Archive for the ‘Sources of Volatility’ Category

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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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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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Rise of the Service Economy

March 19, 2011

According the Organisation for Economic Co-operation and Development (OECD), post industrial economies (i.e. Western developed economies) are now solidly ‘service’ oriented. By some estimates over 75% of US GDP is composed of services, the UK comes in at 71.6%, Switzerland at 72.1%, and Luxembourg at 79.4%.

Unfortunately this transformation of economies from industrial to service presents a series of problems. Economists, being economists, describe it in terms of productivity. For instance, according to the UK Treasury:“The service sector is at least one third less productive than manufacturing.” In some sectors, services reach only 50% of the productivity per head of old line manufacturing. Many believe that services processes have not been designed with the ‘rigor’ applied to such activities as engineering.

But, of course, that’s not all. The old industrial economy was underpinned by tangible assets, which had a number of advantages. First of all tangible assets are given formalized treatment by management and important social institutions. For instance, there are reliable valuation standards for these assets, they qualify under GAAP (Generally Accepted Accounting Practices) which means these assets appear on company balance sheets and are accepted by banks, securities regulators, investors and others as legitimate value. More importantly, businesses can leverage an asset, something that is NOT possible with a service.

With upwards of 80% of our economy now in ‘services’ our economic leverage is vanishing, and with it our ability to reliably finance growth.

Banks (which leverage assets on a 10-1 basis) are desperately trying to increase their asset bases to meet the demands of regulators and shareholders; however many are trying to do so with thinly disguised ‘services’ which at present don’t have the collateral value of older class assets. Public companies are able to leverage their service businesses through their multipliers, most importantly their price to earnings multiples in the stock market. However for the 90% of knowledge-rich small to medium sized companies today there is no financial leverage and therefore these businesses are swimming against the tide – many underperform or simply fail.

It is a fact that civilizations rest upon their asset foundations, solid assets allow them to mobilize their human networks to all kinds of productive purposes, investment in new business opportunities, building systems of education, health and or security. The growth of the service economy is very exciting and it is delivering an economic benefit, generating its fair share of GDP. But presently constituted services are not building solid dependable assets which individuals, companies and society can leverage efficiently to build a sustainable future.

Things to Think About

1.  We all need to take a leaf out of Bill Gates book. In the early days of Microsoft Bill converted his MS-DOS operating software from a ‘service’ to an asset by treating it differently than other software developers. Bill ring-fenced his software with a license agreement and leased it to IBM and others instead of selling it outright. This allowed Microsoft to gain both earnings from the sale of software but also to gain from the accumulating asset value of this valuable source of wealth.

2.  Its time for leaders to look very closely at their businesses and try and understand the sources of value more clearly. And then act to build real asset disciplines, value, and leverage in their non-traditional assets.

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Another Oil Bubble Brewing?

February 24, 2011

There’s trouble in paradise again. It looks like oil prices are taking off as political tensions rise in the Arab world.  In addition, there is a puzzling spread in pricing between two of the more important benchmark crudes, with Brent trading at wide margins to the West Texas Intermediate (WTI). What the heck is going on?

The extraordinary volatility of oil markets in the past few years has been a function of several major developments: (1) there have been significant changes in the oil ‘formula pricing’ regime in the past few years, (2) Index ‘securitization’ of commodities has become big business and (3) there is heightened political risk, driving oil and other commodities on an historic run up in prices.

Oil’s Formula Pricing Model

The older system for pricing oil contracts was fairly simple. Contract prices were determined by adding a premium to, or subtracting a discount from, benchmark crudes. Generally, West Texas Intermediate (WTI) was used as the benchmark for oil sold to North America, Brent for oil sold to Europe and Africa, and Dubai-Oman for Gulf crude sold in the Asia-Pacific markets.

