I know that not all of these facts that I present below are new, but reading about the following five in the morning papers just reconfirmed my position on the future of the financial markets.
First and second, stock exchanges have become dominated by high-frequency trading and index funds.
Third, the combination of the Deutsche Bȍrse and the NYSE Euronext will continue the trend for exchanges to turn to derivatives and technology business. The model here seems to be the CME Group, “the world's leading and most diverse derivatives marketplace” which has a market capitalization that is larger than either of the two combining institutions.
Fourth, the Shanghai Stock Exchange and the BM&F Bovespa, Latin Americas largest exchange is going to announce an agreement which will include the fact that stocks will be cross-listed on both exchanges. This will put Brazilian and Chinese interests together, world-wide.
Fifth, the IBM computer named Watson beat the two “greatest” players on the TV program “Jeopardy!” This, of course, comes only a few years after an IBM computer beat the world champion of chess at his own game. And, this most recent battle of “wits” has set off a plethora of articles on the state of artificial intelligence. The advances are mind-boggling!
A sixth fact could be the unrest in the Middle East where a very serious challenge in being raised against local autocratic leaders. Part of the cause, information technology.
Why are these “facts” important to me?
They are all just another indication the spread of information and information technology continues and cannot be stopped. Not only are things happening faster, they are becoming more ubiquitous.
Once again, for those that have not yet read the book titled “The Quants”, you should because it gives us a glimpse of what the future is going to be like. (See my review: http://seekingalpha.com/article/188342-model-misbehavior-the-quants-how-a-new-breed-of-math-whizzes-conquered-wall-street-and-nearly-destroyed-it-by-scott-patterson.)
And, this is the world that Congress (and other bodies around the world) is trying to regulate?
But, regulating to prevent 2007 and beyond from happening again is not going to protect usin the future.
It is the world that Mr. Gary Gensler, the chairman of the CFTC is trying to get his arms around and control.
But, how do you grab hold of a “whiff of smoke”?
The above facts are dramatically showing that finance is information and that the storing, processing, analysis, use and dissemination of information is going to become more and more technologically advanced as time passes. In fact, it is going to happen faster and faster.
In the future, more and more finance is going to be “quantified”; trades are going to occur at even greater speeds; and information is going to be stored…somewhere…and transactions are going to happen…well, someplace.
Regulation cannot just focus on “outcomes”. Regulation cannot eliminate “systematic” risk.
Furthermore, regulation of the kind we are used to in the United States only takes place “after-the-fact.”
The only way to really gain some insight into what is going on in financial markets is to observe what the market is saying. That is, the only way to get some kind of “advance warning” about market trouble is to watch market information.
Such systems have been suggested. One such suggestion has been given for an “early warning” methodology for the banking system. I have discussed this methodology in several posts over the past year. I will refer to just one of these posts (http://seekingalpha.com/article/242467-america-must-start-again-on-financial-regulation) that references the work of Oliver Hart and Luigi Zingales. The system proposed by Hart and Zingales is a market-based system that can raise “red flags” that regulators can respond to. In this way their system is “anticipatory” and not “reactive.”
Still, this world of the future must avoid some of the problems of the past. No regulatory system is going to be able to survive a regime of undisciplined governmental policy like we have seen in the United States over the past fifty years. Credit inflation undermines an economy and destroys discipline. (See my post http://seekingalpha.com/article/253145-deficits-credit-inflation-and-the-dollar.)
This must be considered within a world that is going through a period of transition that is monumental. Major shifts are taking place everywhere and we really don’t know what the ultimate result is going to be. However, we are moving away from a “labor”-based, manufacturing system to a “knowledge”-based society embedded within whatever the current information technology allows. The government cannot continue to base macro-economic policy on the assumption that the structure of the world still rests on the old, labor-based manufacturing system. It will just perpetuate the errors of the past.
As advancing technology allows us to do “finance” faster and in more ubiquitous ways, the techniques and tools of finance will just be used to take advantage of the credit inflation created by governments. Remember it is the wealthiest, the most trained, and the best positioned that will be able to take full advantage of the incentives created by further credit inflation.
What proof do I have for this?
Take a look at the last fifty years of credit inflation. What have been two of the fastest growing sectors in the economy?
The answer is: information technology and finance. And, these two sectors have complemented each other very well. Computer-based financial innovation has thrived in this environment of credit inflation. In fact, no other environment is so conducive to financial innovation than is an environment based on credit inflation.
And, the results of the past fifty years?
The purchasing power of the dollar has declined by about 85%. Under-employment of the working force is somewhere in excess twenty percent. And, the income distribution has become radically skewed toward the wealthier end of the scale. Need I say more?
Showing posts with label derivatives. Show all posts
Showing posts with label derivatives. Show all posts
Thursday, February 17, 2011
Tuesday, July 6, 2010
Ho-hum, the Financial Reform Bill is Going to be Passed
Perhaps the most benign statement about the passage of the United States financial reform bill passed by the House of Representatives last week and whose passage is pending in the Senate comes from Richard Bove, banking analyst at Rochdale Securities: The bill, he states, “doesn’t seem to be terribly onerous.” (See “JPMorgan Brushes Aside Bill Concerns,” http://www.ft.com/cms/s/0/24bcbc8c-8858-11df-aade-00144feabdc0.html.)
In terms of the regulation of swaps, especially credit default swaps, “The once-feared swap provision has become toothless.”
The recent debate in Congress over the financial reform bill: A lot of “sound and fury signifying nothing.”
This legislation, the most comprehensive reform of the financial system since the 1930s, seems be passing into the history books with very little fanfare.
Sure, the financial institutions “huffed and puffed” and spent tons of money to fight Congress “every inch of the way.” But, what else did you expect. Perhaps you need to read a good economics book on “Game Theory”.
And, now?
Can’t you hear the executives at the big banks say, under their breath, “Well, the bill is passed, now we need to get back to business. Sure we spent a lot of money that could have gone elsewhere, but that is now history. In terms of where we are going to focus in the future, we just continue doing what we have been doing, finding the best way to do business and to make money. The bill, itself, will cause some inconvenience in some areas, hurt the smaller institutions more than the larger ones, but will not basically change what we are going to be doing.”
