Greece and Dimon and Bernanke

Standard & Poor’s rating services have just given Greece sovereign debt the lowest rating it has.  The Greek leadership is upset.  “We have a very tight fiscal package coming” the leaders say.  Yet the downgrades continue. 

The timing of the reduction in the debt rating, according to some pundits, is not coming at a very good time.

But, these things never happen “at a very good time”.  Building up excessive amounts of debt reduce options (http://seekingalpha.com/article/271651-debt-ultimately-leaves-you-with-no-good-options) and they leave you in a state where there is no “good time” to deal with the debt. 

Yet, people and governments, over the past fifty years, acted as if the amount of debt outstanding did not matter to their economy and that any fiscal difficulty a country might find itself in could be overcome by increasing the spending of the government and increasing the amount of government debt.

The amount of debt a government issued did not matter because the economic models the governments used did not include government debt.  Thus, a government could increase debt as much as it wanted and their economic models would be unaffected.

One of the primary reasons that debt, both public and private, was not included in the models was because there was not sufficient historical evidence on the levels of debt outstanding before, during, and after a financial crisis to justify inclusion in the models.  Kenneth Rogoff and Carmen Reinhart have attempted to eliminate this reason with their study of eight centuries of financial data presented in their book, “This Time is Different.”

Another reason why it is hard to study the burden of debt on a country is that the analysis of the risk associated with any given amount of debt is to a large extent psychological.  There seems to be little if any “tight” relationship between when the market determines that the amount of debt being carried by a country is excessive.  There seems to be no unique “trigger” to determine a sovereign debt crisis.

The bottom line is that the role of debt in the precipitation of a debt crisis is very, very complicated and the quantitative tools that exist are just not sufficient to fully capture any one specific situation.

As a consequence, the amount of debt a country carries is a judgment call, but the more debt a country accumulates the more it limits its future options and the more it loses control over the timing of any “crisis” that might occur.    

There seems to be other cases currently in the news pertaining to governmental decisions in areas that are very complicated and cannot be modeled in any satisfactory way. 

This is brought out very clearly is the column by Andrew Ross Sorkin in the New York Times this morning, “Two Views on Bank Rules: Salvation and Job Killers.” (http://dealbook.nytimes.com/2011/06/13/two-views-on-the-value-of-tough-bank-rules/?ref=business)

In this article, Mr. Sorkin re-plays the recent verbal exchange between Jamie Dimon of JPMorgan, Chase, and Ben Bernanke of the Board of Governors of the Federal Reserve System.  Mr. Dimon, among other things, questioned the ability of the Federal Reserve (of regulators) to understand the consequences of their regulatory actions.

Sorkin remarks, “it’s an uncomfortable truth that Mr. Dimon should be taken seriously, at least his suggestion that policy makers can’t predict the full impact of the coming regulation.”

Sorkin reports that when Mr. Bernanke answered Mr. Dimon’s question, he said, “Has anybody done a comprehensive analysis of the impact on credit? I can’t pretend that anybody really has. You know, it’s just too complicated. We don’t really have the quantitative tools to do that.”

Mr. Bernanke’s answer captures something that the economist Friedrich Hayek stated many years ago, that a central organization or one individual body can never possess sufficient information to make decisions that are dependent upon information that is dispersed widely throughout the economy and is relevant for “local” decision making.

With this statement, Mr. Bernanke loses more of the credibility that he had been trying to hang onto over the past eighteen months. 

The economic models that people and governments have been using over the past fifty years are inadequate, at best, and misleading in practice.  They work best when the economy is smoothly growing.  They just do not have sufficient data to handle the very complex situations that happen when things are not going smoothly.

As Hayek taught us, there is just too much relevant information for us to collect, store, and process and even if we could store it all, most of the information pertains to “local” situations that are way beyond our ability to model. 

Hayek also taught us that one of the major roles of the economist is to demonstrate to decision makers how little they really know about what they imagine they can design. 

In this respect, governments need to create the processes though which decisions are made and should not focus on the outcomes.  Outcomes are a result of those things a decision maker thinks he/she can “design” and this applies to bank regulation, unemployment targets, and so forth. 

 

To me the process of openness and disclosure is still the most important thing that a government can require…of itself…or of the organizations it is regulating.  When the government begins to determine what decisions should be made and what outcomes are to be attained, it begins to exceed its ability to succeed. 

And, as the government fails to attain the outcomes it wants, it asks for more control to gain those outcomes…and then more control…and then more control…

It's a High Frequency World

Gillian Tett raises some interesting questions in her Financial Times article today: “What can be done to slow high-frequency trading?” (http://www.ft.com/cms/s/0/d72966fa-bc2d-11df-8c02-00144feab49a.html)

She closes her piece with the most important economic question that can be asked: “To my mind, the real question which needs to be discussed—but which regulators are still ducking—is why ultra-fast trading is needed at all?”

