Archive for the ‘The New Normal’ 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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Big Data is Watching You!

March 7, 2012

I could feel the frustration in my friend’s voice; “Google is reading my email; they recently targeted me with ads that could only have come from analysis of specific words in my private email.” My friend, Mark, is an experienced entrepreneur and no stranger to the ways of business. He went on; “I know Google analyzes my online searches and shopping behavior to send me targeted ads. What I didn’t know is that Google captures and analyzes the content of private emails and uses that data, too.”

Mark’s anxiety is justified; the ads he received were based on data collected from an email to his lawyer about a legal matter; it scared them both. Mark called me because I’ve been investigating capitalism, economics, and the phenomena of Big Data for some time now.

Mark’s concern is not just about corporations accessing and profiting from his personal data; it is much bigger. When a private company can capture correspondence between a citizen and his lawyer, or between a citizen and anyone, it poses a direct threat to democracy because it undermines the principle of individual autonomy.

I said, “Mark, in future the biggest challenge we’ll have to face in saving capitalism is reversing the extraordinary privileges of corporate sovereignty. Think about a world where the citizen, not the corporation, is sovereign. In that world the technical ability to gather personal data from email, Facebook or Google will not determine ownership of that data.

In an equitably capitalist society the citizen owns their own life and all data about his or her private life. Today, companies like Google gather data – for free – from and about us. They just assume they own that data, and earn hundreds of billions of dollars each year. When the citizen controls access to their private data, companies that choose to use it have to rent or buy it.

Here’s my way out of the Big Data dilemma. We would have to begin treating Big Data as an asset, owned by the individual, but aggregated as a social asset leveraged for the benefit of society at large. The idea of leveraging social assets is not new; many resource rich states raise significant public revenues by leveraging the public asset in their oil, gas, mineral, timber, and other natural resources. These non-tax revenue sources fund education, build highways, research and development. In some places royalties on natural resources provide up to 50% of government funds. Alaska, I believe, is even more.

Why not treat personal data as real estate and allow individuals or their local and state governments to charge a royalty for its use? In the case of Big Data the deal for citizens is relatively straightforward. We as sovereign citizens take ownership of our data and choose to create a social asset from that valuable data. Local governments would incentivize citizen participation in creating this asset by providing tax breaks or coupons for services such as medical care.

The idea of business paying a royalty for data is no pipe dream; why shouldn’t Mark’s personal data benefit Mark, his family, and his community? Royalties from Big Data could help rebuild the roads, bridges, and schools in Mark’s neighborhood, in every neighborhood.

And Big Data is only the tip of the iceberg; in an asset revolution like we’re experiencing today, there are a host of new asset classes for individuals and governments to leverage.

For instance, consider the potential value to the taxpayer for underwriting the banking system, with its implicit guarantee? Why should we as citizens provide security to a bank or its shareholders for free? What if they paid (commercial rates) for the public guarantee that allows them to prosper?

The economy is changing radically and although many dangerous trends are obvious there is a world of unrecognized opportunity. Consider that there are over $3 trillion of invisible intangible assets in the US economy alone, and many potential new sources of public revenue as yet unused.

We need to remember the old adage: ‘money doesn’t manage itself’ and recognize that social assets don’t manage themselves either. A determined body of free and sovereign citizens must identify and manage social assets. It is their right and duty to do so.

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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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Winds of Change are Blowing, Beware

November 12, 2011

WASHINGTON — The Obama administration, under sharp pressure from officials in Nebraska and restive environmental activists, announced Thursday that it would… delay any decision about the Keystone XL pipeline until after the 2012 election.

An election year politician doesn’t really need any more incentive to delay an unpopular decision than thousands of protesters parked in his front garden.  That’s a political no brainer.

But, realistically, if a few thousand activists were the extent of it, precedent suggests that a politician is home-and-dry supporting ‘Job Creation’ activities, particularly in tough times.

Unfortunately for TransCanada Pipeline (and by extension, Oil Sands developers in Alberta) there is a large and growing backlash against ‘Big Business’ in the United States that’s altering the strategic landscape profoundly.

“The public outcry has just continued to get louder and louder, stronger and stronger,” said Annette Dubas, a Nebraska state senator. The issue for Nebraskans is complex.  Although they are a ‘red’ state, supporting business and right-of-center causes consistently, they is growing concern that the XL pipeline will contaminate the Ogallala Aquifer, a crucial source of water in the Midwest.

