

Why, if the IMF supported the use of all available tools to restore financial stability but 18 months ago, does its most recent report highlight the risks of growing sovereign debt, but not the risks of private sector financial institutions whose failure to pilot the open capital market seas successfully played such a large role in the "risky" debt growth?

Louis Pauly asked, "Who Elected the Bankers?" If the IMF is taking its cue from Pope Leo III and playing for power with TBTF institutions, we have an answer. The IMF didn't Elect the Bankers, It Crowned Them.

Coincidences abound these days. GS calls for derivatives clearinghouses, as does the IMF. GS, and in the not too distant future, presumably other TBTF institutions face civil suits enforced by national states from many parties. The IMF declares the debt load of these states the biggest risk to the financial system.

The question of who is in control begs an answer. If the states aim to retain sovereignty, they will be forced to use the tool of capital controls. Indeed, in the current battle with GS, the US may find, if capital controls aren't imposed, that GS leaves a shell company to bear the brunt of any penalties. More broadly, if the national states don't impose control, they may soon find themselves, like Greece, California or New York, overly indebted entities with no power to solve their own problems, and thus waiting for hand-outs from the new supra-national institutions they created.

Let the games commence!

Monday, April 19, 2010

GS Case Begs the Volcker Rules (and Blankfein a lesson in asymmetry)

The core of the SEC’s case is based on the view that one of our employees misled these two professional investors by failing to disclose the role of another market participant in the transaction, namely Paulson & Co., and that the employee thereby orchestrated the creation of materially defective offering materials for which the firm bears responsibility. Goldman Responds

Using methods from theoretical computer science this paper shows that derivatives can actually amplify the costs of asymmetric information instead of reducing them. Working Paper on Information Assymmetry

As Mark Thoma explains in a recent post, the SEC's case against Goldman Sachs (assuming a strict reading of the statute) rests on the issue of asymmetric information- did GS disclose enough information about the offering such that the collateral manager of the CDO "knew or should have known that Paulson was on the other side of the transaction."

There is another aspect of the case, in light of the implicit support of TBTF financial institutions, that begs the Volcker Rules of proprietary trading separation from government supported activities, namely commercial banking, to which I'll return.

Asymmetric information is one of those phrases that makes common people hate economists. Uneven, deceptive or lying captures the essence of the issue.

To indulge a fantasy occasioned by the Goldman fraud, and explain the issue, let's imagine I found out that Mr. Blankfein liked to play a bit of ice hockey from time to time-nothing too strenuous, just for fun. Imagine, upon hearing the news, I invited him up for a skate with my spring hockey crew. "It's just a pick-up, no refs, no checking, lots of fun," I could tell him- "for us," I might say to my friends after hanging up the phone.

Imagine he comes up, suits up and hits the ice. At that point (or as soon as the first puck whizzes by his head), he'll realize that he's on the ice with 1-2 ex-Pros, quite a few ex-College players and we all play all year round, 4-5 times per week in the winter. There's no checking (well, almost, it gets you 2 minutes in the box), but there's quite a bit of contact. Slap shots are coming anywhere from 60-90 mph.

That's a little lesson in asymmetry I'd like to give Mr. Blankfein. Of course, there would be nothing sportsman-like about it. He'd be outclassed (but it would be fun).  It also would be entirely legal, as we may find to be the case with GS.

Getting back to reality, GS will argue that the collateral manager knew or should have known what he was getting into. We'll have to wait for the evidence to be presented to see if that claim is true.

The second issue I raised about such dealings begging the Volcker rules may prove quite important in the financial regulation debate. Currently, all public markets for finance are open to all, and, apparently, deserving of government support. Even if the collateral manager should have known the security was designed to fail, that such a security could be created strongly suggests to me that such dealings have no place in publically supported markets.

All participants in my men's hockey league sign waivers taking personal responsibility for injuries caused on ice. We cannot sue the rink, or the town, etc. We all love the game, so it's not a problem. Imposing costs on the rest of society for the risks we take would not be fair.  It would be assymmetric (if hockey players used such language).

Equally, it seems to me, trading activities such as are detailed in the GS case, should never lead to increased social costs. Not only, in my view, does socializing the costs of such trading activities negate their social virtue (price discovery becomes state sponsored price enforcement) such support drifts ever closer to tax funded gambling. What's next, tax credits for the losers in next year's World Series of Poker?

When a security can be designed to fail, it's time to separate the financial markets into socially protected and unprotected divisions. Just as I play socially unprotected hockey, I'm all in favor of socially unprotected trading- I just don't think my neighbors should have to pay when the risks become real.  Nor should the rink be shut down because we made a mistake.

I'll close with an ice hockey tip for the boys at Goldman: Keep Your Head Up Out There, Boys!

Saturday, April 17, 2010

Thought Reserves, Actionable Posts and Bukowski

We are
Born like this
Into this
Into these care­fully mad wars
Into the sight of bro­ken fac­tory win­dows of empti­ness
Into bars where peo­ple no longer speak to each other
Into fist fights that end as shoot­ings and knif­ings
Born into this
Into hos­pi­tals which are so expen­sive that it’s cheaper to die
Into lawyers who charge so much it’s cheaper to plead guilty
Into a coun­try where the jails are full and the mad­houses closed
Into a place where the masses ele­vate fools into rich heroes
Charles Bukowski

Over the past few months the good folks at Seeking Alpha have been selectively publishing some of my musings. Their selection process involves the "action-ability" of the views (not a critique, just an observation).

Thus, this post will almost certainly be left on SA's cutting room floor (and rightly so).

When attempting to tailor my musings to their needs, I can't help but be reminded of my earlier incarnation as trader asking house economists to tell me me how to translate their views into trades.

I didn't need the theory, I thought, just the trade.

Eventually I ran into an economist who convinced me of the error of my ways.  Alan Ruskin (a very bright economist, and man of great integrity) showed me the virtue of reserves of thought.

If you've spent the time understanding the theories, and creating a library of potentialities, events will "make manifest the theories".

I've spent the years since this epiphany studying theories and creating my own library. The blog you are reading is one repository of this process.

The longer it remains online, the more current events can be covered by referencing earlier thought experiments.

Now I'm on the other side of the issue, with others requesting actionable views.

Months ago, I wondered, "Will Goldman Sachs do it again?" They did. The earlier musings weren't a forecast, just a potential, waiting for an event.

Yesterday I wrote about The Price of Gold Backed FX Reserves. It's not a forecast, just a potential, waiting for an event.

If the event manifests, the work is already done.

Paraphrasing Bukowski,
the events are
born into theory

Air Traffic Congestion and The Flow of Funds

Imagine, instead of stranded passengers, stranded money. Imagine, instead of volcanic ash creating doubts about the safety of flying, a poor auction, bankruptcy, financial fraud charge, or regulatory change creating doubts about the safety of investments. Just as planes don't have to crash, concern itself is enough to stop the flow of passengers; investments don't have to go bust, concern itself is enough to stop the flow of money.

