Archive for the ‘Financial Volatility’ Category

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Instability in the Global Financal System

May 8, 2012

Instability at the core of the modern financial system is a hot topic, particularly given the electoral shocks in France and Greece these days.  Whatever the color of the new Greek government, the people of Greece have spoken: the sovereign bond deal is dead as a doornail.

This will almost certainly lead to a more extensive default than the one negotiated in March, sending shockwaves through global markets.

But that’s not the only source of instability in the global financial system according to Andrew Haldane, executive director of stability at the Bank of England.

Andrew likened the present world of banking to the Arms Race between the US and Soviets. The desire to increase individual security created greater systemic insecurity. He goes on to give three similar ‘arms races’ in banking and financial markets.

Return Races

The race for returns was a key reason for the financial crisis. There were two aspects to the race on returns, one the return on equity for banks (ROE) and returns for bank CEO’s. Both of which were unprecedented in any historical context in the run up to the crisis.

Return on equity (in UK banks) was at historic highs in 2007, the only parallel is the 1920’s. The behaviors that drove that were similar to an arms race. It was not so much keeping up the Jones, but keeping up the Goldmans. If Goldman posted a ROE of 20%, all the rest had to meet or beat that figure.

The way this was achieved was taking on additional leverage; which pushed the banks and shadow banks into higher risk positions, creating a higher risk industry ‘equilibrium’ that destabilized the system.

Speed Race

Trade execution times:

20 years ago (minutes), 10 years ago (seconds), 5 years ago (milliseconds), Today its microseconds (million’s of a second)

Tomorrow it will be nanoseconds (billion’s of a second); it could well be picoseconds (trillion’ of a second) in short order.

‘High Frequency Trading’ now dominates mainstream financial markets, accounting for somewhere between 50% and 75% of trades by volume today. The average share on the NYSE is held for 11 seconds.

One reason they dominate markets is that they submit HUGE volumes of quotes the vast majority of which are never exercised. The firms cancel the majority of them before their exercised. Today for every order exercised, 60 are cancelled.

What’s going ON here; fake liquidity. Although it looks like they’re lots of quotes in the market, lots of liquidity  – there is actually a mirage of liquidity. Quote ‘stuffing’ is a means of gaming the market. Why, because bandwidth is limited; quote stuffing loads the system slowing down everyone else. Slower traders simply can’t access the board.

Safety Race

The final race is the flip side of the first race; the race for risk aversion is particularly acute in that investors (in banks and other financial institutions) want the safety of collateral. In other words investors in banks are more unwilling to invest in banks on unsecured terms than in the past.

Everyone wants to be senior, everyone wants to be first in line – to have first claim on the assets of the bank. For instance the refinancing of Euro zone banks a few years ago was 60% unsecured, now the unsecured portion is less than 5%.

This race also comes with a price; it leads to bank balance sheets become more encumbered, banks assigning away their assets to investors which can not go on forever. The way it impacts the market is thus: ‘If I’m an unsecured creditor, why would I refinance, why should I let everyone else be ahead of me on the pecking order.

The result is a drying up of the pool of bank capital; a new higher risk equilibrium and destabilized system.

All these ‘races’ are populated with individually rational decisions, the outcome of which is systemically irrational and worse – creating the opposite – systemic instability.

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The Maiden Voyage of Financial Capitalism

April 2, 2012

“Disgruntled Goldman Sachs employee attacks the bank’s ‘toxic’ culture”

“Greek prime minister has warned lawmakers against undermining reforms agreed with the international lenders in an attempt to boost their popularity as the country heads for the polls in May.”

These recent headlines in the Financial Times expose the uncomfortable truth of our present financial reality. How bad is it? Think Titanic; the banking system essentially hit the iceberg at full speed in 2008. We’ve kept her afloat ever since with massive interventions of TARP funds, bank bailouts, zero interest rates and quantitative easing.  But a large gash has been opened in the ship of global Financial Capitalism and the water is rushing in.