For TransCanada, pipeline sponsor, this is an unexpected surprise. The company has been developing this project for years and has sailed through its governmental reviews and environmental impact studies with flying colors. Their astonishment at recent developments was made perfectly clear by spokesman Shawn Howard, “A lot of people would stand back and say, ‘If this was such a concern, where were you three or four or five years ago?’ ”

Shawn’s surprise is typical. But how do you know you’re in the middle of a revolution? Answer: you don’t. Not until it’s too late.

Our societal tectonic plates are shifting. The “Occupy Wallstreet” movement marks a turning point. It is the radicalized thin-edge of a giant wedge of public resentment that has been building for many decades. The establishment is unaware that a volano of middle class anger is about to erupt Vesuvius-like over the business landscape. The speed and violence of this explosion will simply overwhelm the established way of doing things. What does a business leader do in such situations: act now to strengthen the company’s most valuable asset, the ‘Social License to Operate’.

Most hard-nosed business people pay lip service to the idea of social responsibility, and, in this, they have lots of institutional support. No less an authority than economist Milton Freedman laid down the law: “…there is one and only one social responsibility of business – to use its resources and engage in activities designed to increase its profits….”.  Making profits and (secondarily) providing jobs IS the social responsibility of business; it’s no wonder that many businesses take their Social License for granted.

However the winds of change are blowing. American banks, authors of the ‘sub-prime’ mortgage disaster, illegal foreclosure practices, and serial incompetence are leading the way, The oil industry, although not free of embarrassing public gaffes, is still reeling from the Gulf of Mexico fiasco and a host of pipeline problems.

What should be clear from recent events is that the status quo is dangerous. Much more will need to be done to win back public trust and confidence. A good start would be a sober analysis of the situation, and a willingness to understand businesses’ ‘relationship with the public’ is damaged and needs repairing – fast.

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New Assets, Bankers Still Don’t Get it

October 26, 2011

I had a conversation recently with a banker friend of mine, who’s skeptical about the ‘new’ economy (“there is nothing new about the new economy”, he claims). While I’m ranting on about great opportunities and how the new assets are essentially ‘invisible’ he interrupted and said: “But Robert we can’t bank that stuff, there‘s no intrinsic value there. Its not real like land, or plant and machinery.”

After that, I had to stop and catch my breath for a moment. Apart from the horror of absorbing this shocking statement, I was beginning to see how difficult it is for many knowledge-rich businesses today to get banking facilities – they might just as well be talking to a brick wall.

David and Goliath

After I recovered my composure, I said, “Matthew, let me tell you a little story about how attitudes just like yours almost destroyed the most powerful company in the world.”

I don’t know of you remember at all, but during the ’60s and ‘70s IBM owned the computer business. It was the biggest and most powerful technology business on the planet. IBM began its life in the 1880’s as International Business Machines, and had grown up during the 20th century as a machine-maker ‘extraordinaire’. By the late ’70s, IBM was unsurpassed in terms of technology development, but was even more dominate in reputation, in the power of its brand. It was often said in those far away days “nobody was ever fired for buying IBM.” In other words they were, and were perceived to be, the best in the business. They owned the computer market by virtue of their brand reputation and the excellence of their hardware, selling frighteningly expensive mainframe computers.

With success came a kind of arrogance and complacency, a fatal flaw very evident in their negotiations with start-up software pioneer Bill Gates. Bill was so young and Microsoft so small in the late ‘70s that neither registered on IBM’s radar screen. Good fortune, however, was just around the corner. Early in 1981 Microsoft was approached by IBM to produce some operating software for IBM’s ground breaking, soon to be released PC, the Personal Computer.

As it happened Bill and Microsoft didn’t have a ready operating system to sell to IBM, so they went out and purchased a basic operating system from software developer Tim Paterson for $50,000 and adapted it. The renamed version eventually became IBM’s PC-DOS.

New Approach to Software

Developing software and selling it outright to customers was standard operating procedure in the software world of that day. Remarkably, in Microsoft’s case, something quite amazing happened. Bill recognized that his simple operating system was more than a toss away service for IBM’s hardware; his software had great utility and value. Bill Gates pondered on how best to sell his operating system to IBM, but also retain the right to sell it to other customers as well.