BRUSSELS (Reuters) - Disruption of air traffic because of the spread of volcanic ash from Iceland worsened on Saturday with no landings or takeoffs possible for civilian aircraft in most of northern and central Europe.

The European aviation control agency Eurocontrol said it expected about 5,000 flights in European airspace on Saturday, against 22,000 normally. This compared with 10,400 flights against a normal 28,000 on Friday it said, adjusting figures from an earlier statement.

During an Internet Chat with the In-Laws in Singapore I discovered that air traffic disruptions in Northern Europe had clogged Singapore's Changi airport with stranded travelers- a reflection, no doubt, of many busy airports around the world. This real world experience seems to me a great metaphor to explain disruptions in the flow of funds which operate on similar principles but don't manifest in such easily seen ways.

Due to the grounding of flights in Europe, passengers all over the world are stuck where they are. Whatever tasks await them at their destinations will either not get done or will have to be done by others.

Imagine, instead of stranded passengers, stranded money. Imagine, instead of volcanic ash creating doubts about the safety of flying, a poor auction, bankruptcy, financial fraud charge, or regulatory change creating doubts about the safety of investments. Just as planes don't have to crash, concern itself is enough to stop the flow of passengers; investments don't have to go bust, concern itself is enough to stop the flow of money.

Air traffic congestion brought on by safety concerns is one cause of a significant decline in the velocity of travel.  Similarly, monetary congestion brought on by safety concerns is one cause of a significant decline in the velocity of money.

Stranded passengers mean work may be undone, meetings may be postponed, and dates may be cancelled. Stranded money means the same things- bills may be unpaid, investments may be postponed, and equity and security issues may be cancelled.

Due to the interconnectedness of the world through air travel, problems in one part of the world affect the whole. So it is with our interconnected world of finance.

One issue of concern, no doubt, for quite a few stranded passengers is their available reserves. Will the family at home have enough money to pay their bills while some members are gone? Will the stranded passengers have enough available cash to satisfy their needs?

Paraphrasing Warren Buffett, it's only when volcanic ash grounds planes that you find out who's been flying naked.

When the flow of funds is similarly disrupted, reserves are key. The nearer financial entities operate to insolvency the less able they are to deal with disruptions in cash flow. This is the principle behind reserve requirements in banking, and it applies to all financial entities, from a Professor stranded in London to a Hedge Fund waiting for settlement- without sufficient reserves, small defaults can cascade into global problems.   Thus are some financial market crashes precipitated.

Indeed, we may well find that this round of air traffic congestion leads to a growing flow of funds disruption.  The metaphor may become life. 

Chaos theorists refer to the butterfly effect- how a butterfly's flapping wings may change the weather on the other side of the world.   This would be the volcano effect- how volcanic ash precipitated a market crash on the other side of (or the entire) world. 

There are three key determinants to the extent of this financial chaos effect: 1) the degree to which a critical mass of  people are operating near insolvency 2) the degree of payment interconnectedness 3) the duration of the congestion.

In my view, the first two determinants are quite high, only the duration remains unknown.

If only there were Human Central Banks who could conjure up simulated people where needed in the same way Monetary Central Banks conjure up money.  Conjuring up people to relieve declining velocity of travel, however, would over-populate the world with people in the same way that monetary stimulus to relieve declining velocity of money over-populates the world with money.

What was that about Death Panels.....

Friday, April 16, 2010

The Price of Gold Backed FX Reserves

While perusing the IMF's data set of Central Bank reserves I did a bit of calculating.  The graph below depicts the calculated $ price at which aggregated Central Bank FX reserves could be backed (100%, 35%, and 65%) by their holdings since 1980.

Currently, the IMF figures that Central Banks have 970M oz. of gold and $8,463B worth of FX reserves.  100% cover equates to a price of $8,720. 

Alternatively, they could just buy more.

Goldman Goes For The Jugular With Derivatives' Control

"Given that much of the financial contagion was fueled by uncertainty about counterparties' balance sheets," Goldman Chief Executive Officer Lloyd Blankfein and President Gary Cohn wrote in a letter at the beginning of the annual report, "we support measures that would require higher capital and liquidity levels, as well as the use of clearinghouses for standardized derivative transactions." Washington Examiner

I've spent countless hours taking Goldman (GS) "to the woodshed" for underhanded dealings (and I'll end this article that way) but they have always been astute traders. Their recent request for derivatives clearinghouses seems to me like a coup de grace administered to all other derivatives dealers.

When I was trading FX Options at Chase, J. Aron (owned by GS) was rightly regarded as one of the best derivatives dealers along side First Chicago (which was eventually swallowed up by UBS). They had the best models, and were religious about hedging away their risk.

I assume the past few years taught them that their biggest risk lies, not in the market, but in their counterparties. Their book might be well hedged, but if their counterparties default, they are doomed.

Thus, it seems to me, the request for clearinghouses. GS will force other dealers to use their models and risk mitigating tactics.

Let's assume they get their way. Other dealers, like JP Morgan (JPM), Bank of America (BAC) and Citibank (C), will likely find they haven't properly valued and hedged their books. The government, in its zeal to enact reform will likely be forced to pick up the cost of reducing these other banks' risk, and the banks themselves will likely find that GS is the last player standing.

Let's be cynical and assume that GS expects it will be the spring from which derivatives' regulators will be drawn.  That would be one way to avoid embarrassing fraud charges from the SEC, (the coincidence is striking) and a way to watch what other dealers are doing, in the bargain.

Death by regulation.

If I were sitting at the negotiation table I'd be willing to give GS what it wants, with one proviso, the government will pick up the tab of reducing sector wide risks in derivatives if and only if size limits on banks, and separation of commercial banking from proprietary trading activities (i.e. the Volcker rules) are part of the bargain.

It might not hurt to later impose some strict limits on the revolving door between GS and the public sector.

Without such a bargain, the creation of clearinghouses will only further concentrate pricing control of these instruments, in the hands of GS. However skilled the GS boys currently are, monopoly control of derivatives will beg abuse down the road.

One coup de grace deserves another.

Disclosure: No positions in GS, JPM, BAC, or C

Thursday, April 15, 2010

China, TBTF, and dancin' with the gal that brung ya'

QUESTIONER: Changing the part of the world and going to China. Yesterday I read a statement from Mr. Strauss-Kahn about the yuan, the currency, being definitely undervalued. I wanted to know if you had anything to articulate on this or to comment. Thank you.