The article cited above states it all. JPMorgan acquired a large energy and metals trader last week. How will the financial reform bill impact this deal? After all, “Commodities are among a handful of derivatives still targeted…” by the bill.
The author of the article writes: “Blythe Masters, head of commodities at JPMorgan, said the bank already traded most energy through an affiliate and the law would ‘not substantially’ affect business.”
I have been arguing for months that the large banks had already moved beyond the reach of the regulations being discussed in Congress and that anything enacted by the legislators would be DOA, “dead on arrival.” The large banks started to reform and restructure themselves soon after the fall of 2008 when the financial crisis was at its peak! By the spring of 2009 these banks were well on the way to the future.
Congress, on the other hand, was mired in the past.
JPMorgan, to my mind, is one of the organizations leading us into the future. See, for example, my blog post “Follow the Dimon,” (http://seekingalpha.com/article/212236-follow-the-dimon). But, there are many others that are also out there pushing finance into the future.
Similar discussion are taking place in all areas of the finance field. Just this morning, the Wall Street Journal contained the article “What’s a ‘Prop’ Trader Now?” relating to the proprietary trading that many of the largest financial institutions engage in. (See, http://online.wsj.com/article/SB10001424052748703620604575349161970563670.html?mod=ITP_moneyandinvesting_0&mg=com-wsj.) The article addresses issues like, “What are ‘Prop’ traders?” and “How are banks redefining ‘Prop’ traders?” and “Where are ‘Prop’ traders located within the organization?”
The answers to these questions will help the larger financial institutions “churn out” billions of dollars in profits. Thus, the banks are willing to spend millions of dollars in hiring “the best and the brightest” lawyers and financial experts to come up with the answers. Congress is just not capable of matching the resources available to these publically-traded firms and so will lag behind what is going on in the private sector. To me, the information “gap” between the public sector and the private sector has never been larger.
The problem is that Congress is attempting to achieve “outcomes”. They want to keep banks from becoming “too big to fail” and to keep banks from taking on too much risk. Historically, we see that laws and regulations that seek “outcomes” are bound to fail because, specifying “outcomes” tells those being regulated what they have to “get around”, what they have to “evade.”
In this Age of Information, it has become exceedingly easy to “get around” laws and regulations and “evade” the restrictions imposed by the legislators and regulators. (See the series of posts I began on January 25, 2010, “Financial Regulation in the Information Age”: http://seekingalpha.com/article/184153-financial-regulation-in-the-information-age-part-a.)
Laws and regulations work better when they are aimed at processes, the way that the regulated firms do business. These kinds of rules and regulations have to do with information flow (corporate disclosure and transparency), how trades are made, how trades are constructed, margin requirements, and so forth. One can see successful examples of “process” oversight in the creation of the Financial Futures Market and the Options Market in the latter part of the 20th century.
A proposal for overseeing the assumption of risk by financial institutions has been put forward by Oliver Hart, an economics professor at Harvard, and Luigi Zingales, an economics professor at the University of Chicago, in the Spring 2010 copy of National Affairs, titled “Curbing Risk on Wall Street,” (http://www.nationalaffairs.com/publications/detail/curbing-risk-on-wall-street). I have threatened several times to present a critique of this proposal in one of my posts. Hopefully, I will accomplish this soon for the Hart/Zingales proposal, I believe, offers a lot for people to consider.
So, the world goes on. The financial reform package will be passed. Banking and finance will continue to thrive. Big banks will get bigger and there will be fewer and fewer small banks. Hedge funds and venture capital funds will, in general, continue to do what they do well. And, sometime in the future there will be another financial crisis.
Things are not different.
End note: for a “good read” check the lead article in the business section of the New York Times on Sunday about Ken Rogoff and Carman Reinhart and their book “This Time Is Different”: http://www.nytimes.com/2010/07/04/business/economy/04econ.html?_r=1&scp=1&sq=ken%20rogoff%20and%20carmen%20reinhart&st=cse.
In terms of the regulation of swaps, especially credit default swaps, “The once-feared swap provision has become toothless.”
The recent debate in Congress over the financial reform bill: A lot of “sound and fury signifying nothing.”
This legislation, the most comprehensive reform of the financial system since the 1930s, seems be passing into the history books with very little fanfare.
Sure, the financial institutions “huffed and puffed” and spent tons of money to fight Congress “every inch of the way.” But, what else did you expect. Perhaps you need to read a good economics book on “Game Theory”.
And, now?
Can’t you hear the executives at the big banks say, under their breath, “Well, the bill is passed, now we need to get back to business. Sure we spent a lot of money that could have gone elsewhere, but that is now history. In terms of where we are going to focus in the future, we just continue doing what we have been doing, finding the best way to do business and to make money. The bill, itself, will cause some inconvenience in some areas, hurt the smaller institutions more than the larger ones, but will not basically change what we are going to be doing.”
The article cited above states it all. JPMorgan acquired a large energy and metals trader last week. How will the financial reform bill impact this deal? After all, “Commodities are among a handful of derivatives still targeted…” by the bill.
The author of the article writes: “Blythe Masters, head of commodities at JPMorgan, said the bank already traded most energy through an affiliate and the law would ‘not substantially’ affect business.”
I have been arguing for months that the large banks had already moved beyond the reach of the regulations being discussed in Congress and that anything enacted by the legislators would be DOA, “dead on arrival.” The large banks started to reform and restructure themselves soon after the fall of 2008 when the financial crisis was at its peak! By the spring of 2009 these banks were well on the way to the future.
Congress, on the other hand, was mired in the past.
JPMorgan, to my mind, is one of the organizations leading us into the future. See, for example, my blog post “Follow the Dimon,” (http://seekingalpha.com/article/212236-follow-the-dimon). But, there are many others that are also out there pushing finance into the future.