I don’t know if you remember the details, but the original Titanic was kept afloat for some time after its tragic accident by the valiant efforts of its crew. In the James Cameron movie we witnessed the heavy bulkhead doors slamming down one after another in an attempt to contain the deadly influx of ocean waters. We have observed much the same in Greece, Ireland, Spain and Italy. The global financial powers have slammed the doors of austerity and debt restructuring on these flooding economies. Unfortunately like the Titanic these chambers are not totally isolatable. In the case of the ship, the water kept rising, eventually overspilling the flooded chambers, filling one after another until the Titanic sank to the bottom of the ocean.

What’s happening in Greece and other affected economies is the fiction of debt resolution. Despite a 100 billion euro default, debt restructuring and the massive support by the ECB the water continues to rise in Greece. The bond friendly resolution has been purchased with the liberty and future of the Greek people. Many young people, all the smart money and anyone else who can walk or run, are leaving Greece at speed while the economy labors under an increasing burden of debt and upwardly ratcheting interest rates. The elections in May are likely to be fought and won by forces deeply opposed to the Euro technocrats that run the government and the financial deal stuck last month. And the water continues to rise; its unstoppable.

In Titanic terms we’re still on the surface, the stars are shinning brightly and the band is playing. However all is not well below the surface; the economic engine room is flooded and water is rising fast on the lower decks. Today the financial press are playing the part of the heroic Titanic orchestra as the situation deteriorates to its dramatic close. It’s a mathematical certainty that the great ship will sink; it’s simply a matter of time. The only unanswered question is: who’ll be in the lifeboats?

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Backing off the Resource Boom

March 13, 2012

There are some troubling indicators on the resource front that could dramatically impact the plans of Western Canadian businesses. Let’s face it the Western resource economy is one of the ‘feel good’ stories in the Canadian economy, so a decline in its growth potential would not be welcome.

Recently, of course, the news has been fairly positive. Apart from declining contract prices for hard coking coal, metal (in particular) and oil prices have been buoyed by massive swings in the indexed commodity funds which have recently shifted back into long positions, based on improving jobs numbers in the U.S., rebounding auto sales and other ‘positive’ news like the Iranian situation (which may result in the closing of the Straits of Hormuz) which could dramatically hike oil prices.

Realistically though, these indicators are not the most significant indicator; that distinction still belongs to China and its continued growth potential.

The Chinese government recently cut growth forecasts to 7.5%, on worries over its over-built property and export manufacturing sectors.  These two sectors are highly leveraged but receive the bulk of foreign direct investment in China. The rest of the economy is bank financed and struggling. This is where the problems in China are really starting to get ugly.

China’s growth strategy has always been heavily debt focused. In the early days of the China miracle, the immaturity of its capital markets left China with few financing options. The model that emerged was unconventional, but very effective. Government controlled banks would lend to businesses up and down the economy; they did so without conventional restraints and with few hard-nosed business metrics. As a result many of these loans ended up under-performing or non-performing (NPL’s). Once a decade or so, the Chinese government would acknowledge the problem and clean these NPLs off the bank balance sheets,  often writing them off. This process essentially reset the Chinese banking clock once a decade.

According to Michel Pettis the debt problems are emerging once again, only this time the scale of the problem is much greater than in the past:  “China has instructed its banks to embark on a mammoth roll-over of loans to local governments. Unfortunately, to date these local government have already accumulated over Rmb10.7tn ($1.7tn) in debts – about a quarter of the country’s output – and more than half those loans are scheduled to come due over the next three years.”

This largely hidden ‘China Problem’ is a function of the rapid growth of un-repayable debts. The Chinese government, for a variety of political reasons, is not inclined to force asset sales. So, although there are no principal payments on these loans, the carrying costs alone will impact China’s growth model, which will clearly be handicapped. Michel Pettis sees debt burdened China growth slowing towards 5-6% annual growth over the next year or so, and longer term settling into the 3% region there after. Not bad, but not sufficient to drive marginal demand for commodities as it has in the past.

The impact on oil and other commodity prices will likely be dramatic, metal prices could fall sharply. None of this is going to happen over night, but over the next few years the sovereign debt crisis could cripple western economies. Optimists who expect China growth to offset this declining demand could be in for a surprise.