However in the past few years this all changed when Middle Eastern producers noticed that the spot market was subject to increasing manipulation. Basically producers didn’t trust the market so they changed the rules of the game. Instead of using dated Brent as the basis of pricing crude exports, Saudi Arabia, Kuwait and Iran came to rely on the IPE Brent Weighted Average (BWAVE). The BWAVE is the weighted average of all futures (Brent crude) price quotations that arise for a given contract of the futures exchange (IPE) during a trading day. These changes in ‘formula pricing’ have placed the futures market at the heart of the Brent oil pricing regime. So unlike the more spot oriented WTI, which is experiencing a localized over-supply of NA crude, Brent benchmark pricing is going its own direction; factoring in the growing political instability in North Africa and the Middle East.

On top of all this, commodity markets tied to the futures market, the Brent benchmark in particular, are subject to a volatility accelerator in the form of index Speculators; major institutional investment in the oil futures market, trying to cash in on market instability. Index speculation in commodities is being driven by a potent cocktail of political instability, a lack of confidence in global stock markets and rising commodity prices.  Importantly – there are enormous volumes of index speculation sloshing around in the futures market, and after recent events the vast majority are leaping on preprogrammed ‘long’ positions in oil. The net effect is to drive oil-futures yield curves into the stratosphere in a self fulfilling death march to oil bubble land. I believe we’ve seen this movie before, a couple of years ago in fact.

Things to Think About

  1. Could it be that the Brent – WTI spread, which has been as high as $15 a barrel, is really a measure of the speculative bubble in oil pricing?
  2. If history has any lessons, it’s that these markets are not accurately pricing crude which is likely going to over shoot its strike price in both directions. Timing is everything in life, it’s the difference between winning and losing in oil markets these days. Heads up.
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THINGS ECONOMISTS CAN’T TELL US, and WHY

June 9, 2010

Many not so casual observers, including Queen Elizabeth II, have wondered why economists did not anticipate the recent Financial Crisis. The reality is most economists were stunned when the Crisis arrived, panicked at its blinding speed and can only recommend ‘the same old, same old’ going forward. There’s two principal reasons they didn’t see it coming. One, economists weren’t looking broadly enough at the economy to see the problems developing in the first place, and second, what evidence was available (and there was plenty) tended to be discounted or ignored for ideological reasons.

The Dismal Science

Economists, despite being highly respected and sophisticated scientists, have been on the defensive for centuries. Truthfully, the study of economics was in difficulty even before Thomas Carlyle leveled his famous ‘dismal science’ charge in 1850. Perhaps the one nagging criticism  that stings most strongly these days is the charge that economists are so infatuated with the wonder of their theory that they ignore practical reality.  

Why should the rest of us care? It’s a serious issue because economics matters. The management of a modern economy, the decisions and actions undertaken by politicians, senior policy advisors, Chairmen of the Federal Reserve Bank, business leaders, Wall Street investment bankers and others, are derived from an underlying body of economic thought; today those underpinnings rest largely on the shoulders of neoclassical economics, the foundation stone of modern capitalism.

Neoclassical Economics

Although neoclassical economics is a foundation, it is by no means a unified body of theory. However modern economists working within the neoclassical paradigm tend to agree on both a quantitative approach to economic analysis and a field of study centered on the exchange process. Neoclassicism is a mathematical system of thought concerned with market related phenomena, particularly the determination of prices, outputs, and income distributions.

This is quite a change from the past. A century ago the great Alfred Marshall could say of economics: “Political Economy or Economics is a study of mankind in the ordinary business of life; it examines that part of individual and social action which is most closely connected with the attainment and with the use of the material requisites of wellbeing. Thus it is on one side a study of wealth; and on the other, and more important side, a part of the study of man.” These days you’ll find a much less ambitious definition for economics, generally along the following lines: “Economics is the social science that examines how people choose to use limited or scarce resources in attempting to satisfy their unlimited wants.” …a dismal science indeed.

So, where did it all go wrong?