Similar discussion are taking place in all areas of the finance field. Just this morning, the Wall Street Journal contained the article “What’s a ‘Prop’ Trader Now?” relating to the proprietary trading that many of the largest financial institutions engage in. (See, http://online.wsj.com/article/SB10001424052748703620604575349161970563670.html?mod=ITP_moneyandinvesting_0&mg=com-wsj.) The article addresses issues like, “What are ‘Prop’ traders?” and “How are banks redefining ‘Prop’ traders?” and “Where are ‘Prop’ traders located within the organization?”
The answers to these questions will help the larger financial institutions “churn out” billions of dollars in profits. Thus, the banks are willing to spend millions of dollars in hiring “the best and the brightest” lawyers and financial experts to come up with the answers. Congress is just not capable of matching the resources available to these publically-traded firms and so will lag behind what is going on in the private sector. To me, the information “gap” between the public sector and the private sector has never been larger.
The problem is that Congress is attempting to achieve “outcomes”. They want to keep banks from becoming “too big to fail” and to keep banks from taking on too much risk. Historically, we see that laws and regulations that seek “outcomes” are bound to fail because, specifying “outcomes” tells those being regulated what they have to “get around”, what they have to “evade.”
In this Age of Information, it has become exceedingly easy to “get around” laws and regulations and “evade” the restrictions imposed by the legislators and regulators. (See the series of posts I began on January 25, 2010, “Financial Regulation in the Information Age”: http://seekingalpha.com/article/184153-financial-regulation-in-the-information-age-part-a.)
Laws and regulations work better when they are aimed at processes, the way that the regulated firms do business. These kinds of rules and regulations have to do with information flow (corporate disclosure and transparency), how trades are made, how trades are constructed, margin requirements, and so forth. One can see successful examples of “process” oversight in the creation of the Financial Futures Market and the Options Market in the latter part of the 20th century.
A proposal for overseeing the assumption of risk by financial institutions has been put forward by Oliver Hart, an economics professor at Harvard, and Luigi Zingales, an economics professor at the University of Chicago, in the Spring 2010 copy of National Affairs, titled “Curbing Risk on Wall Street,” (http://www.nationalaffairs.com/publications/detail/curbing-risk-on-wall-street). I have threatened several times to present a critique of this proposal in one of my posts. Hopefully, I will accomplish this soon for the Hart/Zingales proposal, I believe, offers a lot for people to consider.
So, the world goes on. The financial reform package will be passed. Banking and finance will continue to thrive. Big banks will get bigger and there will be fewer and fewer small banks. Hedge funds and venture capital funds will, in general, continue to do what they do well. And, sometime in the future there will be another financial crisis.
Things are not different.
End note: for a “good read” check the lead article in the business section of the New York Times on Sunday about Ken Rogoff and Carman Reinhart and their book “This Time Is Different”: http://www.nytimes.com/2010/07/04/business/economy/04econ.html?_r=1&scp=1&sq=ken%20rogoff%20and%20carmen%20reinhart&st=cse.
Wednesday, March 10, 2010
A Time for Crybabies
The headlines of the day: “European Leaders Call for Crackdown on Derivatives” (http://www.nytimes.com/2010/03/10/business/global/10swaps.html?hpw) and “Call for Action on Speculation Rules” (http://www.ft.com/cms/s/0/7a22b968-2bad-11df-a5c7-00144feabdc0.html).
Alternative headlines to these are “Financial Markets Call for Crackdown on Undisciplined and Irresponsible Government Budget Behavior” or “Call for Action on Fiscal Policy Biases.”
This is the time for cry-babies and the leaders of many nations in the world are not letting us down.
Their basic theme is “All our problems can be laid at the feet of the financial community, its innovations, and its speculative behavior. We need better and tougher regulation and we need stricter laws and rules about what can be done. Doing this will make everything better!”
This, however, is getting “cause and effect” turned around!
My question is, “Who created the inflationary environment of the last fifty or sixty years that resulted in the financial innovation and speculation that resulted? Who promoted almost perpetual government budget deficits, in recessions as well as booms, and who underwrote this deficit spending with supportive monetary policies that encouraged the expansions but fought the contractions? Who is responsible for the 85% decline in the purchasing power of the United
States dollar since January 1961?”
The stage was set in the United States in 1946 when Congress passed the “Full Employment Act of 1946.” In 1961, an administration took over the presidency that was devoted to the Keynesian full employment policy. In 1971, President Nixon in an effort to stimulate the economy to get himself re-elected claimed that “We are all Keynesians now!” In this effort to get re-elected, Nixon appointed Arthur Burns as the Chairman of the Board of Governors of the Federal Reserve System. Monetary policy supported the effort to achieve the economic goals Nixon believed he needed to have in order to get re-elected. Then in 1978, Congress enacted the “Full Employment and Balanced Growth Act”, often referred to as the “Humphrey-Hawkins Full Employment Act.”
The true test of government monetary and fiscal policy, as written into the law of the land was full employment and high levels of economic growth. And, explicitly or implicitly, countries throughout the free world followed this pattern in the post World War II world.
And, what resulted from this policy bias?
Well, by the last half of 1968 we had high-grade corporate bond rates in the 6.5% range. These yields had not really gotten much above 4% until late 1959 into 1960, and did not cross 5% until the middle of the latter decade. It was during the late 1960s that researchers started discussing the presence of “inflationary expectations” in interest rates, a concern that vanished toward the end of the 1920s.
In the 1960s we also saw the first real post-World War II financial innovation take place. The primary source of business credit at that time was the commercial banks. As the presence of inflation spread and in order to expand their capacity to lend and to compete against banks worldwide, United States commercial banks developed the negotiable Certificate of Deposit, the Euro dollar, and the use of Commercial Paper to raise funds through bank holding companies. Large banks ceased to have funding limits on their ability to raise money to lend. This was an omen for the future.
In August 1971, President Nixon froze wages and prices and took the United States off of the gold standard. Inflation had obviously reached a point where it had become a concern of the nation.