MS. ATKINSON (IMF): We have said a number of times that the yuan appears to us to be substantially undervalued. We've also said that what's important is to think about the rebalancing of China's economy. More broadly it's important that the Chinese themselves are interested in boosting domestic demand and private consumption, and exchange rate movements would be just a part of that. It's also of course important to think about global rebalancing, and that means that deficit countries as well as surplus countries need to make some adjustments. IMF Press Briefing 3/18/2010

Perhaps because of my rebellious nature, I've always been attracted to the counter-trend trade. Back in my days as a Hedge Fund trader, I learned about the "max pain" (there are more colorful descriptions) trade. When the market is positioned for a currency price rise, IF (timing is everything, here) you can catch the changing winds of news, you can make a killing (or at least avoid getting caught in the slaughter). In Sorosian jargon, this is the bet against the false premise.

As James Chanos has been arguing: We’re all looking at -- one of the most obvious, obvious trades of the world right now is that the RMB, the Yuan is undervalued. Mr. Geithner, I think, is in Beijing tonight talking about whether or not China is a currency manipulator. Everyone is assuming China needs to peg its currency higher to avoid the export deflation going on.

Well, Chinese exports aren’t the problem here. And what if it turns out that by having to nationalize lots and lots of real estate, bad debts, the RMB is devalued?

These days, the mother of all "max pain" trades would be an RMB decline.  How likely might such an event be?

Let me preface my view (with which, and $4.50, you can get a coffee at Starbucks) with my more general sense that China is in the midst of an amazing transformation which has many more years to run. I wouldn't bet against China in the long term (or at least until demographics catch up to them).

However, other countries which have similarly transformed have hit speeds bumps in the process. Rapid growth creates a financial environment that begs (usually temporary) over-extension.  In China's case, their history of modern financial corporate governance is quite short (on that score, we, in the US still have more than a few kinks to work out). The burned hand, as they say, teaches best (or will after the stove is touched a few more times).

For the past few months China has been trying to slow the economy down, in particular the property market, probably in search of the elusive soft landing.  I've never been much of a believer in the "soft-landing" thesis. There are too many unknowns in a huge economy so policy inevitably over-shoots (or never uncovers the excesses at all). At some point, a threshold will be reached and we'll find out just how sound Chinese property (et alia) lending has been.

My guess is, as almost always tends to be the case, there will be a big difference between viable credit levels of an economy growing at 8% (or, according to the latest data more than 11%) and one growing at 1-2%.

Given that the Chinese banking system totals upwards of $11.5T in assets, even a small "hair-cut" means a couple $100Bil.  

China is now a key piece of our increasingly interconnected global economy. It certainly qualifies, in a more profound sense than the largest US banks, as Too Big To Fail.  We may even find that China's economy has grown sufficiently to ensure that when China sneezes, the rest of the world gets a cold.

In the event of a speed bump, support, in one form or another, will certainly be forthcoming and that support will not be predicated on how the IMF or other nations wish China to develop but on the infrastructure already in place in the same way that TBTF banks were given support based on their infrastructure in place (i.e. continued prop. trading, continued derivatives, etc.) and not on the proposed models envisioned in reform plans.

In times of crisis, ya' gotta dance with the gal that brung ya'.

China is an export driven economy (net exports were 8.9% of 2009 GDP), and the best way to goose such an economy is by letting the currency slide. Moreover, China has been the recipient of substantial capital inflows (the cumulative current account surplus only accounts for roughly 65% of the growth in FX reserves over the past 15 years- just to give a flavor and sense of magnitude). During a crisis, these flows will tend to reverse (or minimally, stop flowing in).

In other words, I wouldn't be surprised to see a not insignificant RMB decline in the medium term, as palliative to a domestic credit problem, before it resumes its more general uptrend against the US$.

I leave for future essays questions of the impact of China's first "speed bump" as a maturing, and huge world power on the international financial architecture (and the impact of a necessary increase in China's current account surplus on the US). Suffice it to write that if such an event occurs (and it will sooner or later) I suspect many known, but currently politically intractable flaws in the regulatory arena (or lack thereof) will come into sharp focus. But they will have to wait.

To repeat, in times of crisis, ya' gotta dance with the gal that brung ya'.

And from a broader perspective, the gal that brung us all to the dance is the gal of monetary stimulus to fix all that ails us.  I'm not, at the moment, arguing for a rethink of this policy, just observing.

Tuesday, April 13, 2010

The Big School and Convertibility Lost

As described in The Partnership: The Making of Goldman Sachs: Coyne [CEO of J. Aron] learned that the central banks of many nations kept their currency reserves in gold bars stored in the vaults of the Bank of England in London or the New York Federal Reserve Bank. Taken together, all this great wealth of nations had what Coyne saw as one fascinating characteristic: It earned zero return. It just sat in the vaults. But Coyne knew that the time value of money always figured into any futures he called on the central bankers in one country after another and made what appeared to be a generous and innovative offer: "Lend me your sterile bars of gold bullion and I'll pay you a fee of one half of one percent every year!"

Why then was this forbid? Why but to awe,
Why but to keep ye low and ignorant,
His worshippers; he knows that in the day
Ye Eate thereof, your Eyes that seem so cleere,
Yet are but dim, shall perfetly be then
Op'nd and cleerd, and ye shall be as Gods
Milton: Paradise Lost

There are, it may seem to a new student of economics, more schools of thought in the field than stars in the sky. I sometimes wonder if David Bohm, author of, inter alia, The Qualitative Infinity of Nature, might have felt more comfortable as an Economist than a Physicist. While the physical sciences, according to Thomas Kuhn, exhibit totalitarian tendencies with violent revolutions, Economics is far more democratic, tolerating, albeit not without disputes, multiple coincident schools of thought.

Of late, however, one school of economic thought has become increasingly dominant in policy making circles. The Big School holds that the larger a financial institution becomes the more protected it should be, and vice versa, the smaller a financial entity is, the less protection it should receive.

As an example of this (somewhat) facetious claim, consider the views of JPM's David Lowman: Like all loans, mortgage contracts are based on a promise to repay money borrowed. Importantly, there is no provision in the mortgage contract, express or implied, that the lender will restore equity or reduce the repayment amount if the value of the collateral – be it a home, a car or a stock market investment – depreciates. If we re-write the mortgage contract retroactively to restore equity to any mortgage borrower because the value of his or her home declined, what responsible lender will take the equity risk of financing mortgages in the future? What responsible regulator would want lenders to take such risk?

In other words, the same bank (there were, of course, others) whose inability to meet its contractual obligations a few years ago was such that it needed loans from, and preferential swapping of toxic for performing securities with, the Fed, equity support from the Treasury, and a release from the onerous task of marking securities to market, NOW thinks contracts, regulations and agreements are sacrosanct.

I wonder if the issue up for debate was deriviatives regulation or marking toxic assets to market, would any person from a bank end a paragraph with "what responsible regulator would want lenders to take such risks?"

Big School Rules.

In a Jonathon Demme film appropriately (for our purposes) titled "Stop Making Sense", the Talking Heads' David Byrne asked, "Well, how did I get here?"