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Euro Debt Crisis: No Strategy for Growth

January 13, 2012

Angela Merkel emerged from the European Summit last month with lofty visions, speaking to reporters in flowery terms like ‘European family’, ‘running a marathon’ and preparing Europe for… who knows what? A Prussian dominated European Federal State perhaps?

Missing was a coherent plan to reduce the levels of sovereign debt and, more importantly, a strategy to restore growth to European economies.

Fiscal Policy Integration

Yes there was the “fiscal compact”; a Plan for centrally ‘approved’ national budgets and greater fiscal discipline; all good news to Euro federalists. Meanwhile budget deficits continue to exceed revenues in all European countries.

The Plan, if actually implemented, would place Europe in a death spiral of ever-greater austerity, slowing economic growth and rising debt servicing costs. Europe will simply die on the Bond Market rack.

Addicted to Debt

Meanwhile the debt burden rolls on, and the Euro-Zone nations, like alcoholics on a binge, have, with this Plan, simply stepped to the bar and ordered a couple of cool ones in the morning: ‘hair of the dog’ so to speak.

True to form the IMF seems more than willing to play the role of bootlegger.  There are plans for the International Monetary Fund (“IMF”), to essentially recycle boomerang loans; i.e. IMF is to borrow money from member states and lent it back to Greece, Ireland and other troubled economies. The IMF involvement it seems is necessary for Treaty reasons, but also to lend an air of legitimacy to the process.

The Brits refused to contribute to the Plan and many other member states are hedging their bets. Germany, for instance, has placed its commitment on hold awaiting the formal commitment of others; who indeed are waiting for Germany to commit. The international community (read USA) is also hedging its bets and if they don’t fulfill their commitments soon the Plan could unravel quickly.

Priorities are Twisted

Europe (like the US) is living in a Bond Market induced coma; just more evidence that the ‘financial sector’ has hoodwinked the politicians into believing they’re the center of the economic universe.

According to the ‘gods of finance’, recovery is assured. We need only rescue the banks and embrace the Miracle of Austerity: the wacky idea that you can CUT your way to recovery.

Unfortunately this thinking is dangerous, delusional. This crisis will not be solved by austarity. The cold reality is this: post-industrial economies, including the US, UK and Europe, have changed their ‘engines of growth’. Recovery in the 21st century requires deliberate, informed capital direction, which is not happening.

Direct Capital (immediately) to the Productive Heart of European Economies

According the Organisation for Economic Co-operation and Development (OECD), postindustrial economies (i.e. Western developed economies) are now solidly ‘service’ oriented. The proportion of traditional (i.e. bankable) assets presently being generated in European economies is somewhere in the region of 20% of GDP. In industrializing China the proportion of hard, tangible assets runs about 80% of GDP; similar numbers to J.P. Morgan’s industrializing America a century ago.

According to studies, intangible (asset) investment by U.S. businesses has now risen to $3 trillion per year (2010) dwarfing investment in capital assets.  The new ‘intangible’ economy dominates but is concentrated in small to medium sized businesses that are massively undercapitalized.

Unfortunately, this sector alone is capable of driving growth and employment in the West.

IMF boomerang loans will buy time, but not solve the underlying problem. Hang on to your hats, 2012 could be rough ride.

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A New Golden Age of Growth

December 20, 2011

As the calendar closes on 2011 panic is spreading through the establishment.  2012 will be a make or break year and a lot of people are very nervous. Personally I believe we’re heading for trouble, probably a bond market crisis. More importantly 2012 will likely be the year that we finally abandon our faith-like allegiance to The Market. Economic stability and growth will not return until we realize that it is not markets that matter but assets, and, considering we’re in the white heat of an asset revolution we’ve all got some work to do. Fortunately it’s all been done before, at the industrial ‘asset’ revolution a little over a century ago. Here’s the story.