The answer: people believe that they can make money if they have a slight edge in the speed at which they can make trades.

I don’t think that this answer is changed by going into the debate relating to the neurological research which argues that “the brain has two contradictory instincts: part of it is hard-wired to chase instant gratification; however, another part of our brain also has the ability to be ‘patient’, and delay immediate gratification for future gains.”

This is just the argument raised by the behavioral finance and economics researchers. (See my review of the book “Snap Judgment” for a discussion of this issue: http://seekingalpha.com/article/145660-book-review-snap-judgment-by-david-e-adler.) The general assumption that accompanies this train of thought is that “instinctional” behavior is irrational and therefore not productive.

To quote from Tett’s article, “in practice innovation…has a darker, impatient side too: as markets have become deeper, and more liquid, that has enabled trading to become more frenetic; similarly, as information has become more frequently available this has encouraged skittish, herd behavior.”

But, life is full of situations in which “instinct” or the ability to make quick decisions is of crucial importance. For example, we need military leaders that can make decisions “on-the-spot” as well as those that can plan out strategies for long, drawn-out battles. The military trains people over-and-over again to develop the perception and experience to make decisions in the “real time” that is necessary for winning battles and winning wars.

We can find examples in many fields where “immediate” action is needed. The education and training in these areas is intense and efforts are made to find the people that are the very best in their ability to diagnose a situation and come up with the “right decision” as often as possible.

The real difference is the capability of the person or persons making the decisions. In the military, in medicine, and in many other professions, there is a hierarchy in terms of who makes the decision. Hopefully, the people that rise to the top are those individuals that can perform well and are able to make good “snap” decisions if they are needed.

Sometimes there is licensing or other forms of identification that require test taking and hurdles to overcome in order to get the certification or advancement that will put the “right people” in the “right spot” for a specific type of “real time” decision.

In economics, these tests or hurdles are called “barriers to entry”.

In the trading of stocks and other investment vehicles, there are low barriers to entry into the industry and this includes the costs one must pay to enter an industry. As a consequence, there are many traders and not all of these have the “jet pilot” capabilities to execute trades at the speeds that are now available.

The crucial thing is that in areas where quick decisions need to be made, a premium is paid to those with the education and training, the experience, and the mental capacity to make such decisions. As I stated in the post cited above, successful decision making, over any time period, depends upon “cold analytical methodology and steely discipline, characteristics that most people, who rely too much on their instincts, don’t possess.” That is, some people are better decision makers than others, even in the very short run.

People are going to engage in an activity where they believe that they can make money. So high-frequency trading is going to take place. Individuals that cannot perform within such an environment are going to lose, and could lose a lot.

The concern of the other market participants is “what damage can these not-so-good traders do to the overall market?” As Ms. Tett states, one result of the move to high-frequency trading seems to be “more market volatility.”

The fear in this: “rising levels of speed, impatience—and short-terminism—might have actually made the (financial) system less efficient, and rational, than before” this increase in speed.

My feeling with this is that speed is something we are going to have to live with. I have argued this point before in my post “Banking at the Speed of Light”. (http://seekingalpha.com/article/208513-banking-at-the-speed-of-light) The point is that this “speed up” is happening all over the world in different kinds of decision making. It is just that high-frequency trading is getting a lot of publicity now and thus attracting a lot of debate.

In the post just mentioned, I cite the example of events happening in South Africa relating to the use of mobile phones by commercial banks to develop their customer base. In this example the discussion was around the 15 million adult South Africans that had previously been excluded from the financial system. And, the players in this effort are not small.

But, this points to another issue, the growing strength of the “new rising powers” in the world as discussed in an opinion piece in the Financial Times titled “The new disintegration of finance.” (See http://www.ft.com/cms/s/0/938e7228-bc55-11df-a42b-00144feab49a.html.) The authors, Stéphane Rottier and Nicolas Véron, are concerned about how the effort to organize and co-ordinate global financial regulation and supervision is facing issues that might reverse the trend to great co-operation. One of their concerns is that “Financial institutions from emerging countries are beginning to overtake their western peers. New financial centers are gaining market share, while emerging countries are asserting themselves in global financial rulemaking, and increasingly resist standards proposed by the member of the old north Atlantic consensus.”


This is the world of the future. This is how competition is going to progress. See “The New World Order: Smaller and Faster”, my post of August 31, 2010 (http://seekingalpha.com/article/223127-the-new-world-order-smaller-and-faster). I think most of you know how I feel about the ability of regulations to control this world. I think most of you know that I believe that many, if not most, of the big players have already moved beyond what American…and world…regulators are trying to do with respect to financial institutions and markets. Laws, regulations, and regulators must deal with processes and not “outcomes.” I have written about this many times in my posts.

