28 July 2009

The origin of the financial crisis: an iconoclastic view (3)

3. Regulation

Since the crisis flared up, we have heard in many corners of society about the need to regulate more. I disagree. Let's see the role of regulation in the financial crisis.

Beyond the expansionist monetary policy, upon which anybody will agree the private sector has no control, regulations imposed upon financial intermediaries in retail real estate financing (for example the Community Reinvestment Act and its successive amendments, in 1995 in particular) and the modification of Fannie Mae and Freddie Mac status, the SEC has a huge responsibility in the development of the crisis. The SEC authorized the naked short selling (where the short selling is perfectly legitimate). This led to a situation where, in some instances, the number of shares in circulation was higher that the authorized number: the SEC never enforced the obligation to deliver shares on settlement day. The SEC also failed in its supervision role, as exemplified by the Madoff affair. This failure is not bound to the US and can be extended globally.

I am also not convinced that FAS 157 accounting rule had the magnifying role : if the abscence (or quasi-abscence) market/liquidity led to a collapse in prices, hence losses to be accounted for, it is due to:
  • The lack of buyer, nobody knowing where real estate prices would fall
  • Investment banks had excessive debt (or lack of shareholders funds) particularly with respect to the imbalance of their balance sheets (short term financing on the interbank market and long term commitments). For example, class 3 assets (the most difficult to value) stood at 251% of shareholders funds Morgan Stanley, 185% for Goldman Sachs, 159% for Lehman Brothers and 105% for Citigroup.
  • Being in the same situation, banks knew the difficulties of their counterparties and the unstoppable collapse of their assets (mark-to-market or not); this is what conducted to the interbank market standstill.
The crisis outlined the difficulty to value volatile assets when there is no market available, however.

Finally, Basle II rules require the use of complex mathematical models to fix the level of capital required for banks. When banks have a low level of losses (as it had been the case since the mid-90s), low level of capital are required which encourages the expansion of balance sheets. Conversely, when the period witnesses huge losses, like today, these models require a substantial increase in the capital base when it is not available, which led to the steep downsizing of banks' balance sheets (and we have not seen the end of it as yet). For example (and for illustration only), if the capital ratio is 1/10, any decrease of 1 billion of the capital base must translate into a 10 billion reduction in assets to comply with Basle II rules.

Derivatives are very useful tools for the real economy, particularly for hedging purposes (but not limited to), it is the excessive confidence in mathematical models that is damaging: remember the collapse of LTCM in September 1998 despite its two Nobel prizes; yet the FED saved it (in fact the banks counterparts) considering LTCM to big to fail...

We do not need more regulation and control but better regulation and control and make sure that useful existing rules are applied and useless/inefficient ones dropped. Policy makers see this crisis as one in a lifetime way to gain more control on the economy, on our life whilst in may cases they either created rules that magnified (or even sow the seed of) the crisis and did not do anything since the bubble started to implode in August 2007 until September/October 2008.

21 July 2009

The origin of the financial crisis: an iconoclastic view (2)

2. Competence, governance and ethics

On this favorable background, the lack of competence, governance and ethics have exacerbated this dangerous policy.
  • Competence
I do not feel sorry for all the institutions and investors who bought all these ABS, CDOs and others derivative's acronyms without analysing these products, understanding the risk, relying purely on credit rating agencies and interest rates received.

I however feel sorry for the investors that entrusted their savings in fixed income and money market investment funds that were invested in these toxic-non-performing-whatever-name-you-give: they did not know and could not know; they were ripped off by at best incompetent professionals / organisations and at worst dishonest (they are always good clients of law firms to make sure they do not have to indemnify clients!).

This was coupled to a remuneration system that encouraged short termism vis a dual asymmetry:
  • Timewise: the bonus paid is never withdrew if after X years profits turn out to be losses
  • Riskwise: the risk is entirely supported by the organisation
Regarding investments via feeders (either institutions or independent advisors), the Madoff affair just exemplified what happens when professionalism and ethics disappear to the benefit of quick profits and easy money: a huge scandal and tremendous losses for investors. In this case, both regulators (the SEC, but frankly other regulators did not do better) and feeders share the responsibility for the lack of supervision and due diligence respectively.

Derivatives were pointed out as being the origin of the crisis: I disagree! Derivatives magnified the crisis but did not originate it. Incompetence and greed are the culprits.
  • Governance
Governance is a word that has been very fashionable with politicians and CEOs of large organisations for the past 10 years or so. Talking is not acting.

Most of the time, boards of directors are not independent and just there to agree to whatever the Chairman/CEO decides (golden parachutes, remuneration out of reality, platinum pensions, no takeover but if there is a fat check attached to it - remember Mannesmann/Vodafone Air Touch in 1999/2000-, etc.) : no questioning please! But why should questions arise when these boards work like a club of friends that distribute directorships regardless of the competence and of course independence whilst getting juicy indemnities...

