Winning Strategies

Good teams find ways to win even when the calls go against them, even when the weather is bad, and even when their opponents change their strategy. 

Bad calls are a part of sports…and business…and politics.  You have to go on.  It is a part of the game.  Yes, the ref missed the call, but you still have to play out the rest of the game.  Sure, Standard & Poor’s may have not handled the ratings adjustment and timing in the best way possible, but the Obama administration knew that the government’s bond rating might be changed and it also knew that the United States had fiscal problems, political problems, and economic problems. 

The announcement on Friday evening was not a surprise.  Yet, the administration chose to claim that Standard & Poor’s was “incompetent and not credible.”

To some this puts the United States right up there with Greece…and Portugal…and Spain…and Italy.  The blame rests elsewhere.  This is what losing teams do.

The weather, the external environment, is a part of games…and business…and politics.  Yet, your opponent, others, has to face the same external environment that you do.  The snow or wind or rain made playing rough, but the game continues.  Sure, the economic conditions being faced by the United States are difficult, but the Obama administration has been facing them for two and a half years, as have many other countries, and blame cannot continually be placed upon the Bush(43) administration or the rest of the world. 

Again, losing teams put the blame on somebody or something else, like speculators, like rating agencies, like previous Presidents.  And, then they keep on doing just what they have been doing in the past.

Opponents change their strategies during games, or, they may change personnel.  Given the refereeing, given the weather, given the strategy you are pursuing, your opponents may alter the way they do things in order to take advantage of your strategy or your personnel or the weather.  Yes, the Republicans won the mid-term elections, sure the Tea Party advocates came on very strong, and sure the economy did not respond the way that the Obama administration expected, but that is not a reason to blame these factors as a reason why the Obama team didn’t succeed. 

President Obama relied on the same strategy and game plan established at the start of his presidency.  Every issue was addressed by a speech after which the construction of a plan, whether for health care, financial reform, or debt control, was turned over to Congress.  The opponents of President Obama changed how they played the game and largely succeeded in their efforts because the Obama team played the game exactly as they had in the past.      

Losing teams always seem to blame other factors, like their opponents changing strategies for their failures. 

It is obvious that there is great concern in the world over the financial affairs of governments in the United States and Europe.  Yet, these governments continue to claim that others are imposing the problems upon them.  And, as this attitude continues, we all are worse off for it.  This is the way losers play the game. 

The conditions are what they are.  The people in power need to make adjustments to their game plans…they cannot continue to follow the same strategies they have been pursuing in the past.  When is it going to become obvious to these people that what they are doing is not working.  When are they going to realize that the past is the past and that maybe they need to listen to new voices?   Politicians are supposed to be pragmatic…so let’s seem some of that pragmatism.

Where should they start?   

I believe that the United States government needs to change its economic objective.  For more than fifty years, the primary economic objective has been to achieve high levels of employment…a low unemployment rate.  Under this objective, the percentage of people working in labor force has dropped to an historic low of about 55 percent and the underemployment rate has risen to about 20 percent of those of employment age.  Furthermore, pursuing this policy objective has resulted in an income/wealth distribution skewed more toward the rich than ever. 

To continue to maintain this policy as the number one priority of the United States government is like a football team continuing to run the same play over and over again even though the opponent has stacked the defense to stop that very play.

To me, the primary objective of United States economic policy should be the maintenance of a strong dollar.  Although every presidential administration for the past fifty years has supported a “strong dollar”, the policy of credit inflation followed by both Republicans and Democrats to achieve high levels of employment for the past fifty years has achieved exactly the opposite end.  First, the United States dollar was taken off the gold standard on August 15, 1971 and its value was allowed to float.  Next, the credit inflation policies followed by these Republican and Democratic administrations have resulted in a decline in the dollar in world markets of about 40 percent since 1971.

The game plan of credit inflation to achieve low levels of unemployment has not succeeded and the standing of the United States in the world has suffered for it.  That game plan needs to be changed. 

A strong dollar is the foundation for a strong economy because the emphasis is placed upon the competitiveness and innovative capabilities of the businesses and workforce of the economy.  The government must be concerned with education and training, with the ability of companies to innovate and change, and with incentives for people to start and grow companies.  High levels of employment and labor participation are achieved in this way. 

Putting all the emphasis on credit inflation to ensure high levels of employment works against the things mentioned in the previous paragraph.  Credit inflation works to put people back in their old jobs rather than encourage innovation and training to raise productivity and change.  Credit inflation puts emphasis on financial leverage and financial innovation and leads to the financial sectors of the economy becoming more important than the manufacturing sectors.  And, credit inflation results in the income/wealth distribution becoming more skewed toward the wealthy. 

If the basic philosophy of the Obama administration continues to be one based on the further application of credit inflation to the economy it will have fundamental problems going forward.  One, economic growth will continue to stagnate.  Two, the administration will face greater and greater opposition, first, from its opponents because they will see that nothing has changed in the game plan and that the game plan is not succeeding; and second, because its supporters will become more and more dissatisfied with its performance.  Three, potential outside opponents, like China, Russia, Brazil, and so forth, will prepare much more aggressive game plans against the United States because they can smell the weakness.  Note the responses of China, Russia, and others, to the Standard & Poor’s downgrade. 