The bid to get Nixon re-elected re-ignited inflationary pressures and his predecessor Gerald Ford attempted to Whip Inflation Now! (The WIN campaign) By the middle of 1979 inflation had become so bad in the United States that President Jimmy Carter had to appoint someone of the prestige of Paul Volcker to take over at the Fed and “get serious” about the high levels of inflation existing in the country.
In the 1980s financial innovation was rampant. One only needs to go to the Michael Lewis book, “Liar’s Poker” to get an idea of how much financial innovation had taken over Wall Street by the middle of the decade. Increasing tensions between the Reagan administration and Volcker resulted in Volcker resigning in August 1987. Someone much more conciliatory, Alan Greenspan, got appointed Fed Chairman.
All one needs to be said about Greenspan is that the term the “Greenspan put” was created during his tenure. Greenspan supported economic expansion, but protected financial markets on the downside. In the 1990s the United States experienced credit bubbles, the best known being the dot-com boom…and bust. The 2000s saw bubbles in both the housing market and the stock market. And, during the credit inflation of the 1990s and the 2000s financial innovation exploded!
And, I haven’t touched on the governmental deficits created since the 1980s that the Federal
Reserve was helping to underwrite. But, enough said about the United States.
Leaders throughout the free world behaved in this manner through much of the last fifty years. There were, of course, earlier periods in which the cry-babies came out. This occurred numerous times, but the blame then was placed on those “shadowy people” known as “the international bankers.” Government deficits and loose monetary policy resulted in a sell-off of the currency of the country. This sell-off continued until the government made some efforts to bring on fiscal discipline and give some independence to its central bank. But, again, the governments assumed little of the blame; it was always the fault of “the bankers”.
Governmental leaders just don’t get it. Inflation becomes the music that everyone has to dance to. As long as inflation continues the dance goes on. As Charles “Chuck” Prince III, the former CEO of Citigroup famously said, “As long as the music continues to play, you must keep dancing.” And people and governments kept borrowing, bankers and other financial geniuses continued to craft new financial innovations, and bonuses continued to rise. And the music went on and on…
One of the difficulties of economics is that in most situations it takes time for things to work themselves out. That is, there can sometimes be a long lapse of time between the cause of something and the effect that the action brings about.
A classic example given is the long run impact of rent controls. Rent controls are great for renters in the short run. But, if low rents result in landlords reducing the amount of maintenance applied to the rent-controlled properties, the properties deteriorate in quality. Blame is then assessed against the greedy landlords and not against the rent controls.
We see a similar situation in the case of the financial speculation the governmental leaders are crying out against. Blame is assessed against the “bankers” and not against those that created the inflationary environment that produced the financial innovation and subsequent financial transactions. Unfortunately, a lot of people, those that can’t really defend themselves, get hurt in the process.
Whereas the renters got hurt in the previous example; workers, the people that were being helped by the governmental policies, are the ones that end up suffering when the music ends and people stop dancing. See “Irish Take Bitter Medicine to Survive Age of Red Ink”: http://online.wsj.com/article/SB20001424052748704486504575097672075207734.html#mod=todays_us_page_one.
Alternative headlines to these are “Financial Markets Call for Crackdown on Undisciplined and Irresponsible Government Budget Behavior” or “Call for Action on Fiscal Policy Biases.”
This is the time for cry-babies and the leaders of many nations in the world are not letting us down.
Their basic theme is “All our problems can be laid at the feet of the financial community, its innovations, and its speculative behavior. We need better and tougher regulation and we need stricter laws and rules about what can be done. Doing this will make everything better!”
This, however, is getting “cause and effect” turned around!
My question is, “Who created the inflationary environment of the last fifty or sixty years that resulted in the financial innovation and speculation that resulted? Who promoted almost perpetual government budget deficits, in recessions as well as booms, and who underwrote this deficit spending with supportive monetary policies that encouraged the expansions but fought the contractions? Who is responsible for the 85% decline in the purchasing power of the United
States dollar since January 1961?”
The stage was set in the United States in 1946 when Congress passed the “Full Employment Act of 1946.” In 1961, an administration took over the presidency that was devoted to the Keynesian full employment policy. In 1971, President Nixon in an effort to stimulate the economy to get himself re-elected claimed that “We are all Keynesians now!” In this effort to get re-elected, Nixon appointed Arthur Burns as the Chairman of the Board of Governors of the Federal Reserve System. Monetary policy supported the effort to achieve the economic goals Nixon believed he needed to have in order to get re-elected. Then in 1978, Congress enacted the “Full Employment and Balanced Growth Act”, often referred to as the “Humphrey-Hawkins Full Employment Act.”
The true test of government monetary and fiscal policy, as written into the law of the land was full employment and high levels of economic growth. And, explicitly or implicitly, countries throughout the free world followed this pattern in the post World War II world.
And, what resulted from this policy bias?
Well, by the last half of 1968 we had high-grade corporate bond rates in the 6.5% range. These yields had not really gotten much above 4% until late 1959 into 1960, and did not cross 5% until the middle of the latter decade. It was during the late 1960s that researchers started discussing the presence of “inflationary expectations” in interest rates, a concern that vanished toward the end of the 1920s.
In the 1960s we also saw the first real post-World War II financial innovation take place. The primary source of business credit at that time was the commercial banks. As the presence of inflation spread and in order to expand their capacity to lend and to compete against banks worldwide, United States commercial banks developed the negotiable Certificate of Deposit, the Euro dollar, and the use of Commercial Paper to raise funds through bank holding companies. Large banks ceased to have funding limits on their ability to raise money to lend. This was an omen for the future.
In August 1971, President Nixon froze wages and prices and took the United States off of the gold standard. Inflation had obviously reached a point where it had become a concern of the nation.
The bid to get Nixon re-elected re-ignited inflationary pressures and his predecessor Gerald Ford attempted to Whip Inflation Now! (The WIN campaign) By the middle of 1979 inflation had become so bad in the United States that President Jimmy Carter had to appoint someone of the prestige of Paul Volcker to take over at the Fed and “get serious” about the high levels of inflation existing in the country.
