Tuesday, March 1, 2011

Will the Financial Industry Dance Alone?

Last Wednesday, February 23, I argued that “The Music’s Begun Again..” (http://seekingalpha.com/article/254474-the-music-s-begun-again-time-to-start-dancing), and I fully believe that to be the case.

The economy has been growing. Since its low point in the second quarter of 2009, real Gross Domestic Product (GDP) has risen by 4.4%. The compound rate of growth has been approximately 0.7% per quarter which works out to an annual rate of roughly 2.9% per year. So the economic recovery continues.

However, capacity utilization of the manufacturing industries remains low, at 76.1% in its latest reading, substantially below the previous peak of around 82%. Even this peak was the lowest peak since the 1960s when the series was originally constructed.

My calculation for under-employment still hovers above 20%, again a high for the period following the 1960s

And, this, of course, raises the fear of a period of economic “stagflation” for the United States. Although the economy is recovery, one certainly could not apply the term “robust” to describe it.

From the credit side…more and more evidence comes in every day that the credit inflation that began in the 1960s continues. Although the world is going through a massive re-structuring, our leaders in the government continue to cry…more of the same…more of the same.

As with the last fifty years, credit inflation begins with the Federal government. The national debt is set to more than double over the next ten years and none of our leaders seem to be really seriously concerned about it.

For the debt to double over the next ten years, government debt would need to increase at a compound rate of about 7.2% per year during this time period. This is not too different from the compound rate at which the gross federal debt increased annually over the fifty years which began in January 1961.

During this period of time, the United States saw the biggest buildup in private financial leverage in the history of the country and also saw the biggest spurt of financial innovation ever to take place in the world.

Aided by advancements in information technology, the world of finance seemed to take on a life
of its own, separate from what was going on in the real economy. Employment in finance rose to approach 50% of all employment in the country as the number of financial institutions and the number of financial instruments traded ballooned.

We were getting a glimpse of the future.

Thanks to our leaders in Washington, D. C., and elsewhere, the “music” is playing again and, as we read daily, people have begun to dance once again in earnest. We read that auto sales are up because the auto companies have gotten auto finance to step up to the dance floor.

But, sovereigns are also leading the charge. Check out a lead in the Financial Times, “Sovereigns Turn to Pre-crisis Financial Wizardry” (http://www.ft.com/cms/s/0/53b445a0-4045-11e0-9140-00144feabdc0.html#axzz1FMM69iWr). It seems as if Portugal, and others, are getting back to “structured finance technology” with the use of Credit Default Swaps (CDSs) and Collateralized Debt Obligations (CDOs) to help themselves climb their way out of the current crisis in the sovereign debt market.

What else?

Did I hear someone say that issues of mortgage-backed commercial real estate securities are back? They are, and in a fairly big way. (See http://dealbook.nytimes.com/2011/02/28/commercial-real-estate-breathes-life-into-a-moribund-market/?ref=business.) Morgan Stanley and Bank of America have recently completed a $1.55 billion deal while others have sold roughly $5 billion in mortgage-backed securities so far this year. And, more is on the way.

The quote I like…from Brian Lancaster, as securitization specialist at the Royal Bank of Scotland…”Things have going from vicious to virtuous.”

It seems that car loans and collateralized loan obligations “are showing signs of life.”

And, the trading platforms built on the latest technology are beginning to fight for “territory.” GFI, a London interdealer broker, launched a swaps trading platform in advance of what is being done in the United States. (See http://www.ft.com/cms/s/0/e107d684-4369-11e0-8f0d-00144feabdc0.html#axzz1FMM69iWr.) Whereas firms in the United States are having to wait on the Commodities Futures Trading Commission for the new rules and regulations forthcoming from the Dodd-Frank legislations, others are getting a head start on them.

Technology booms ahead…while the regulators scramble to catch up to 2008. The Financial Crisis Inquiry commission just released information that the Office of the Comptroller of the Currency questioned several aspects of how Citigroup valued certain troubled securities way back in February 2008: seems as if “weaknesses were noted.” The question concerns whether or not Citigroup should have reported this information in its public documents. (See http://www.ft.com/cms/s/0/3b673370-4399-11e0-b117-00144feabdc0.html#axzz1FMM69iWr.)

My point is that we are still re-hashing what went on or what went wrong two or more years ago. The world has moved on since then. Information technology has moved on since then.

Note the headline in the New York Times: “For South Korea, Internet at Blazing Speeds is Still Not Fast Enough.” (http://www.nytimes.com/2011/02/22/technology/22iht-broadband22.html?scp=1&sq=for%20south%20korea,%20internet%20at%20blazing%20speeds%20is%20still%20not%20fast%20enough&st=cse) South Korea is seeking to have every home in the country connected with speeds of one gigabit per second. And, this is for homes.

One should also read about the changes that are coming to banking for individuals and families in places like India and Africa! This, while American banking is constrained by archaic restrictions that is causing it to lag behind much of the rest of the world in terms of customer delivery.

And, if all this is happening for the consumer, what is taking place in the biggest, most sophisticated financial institutions? Anyone for some science fiction? And, we are just worried about “flash trading”?

Regulation always lags behind the private sector. In the credit inflation of the last fifty years, the gap widened considerably. But, in re-fighting the last war will Congress and the regulators drive more business “off shore”?

The music has begun to play again. Credit inflation is underway. Further financial innovation is right on its heals. The economic recovery is underway…but, I fear, finance is going to go its own way again.

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