The Big School took its cue from Kuhn and engaged not in democratic debate, but totalitarian revolt. They appropriated Walter Bagehot's views on the Central Bank's Lender of Last Resort facility in times of crisis but perverted them in the process. Instead of the outline presented in Lombard Street of "very large loans at very high rates" which, in modern times, became, "lend freely at a high rate", the Big School preaches the doctrine of "lending freely (to the banks) at a very low rate" thereby relieving the Central Bank of its responsibility to enforce prudence.

I may, however, be wrong in assuming the Big School appropriated their "lend freely (to the banks) at a very low rate" doctrine from Bagehot (they may simply have thought "lots of free money would sure be nice"), because this implies a reading thereof. If they had read Lombard Street they would have found these lines of concern about big banks, and management practices obscured from review:

The second misgiving, which many calm observers more and more feel as to our largest joint stock banks, fastens itself on their government. Is that government sufficient to lend well and keep safe so many millions?

All that the best board of directors can really accomplish [in the largest joint-stock banks] is to form a good decision on the points which the manager presents to them, and perhaps on a few others which one or two zealous members of their body may select for discussion

There is no more unsafe government for a bank than that of an eager and active manager, subject only to the supervision of a numerous board of directors, even though that board be excellent, for the manager may easily glide into dangerous and insecure transactions, nor can the board effectually check him.

Our great joint stock banks are imprudent in so carefully concealing the details of their government, and in secluding those details from the risk of discussion. The answer, no doubt, will be, “Let well alone; as you have admitted, there hardly ever before was so great a success as these banks of ours; what more do you or can you want?” I can only say that I want further to confirm this great success and to make it secure for the future. At present there is at least the possibility of a great reaction. Supposing that, owing to defects in its government, one even of the greater London joint stock banks failed, there would be an instant suspicion of the whole system. One terra incognita being seen to be faulty, every other terra incognita would be suspected. If the real government of these banks had for years been known, and if the subsisting banks had been known not to be ruled by the bad mode of government which had ruined the bank that had fallen, then the ruin of that bank would not be hurtful. The other banks would be seen to be exempt from the cause which had destroyed it. But at present the ruin of one of these great banks would greatly impair the credit of all. Scarcely any one knows the precise government of any one; in no case has that government been described on authority; and the fall of one by grave misgovernment would be taken to show that the others might as easily be misgoverned also. And a tardy disclosure even of an admirable constitution would not much help the surviving banks: as it was extracted by necessity, it would be received with suspicion. A sceptical world would say, “Of course they say they are all perfect now; it would not do for them to say anything else”.

A read of Lombard Street would not have led to the Big School's conclusion that the Lender of Last Resort should, in times of crisis, lend only to the banks, and even insolvent ones.

Bagehot advised differently: A panic, in a word, is a species of neuralgia, and according to the rules of science you must not starve it. The holders of the cash reserve must be ready not only to keep it for their own liabilities, but to advance it most freely for the liabilities of others. They must lend to merchants, to minor bankers, to “this man and that man,” whenever the security is good. In wild periods of alarm, one failure makes many, and the best way to prevent the derivative failures is to arrest the primary failure which causes them.

In other words, Bagehot argued the Central Bank's responsibility was to "the market", not the banks.

Further, he argued: the majority to be protected, are the “sound” people, the people who have good security to offer. He also speaks to the issue of unsound people, perhaps using a bit of wishful thinking: No advances indeed need be made by which the Bank will ultimately lose. The amount of bad business in commercial countries is an infinitesimally small fraction of the whole business. That in a panic the bank, or banks, holding the ultimate reserve should refuse bad bills or bad securities will not make the panic really worse; the “unsound” people are a feeble minority, and they are afraid even to look frightened for fear their unsoundness may be detected;

While the fraction of business which is unsound today is likely larger than in Bagehot's England, I suspect most is sound. Unfortunately, the unsound elements, while small in practical classification (derivatives, mortgage backed securities, etc.) are huge in terms of currency relative to the whole economy.

Big School means Big Problems

Why, I wonder, did the other schools of thought so meekly submit to the Big School's totalitarian revolution? Perhaps the question might better be phrased, what problem(s) deemed intractable by most other schools of thought did the Big School solve.

My best guess; one of the problems the Big School solved is Triffin's Dilemma. Alternatively, a previous (temporary) "solution" of Triffin's Dilemma, the London Gold Pool, was brought back to life, a la Frankenstein's monster which begat Big School thinking.

Triffin's Dilemma states that when a national money is used as an international medium of exchange and international reserve there will be trade-offs between the national and global effects of the reserve currency issuer's monetary policy. Moreover, the reserve currency issuer nation would soon find that it had to run increasing current account deficits to provide liquidity to the rest of the world. This, in turn, would erode confidence in reserve currency convertibility, eventually leading to international currency instability and potentially a break down in world trade.

Robert Triffin forecast the breakdown of the Bretton Woods system based on this dilemma. Of late, his work has been cited by the PBOC.

Issuing countries of reserve currencies are constantly confronted with the dilemma between achieving their domestic monetary policy goals and meeting other countries´ demand for reserve currencies. On the one hand,the monetary authorities cannot simply focus on domestic goals without carrying out their international responsibilities on the other hand,they cannot pursue different domestic and international objectives at the same time. They may either fail to adequately meet the demand of a growing global economy for liquidity as they try to ease inflation pressures at home, or create excess liquidity in the global markets by overly stimulating domestic demand. The Triffin Dilemma, i.e., the issuing countries of reserve currencies cannot maintain the value of the reserve currencies while providing liquidity to the world, still exists. Zhou Xiaochuan: hairman, Monetary Policy Committee of the People's Bank of China

Triffin, in the late 50s, called for the creation of a new global currency to act as international reserve, along the lines of Keynes' Bancor, or the IMF's SDR (deliberations for the creation of which were informed of his concerns), which, in my view, invites a whole new set of problems, but may still, barring a significantly large, in economic terms, country usurping the US$'s role, e.g. China (which invites similar problems, and leads to the US' loss of the exorbitant privilege), prove the best solution. A "free banking" system of competing moneys is another option.

As the US, not entirely without globally altruistic justification, did not want the Bancor in 1960 any more than it wanted it in 1945, the dilemma of convertibility fears was managed by illusion by way of intervention. The London Gold Pool was established in 1961 to keep the "market price" of Gold at $35 and thus reduce the incentive to demand promised convertibility from the Fed.

This worked until French demands for Gold were not satisfied. The cartel failed to maintain prices within the target and within a few years Nixon's closing of the Gold window ended US$-Gold convertibility.

I'll spare you the details of the 70s inflation and early 80s newfound stability. Suffice it to write that US$ reserves were accepted as semi-convertible- if not to Gold at a fixed price, at least to Gold and a basket of commodities with limited (until recently) fluctuations at new, higher prices.