It all happened a long time ago, in the horse and buggy days of the Victorian era. Mid-Victorian capitalism was facing a mountain of trouble. Marxism and the rising working class movement were galloping forward on the left; on the right there was a looming – cataclysmic – breakdown of laissez faire, which eventually launched an era of vicious protectionism and hyper aggressive imperialism. According to economic historian Eric (Lord) Roll, in these confusing times there was a strong desire among classically minded economists to produce a more scientific study of economics and – ideally – find a way to side-step the theoretical challenge of Marxism once and for all.

The Marginalist Revolution of the 1870’s provided just such an opportunity. The marginal utility theories of Jevons, Manger and Walras revolutionized economic thought and with it the entirety of economic study.  Neoclassical economic theory, which emerged as a consequence of the Marginalist Revolution, introduced important new concepts into the economic lexicon, particularly a theoretical perspective that the value of goods is determined subjectively “in use” by the end-user (classical economics had assumed that goods had a hard, objective value, which was equal to the amount of labor applied in its development – the so called labor theory of value).

However, neoclassicism also introduced fundamental changes in the study of economics; its explicitly scientific approach introduced a mathematical bias into economics, which has grown significantly over the course of the past century. Unfortunately, mathematical precision has come with a hefty price tag: the Marginalist Revolution reduced the scope of modern economic analysis considerably. By drawing a ring-fence around the exchange process – forevermore the ‘legitimate’ area of economic inquiry – neoclassical economics retreated into a narrow, quantifiable definition of economics, where the larger (messy) questions were simply ‘out of bounds’. And although economists gained much greater mathematical certainty and logical consistency in adopting neoclassical principles, the Marginalist Revolution placed significant limits on the boundaries of economic study, stifling inquiry of those economic inputs that lay outside the narrow confines of the exchange process.

It was this reduction in scope, this retreat from the larger study of political economy, undertaken over a century ago that created the ‘boundary’, the theoretical wall that defines the limits of economic analysis; the presence of which leaves economists as mere spectators in critical elements of the economy. It is one of the reasons why so many of them didn’t see the storm clouds gathering in the first place and still can’t.

Economist’s counter these charges by pointing out that their market focus is reasonable, given that every meaningful economic activity that takes place outside the boundary eventually winds up in an exchange transaction, which they believe, essentially, brings the outside world to them on their (quantitative) terms.

Yes, economists do consider ‘out of boundary’ inputs, but lumber them into a broad undifferentiated category they call externalities. The practical consequences of this approach, however, distance economic analysis from the primary sources of economic activity. For instance most economics are unconcerned (and presumably unaware) of the nature of new asset classes in an emerging knowledge  economy or more importantly, just how these new assets impact economic risk assessment over time. In other words, economists are left to examine only the derivative (quantitative) effects of economic phenomena rather than their primary causes.

The Ideological Force of Monetarism

Unfortunately, this confusion between cause and effect has been greatly magnified by the late 20th century rise of Monetarism. Like many theoretical considerations in economics, monetarism was controversial and applied carefully within the profession; while outside in the world of finance and business it was swallowed whole, hook, line and sinker. Unfortunately monetarism became more than a new set of economic principals, it morphed into an ideology, a faith like belief in the purity of markets. The practical effect of market purism has been to undermine traditional checks and balances perfected over the ages to preserve the integrity of capital. As a result capital management practices collapsed across the board when it became popular to believe that markets purified the economy of all risk. This ideological sedative infected all aspects of economic decision making, undermining the culture of banking, accounting, credit rating, management and economic policy making.

Modern Economic Thought

Modern economics, despite being an important theoretical advance on the past limits economic thought in several ways. Firstly its dedicated mathematical approach limits the very process of economic analysis, for it implies strongly that anything that is not quantifiable simply doesn’t count. Secondly its constricted focus means it looks at the economy through a microscope rather than a telescope – in other words its missing the capitalist forest for the statistical trees. These reductive forces contribute to the fatal combination that blinded many economists in the run up to the Financial Crisis and are, even now, limiting our ability to put the economy back on a sound footing.