J. P. Morgan’s Industrial Asset Revolution

Every schoolboy and girl knows about the Industrial Revolution. It started in in the 19th century and was characterized by some extraordinary innovation: new technologies, mechanized factories, masses of urbanized workers and a new class of wealthy ‘industrialists’. Less well known is the Industrial ‘asset’ Revolution, which post-dated the original technological revolution by several decades. This revolution also involved considerable ‘innovation’, but this time it was not new widgets, but dull, banking, accounting and financial innovations. Although it has gone almost unnoticed by the general public, this revolution was far more important to our general prosperity.

John Pierpont Morgan was king of the industrial bankers. In his day the world literally came to his feet. He was an iconoclastic Victorian giant, complete with top hat, spats, silver tipped cane and giant cigar.  It is a surprise to many to learn that Morgan the banker was also an industry insider, controlling (or owning outright) dozens of 19th century American railroads. Eventually Morgan expanded his banking network beyond railroads and either founded or merged the industrial giants of the 20th Century, participating in such famous businesses as US Steel, International Harvester, General Motors, and AT&T.

Morgan used his insider’s knowledge to build sustainable earnings in railroads and – indirectly – their industrial class assets; newer kinds of assets that the established banks found foreign and offensive. As hard as it is to imagine the great financial houses of the day, merchant bankers all, quietly ran for cover as the industrial era began. For merchant bankers like Barings and Rothschilds, industrial activity was strange and dangerous; railroads in particular were overloaded with fast talking (American) promoters, vicious competition and businesses that had a disturbing tendency to default on bonds and loans.

Morgan saw opportunity where the merchant banks didn’t, and grabbed it solidly.  Morgan realized quickly that leaving the Railroad business to The Market was not a solution. Railroad entrepreneurs were dream merchants; not only were they out of control (irrational, hyper competitive) but they lacked business and financial disciplines which meant they were chronically under-performing as a group. The Wild West free market approach to Railroads led to misdirection of capital and waste, undermining profitability. This was the situation Morgan set out to repair, and repair it he did.

Morgan was one of the first to realize the importance of railroads. He saw that the many factories being built throughout the country needed railroads to get their goods to market. Railroads were the ‘de facto’ national distribution systems for industrially produced goods; so successful railroads were not only valuable in their own right, but the key to profitability of the entire industrial economy.

With the considerable resources of the London bond markets behind him Morgan acquired and merged railroads across the continent. He bullied everyone, including railroad owners until he finally consolidated the industry to the point where it was controlled, quasi-monopolistic and profitable. In doing so Morgan, almost single handedly, established sustainability in the railroads’ assets and, incidentally, in the ‘capital’ assets of a host of associated industries.

He was so successful that the United States government soon intervened with anti-trust legislation to break up the Morgan trusts. However they did so after the pattern had been set, and the asset model solidified so clearly that industry in the 20th century literally exploded on the back of new-fangled (capital) assets that today we take for granted: plant, industrial machinery and inventory.

The industrial ‘asset’ revolution that J. P. Morgan launched in the 19th century, and the new banking model it shaped, accelerated after his death in 1913, driven strongly by a new generation of commercial bankers.

Today the old industrial economy is expiring in the West. The so-called ‘developed’ economies are desperately hanging on to diminishing returns, hoping (praying) that the economy will return to business as usual. It won’t.  According to a recent University of Maryland study intangible (asset) investment by U.S. businesses has now risen to $3 trillion per year (2010) dwarfing investment in capital assets.  Meanwhile J.P. Morgan’s banking business model, based on collateralizing capital assets, is unraveled rapidly.  How have commercial banks responded to these deep-seated changes in the economy? As the proportion of capital assets in the economy diminishes they’ve changed their businesses, abandoned corporate lending (to the commercial paper markets) and become essentially fee generating service organizations. The net effect of these changes in Western banking has been to direct corporate finance to away from ‘asset’ based commercial & industrial banking to a far risker Wall Street investment banking model.

Bankers today do not realize how rapidly intrinsic value is migrating and how dangerous this is to their profitability. In addition they have become complacent, over-focused on earnings (effects) while ignoring causes (solid, well managed assets). They cannot, or will not, do the hard work necessary to learn the intricacies of the new knowledge-based intangible assets. Like the merchant banks of old they will lose ground steadily as the revolution proceeds; before it’s all over many established banks will collapse in spectacular fashion.