Bill Gates launched Microsoft and (almost accidentally) created the modern software industry by ring-fencing his computer code with a legal agreement and licensing its use to IBM instead of selling it outright. Under the agreement Microsoft retained the right to independently develop and market its own version of PC-DOS under the brand name MS-DOS. Signing this agreement was a colossal blunder for IBM, a mistake that in very short order catapulted this titan of industry to the point of ruin; meanwhile Microsoft, a global superstar, was born.

The lesson for bankers today is this. The launch of Microsoft might never have happened if IBM had not brought an antiquated industrial mind-set to the negotiating table.

IBM, of course, played by the existing rules of business; they KNEW that only ‘real‘ tangible assets were important.  For IBM, software was unimportant; it was simply an expendable service. As a result of this blindness IBM didn’t see the opportunity or the danger and therefore did not object to the licensing arrangement.

Microsoft KO’s IBM

In the stoke of a pen, IBM abandoned two of the most valuable (if non-traditional) assets of the 20th century; simply left them on the boardroom table. And (bankers take note) what were these assets: the MS-DOS software assets, and more importantly a relationship-based customer equity asset that would dominate the world of computing for the next quarter century.

Ownership of the MS-DOS software platform soon paid handsome profits for Microsoft. With its unique capabilities MS-DOS helped launch IBM clones, competitors to IBM in (clone pioneer) Columbia Data Products, Eagle Computer, Compaq and others. This however was only the beginning, soon MS-DOS became Microsoft Windows and the world had a ubiquitous new software operating system for a generation of personal computer users. Microsoft’s ownership of this non-traditional asset, one of the most profitable assets of the 20th century, was – ironically – only made possible through ignorance and neglect: software-as-asset being a contradiction in terms for IBM.

But MS-DOS was not the biggest asset IBM left on the table that day. Customer equity, the magic ingredient that catches customers’ desires, that informs the ‘Why of the Buy’ for computer purchases soon passed from IBM’s hardware to customers’ familiarity with the Window’s operating system. PC buyers were loyal to Window’s (and to a lesser degree Apple’s) operating system, not the hardware platform. Armies of computer buyers flocked to Microsoft based computers regardless of the hardware platform. (Note to Microsoft, today customer equity is moving to Apple’s platform, beware!).  This customer equity asset was, until recently, the most valuable asset in the history of computing – more than anything else it created the myth of Microsoft and almost cratered IBM as a viable business.

So, Matthew, there is something new about the new economy, value is driven in new ways, from unfamiliar, intangible sources that most bankers don’t understand. How can bankers hope to keep pace with all these changes? I don’t know but burying your head in the sand and pretending that nothing has changed won’t help, that’s for sure. “

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Getting out of Technology Jail #2

September 16, 2011

In the past few decades there has been a veritable explosion in innovation, accompanied by exponential growth in important technology drivers, including Internet bandwidths, the performance, the speed and RAM power of computers.  As a result of these and other changes, the engine of growth in our economy has migrated from its traditional industrial base to something substantially different.

Today nontraditional assets, new ideas, patents, software and other forms of intellectual property underpin many of the most exciting businesses in our economy.  Needless to say, these new sources of wealth do not appear on the company’s balance sheets, and sometimes not even on their management’s radar screens.

Despite the fact that these new assets form the largest part of our economy now-a-days, important institutions including business schools, banks, accounting professionals, securities and exchange commissions have not kept pace with these changes and as a result do not know how to interact with the new innovative businesses that have emerged from all this.

With Western economies failing rapidly, there is a desperate need to bridge this yawning gap. What’s required is a means of translating the institutional standards, management disciplines, operational processes and leverage of traditional assets into this rapidly developing knowledge driven ‘new asset’ space.

This means treating nontraditional assets like traditional assets.

Essentially the first step is for management to properly identify and capitalize the nontraditional assets on its own balance sheet on an historical cost basis – which will at least identify the important value drivers in the business. This is NOT traditionally done in the normal course of business, but does conform to a rapidly evolving GAAP (Generally Accepted Accounting Principals)

As important as this step is, its does not extract the full ‘enterprise’ value from innovation.