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Goldman, Fraud and Adam Smith

April 22, 2010

As the Securities and Exchange Commission’s investigation into Goldman Sach’s Abacus transaction moves forward, Goldman is striking back hard attempting to discredit the motives of the SEC, suggesting it is just a pawn in the hands of nasty Democrats. Apparently, it’s all just a political game.

Meanwhile as this scenario plays out publically, the rumor mill is working overtime in respect to a much larger fraud what was allegedly perpetrated by hedge fund Magnetar. Magnetar during 2006 and 2007 was a major player in the sub-prime mortgage CDO (collateralized debt obligations) market. Apparently, as an equity stakeholder in key funds Magnetar was stuffing CDO’s with incendiary mortgages knowing full well they would fail. Indeed it seems that Magnetar shorted the sub-prime mortgage market at the perfect moment and made an extremely large fortune. It could be luck or simply good timing but insiders are calling this the greatest fraud of the financial crisis era.

It is well known in the trade that the big investment banks play loose and fast with the market, and that they treat their customers and clients according to ‘jungle rules’. In other words anything goes. You may think a bank that is partnering with an up and coming technology firm, organizing their IPO (initial public offering) for instance, would have an interest in the success of that company going forward. If you thought that, you would be wrong. Banks regularly ‘Pump and Dump’ newly minted public companies gaining fortunes for themselves and their favorite clients while leaving their ex clients in ‘penny stock jail’.

Unfortunately this so called ‘hard’ reality of capitalism is anything but. Although tolerating an enormous range of behavior, capitalism depends critically upon trust and trustworthiness. As we are discovering today to our shame, the erosion of trust and confidence in capitalism is like having a heart attack; it seizes capitalism’s circulatory system – slowing or seriously impeding the free flow of capital. And as history has demonstrated many times over… trust, hard won, is easily lost. It must not be taken for granted.

Proponents of hard ball capitalism, when faced with this kind of logic, fall back on Adam Smith and his ‘invisible hand’ or Milton Friedman who claimed that “…there is one and only one social responsibility of business – to increase its profits….”. The idea that bad behavior actually threatens the capital base of society is greeted with laughter, ‘you got to be kidding me’ – well no actually I’m not. Adam Smith, in particular, knew this well.

To fully understand Smith’s ‘invisible hand’ it is necessary to look beyond economics and investigate Smith’s assumptions concerning moral responsibility. In ‘The Theory of Moral Sentiments’ Smith identified three virtues (or factors), Prudence, Justice and Benevolence that he felt govern an individual’s economic motivations. Prudence for Smith is relatively straightforward; it’s simply self-interest by another name. Everyone, he realized, whether prince or peasant has this sort of motivation. A ‘sense of justice’ is more complex, for Smith it implies that rational individuals obey the law, and more importantly can be depended upon to obey the law most of the time. Benevolence is where Smith gets more controversial. For in Smith benevolence implies some sort of interest in people to do the ‘right’ thing even in the absence of specific law.

It is clear that Smith’s ‘invisible hand’ rests on his belief that individuals would strike some kind of balance between the three competing virtues: “The man who acts according to the rules of perfect prudence, of strict justice, and of proper benevolence, may be said to be perfectly virtuous”.

Adam Smith loved free markets, but he would not have approved of modern investment banking behaviour. For Smith virtue and self-command were crucial ingredients in the effective operation of a free market system: “But the most perfect knowledge of these rules (prudence, justice and benevolence) will not alone enable him to act in this manner; his own passions are very apt to mislead him- sometimes to drive him, and sometimes to seduce him, to violate all the rules which he himself, in all his sober and cool hours, approves of. The most perfect knowledge, if it is not supported by the most perfect self-command, will not always enable him to do his duty”.