In the 1980s financial innovation was rampant. One only needs to go to the Michael Lewis book, “Liar’s Poker” to get an idea of how much financial innovation had taken over Wall Street by the middle of the decade. Increasing tensions between the Reagan administration and Volcker resulted in Volcker resigning in August 1987. Someone much more conciliatory, Alan Greenspan, got appointed Fed Chairman.
All one needs to be said about Greenspan is that the term the “Greenspan put” was created during his tenure. Greenspan supported economic expansion, but protected financial markets on the downside. In the 1990s the United States experienced credit bubbles, the best known being the dot-com boom…and bust. The 2000s saw bubbles in both the housing market and the stock market. And, during the credit inflation of the 1990s and the 2000s financial innovation exploded!
And, I haven’t touched on the governmental deficits created since the 1980s that the Federal
Reserve was helping to underwrite. But, enough said about the United States.
Leaders throughout the free world behaved in this manner through much of the last fifty years. There were, of course, earlier periods in which the cry-babies came out. This occurred numerous times, but the blame then was placed on those “shadowy people” known as “the international bankers.” Government deficits and loose monetary policy resulted in a sell-off of the currency of the country. This sell-off continued until the government made some efforts to bring on fiscal discipline and give some independence to its central bank. But, again, the governments assumed little of the blame; it was always the fault of “the bankers”.
Governmental leaders just don’t get it. Inflation becomes the music that everyone has to dance to. As long as inflation continues the dance goes on. As Charles “Chuck” Prince III, the former CEO of Citigroup famously said, “As long as the music continues to play, you must keep dancing.” And people and governments kept borrowing, bankers and other financial geniuses continued to craft new financial innovations, and bonuses continued to rise. And the music went on and on…
One of the difficulties of economics is that in most situations it takes time for things to work themselves out. That is, there can sometimes be a long lapse of time between the cause of something and the effect that the action brings about.
A classic example given is the long run impact of rent controls. Rent controls are great for renters in the short run. But, if low rents result in landlords reducing the amount of maintenance applied to the rent-controlled properties, the properties deteriorate in quality. Blame is then assessed against the greedy landlords and not against the rent controls.
We see a similar situation in the case of the financial speculation the governmental leaders are crying out against. Blame is assessed against the “bankers” and not against those that created the inflationary environment that produced the financial innovation and subsequent financial transactions. Unfortunately, a lot of people, those that can’t really defend themselves, get hurt in the process.
Whereas the renters got hurt in the previous example; workers, the people that were being helped by the governmental policies, are the ones that end up suffering when the music ends and people stop dancing. See “Irish Take Bitter Medicine to Survive Age of Red Ink”: http://online.wsj.com/article/SB20001424052748704486504575097672075207734.html#mod=todays_us_page_one.
Monday, April 13, 2009
Are Banks Telling the Truth?
On the front page of the Financial Times this morning we read the disconcerting headlines, “’Tarp cop’ to investigate whether banks have ‘cooked their books.’” (See http://www.ft.com/cms/s/0/163c85c4-2789-11de-9b77-00144feabdc0.html.) Neil Barofsky, special investigator-general for the Troubled Asset Relief Program (TARP), is “seeking evidence of wrongdoing on the part of banks receiving help from the fund.”
The game—“institutions applying for TARP money had to show they were fundamentally sound, potentially prompting them to misstate assets and liabilities.” Barofsky is quoted as saying, “I hope we don’t find a single bank that’s cooked its books to try to get money but I don’t think that’s going to be the case.”
Mr. Barofsky also said the Treasury’s expanded Term Asset-Backed Securities Loan Facility (TALF) was ripe for fraud.
The potential—fraudsters would be receiving indictments!
Two thoughts cross my mind when reading this. First, bankers in deteriorating situations tend to hide their heads in the sand when it comes to bad assets because they keep hoping that things will get better and the assets will recover their value. Having (successfully) completed several bank turnarounds I have found that this is one of the first things that becomes obvious when you initially investigate the loans and other assets of a troubled institution. Bankers, lenders, or portfolio managers continually think that ‘the economy will turn around’ or that ‘the company is getting its act in order’ or that some other event will come along that will result in the ‘asset gone bad’ becoming the ‘asset has become good again.’ And, so the asset is carried along but never comes back to life.
The problem with this is that these bad assets continually undermine the ability of the financial institution to right itself and become profitable again. The example is always there on the books of the banks and whether the executives or officers admit the fact, internally they know that things are not right and this drains efforts to instill a healthy culture to “do the right thing.” Managements that allow this unhealthy culture to continue are just perpetrating a bad situation, one that very rarely ever turns itself around.
The managements that participate in such a charade tend to be desperate and susceptible to moving to the next step when they are thrown a life boat like many financial institutions received in the past nine months or so.
Before following up on this point, let me just say that, historically, the bank either brings in someone to turn the institution around, or, a regulatory agency steps in and dissolves the organization. The American banking system has worked very well in the past with respect to “sick” banks. Contagion has been avoided through quick action connected with the swift resolution of problem assets. Financial institutions that were in trouble were taken care of—period!
But, that is not the case in the current situation. We have had a bailout. The banks have been tossed a life boat. However, financial institutions were supposed to be “fundamentally sound” in order to obtain TARP money. Here we get into the muddy waters of conducting a “general” bailout.
Let me just say that I have been suspicious from the start when government officials claimed that the need for the TARP funds was because the banks were facing “a liquidity problem” with respect to their troubled assets.
Again, my experience in doing bank turnaround’s is that the officers of the bank that claimed their assets were in trouble because of liquidity problems were attempting to cover up the real difficulties connected with the assets which were almost always associated with the issue of solvency.
It would not be much of a surprise to me to hear that the banks justified to the government that they were “fundamentally sound” because their asset problems were associated with liquidity issues rather than ones of solvency. This assessment could perhaps be supported if government officials only took a cursory glance at the assets. But, one could argue that this is the conclusion that government officials wanted to hear at that time.
Is this fraud? That is what Mr. Barofsky is going to have to find out.
Other than outright “cooking of the books”, in many cases the distinction between liquidity and solvency may fall back on an argument about “judgment”, about the “eye of the beholder.” Thus, Mr. Barofsky is going to have his problems proving his case.