The unpleasant reality is this: the western ‘industrial’ economy is sinking, while the assets of our lifeboat, our new ‘creative’ economy, are still too immature, too small to carry the societal load. The secret to making a successful transition, however, will be found in a formula that J. P. Morgan would recognize instantly.

Like the Morgan of old, successful commercial bankers in future will need to become pro-active. Modern banking needs innovators, specialists in the creative world of intellectual property and technology commercialization. The new banking order will be initiated by hard working insiders who having learnt the secrets of the new economy and who are prepared to work with businesses to bring order and sustainability to this new class of assets. It will be new, but once again rooted in assets, not simply (derivative) earnings. Success will breed success and a new much more productive economy will emerge that will lead to another Golden Age of Growth.

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Bank of America, The New Lehman?

August 12, 2011

This is my last negative post, from now on I’m going to be focused on solutions to reinvigorate capitalism; presenting ways of unleashing the full potential of the most talented, connected and creative generation in the history of the human race. That we’re reduced to trembling in fear, talking about a double dip recession or another Great Depression is a disgrace.

Having said that the problems we face in the aftermath of the Financial Crisis are not going away. Apart from the unsustainable debts of almost everyone, municipalities, individuals, sovereign governments etc., there are unresolved liabilities emanating from the 2008 mortgage mess that are about to break through our defensive perimeters. Think Titanic; the banking system essentially hit the iceberg at full speed in 2008. We’ve kept her afloat ever since, but at the moment the economic engine room is flooded and water is rising fast on the lower decks. It’s a mathematical certainty that we’ll sink; it’s simply a matter of time.

Why single out the Bank of America? Well there are a couple of reasons. First of all their behavior was and continuous to be deplorable.  To say banking standards were compromised in the past decade is like saying Bonny and Clyde were good kids out to have some fun; the reality is bankers were overwhelmed by greed, recklessness and incompetency. How many banks foreclose upon a home that the owners paid cash for, and don’t have a mortgage? Bank of America did. But that level of incompetency is only the tip of the iceberg; there is a growing army of Attorney Generals lining up to sue Bank of America for illegal foreclosures in their States. Wisconsin is only the latest. Attempts by the bank to settle this matter are unraveling fast.

Even that paragon of virtue, AIG is suing BofA (for $10 billion) over a variety of abuses. But they’re only one of a long (and growing) line of litigants seeking to recover losses on hundreds of billions of dollars of mortgage-backed securities, claiming that Bank of America, its Merrill Lynch and Countryside Financial divisions knowingly misrepresented the quality of mortgages placed in securities and sold to investors.

Bank of America is not alone in having these problems, many banks share them, but unfortunately for shareholders, BofA is the weakest in the herd. With a share price in the single digits there is a growing sense of unreality at the senior management level. Although it remains the largest bank in the United States by assets, the BofA has dangerously weak capital ratios. But as CEO Moynihan said recently: “We simply could not continue… diluting our shareholders to raise capital.”

The banking industry has been sleepwalking through the crisis ever since TARP program was announced.  And complacency reigns; when the banking industry has gotten in trouble in the past (i.e. after the Enron fiasco) they’ve received only a slap on the wrist and a bank friendly settlement acknowledging no wrongdoing or liability. How do the banks do it? The banks have important cards to play; they can rightly claim that they are central to the material well-being of the nation – not just too big to fail, but too important to be held accountable for wrongdoing.

The Justice Department, true to form, is concluding its inquiries into bank malfeasance without filing any serious charges. Banks are hoping and expecting that they’ll receive a politically brokered ‘free pass’ when the dust settles. Unfortunately, neither banks nor officialdom will be able to withstand the public backlash that’s coming when the economy takes another steep nosedive. The public, already plenty angry, will be out for blood and the politicians will simply throw the rotten bankers to the mob to save themselves.