In one (presumably easily accepted) respect, Big School banks that created and kept markets going in multiple new ($ based) investment vehicles helped sustain the sense of convertibility so long as those markets were trading.  Markets to spend one's $s, even if one never shops there, engender a sense of stability.

Also coincident with this new found stability was the beginning of a business deal between J. Aron (purchased by Goldman Sachs in 1981) and Central Banks around the world. As described in The Partnership: The Making of Goldman Sachs: Coyne [CEO of J. Aron] learned that the central banks of many nations kept their currency reserves in gold bars stored in the vaults of the Bank of England in London or the New York Federal Reserve Bank. Taken together, all this great wealth of nations had what Coyne saw as one fascinating characteristic: It earned zero return. It just sat in the vaults. But Coyne knew that the time value of money always figured into any futures he called on the central bankers in one country after another and made what appeared to be a generous and innovative offer: "Lend me your sterile bars of gold bullion and I'll pay you a fee of one half of one percent every year!" (pg. 258)

The book goes on to detail that J. Aron was actually making 8% on the deal with no money down, "it produced a nearly infinite rate of return." The book suggests they pulled a fast one on the central banks.

What Coyne may not have known was that at least some governments may well have done the deal for nothing. J. Aron offered to do what the London Gold Pool had done, and was willing to take the risk itself- a risk passed on in the merger to GS.  An added benefit, assuming the deal worked as described, no gold had to actually be sold on the market, paper gold would suffice.

GS was not alone in this game. By the mid to late 80s when I was at Chase (now JPM), our Gold desk (fortunately positioned right behind the options desk where I worked) was playing the same game. Paper gold flooded the market.

One of the reasons I began working with GATA a decade ago was my observation (shared by them) of Gold's stubborn reluctance to rise in price despite the rapidly increasing external US$ reserves. If Gold was, as Triffin asserted, undervalued in the early 60s, surely, I thought, it was a steal in 2000 at $275.

Global US$ reserves have done nothing but rise since, at an increasing pace.

In 1978, Triffin and Mundell were warning of a sudden collapse of the US$ due to the growth of those reserves. Back then they wrote in astonishment of US$ reserves in the few hundreds of billions. Now, such reserves are measured in the trillions.

Without concrete data I can only speculate as to the extent of Central Bank gold leasing, or its effect on the price. In the past few years, the price of Gold has risen above $1000. Interestingly the price broke above the early 1980s high of $800 when problems began appearing in large US banks. The mid 2008 dollar squeeze in international markets capped its advance at that time, only to bring the US banking system to the brink of disaster.

How causal the coincidence proves to be remains a mystery. What seems certain is that, if Central Bank gold leasing is a policy aimed at extending the life of the US$ as global reserve currency, the banks so engaged cannot be allowed to fail, or the game is over.

Thus, I wonder how much effect, if any, the Gold leasing practices of the big NY banks had on the decision to make them too big to fail.

Have we dodged Triffin's dilemma by trying to maintain the illusion of convertibility only to invite a banking collapse worse than Bagehot's worse nightmare?

How will the US respond if an economy as large as China's needs a boost in international liquidity?  How large might an IMF rescue package need to be to keep China from suffering a disastrous contraction?  Would the US, as is its wont, allow the current account to widen further to ensure China repaid the IMF?

What if Japan needs IMF support?

How far off might such events be?

Big Questions for the Big School

Monday, April 12, 2010

Forget Kagan and Clinton. Rakoff for Supreme Court.

Given the somewhat tortured background of these cases and the difficulties the motion presents, the Court is tempted to quote the great American philosopher Yogi Berra: “I wish I had an answer to that because I’m getting tired of answering that question.” Judge Rakoff in SEC vs. Bank of America

In what may prove to be a case of affirmative action run amok, media reports suggest that the short list of potential Supreme Court Nominees (replacing retiring Justice Stevens) includes Elena Kagan and Hillary Clinton.

While Mrs. Clinton seems an able politician (damning with faint praise) her record as a Judge (or even as clerk to a Federal Judge) is non-existent.

Ms. Kagan, by contrast, has a record. She clerked for, inter alios, Supreme Court Justice Thurgood Marshall.

As President Obama's Solicitor General, she lost the case of Citizens United vs. F.E.C., which cleared the way for corporations to stand on equal footing as citizens in the rights to political speech. 

While it seems to me this may have been a lost cause from the start given the current "bent" of the court, it may be that Ms. Kagan failed to anticipate the proper grounds for argument as Justice Stevens noted in his dissent, in particular, this view:  In the context of election to public office, the distinction between corporate and human speakers is significant. Although they make enormous contributions to our society, corporations are not actually members of it. They cannot vote or run for office. Because they may be managed and controlled by nonresidents, their interests may conflict in fundamental respects with the interests of eligible voters. The financial resources, legal structure,and instrumental orientation of corporations raise legitimate concerns about their role in the electoral process.

A subtle mind, in my view, is needed in the Supreme Court, if the intent is battle with Financial Concentration.

Enter Judge Rakoff. While the main qualification media reports suggest as supportive of Ms. Kagan's Nomination is "non-ideological", Judge Rakoff is a man of opinions. He loves baseball, and thinks the banks have gone too far. (Batting 1000 so far)

In SEC vs. Bank of America, the Judge demonstrates to me a subtle mind, waiting for (indeed begging for, and presenting clues thereof) the right arguments to be presented. To wit: An even more fundamental problem, however, is that a fine assessed against the Bank, taken by itself, penalizes the shareholders for what was, in effect if not in intent, a fraud by management on the shareholders. This was among the major reasons the Court rejected the earlier proposed settlement. Where management deceives its own shareholders, a fine most directly serves its deterrent purposes if it is assessed against the persons responsible for the deception. If such persons acted out of negligence, rather than bad faith, that should be a mitigating factor, but not a reason to have the shareholder victims pay the fine instead.

I don't have a say in the matter (besides this opinion) but if I did, I'd bench the starters and get Rakoff in relief (of us all).

Sunday, April 11, 2010

The Tyranny of Financial Technicians (and its demise)

The people always have some champion whom they set over them and nurse into greatness. This and no other is the root from which a tyrant springs; when he first appears he is a protector. Plato - The Republic

One of the earliest civilizations of which we still have record, Ancient Egypt, was, in a sense, run as a Technocracy (rule by technical experts). Technicians of that period were revered as priests and studied not money or credit, but time. Their worship of the sun set them apart from other cultures which used the more frequent lunar cycles to track time. By tracking the sun's movement in the sky the priest-technician forecast the coming of the Nile flood on which Egyptian food production was based.

These days the reverence accorded the ancient priests of time seems silly. Children with a few years of school can explain how the earth's revolution around the sun, and the earth's axial tilt leads to seasonal change. The basic secrets of the temple of time can be known by any who wish.