Hold on, it is going to be an interesting and exciting ride!

Audits and Auditors

I would like to recommend to the readers of this post the column by Jennifer Hughes in the Financial Times this morning. The title of the article is “Lehman Case Revives Dark Memories of Enron”: http://www.ft.com/cms/s/0/c9516dea-3792-11df-88c6-00144feabdc0.html.

The issue at hand is the relationship between a firm and its external auditors. The reason for the attention given to this issue by Hughes is the examination of the collapse of Lehman Brothers by Anton Valukas. Although not a major thrust of the review, questions did arise in the study concerning the role of Lehman’s external auditor Ernst & Young in the accounting practices adopted by the firm.

Ernst & Young began auditing Lehman Brothers in 1994 and two Lehman of Chief Financial Officers came from this external auditor. One, David Goldfarb, joined Lehman in 1993 and became CFO of the firm in 2000. The other, Chris O’Meara, joined Lehman in 1994 and was the CFO from 2004 to 2007. It was under Goldfarb that the accounting policy with respect to “Repo 105” transactions was developed.

To Hughes, this brought up memories of the accounting relationship between Enron and the external auditing firm Arthur Andersen. Again, a very close relationship had been established between the two organizations and many Andersen staff worked for Enron over the years.

I am not out to just criticize the accounting profession and the good and proper working relations that exist between many companies and their external auditors. However, the relationship between companies and their auditors can become too cozy and can present the opportunity to do things with company books that are, let’s say, not quite what the owners would like them to pursue.

My interest in this relationship comes from my experience as a senior executive, including President and CEO, of several publically traded banking companies. Each case was a turnaround situation.

In such a situation it is vital to get the accounting books in order and presentable to shareholders and the investment community for their close scrutiny. Internally, it is good to have “fresh eyes” to perform such a review. In a troubled institution it is problematic to have the same people, from inside as well as from outside the organization, performing this exercise. The first reason for this, of course, is that these same people watched the organization become troubled and they have a self-interest in defending the status quo. This is neither good for the company nor the shareholders and, thus, certainly not good for the executives hoping to turn-around the firm.

But, this pointed me to the problem that the financial controls that had existed were not sufficient for the company or for the executives in charge to prevent the firm from collapsing into a troubled institution. So, either the work was not getting done adequately or the executives that had been in charge did not want the work to get done adequately. Either way, the situation was not a good one for the institution or the shareholders.

It became my rule that any organization in which I was the CEO would put the job of external auditor out for bids in the fifth year of an engagement. I felt this was necessary for me to keep on top of what was going on in the organization and to have “fresh eyes” review the books and the accounting procedures on a regular basis. Furthermore, doing this periodically encouraged the openness and transparency on the part of the employees that I believed was necessary for the shareholders and the investment community.

This “rule” of mine may have been a little severe, but I was doing turnarounds at that time and the tighter time schedule seemed important to me then. Perhaps a seven year turnover of external accountants would be better, except in cases where the CFO of the company happens to be a former employee of the accounting firm doing the external auditing.

Hughes mentions in her article that Italy, among other countries, have limits on audit firm tenure. There the length of time allowed is nine years. Other countries require that the “lead partner” from the accounting firm be changed every five years. Also, there are rules about hiring individuals from the external auditing firm, rules that require a “cooling off” period for anyone joining an audit client.

To me, this requirement seems of particular importance to banks and other financial institutions. Yes, the banks are examined by the regulators and this should provide a check on what banks are doing. But, this is not enough in my mind.

When I was a bank President and CEO, I wanted the bank to have stricter requirements on what it did than the regulators. The reason is that I wanted the company to control the position of the bank and not the regulators. This also applied to the safety and soundness of the bank. That is why I wanted to ensure that the external auditors were truly independent of me and the staff of the bank. Having the external auditor “turnover” on a regular basis was one way to help achieve this goal. To my mind, any CEO that has the best interests of his/her shareholders in mind would want this to be the case.

I know that this is not the case of all CEOs in all industries. That is why some regulation of company/external auditor relationships is important. This is true especially for the commercial banking industry. Any regulatory reform that is passed should have some statement about the presence of an external auditor and the regular replacement of external auditors. This is a first round effort to insure the safety and soundness of the banking system and should, if it existed, ease some of the burden placed on the examination efforts of the regulatory agencies. It is a part of the openness and transparency that should be required for all companies, but especially for those related to banking.

I know that there is little academic research, as Hughes reports, connecting “audit, or auditor tenure, and the quality of the work.” I know that most situations and people work out well. I know the value that hiring someone familiar with your books is a “good thing” because of the complexity and sophistication of accounting practices today.

Still, I always wanted to be on top of things and continually have “fresh eyes” looking over the operations and the books. I always wanted to be challenged to do things in the best way possible. I always wanted people to push me to do better. Openness and transparency never bothered me. To me, performance always went back to how well you executed your game plan and not on how much trickery or deception you needed to win.