In my opinion, many of the banks that received bailout relief had and still have a solvency problem and until the situation is handled that way the dislocations associated with the banking industry and the financial markets are going to continue. Consequently, I believe that Mr. Barofsky and others are going to find evidence that all along the issue has been solvency and not liquidity. If so, then there is a real issue of whether or not that these institutions that received TARP money were “fundamentally sound.”
My second thought on this issue is a very simple one. If people inside the banks covered up the real issues related to solvency heads should roll. Those that committed fraud should be indicted! Those that knowingly misled should be dismissed!
And, top executives, even though they were not directly involved in fraud or in a cover up, should be removed from their positions as well. They have proven that they cannot manage their institutions with sufficient control to justify their ability to move those institutions on into the future. The “buck stops with the top position” and the argument that they didn’t know what was going on is insufficient. It was their responsibility to know what was going on!
Risk management, the other “bug-in-the-coffee”, and financial control are not glamorous pursuits, especially when compared with the “jet pilots” of finance that were tossing around all sorts of money chasing narrow spreads with lots and lots of leverage. Performance over time, however, is closely related to an institution’s ability to successfully exert risk management and financial control.
We have to know what is going on in the banks and other financial institutions. The pressure needs to be stepped up to find out where things are. And, the sooner this pressure is exerted the sooner we will be able to find ways out of the mess we are in.
And this brings me to one final point. The Financial Times also had another headline on its front page that I found disturbing. The article cried out “AIG in derivatives spotlight.” (See http://www.ft.com/cms/s/0/cb2ddafc-278c-11de-9b77-00144feabdc0.html.) “The unit that all but destroyed AIG has failed to sign up for the overhaul of the global derivatives market, which was given added impetus by the troubles at the US insurance group.” The government is involved with AIG—the government owns most of AIG. It is mind boggling to me that a government that supposedly wants to bring greater openness and transparency to the financial markets allowed this to happen!
The game—“institutions applying for TARP money had to show they were fundamentally sound, potentially prompting them to misstate assets and liabilities.” Barofsky is quoted as saying, “I hope we don’t find a single bank that’s cooked its books to try to get money but I don’t think that’s going to be the case.”
Mr. Barofsky also said the Treasury’s expanded Term Asset-Backed Securities Loan Facility (TALF) was ripe for fraud.
The potential—fraudsters would be receiving indictments!
Two thoughts cross my mind when reading this. First, bankers in deteriorating situations tend to hide their heads in the sand when it comes to bad assets because they keep hoping that things will get better and the assets will recover their value. Having (successfully) completed several bank turnarounds I have found that this is one of the first things that becomes obvious when you initially investigate the loans and other assets of a troubled institution. Bankers, lenders, or portfolio managers continually think that ‘the economy will turn around’ or that ‘the company is getting its act in order’ or that some other event will come along that will result in the ‘asset gone bad’ becoming the ‘asset has become good again.’ And, so the asset is carried along but never comes back to life.
The problem with this is that these bad assets continually undermine the ability of the financial institution to right itself and become profitable again. The example is always there on the books of the banks and whether the executives or officers admit the fact, internally they know that things are not right and this drains efforts to instill a healthy culture to “do the right thing.” Managements that allow this unhealthy culture to continue are just perpetrating a bad situation, one that very rarely ever turns itself around.
The managements that participate in such a charade tend to be desperate and susceptible to moving to the next step when they are thrown a life boat like many financial institutions received in the past nine months or so.
Before following up on this point, let me just say that, historically, the bank either brings in someone to turn the institution around, or, a regulatory agency steps in and dissolves the organization. The American banking system has worked very well in the past with respect to “sick” banks. Contagion has been avoided through quick action connected with the swift resolution of problem assets. Financial institutions that were in trouble were taken care of—period!
But, that is not the case in the current situation. We have had a bailout. The banks have been tossed a life boat. However, financial institutions were supposed to be “fundamentally sound” in order to obtain TARP money. Here we get into the muddy waters of conducting a “general” bailout.
Let me just say that I have been suspicious from the start when government officials claimed that the need for the TARP funds was because the banks were facing “a liquidity problem” with respect to their troubled assets.
Again, my experience in doing bank turnaround’s is that the officers of the bank that claimed their assets were in trouble because of liquidity problems were attempting to cover up the real difficulties connected with the assets which were almost always associated with the issue of solvency.
It would not be much of a surprise to me to hear that the banks justified to the government that they were “fundamentally sound” because their asset problems were associated with liquidity issues rather than ones of solvency. This assessment could perhaps be supported if government officials only took a cursory glance at the assets. But, one could argue that this is the conclusion that government officials wanted to hear at that time.
Is this fraud? That is what Mr. Barofsky is going to have to find out.
Other than outright “cooking of the books”, in many cases the distinction between liquidity and solvency may fall back on an argument about “judgment”, about the “eye of the beholder.” Thus, Mr. Barofsky is going to have his problems proving his case.
In my opinion, many of the banks that received bailout relief had and still have a solvency problem and until the situation is handled that way the dislocations associated with the banking industry and the financial markets are going to continue. Consequently, I believe that Mr. Barofsky and others are going to find evidence that all along the issue has been solvency and not liquidity. If so, then there is a real issue of whether or not that these institutions that received TARP money were “fundamentally sound.”
My second thought on this issue is a very simple one. If people inside the banks covered up the real issues related to solvency heads should roll. Those that committed fraud should be indicted! Those that knowingly misled should be dismissed!
And, top executives, even though they were not directly involved in fraud or in a cover up, should be removed from their positions as well. They have proven that they cannot manage their institutions with sufficient control to justify their ability to move those institutions on into the future. The “buck stops with the top position” and the argument that they didn’t know what was going on is insufficient. It was their responsibility to know what was going on!
Risk management, the other “bug-in-the-coffee”, and financial control are not glamorous pursuits, especially when compared with the “jet pilots” of finance that were tossing around all sorts of money chasing narrow spreads with lots and lots of leverage. Performance over time, however, is closely related to an institution’s ability to successfully exert risk management and financial control.