In modern times, the secrets of the temple of money, however, despite demystification attempts by William Greider, et alios, are still considered secret. Financial Technicians are revered perhaps as much as were the Time Technicians of old. Just as the Pharaohs of Egypt thought twice about confronting his priests our rulers think twice about confronting ours.

The Passover season just passed commemorates, from one perspective, the freedom gained from the ancient technocracy of Egypt, who, in the story, weren't as prescient in their forecasting as they professed. In that light, the timing of this op-ed, taking a modern technocrat to task for his lack of prescience, was perfect.

In modern times, internet connectivity makes the secrets of the temple of money far more open than was the case in ancient times. The big secret of the temple of money is that there is no secret. Men like Blankfein, Paulson, Rubin, Dimon, Greenspan, Bernanke, and (perhaps especially) Geithner, are not possessed of intellect and wisdom not found in many thousands of others. Moreover, their judgments, even granting solid "market sense" might be detrimental to the people and corporations that make up the nation (and whose actions are the ultimate determinants of the market).

Louis Brandeis, in his Other People's Money: and how the bankers use it, speaks to this issue:  Prominent in the banker-director mind is always this thought: "What will be the probable effect of our action upon the market value of the company's stock and bonds, or indeed, generally upon stock exchange values?" The stock market is so much a part of the investment-banker's life, that he cannot help being affected by this consideration, however disinterested he may be. The stock market is sensitive. Facts are often misinterpreted "by the street" or by investors. And with the best of intentions, directors susceptible to such influences are led to unwise decisions in the effort to prevent misinterpretations. Thus, expenditures necessary for maintenance, or for the ultimate good of a property are often deferred by banker-directors, because of the belief that the making of them now would (by showing smaller net earnings), create a bad, and even false impression on the market. Dividends are paid which should not be, because of the effect which it is believed reduction or suspension would have upon the market value of the company's securities. To exercise a sound judgment in the affairs of business is, at best, a delicate operation. And no man can successfully perform that function whose mind is diverted, however, innocently, from the study of, "what is best in the long run for the company of which I am director?"

Like the Ancient Egyptians waiting for the flood, a critical mass of modern people, many of whom dream of a comfortable retirement, are willing to revere those who promise market prices supportive of their financial expectations, and ignore those who don't. The market concerns of the investment banker described by Brandeis have increasingly became a major factor on policy.

As one example, consider the changed IMF perspective of capital flows (and its analog in the 2008-09 US Financial Rescue package) detailed by Raymond Mikesell, who attended the Bretton Woods Conference: Both White and Keynes believed that the IMF's assistance to members should not finance capital flight. However, the IMF has not maintained this position. The IMF's loans in response to the financial crises in the East Asian countries during the 1990s were primarily for the purpose of helping members restore confidence in their securities markets and currencies, rather than for financing imports. Moreover, according to a recent statement by Secretary of the Treasury Lawrence E. Summers, emergency loans to countries facing currency crises should be the principal lending function of the IMF (Kahn 1999).

Ultimately the Tyranny of Financial Technicians is the Tyranny of the Markets. Admittedly, I've employed hyperbole to make my point. The object of people's fascination varies over time. Following WWII, the people revered war heroes and elected Eisenhower and Kennedy. Their Treasury Secretaries did not come from Wall St. (or even close) and finance was but one of many technical skills deemed useful, and not the most popular.

In all likelihood, the modern fascination with our Technocracy will fade when the promises are seen to be empty. And empty they will prove to be so long as finance is primarily concerned with the markets and not the real sector on which they are based.

** Late addition:  In further support of the Investment-Banking mind driving policy thesis, consider the following argument in favor of EU and IMF support for Greece, granted at below market rates:  Jean-Claude Juncker, the Luxembourg prime minister and eurogroup president, said he hoped the agreement would calm the markets and help to avert the crisis facing Greece and the single currency. "This is the step of clarification the markets are waiting for," he said. "It shows there is money behind this."

Thursday, April 08, 2010

Financial Regulation: Then and Now (Busting TBTF)

Like the internet, finance would benefit from redundancy, and competition, not just in the sense of distributed shareholdings (which is already the case) but viewpoints (which is not helped when directors merely “rubber stamp” CEO opinion, and Fed, Treasury, and other financial regulatory officials are always on loan from GS and the rest of Wall Street). Like minded-ness, if you will, is the issue here and "restraint of trade" the lever. TBTF engenders the myopia which leads men like Greenspan to argue, “nobody saw it coming.” Quite a few did, but they were, in a sense, crowded out of the market.

Simon Johnson and James Kwak of 13 Bankers and The Baseline Scenario, urge President Obama, in a recent Washington Post Op-Ed, to channel Teddy Roosevelt’s defiance of Wall Street, exemplified by the break-up of Northern Securities in 1904 in order to clean up the US financial system.

I agree with Johnson and Kwak’s call to arms, and am sure their views are far more nuanced than a space limited op-ed can relate, however, my examination of the Progressive period in US history, of which the chapter on US financial regulation is but a part, suggests that repetition of that period is most unlikely, and hopefully unnecessary. While there are many similarities between then and now, both the context and issues of concern are, in certain key respects, different.

The Federal Government during the Gilded Age bore little resemblance to that existing today. As a financial entity, in the main, the government collected customs’ duties, which were more than half its receipts, paid interest on the debt, the bulk of which was incurred during the Civil War, and fought the Native Americans and Spain (wars were much cheaper then, additional Army and Navy costs for the 1898 Spanish American War came to $190M).

The malefactors of great wealth, as the industrial and financial titans of the day were known, controlled commerce and finance. They mined iron and made steel, connected the nation via railroads, telegraphs and telephones, and controlled the banks. They set prices and controlled the supply of money, credit and raw materials, which gave them the power to “shake down” people and firms of which they didn’t approve, competitors and frauds alike.

Unlike today, the leading banks which emerged at the end of the Gilded Age weren’t Too Big To Fail, they were Too Solvent To Fail. They owned much of the US gold stock, then the basis of money, and were seemingly immune from the Panics which shook the rest of the nation every decade or so, more often than not, it was claimed, at their instigation.

I’m confident if JP Morgan were running the Fed, credit growth would have been restrained long ago.  There is some merit to having someone "own" an issue- unlike Greenspan, Geithner, Rubin et alios, who claim no responsibility.  Thus, some believe we need more regulatory officials rather than better ones.

When the government was running dangerously short of gold reserves, in 1895, they went to Wall Street for help- call it a reverse bail-out- and had the Treasury supply replenished. A very small group of unelected men, in effect, owned the government.

This small group of men directed the transformation of America from a disconnected agrarian to a connected soon to be industrial society- from the states united to the United States. In the process, however, they paved the ground for the Progressives to use the power, not of money, but of public opinion, via the ballot box, to usurp their control.