To me, it all comes back to fundamentals and ability. If you lack one or the other or both…I guess you need to rely on other means, like “cooking the books”, to come out on top.

Tax Evasion?

In the last few days we have seen a ton of headlines and articles talking about how President Obama is going to tax the major banks of the country (including US branches of foreign banks) in order to recoup the bailout funds paid to the banks that went to save them.

The President pledged to “recover every single dime the American people are owed.”

Remember that Mr. Obama is the protector of the dime since he vowed that the health care plan would not cost the American public “one dime”!

The estimated bottom-line cost to the banking system is about $100 billion over a ten-year period.

The banking system is, of course, lobbying as hard as it can to prevent such a tax from being levied. And, lobbyists are earning a lot of money off of this.

But, the President has heard the voice of the little people who are angry at the bankers.

Oh, and then there is the need for new bank regulation.

The estimated cost of this new regulation is in the billions of dollars.

The banking system is, of course, lobbying as hard as it can to prevent such regulation from being inacted. And, lobbyists are earning a lot of money off of this.

But, the President has heard the voice of the little people who are angry at the bankers.

What can we bet on?

My experience in running banks and in studying banks and the banking industry is that the big banks will not, ultimately, pay much of the bill at all.

The reason for this is that the banks will find many, many ways to get around any new laws, regulations, and taxes or will pass the cost of the new laws, regulations, and taxes on to others.

Let me just say here that I don’t mean to single out just the banks in this area. In this Age of Information and with a global network of business and finance almost everyone that has wealth or financial clout or is big can find ways to avoid laws, regulations, and taxes. And, if you don’t believe this it just shows how good these people and organizations are at evading them.

And, the people and organizations that can evade or avoid these new laws, regulations, and taxes the best are the ones that the President and the “populists” are after. The people and businesses that are the least able to avoid the new laws, regulations, and taxes are those that can least afford the consequences of the new laws, regulations, and taxes. This will include the small- and medium-sized banks and people from Main Street. This has happened over and over again throughout history.

Just an example: in the 1960s it was almost the mantra of a certain brand of economist that a little inflation (an inflation tax, if you will) would help the “little people” because it would result in more employment. This was captured in something called “the Phillips Curve.”

The result? In the short run employment was a little higher but people found that inflationary expectations adjusted and over a longer period of time it took more and more inflation to sustain the small rise in employment associated with the higher inflation. By the end of the 1970s we had a real crisis!

Furthermore, those with more wealth or who were better connected could protect themselves from inflation. They could purchase assets, like homes, and art, and securities that appreciated in value with increases in prices. The less well-to-do or the less well-connected could not do this and so the wealth distribution in the country became more skewed.

Thirdly, higher and higher inflation affects productivity and this impacted the use of existing capital and the hiring of the less educated and less trained worker. Unused capacity in manufacturing and under-employment rose over time again hurting those that were the least able to protect themselves.

The purchasing power of the dollar declined from 1961 to the present: where one dollar could buy one dollar’s worth of goods at the former time, it could only buy 17 cents worth of goods now. And, who has suffered the most? Main Street and not Wall Street!

There are two forces dominating the banking scene right now and neither one of them can lead to the construction of sound banking regulations and banking practices. The first is the emotion of the present. People may be upset about what has happened and are particularly incensed at the profits that the large banks are posting. However, an emotional response to current events cannot lead to a rational result. Basing laws, regulations, and taxes on a populist outburst will only produce consequences that are regretted in the future.

Second, it has been my observation that politicians only fight the last war. This is popular because the “last war” is discussed in the press and it is what the constituents of the politicians are responding to. Furthermore, the issues are so complex that the politicians don’t even understand what happened in the “last war”. If you don’t believe this take a look at the initial work the Financial Crisis Inquiry Commission.

Finally, the big banks that the politicians are going after have already moved on “light years” ahead of what happened in the “last war”. I have written several posts on this very fact. Thus, the politicians are firing at the wake of a rapidly moving boat and will miss their target by a lot!

Oh, well, politicians have to get their 15 minutes of fame and try and get re-elected: Seems like we could spend our time concentrating of more productive efforts.

BIG BANK PROFITS

If anyone should be congratulated for the massive profits that have been posted by the “big banks” over the past nine months it should be Ben Bernanke and the Federal Reserve System. Since the real strength of the earnings, especially in banks like JPMorgan Chase, have been in investment banking and trading, one can argue that the Federal Reserve policy of keeping short-term interest rates near zero has subsidized the pockets of the big bankers. Thus one could ask if any of the huge bonuses being paid out by the “big banks” are going to the Chairman and his officers in the Federal Reserve System. They certainly deserve them!