We have to know what is going on in the banks and other financial institutions. The pressure needs to be stepped up to find out where things are. And, the sooner this pressure is exerted the sooner we will be able to find ways out of the mess we are in.
And this brings me to one final point. The Financial Times also had another headline on its front page that I found disturbing. The article cried out “AIG in derivatives spotlight.” (See http://www.ft.com/cms/s/0/cb2ddafc-278c-11de-9b77-00144feabdc0.html.) “The unit that all but destroyed AIG has failed to sign up for the overhaul of the global derivatives market, which was given added impetus by the troubles at the US insurance group.” The government is involved with AIG—the government owns most of AIG. It is mind boggling to me that a government that supposedly wants to bring greater openness and transparency to the financial markets allowed this to happen!
Wednesday, January 28, 2009
Are Derivatives the Problem?
Bob Shiller, the Yale economist, has gotten a lot of press in recent days supporting the use of derivatives and arguing against the use of the efficient markets model in understanding financial (and non-financial) markets. I am supportive of what he is trying to say. In this post I present my reasoning for this support…you can go to Bob’s articles in the Wall Street Journal and elsewhere and his upcoming book (along with his many other books) to get his view.
First, human beings are innovators. They are problem solvers and are constantly pushing the edge trying to come up with something new that makes things better.
The problem we are dealing with here is risk. People, investors, don’t like risk. They are constantly trying to reduce risk in their lives…and they are willing to pay to reduce risk.
And, this is the essence of derivatives. Derivatives are risk reducing tools that can be used to hedge cash flows and thereby protect individuals from assuming more risk than they would like. People will pay for this…derivatives will get invented.
Answer me this…will a large number of people pay someone to invent a tool for increasing risk? The answer to this is no! People don’t pay people to build speculative instruments. The expected return to speculation is zero or less. Now how much will you pay for someone to create a tool that can provide you with an expected return of zero or less? Right…nothing!
People will pay innovators to build instruments that help to reduce risk because they are receiving value by being able to reduce the risk. Now this does not mean that people will not use these risk reducing instruments to speculate with. Hedging is providing a cash flow to offset the movements of all or part of another uncertain cash flow. Speculation means that you are taking an uncovered position…that is, you are working with only one of the cash flows.
So, like other innovations, derivatives have been created for a positive reason…but can be used in ways that increase risk. Like cars…or drugs…or nuclear energy plants. All these can be used in positive ways…but they can also be used in other ways as well.
Conclusion: derivatives will continue to be used, created, and, at times, misused. Financial innovation is with us and will continue with us. My experience supports the view that only a minimal amount of regulation will be effective to control the use of derivatives because part of innovation…is to get around the rules. That’s life!
My second point has to do with the efficient market hypothesis. People who support the efficient market hypothesis argue that market prices reflect all the information that is available to the market at a particular time. That is, market prices are correct. In essence, everyone in the market knows what information is available, what that information means, and how that information is translated into market prices…for all time. At least, there is a well informed group of arbitragers that know these things so that “on the margin” market prices can be made “right”.
In the world I live in, individuals have to deal with incomplete information…especially about the future. That is why uncertainty exists and why people have created probability theory as a way to deal with incomplete information and the resulting uncertainty. For prices to be “correct” and for markets to be “efficient” we need complete information which means no probability distributions for we will have certainty. I can’t believe that everyone in the market, given what information is available, knows what the price of every stock will be at every period of time in the future.
When we have incomplete information markets cannot be efficient because we don’t know the exact models to forecast the future with and we don’t know the appropriate probability distributions that surround our forecasts. As a consequence, our risk management models, as well as our risk management controls, have been inadequate. As such, our hedges have contained more risk in them than we had anticipated and our speculative positions have provided way more risk that we had assumed. Thus, our financial structure has been out-of-line with where we thought we were and our financial system has been more fragile than we thought.
My third point concerns the incentives present in an economy. People will use the instruments that are available to them in ways that are consistent with the incentives that exist within the economy at a given time. For example, in the past, the price of a house may have appreciated over time but this was not the real value of the house. The real value of the house was the flow of services that people received over time…it was this which made the house a home. What people acquired was the flow of housing services…not the stock…not the house itself. This was because the house was not going to be sold…at least not for a long time into the future. In this sense the price of the house was only important at the time of purchase.
What changed? In recent years in too many cases the price of the house became more important than the flow of services. Why? Because in many cases, houses were “sold” every two or three years. People with teaser interest rates, or whatever, that reset every three years, “sold” their house to themselves because the game was to refinance the house using the inflated house price to get a better mortgage rate. Living in the home was not the essence of the deal…speculation on the house price was the focus…and this was seen explicitly in the many “speculative” deals that arose at this time. And this was the essence of the asset-based securities used to support these transactions.
Also, remind me sometime to tell you about my friend that ran a mutual fund who avoided moving into dot.com stocks until the year before the stock market bubble burst. He did not move into these securities until he saw that too much money was leaving his fund…going into funds showing better results because they had invested in dot.com stocks. And he made the front page of the Wall Street Journal when the bubble burst and his “late-in-the-day” bets…collapsed.
Finally, my last issue has to do with the government. Unfortunately, in many cases, government policies can dominate the economy; government policies can create the incentives that people respond to. And, although the government may not mean to, it can create incentives that are detrimental, at least over the longer run, to the health of the economy.
If you have read many of my posts, you know that I believe that the Bush43 tax cuts, the war on terror along with other events that inflated the spending of the government, and the Greenspan “low interest rate” policy set the scene for the bubble in the housing market, the exponential increase in credit over the past eight years, and the overwhelming increase in leverage. The incentives that were created during this time put more and more pressure on business executives to take speculative positions and finance these positions with more and more leverage.