The government that almost died in 1895, was reborn in 1901, when the assassination, by an anarchist (love the irony), of President McKinley, made Teddy Roosevelt President.

Teddy Roosevelt’s Trust Busting kicked off a vigorous 20 year period for the new government. Progressives, who had pushed potentially transformative legislation through Congress from 1885-1900 finally had an executive willing to use it, and his big stick, for change. The Rough Rider took the de jure power of the Interstate Commerce and Sherman Anti-Trust legislation, which had hitherto been used against labor, and prepared to make it de facto, against big business.

The Federal Government, as we know it today, was born. It was a small child about to battle grown men. US Federal Government receipts totaled $670M in 1900 (JP Morgan bought the Carnegie Steel Company around that time for $487M). In 1904, Northern Securities, a railroad trust owned by JP Morgan, JD Rockefeller et alios, was ordered to break up. The precedent, after appeal, was set and many other trusts followed. In 1911, after more than a decade of court battles, the Supreme Court dissolved Standard Oil, making JD Rockefeller, according to some, the richest man in the world, in cash.

He and the other Titans got rich, but lost control of their businesses.  Like the Titans of Greek Mythology, they are, for good or ill, only going to appear once.

The child was growing quickly. In 1913, the Federal Reserve was created and the 16th Amendment, which made income taxes Constitutional, was ratified. Four years hence, the US entered World War I. At war’s end, the child had given way to the man. By 1920, receipts had grown to $23B. The Federal Government was now the biggest guy in town.

On one level, this growth of government is like that of Gilded Age business-built on the destruction of competition. There are, however, two key differences: 1) government didn’t “swallow” competitors, they dissolved them into smaller pieces, diluting their control 2) Gilded Age businesses were dynastic and decision-making was concentrated into few hands, government officials were (and are) popularly elected, operate within a system of checks and balances, and change more frequently.

The context in which Progressives operated was, as I’ve hopefully made clear, very different from today. The Federal Government then was, at least in a critical mass of minds, like a Deus ex machina, come to save the day. It didn’t tax the average citizen, but was likely to tax the wealthy and promised to not only break up the trusts, but also to open the credit spigot much wider.   One hundred years hence, the bloom is off the Federal Government's rose.  Increased taxation to fund another government expansion seems most unlikely.

Back then, the “money question”, as the debate between those who favored deflation or inflation was called, was one which brought people to the ballot box (I can’t imagine President Obama giving a Cross of Gold type speech). Elastic money seems to me the deciding factor which cemented Woodrow Wilson’s support of the Fed’s take-over of financial regulation.

Before turning to the present period, a few words about the Fed’s creation. There were two competing visions for the proposed central banking system, the Aldrich plan, which kept bankers in control, but allowed banks, at their discretion, access to government created liquidity (thus the need, under either vision, for the government, as financial entity, to grow, via increased taxes), The Bryan plan wanted government totally in control of a Central Bank which regulated the banks, and, at its sole discretion, could also supply liquidity.

The creature, as some call it, which emerged, was a compromise: government top down control of some key board members, banker control of others, the controlling board would be in D.C., thus demoting NY bankers, banks had access to liquidity, but the national liquidity level was at the board’s discretion.

Fortunately, unlike Johnson and Kwak, I’ve had the luxury of virtually unlimited internet space to flesh out the history. Unfortunately, I’ve probably lost most readers in this exercise of pedantry.

For those few that remain, let’s soldier on.

A Progressive solution, for our era, would involve for the creation of an empowered, taxing, global government with its own central bank, empowered with regulating all banks. This is, in a sense, the Nietzsche solution, fight monsters by creating bigger monsters. The United Nations (which replaced the earlier League of Nations) could be seen, in a Progressive dream, as the US Federal Government during the Gilded Age, an institution that, under direction of charismatic individuals, should become the biggest monster on the block, and maintain world order.

In my view, such a solution would but buy time in the same way that, 100 years from the empowering of the US government, many of the old problems remain. Ideas and conviction, not power, seem to me the missing elements. Further, the newly empowered Federal Government of a century ago was battling individuals, not national governments with armies, which would be the objects to be brought under control of any world government. If national governments begin to collapse, or fail to restrain growth of their internal monsters, however, I wouldn’t be surprised to see this “solution” emerge.

Supporters of continued US sovereignty within our borders, and the big bankers themselves, who might win the battle against US regulation only to risk eventually losing the war to world regulators (as the NY banks won the battle against state regulator but lost the war to the Feds) should take note. Men like Rockefeller and Carnegie, who ultimately submitted to government restraint, financed legacy institutions like the Trilateral Commission and its ilk to lay the basis for these bigger monsters. For a preview, consider: The IMF and the EU are currently battling for control in Greece, which seems willing to trade sovereignty rather than restrain its appetites via default.

Today, as then, the issue of size is key in one sense. Our regulators were seduced by “economies of scale” arguments and allowed a few financial institutions to grow beyond the ability of an indebted government to restrain. The 1895 analog is striking and, in that sense, Johnson and Kwak’s call to channel Roosevelt seems right on the mark. Terms like charisma and force of personality are often used to explain Teddy Roosevelt’s ability to bend people, ostensibly possessed of more power, to his will.

In the event, it took more than Roosevelt’s charisma to beat Morgan and his crew (or his charisma, and fear of popular backlash, was such that he bent a critical mass of the Supreme Court, to his will). US vs. Northern Securities was decided 5-4, with Chief Justice Fuller and Justices White, Peckham and Holmes dissenting. From a financial perspective, David, in the form of the US Government, had slain Goliath, a Trust whose capitalization was almost 2/3 of US revenues.

The basis of the decision, which, after appeal, and modification, became unanimous, however, was not bigness, but restraint of trade, via the stifling of competition. As Justice Holmes wrote in his dissent, “Size has nothing to do with the matter.”

Justice Harlan, writing in the affirmative: The Government charges that, if the combination was held not to be in violation of the act of Congress, then all efforts of the National Government to preserve to the people the benefits of free competition among carriers engaged in interstate commerce will be wholly unavailing, and all transcontinental lines, indeed the entire railway systems of the country, may be absorbed, merged and consolidated, thus placing the public at the absolute mercy of the holding corporation.

Adding: it need not be shown that the combination, in fact, results or will result in a total suppression of trade or in a complete monopoly, but it is only essential to show that, by its necessary operation, it tends to restrain interstate or international trade or commerce or tends to create a monopoly in such trade or commerce and to deprive the public of the advantages that flow from free competition;

Having read both sides, I understand the dissenting view; until trade is restrained, monopoly, per se, isn’t a crime, and might even lead to reduced consumer costs. Should there always be at least two rail options for every possible route? I assume, however, that the objects sought by President Roosevelt were a precedent, and distributed control and profits, not a strict reading enforcement.