Shareholders rigths are rarely exercised by individual investors that either do not fill in the proxy forms, or when they are filled, leave it to the board to vote. True, institutional investors are becoming more vocal as well as small groups of militant shareholders; they however are the tree before the forest.

And could carry on discussing about conflicts of interest lying with rating agencies or auditing firms.

To change this culture, it has to come from the top of organisations. What we witnessed is a problem of ethic at the highest level.

Boards of directors have largely failed in their role of control. The independence, accountability and competence of boards is THE prerequisite for governance, ethics and competence again take command of corporations and spread within.

The third part will discuss Regulation and control.

20 July 2009

Cartoon of the day

17 July 2009

The origin of the financial crisis: an iconoclastic view (1)

In a previous post, I commented on Goldman Sachs Q2 2009 profits and bonuses. I heard and read almost everything about the origin of the crisis and how to resolve it. I am not going back to silly comments like the one of Nicolas Sarkozy who, in October last year, identified tax havens as one of the two causes of the financial crisis, relayed soon afterward by many politicians, particularly in over indebted countries (curious isn't it?); unfortunately a wrong analysis of the causes of the crisis will lead to the wrong solutions. Let's reviex the origin of the crisis as I perceives it (this is largely extracted from a paper I wrote in French in December 2008).

1. Monetary expansion and indebtedness

Since Alan Greenspan took over the helm of the FED
from Paul Volcker, and in particular since October 20, 1987, money has been flowing at will (with some restraints from time to time). The FED has pursued a cyclical monetary policy whilst policy makers did not engaged into structural reforms. Interest rates remained abnormally low thanks to the transfer of large chunks of the industry into low cost producing countries in the 1990's, phenomenon that accelerated in the 2000s, whilst developed world companies became so-called platform companies. This in turn had a deflationary effect, allowing developed countries to display low inflation rate (whether I believe official statistics is an other matter - have a look at Shadow Government Statistics - but the phenomenon was there anyway).

This lax monetary policy had three consequences:

  • Government around the world could borrow cheaply and continue to see their sovereign debt grow
  • Corporate had no problem to access borrowing to pay for a-never-seen-before flurry of takeover bids, as well as hedge funds and other that could easily leverage (over-leverage)
  • Consumers could buy on credit many consumer goods (even at prohibitive interest rates) and not the least real estate, and think they were wealthy
This coupled with the blind belief in the modern portfolio theory and all the statistical/probabilist based models led people to ignore the reality of the human factor (I recommend everybody to read books written by Nassim Nicholas Taleb "Fooled by the randomness - the hidden role of chance" and "The black swan").

Everybody was happy and... shortsighted. The rare voices that expressed their concerns were rapidly silenced (consumers/electors prefer to listen to the free lunch story). Politicians continued in numerous countries to encourage people (with may incentives) to become owners of their home and banks to lend with total disrespect to the reality of life and credit risk.

This had a two side-effects:

  • Enriching some developing countries (China in particular) whilst impoverishing the Western world (like for any corporation, to know your real wealth at any time, you have to substract net debt).
  • A rapid change in the world balance of power from the West to the East, from democracy to authoritarian regimes. This will have tremendous consequences in term of imposing an agenda (environment, etc.) and access to commodities and energy (Chinese don't care about human rights, hence their successes in ensuring long term supply of natural resources in many underdeveloped countries).

So, all economic and policy makers took advantage of a situation that led to over indebtedness without Governments undertaking any fundamental/structural reform aiming at reducing this debt and preparing the future for our children and grand children (among world leaders, Thatcher is probably one of the few exceptions). Look at the state of the social security and retirement benefits in all developed countries: dismay!

The financial crisis is the brutal adjustment to this situation.

The second part of this paper will review Competence, Governance and Ethics.

15 July 2009

Goldman Sachs quarterly profits bonuses and politics

1. The facts

Goldman Sachs, the world leading Investment Bank (forget about the universal bank status they took amid the financial crisis late last year, and that they will surely abandon as soon as politically feasible) posted this week record profits for its second quarter ending June 30, at $3.44 billion. Its share price has appreciated more than 70% this year and is now around the pre-Lehman Brothers bankruptcy filing in September 2008. The return on equity (ROE) is standing at 20.3%.

Trading and principal investments were $10.78 billion, 93% higher than Q4 2008 and 51% higher than Q1 2009. Trading in fixed income, currency, commodities and equities generated over half the bank’s record net revenues, almost tripling from last year’s second quarter. The rest of the business remained weak.

Accordingly record compensation will be paid on trading floors: bis repetitas.

2. Comment

Goldman is a private company and conducts its business in the best interest of its stakeholders; it has been very successful in doing so (do you remember that they were amongst the first to sell the real estate and financial sectors pre-crisis in 2008?).