Who was responsible for the behavior of these business executives? Like my friend that ran the mutual fund…even those that were relatively conservative in their business decisions…ultimately found themselves forced into positions where they had to take on more risk than they would like. Competitive pressures “forced” decision makers to respond to the current environment that existed in the market place. After-the-fact they seem to have been overly greedy. After-the-fact they appear to have been insensitive to the risk they were taking…careless even. And now, people and politicians have dumped on them for their mis-guided behavior. The politicians that created the environment many years ago…although they might have lost the election…walk away defending their legacy in other areas. This is one of the difficult things about economics…results often trail, by many, many years, those policies and programs that were their cause.
Yes, I agree with Shiller that derivatives are here to stay. And, I agree with Shiller that many new kinds of derivative securities will be invented in the future. I just wish that we could invent a derivative that would allow us to hedge against bad policy making in Washington, D. C.
First, human beings are innovators. They are problem solvers and are constantly pushing the edge trying to come up with something new that makes things better.
The problem we are dealing with here is risk. People, investors, don’t like risk. They are constantly trying to reduce risk in their lives…and they are willing to pay to reduce risk.
And, this is the essence of derivatives. Derivatives are risk reducing tools that can be used to hedge cash flows and thereby protect individuals from assuming more risk than they would like. People will pay for this…derivatives will get invented.
Answer me this…will a large number of people pay someone to invent a tool for increasing risk? The answer to this is no! People don’t pay people to build speculative instruments. The expected return to speculation is zero or less. Now how much will you pay for someone to create a tool that can provide you with an expected return of zero or less? Right…nothing!
People will pay innovators to build instruments that help to reduce risk because they are receiving value by being able to reduce the risk. Now this does not mean that people will not use these risk reducing instruments to speculate with. Hedging is providing a cash flow to offset the movements of all or part of another uncertain cash flow. Speculation means that you are taking an uncovered position…that is, you are working with only one of the cash flows.
So, like other innovations, derivatives have been created for a positive reason…but can be used in ways that increase risk. Like cars…or drugs…or nuclear energy plants. All these can be used in positive ways…but they can also be used in other ways as well.
Conclusion: derivatives will continue to be used, created, and, at times, misused. Financial innovation is with us and will continue with us. My experience supports the view that only a minimal amount of regulation will be effective to control the use of derivatives because part of innovation…is to get around the rules. That’s life!
My second point has to do with the efficient market hypothesis. People who support the efficient market hypothesis argue that market prices reflect all the information that is available to the market at a particular time. That is, market prices are correct. In essence, everyone in the market knows what information is available, what that information means, and how that information is translated into market prices…for all time. At least, there is a well informed group of arbitragers that know these things so that “on the margin” market prices can be made “right”.
In the world I live in, individuals have to deal with incomplete information…especially about the future. That is why uncertainty exists and why people have created probability theory as a way to deal with incomplete information and the resulting uncertainty. For prices to be “correct” and for markets to be “efficient” we need complete information which means no probability distributions for we will have certainty. I can’t believe that everyone in the market, given what information is available, knows what the price of every stock will be at every period of time in the future.
When we have incomplete information markets cannot be efficient because we don’t know the exact models to forecast the future with and we don’t know the appropriate probability distributions that surround our forecasts. As a consequence, our risk management models, as well as our risk management controls, have been inadequate. As such, our hedges have contained more risk in them than we had anticipated and our speculative positions have provided way more risk that we had assumed. Thus, our financial structure has been out-of-line with where we thought we were and our financial system has been more fragile than we thought.
My third point concerns the incentives present in an economy. People will use the instruments that are available to them in ways that are consistent with the incentives that exist within the economy at a given time. For example, in the past, the price of a house may have appreciated over time but this was not the real value of the house. The real value of the house was the flow of services that people received over time…it was this which made the house a home. What people acquired was the flow of housing services…not the stock…not the house itself. This was because the house was not going to be sold…at least not for a long time into the future. In this sense the price of the house was only important at the time of purchase.
What changed? In recent years in too many cases the price of the house became more important than the flow of services. Why? Because in many cases, houses were “sold” every two or three years. People with teaser interest rates, or whatever, that reset every three years, “sold” their house to themselves because the game was to refinance the house using the inflated house price to get a better mortgage rate. Living in the home was not the essence of the deal…speculation on the house price was the focus…and this was seen explicitly in the many “speculative” deals that arose at this time. And this was the essence of the asset-based securities used to support these transactions.
Also, remind me sometime to tell you about my friend that ran a mutual fund who avoided moving into dot.com stocks until the year before the stock market bubble burst. He did not move into these securities until he saw that too much money was leaving his fund…going into funds showing better results because they had invested in dot.com stocks. And he made the front page of the Wall Street Journal when the bubble burst and his “late-in-the-day” bets…collapsed.
Finally, my last issue has to do with the government. Unfortunately, in many cases, government policies can dominate the economy; government policies can create the incentives that people respond to. And, although the government may not mean to, it can create incentives that are detrimental, at least over the longer run, to the health of the economy.
If you have read many of my posts, you know that I believe that the Bush43 tax cuts, the war on terror along with other events that inflated the spending of the government, and the Greenspan “low interest rate” policy set the scene for the bubble in the housing market, the exponential increase in credit over the past eight years, and the overwhelming increase in leverage. The incentives that were created during this time put more and more pressure on business executives to take speculative positions and finance these positions with more and more leverage.
Who was responsible for the behavior of these business executives? Like my friend that ran the mutual fund…even those that were relatively conservative in their business decisions…ultimately found themselves forced into positions where they had to take on more risk than they would like. Competitive pressures “forced” decision makers to respond to the current environment that existed in the market place. After-the-fact they seem to have been overly greedy. After-the-fact they appear to have been insensitive to the risk they were taking…careless even. And now, people and politicians have dumped on them for their mis-guided behavior. The politicians that created the environment many years ago…although they might have lost the election…walk away defending their legacy in other areas. This is one of the difficult things about economics…results often trail, by many, many years, those policies and programs that were their cause.
Yes, I agree with Shiller that derivatives are here to stay. And, I agree with Shiller that many new kinds of derivative securities will be invented in the future. I just wish that we could invent a derivative that would allow us to hedge against bad policy making in Washington, D. C.
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