I dwell on the decision to suggest a legal challenge to the current concentration of financial control into very few hands. Contrary to the above, financial concentration has already restrained trade, and imposed additional costs to all. Financial support (and even the expectation thereof) of TBTF firms also restrains trade in that potential (and actual) competitors who avoided (or even profited by) the declines in certain asset markets were restrained in gaining increased market share. Surely one of the benefits of competition is the weeding out of the short-sighted.

Fortunately, I don’t think we need new legislation, we just need to enforce what’s already on the books.

Like the internet, finance would benefit from redundancy, and competition, not just in the sense of distributed shareholdings (which is already the case) but viewpoints (which is not helped when directors merely “rubber stamp” CEO opinion, and Fed, Treasury, and other financial regulatory officials are always on loan from GS and the rest of Wall Street). Like minded-ness, if you will, is the issue here. TBTF engenders the myopia which leads men like Greenspan to argue, “nobody saw it coming.” Quite a few did, but they were, in a sense, crowded out of the market.

The need for redundancy would become more apparent if we held as self-evident the belief that there is no magic cure for financial overextension (bubbles) and their dissolution (busts) in a fractional reserve banking system. It will happen, again and again. Mitigation, as should now be clear, is not just an issue of additional liquidity but also a financial industry comprised of smaller, and more numerous, competing firms. It might also help to examine the books of any firm (including the Fed) which promotes the notion that “this time is different.”

I hold no illusions about being the sharpest knife in the drawer, as the Brits say, and thus assume others have considered similar legal arguments against financial concentration. Given the obvious trade restraining effects of TBTF, why isn’t the Supreme Court hearing arguments?

Like the Federal Government in 1895, ours too needs a bail-out. While the big financial firms can no longer provide such support, they can keep the Feds afloat by selling bonds as Primary Dealers, and, if needed, increase their own holdings thereof (particularly after the Fed has graciously relieved them of toxic mortgage, et alia, assets). If the Federal Government is ever to restrain finance, they need to break this dependency, and prepare to take their lumps, so to write, for poor fiscal management. If they were crafty they would blame the firms they were about to break up…just a thought.

This will require either skillful diplomacy or a good deal of charisma from some in power, and a good deal of conviction that this problem cannot be fixed without radical solutions, and will only worsen if left to fester. The "break-up" strategy from the early trust busting days may well prove effective today, and increase the number of balance sheet managers in the bargain.  It will also, I suspect, require inflation ($ debasement) as a self-administered bail-out. President Obama might need to channel William Jennings Bryan, as well as Teddy Roosevelt to get the US out of this mess.

Perhaps President Obama can deliver a Cross of TBTF speech at the next Democratic convention.

Monday, April 05, 2010

A Fascinating Exchange on Pre-Fed Banking Regulation

Almost 100 years ago, the US Congress was investigating the Money Trust, as the concentration of money and power on Wall Street was then called.  The St. Louis Fed has documentation of the hearings of the House of Representatives Subcommittee on Banking and Currency into the matter, better known as the Pujo hearings, which make for fascinating reading.

Then, as now, people were concerned with the power of Wall Street, and the deceit (stock and commodity price manipulation, inter alia, has been around for a long time).  Unlike the current situation, however, big finance was largely self-regulated  (then, as now, there were laws, but then, it seems, big finance thought the government too lax, and slow to act), and the idea of a government bail-out would have been absurd to men like J.P. Morgan. 

Also unlike today, the then captains of finance were all in favor of closing down insolvent banks, and even temporarily solvent banks who might well be frauds, even before the government got involved, as this exchange between Samuel Untermyer, Esq.,  counsel for the committee and J.P. Morgan demonstrates.

Mr. Untermyer: Do you not think there ought to be some authority, in the State or Government somewhere, to give to a solvent bank the right of clearance through the association?

Mr. Morgan: Yes; but it depends upon in whose hands the bank is.

Mr. Untermyer: Oh, you think the competitors of a bank ought to determine into whose hands it should go?

Mr. Morgan: For instance, suppose I were the clearing house- I would not be in favor of allowing a man to be associated with me that I thought was a fraud, simply because he owned a bank which at that particular moment was solvent.

That's a powerful argument in favor of private owners policing their own industry, which, as an aside would not work today as the banks are all publically ownedPerhaps the current regulatory problems are unintended consequences of breaking up the large privately held conglomerates. Nothing like fear of personal loss to keep one on the straight and narrowWould Goldman have taken a different path over the past decade if they had remained private?

The view above might also be a defense against claims that certain banks had "shaken down" others in the Panic of 1907.  It's hard to tell without all the accounts available.  It does make me wonder if JP were alive today, (and as good as his word) would he have instigated a panic before things got so out of hand, and wound down the offending banks (and gotten grief about it for having too much power).  As best I can discern he seemed to take the issue seriously. 

The exchange continued:

Mr. Untermyer:   The question I ask you is as to whether competitors should have the fate of another competitor entirely in their hands. to close it up or let it go on, without any review anywhere.

Mr. Morgan: If they are insolvent, I think they should be shut up at once.

Mr. Untermyer: But do you think the competitors should have the right to pass upon that without any review.

Mr. Morgan: There is no other review possible that I know of.

Mr. Untermyer: Do you not think a review on the part of the banking authority would be possible?

Mr. Morgan: Not unless there is time. The question of time comes in.

Mr. Untermyer: It does not take long to telephone, does it?

Mr. Morgan: It does sometimes.

Mr. Untermyer: It takes too long to give the bank a chance, Anyway?

Mr. Morgan: Yes. Sometimes some people have to step in and take the bank’s balance in order to get them cleaned, at that.

Mr. Untermyer: Have you known of other banks doing that and getting well paid for it?

Mr. Morgan: I have known of some people doing it without being paid at all.

For Mr. Morgan, the key question in banking was character.  The idea of keeping a failure in business, even with financial backing, made no sense.  To wit:

Mr. Untermyer: If that is the rule of business, Mr. Morgan, why do the banks demand, the first thing they ask, a statement of what the man has got, before they extend him credit?

Mr. Morgan: That is what they go into; but the first thing they say is, "We want to see your record."

Mr. Untermyer: Yes; and if his record is a blank, the next thing is how much has he got?

Mr. Morgan: People do not care, then.

Mr. Untermyer: For instance, if he has got Government bond or railroad bonds, and goes in to get credit, he gets it, and on the security of those bonds, does he not?

Mr. Morgan: Yes.

Mr. Untermyer:. He does not get it on his face or his character, does he?

Mr. Morgan: Yes; he gets it on his character.

Mr. Untermyer: I see; then he might as well take the bonds home, had he not?

Mr. Morgan: Because a man I do not trust could not get money from me on all the bonds in Christendom.

I'm still working on an examination of Fed goals that transcend their stated directives of maximum non-inflation growth and thought this might make interesting reading in the meantime.