Politicians are certainly going to cry foul whilst they should cheer the success of a private entity that will pay handsomely the Treasury directly via corporate taxes and indirectly via employees' income tax. True it will be a drop in the ocean of debt accumulated not only recently but over the years via relentless public spending and no forward looking policy (consumers are electors first), but it is still better than the current and future state of public finances (stripping off the aid brought to the financial and automotive sectors - by the way Goldman paid $426 million on the preferred stocks it received under the TARP programme). The methodology on which bonuses are paid and the risk asymmetry between the earners and the organisations can be disputed, but the freedom of any company to run its business as it wishes within the limits of the Law should not be disputed in a free society, whether we like it or not.

When one witnesses the attendance of politicians at Parliaments across the democratic world and the jitters between the Governor of California and the Assembly whilst the situation is more than critical for this State, having to issue IOU bills that have been refused by major banks from July 10, I wonder whether they should not get a pay cut for irresponsible behavior, incompetence and absenteeism.

What is at the center of the polemic since the financial crisis started (by the way in August 2007 and not in September 2008), is a power struggle between politicians trying to regain as much control on everything and free market enterprise, or a struggle between unaccountability and accountability. History demonstrates that the former is inefficient, costly, shortsighted and long term leads to a lower standard of living either in relative terms or in absolute terms in some circumstances.

Since the end of the Volcker era (a man of no compromise and Chairman of the FED pre-Greespan), the Western world economy has grown on debt steroids which has accelerated crisis after crisis with always more money thrown (Internet stock collapse, LTCM, 2001 etc.).

I will soon discuss the origin of the crisis from a totally independent standpoint having often been critical about the way investment banking was functioning during my 20 years in the City.

10 July 2009

The magnificent 7 and equity markets - Review 2

After the low of March 9 and the recent high of June 11, we have entered a phase of market consolidation. Let's review what the magnificent 7 are telling us (I recommend the reader to go to the GTI web site for their monthly newsletter, one of the best available).

S&P 500 Banks index: after recovering from the early March lows and reaching a peak early May, the sector is consolidating. There are still uncertainties regarding the public/private plan to buy toxic assets from banks. Let's see whether the 100 mark will hold. Whilst consolidating, still positive.

Global 1200 financial index
: Like in the US, the world financial sector is posing and closing on its 200 days moving average. Still positive.

TED spread (LIBOR USD 3 mth - US 3 mth T-bills
): The spread continues to contract and is now well below the pre-panic level. Positive.

USD bank BBB 10 yr - US 10 yr yield
: Still much too high and not fully convincing; no break of the 7% level as yet. Slightly positive.

OEX volatility
: OEX volatility has recently increased reflecting new doubts about the pace of the recovery and uncertainties about a possible second stimulus package in the US. The rise is however not substantial. Still positive.

S&P Case Shiller house price index
(source: S&P): The latest data published in June (151.27 for the Composite 10 and 140.10 for the composite 20) still going down whilst at a slower pace (Composite 20 down 18.1% yoy vs 18.7% for March 19% in January). Existing home price went up in May (172.9vs. 166 in April) and housing supply is also edging down in May (9.6 months vs 10.1 months in April). A few signs are pointing towards an improvement but not bottomed yet hence still negative.

Oil price: Oil prices reached $70/b in June before retreating sharply over the past few days. It will not last but positive.

Conclusion: In our last review (May 18), we advise to take profits off the table. Fundamentals in the interbanking market have much improved but many uncertainties still remain in the Western world banking sector. Several economic indicators point towards an improvement but nothing to get really excited about it. Many clouds are still around, even if hurricanes have disappeared despite the favourable period in the Gulf of Mexico and the East coast. Relax, enjoy the summer, take time for the next action: no need to be in a hurry.

03 July 2009

Chart of the Day

Yesterday, US nonfarm payrolls (jobs) decreased by 467,000 in June. The headline came in at -467k compared with -350k consensus and the back revisions were negligible(+8k). The diffusion index fell to 28.6 from 31, which means that nearly three-quarters of the corporate sector is still in the process of shedding jobs. The 4 weeks average is continues it downward slope however. The stock market as well as commodities and energy declined sharply on the news.

Today's chart puts that decline into perspective by comparing job losses during the current economic recession (solid red line) to that of the last recession (dashed gold line) and the average recession from 1954-2006 (dashed blue line). The US have lost a record 9 million full-time jobs this cycle, more than triple the average in the context of a post-WWII recession, with over 2 million pushed onto part-time work. In fact, if this were an average recession/job loss cycle, the number of jobs would have begun to increase three months ago. This confirms the severity of the recession, but do not forget that employment data is a lagging indicator.

Bloomberg: July 03, 2009

Gluskin Sheff: July 02, 2009
Market and data musings - David A. Rosenberg