Like Lehman the fall of Bank of America will be very much greater in perception than in reality. It will have a knock on effect that staggers the imagination. Batten down the hatches, and man the lifeboats.

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Technology Jail #2: Wall Street Wolves

July 1, 2011

According to a recent University of Maryland study, the United States economy is generating (annually) trillions of dollars of undocumented intangible asset wealth. This wealth is literally invisible; it does not show up on company balance sheets, in GDP statistics or other national economics measures.


Interestingly this new wealth is, to a large extent, accumulating in the vast army of innovative small to medium sized businesses (SME). Unfortunately, because we don’t (at present) manage, account or securitize these sources of wealth properly or consider the assets ‘real’ we’re creating unnecessary hardship for SME’s and society at large.

Technology Jail (see last months post), handicaps knowledge-rich businesses and vastly increases their cost of capital but, also, in a real sense contributes to the relative decline of the West in global economic terms.

Many SME’s today, lacking solid bankable assets, chose to ‘Go Public’ early to gain access to the capital they so desperately need.  But going public in this way is expensive and is loaded with unexpected perils. Indeed the markets are filled to the gunnels with bright young companies essentially locked in the ‘Penny Stock’ wing of Technology Jail.

Andy Kessler, a financial journalist and writer, being interviewed on NPR recently said: “You know IPO’s are capitalism’s carrot, right, they’re hung out in front of entrepreneurs as an incentive for them to work hard, pull all-nighters, chug ‘jolt’ cola and change the world.”

But Andy also pointed out a few home truths for the audience.

What most people don’t know is that in an IPO process the management of the company fly’s around the world meeting institutional investors, meeting with the Fidelity’s, Janus’s the mutual and pension funds in a process of whipping up excitement for what they do. And then the underwriters, Goldman Sachs or Morgan Stanley go around and say ‘how many shares can we sign you up for”.

So it’s this funny kind of auction (that takes place)… You know the management of the company, the employees of the company and certainly the venture capital investors of the company do well when the company’s goes public – they can’t sell for six months by the way. But the ones who do best are the ones who get allocated shares on the deal and if it doubles in the first few minutes… you know they do quite well”.

What’s wrong with this picture Andy?

The company sweats bullets for years to get something worthwhile off the ground; the management then go around and ‘drum up demand’ for the shares. Then the guys who have done the least, the bankers and their favorites, load up on fees, divvy up the tradable shares and ride the initial demand to great profits while the company, including the guys who pulled all-nighters, are stuck.

What’s the out come of all this at the end of the day? Unfortunately not all companies are lucky enough to be a ‘Linked-In’ with huge brand recognition and earnings. Today the NASDAQ – OTC Bulletin Board and the Pink Sheet Board are littered with broken deals – public Companies with partially developed technology, trading at pennies and struggling to keep current with their SEC filings.  The SEC’s response to this is to make the filing requirements even more stringent. Unfortunately, It’s not the filing system that is broken; it’s the presence of so many un-bankable intangibles and a predatory finance industry.

The process of ‘Going Public’ is so distorted, the incentives so misplaced today that it reminds me of “Little Red Riding Hood.” You know how the story goes: an innocent little thing in her red cape is on her way to grandmothers house in the dangerous woods. When she (i.e. the high tech SME) arrives at the offices of her financial savior, she notices her ‘grandmother’ (broker dealer/investment advisor) has an odd look in his eye while he promises the little ‘darling’ cupboards filled with bread and cookies. Little Red Riding Hood then says, “But grandmother, what a big investor network you have!”. “All the better to fund your deal my dear…” This eventually culminates with Little Red Riding Hood saying, “But grandmother, what big teeth you have!”, to which the wolf (broker dealer/investment advisor) replies, “The better to eat you with my dear,” and swallows her whole.

Most truly innovative companies gain very little in real terms from going public this way; unfortunately, apart from being fleeced by their broker dealers they find themselves burdened with a host of free trading shares and absolutely the wrong (short term, opportunistic) shareholders chosen not by themselves but by underwriters.

Its a short sellers dream; welcome to Penny Stock land.

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