Hey, that sounds familiar.

Things to Think About

1. Abacus and Magnetar are not aberrations, in many ways they are the norm. Practices of this sort are essential to the investment banking business model, bankers’ profitability and personal bonuses. They’re not going to change these practices without a fight.

2. This situation is unsustainable, predatory behaviour undermines trust in the capitalist system and has a negative impact on the economy at large.

3. This situation will not end without pain. Therefore, like a Boy Scout, Be Prepared!

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Davos, World Economic Forum

January 31, 2010

You may have heard about the goings-on at Davos. If you’re like me you are probably wondering what all the fuss is about. The Davos World Economic Forum is a rather oversold talking shop, where – truth be told – nothing very substantial happens. But Davos is important because it is a place where the world’s movers and shakers set their jib for the coming year. And, considering these players represent major forces in the economy and capital markets, their general perceptions are important to businesses, large and small, in the real economy.

The themes that are getting all the attention this year are the recovery (so called) which seems to be faring much better than most pundits expected this time last year. These positive sentiments are, however, contrasted by a dark prevailing gloom; nobody seems to expect the global economy to return to robust growth anytime soon.

The reasons lie in the now obvious structural flaws in the international system. First of all, there is the big problem of global imbalances, which have been growing for decades. The problem is most countries around the world are planning export-lead growth strategies and secretly (quietly) taking steps to limit imports. The obvious flaw in this logic is with everyone exporting ‘who will be importing’? The answer… not the United States which for sixty years has played that role and today is simply not capable of carrying the world on its shoulders.  So this structural flaw will very likely lead to a downward spiral of currency manipulations, increasing protectionism and mud-slinging – not a happy prospect for growth.

The elephant in the Davos room is, of course, regulation of the banking industry. While bankers are reluctantly admitting (at least publically) that greater regulation is coming, they prudently point out that such regulation must be globally coordinated. This is true, but as the bankers know only too well, is practically impossibility in the time frame. So the bankers are cranking things back up and trying (without much success) to avoid saying anything foolish.

The fact of the matter is it’s not the 1930’s or even the 1980’s anymore, the world of credit and banking have changed, morphed into a self perpetuating, multi-headed hydra that nobody really understands. It’s NOT about banking anymore, for the banks themselves are only one part of a much larger global credit market ‘system’ that is beyond the scope of national regulation. Such contentious issues as bank proprietary trading, securitization and credit derivatives are not going away; fact is, they simply defy national borders. So the genie cannot be put back in the bottle. And, given the damage they’ve caused in recent years and the hopelessness of trying to bring them under any kind of supervisory system, more trouble undoubtedly awaits.

Finally the sovereign debt crisis has been reduced to farce. Unfortunately it is the most likely trigger for systemic crisis this coming year. Last week with the price of Greek gilts (government bonds) falling like a stone and yields rising, the EU intervened with a ‘kind of’ guarantee, which was greeted with a huge sigh of relief in markets.  But the underlying sentiment is not good. The latest, not very funny joke going around is that the “Pigs” won’t fly: the Pigs are Portugal, Ireland, Greece and Spain, who all have chronic debt problems and who now find themselves consigned to the financial out-house, with Greece at the head of the line.

Things to Think About:

  1. Most of us were hoping that this recession would be like previous recessions. We’d have a bit of belt tightening and then things would return to normal. That doesn’t look likely, at least in the near term, so a new normal of (at best) stagnant growth, increasing trade friction coupled with growing government fiscal crises will put the squeeze on business.
  2. The status quo, easy returns of the past are going to be much more difficult to maintain in the coming years. But every crisis presents both danger and opportunities, there will be growth areas in the economy, which need to be identified and focused on. Areas of growth seem to be emerging in Energy, Health Care and the Green/Environmental market spaces.  However, even in these areas new thinking, innovation and flexibility will be required to find and capitalize on opportunities.
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