So… what is enterprise value? If you’re fortunate enough to own traditional assets, developable property for instance, accounting standards allow you to estimate the property’s value on a ‘best use’ enterprise basis.

Highest and best use, or highest or best use (HBU) is a concept in real estate appraisal that shows how the highest value for a property is arrived. HIGHEST AND BEST USE is calculated optimistically on the reasonably probable and legal use of property, that is physically possible, appropriately supported, and financially feasible, and that results in the highest value.

This enterprise value will very often be many times the purchase price. This kind of valuation technique allows property developers to accelerate their businesses through increased financial leverage.

Translating these traditional valuation concepts into nontraditional assets assumes a ‘best use’ valuation of the intellectual property with all kinds of caveats and assumptions. Enterprise valuations tend to be larger than standard values at play in the market today because of many factors, including optimistic assumptions about:

(1)  Access to capital and other resources of all kinds

(2)   Management competency and skill, and not least

(3)  Globalization’s impact on Market Size calculations.

So why is Enterprise Value so important?  In a word… LEVERAGE

Leverage the Assets at Full Value: traditional businesses take full advantage of leveraging their assets on a best use basis. For instance owners of development property are able to use the full develop-able collateral value of their assets to attract bank finance, to establish valuations when going public, doing joint ventures etc. Enterprise valuations unleash this best use value of nontraditional assets so they can be leveraged in the same way, commercially and in the stock market. 

By identifying the asset strength, bolstering the company’s balance sheet and structuring properly, it is possible to greatly increase the Net Worth of a company, preparing it for investment, increasing the bargaining power in real financial terms.

What’s the benefit of Enterprise Value: Now, it is possible to fit a substantial investment into the company without punishing dilution.

Things to Think About:

  1. Unfortunately it is very difficult – if not impossible  – for your ordinary accountant to obtain Enterprise Value for nontraditional assets in the originating organization. Specialized GAAP accounting techniques (it really is brain surgery) are required to accomplish this goal.
  2. If you’re interested in more details on how to accomplish all this, write a summary of your new asset business in the comment box below and I’ll see that someone contacts you.
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‘Servicing’ the Economy

May 17, 2011

The Irish property boom and subsequent bust is a portent reminder of the hazards of the Wall Street version of banking, which over several decades has managed to turn the most conservative institutions in our economy into Las Vegas like gambling casinos.

Bankers have traditionally been the guardians of assets, its why it they were so dour; their job and role was to protect the value in assets, and thereby protect their depositor’s principle and the integrity of the capital system. In Wall Street’s version of the game, traditional banking is a bit of a dog; much better to turn boring (low return) mortgage assets into a stream of high value ‘services’ that generate multiple sources of immediate fees (earnings and personal bonuses).

The ‘sub-prime’ mortgage scandal demonstrated clearly that under this regime, NOBODY in the system is focused on stability. Every player in the property game these days, mortgage ‘originators’, servicers, securitization specialists, banks and their and sophisticated investment advisors, even credit rating agencies are focused entirely on fees, no one is watching the asset. In changing the focus of attention and misaligning the incentives in the system, the quality of mortgage assets was degraded – to devastating effect.

Assets matter, for instance, with a solid housing market individuals are able to leverage their homes to raise funds for, perhaps, sending their children to school, for investing in their businesses or expensive life-savings operations. Businesses are able to leverage their commercial property for a variety of purposes, including managing cash flow. Banks holding solid mortgage assets are able to leverage these assets to provide liquidity for the local business community, while national governments are able to leverage the housing stock to support currency values and central banking liquidity to the benefit of the economy as a whole.

As the Irish are discovering today to their dismay, blindly following Wall Street model of ‘servicing’ an economy creates instability; for the Irish it created a kind of economic whiplash.

Assets, and their sustainable value are the underpinnings of the capitalist system and all nations value and in many ways ‘rest’ upon their asset foundations. Turning assets into fee generating ‘services’ is the reverse of what a sensible economy should be doing. Unfortunately the game today is all about finding new and exciting ways of converting assets into services; this means that capital stability is sacrificed for expediency.

‘Servicing’ the economy not only degrades an economy’s strength but also reduces leverage and growth potential. Not that leverage disappears in this new Wall Street system, banks, naturally, publically traded, are able to leverage their new ‘mortgage’ related earning steams – good for them. Unfortunately this is very bad for the rest of us.

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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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