Winning teams focus on building strong organizations with the best personnel for the times and with the best game plans for the game they are playing.  They adjust with the conditions.  They find ways to win.  And, they do not make excuses.  

Why Invest in Commercial Banks?

 Why should anyone invest in commercial banks these days?

My answer is that they should not.

My reason for this is that bank accounting is so screwed up that it is extremely difficult, if not impossible, to place a value on the assets of a bank. 

Now, this is a broad ranging generalization and I know that there are banks who are open and transparent about the value of their assets, but…

A case in point: yesterday, Citigroup released its earnings for the first quarter.  Let’s look at the analysis of these earnings by Francesco Guerrera and Patrick Jenkins for the Financial Times (http://www.ft.com/cms/s/0/8c5fb104-69e0-11e0-89db-00144feab49a.html#axzz1JsjXsOj5).

In order to reduce the impact of the new capital rules, Basel III, Citi has put “up for sale a $12.7 billion portfolio of bad assets that were responsible for some of its huge losses during the financial crisis.”

“Citi said the assets, which are believed to include subprime loans, mortgage-backed securities and corporate bonds, carried a ‘disproportionately high’ risk weighting under the new capital rules…”

Hence the desire to get rid of the assets.

“Citi’s decision resulted in a $709 million pre-tax charge in the first quarter but enables it to take advantage of a recovery in the market for distressed assets and boost capital buffers…”

“Citi said it had already sold about three-quarters of the assets at prices above the levels at which it valued them on its balance sheet…”

But, this background information follows.

“In order to put the assets up for sale, Citi had to reverse an accounting maneuver performed during the crisis, when it moved them from its ‘trading’ book to it ‘banking’ book.”

“Such a shift, which mirrored moves by other commercial banks, helped Citi to avoid suffering quarterly mark-to-market losses on those assets at the height of the turmoil.”

“However, accounting rules require financial groups seeking to move assets back to their ‘trading’ book to show that the facts around their initial decision had significantly changed.”

“John Gerspack, Citi’s chief financial officer, said the company argued that Basel’s higher risk weightings constituted such a change.  Citi’s argument was accepted by the US Securities and Exchange Commission, potentially paving the way for other banks to follow suit.” 

“Several banks have shrunk their balance sheets and shuffled assets in order to cope with the rise in capital requirements demanded in the Basel III regime.  However, their efforts have taken place largely behind closed doors, with very few providing details of their plans.” 

How is an investor really to know what assets will be treated in which way at what time?

And, the question can be raised concerning the treatment of Citigroup or other large banks relative to other, smaller financial institutions.  Smaller banks don’t have the expertise or can’t hire the expertise or don’t really have the ability to maneuver their portfolios in such a way.

However, in many cases in which assets cannot be “re-classified”, asset values have not been written down because “hope” was expressed that many of these assets would improve in value once the economy began growing again.

The ‘hope’ may be wearing a little thin as some borrowers may be running out of time.  See my post “Commercial Bank Closures,” http://seekingalpha.com/article/264104-commercial-bank-closures-2-3-banks-per-week-in-2011.

The situation may be changing in other areas as well.  In some cases, the change is coming from the regulatory side.  Take the case of the rating agencies and the municipal bond market.  In January 2011, Standard & Poor’s cut the rating of DeKalb County, Georgia from triple A to double A and then reduced it to triple B.  Now, S & P has withdrawn rating from it at all. (See http://www.ft.com/cms/s/0/106b35da-69e2-11e0-89db-00144feab49a.html#axzz1JsjXsOj5.)

“Matt Fabian, managing director at Municipal Market Advisors, says one reason why rating agencies may be acting more aggressively with patchy disclosure is regulation.  New rules, set out in the Dodd-Frank Act, have been introduced after rating agencies came under fire for miscalculating risk in mortgage debt before the financial crisis.”

The question now becomes: If Dekalb County was rated triple A in January and currently is not rated at all, what other triple A rated entities…or even A rated entities…might face lower ratings in the near future?

How should these assets be valued on bank balance sheets?

Over the past forty years, too many tricks have been played with bank accounting and bank accounting standards. 

As readers of my blog know, I am a strong advocate of “mark-to-market” accounting.  Bank executives make decisions and they need to be held accountable for them.  If they take risks then they need to own up to the risks that they have taken.  Bank accounting must become straight-forward enough and open enough for people that want to invest in them to have sufficient information to value their assets. 

I would think that the regulators would want this as well.

I am tired of hearing stories like the one on Citigroup reported in the Financial Times.  And, new stories pop up all the time.  In terms of accounting and openness related to the books of banks, there seems to be no difference between the regulators and the banks. 

If we are to have a safer banking system I believe that this situation must end!

E-Mails, Investment Banking, and the Rating Agencies

Thank goodness for emails! Now we know what was really going on at Goldman Sachs and Moody’s and Standard & Poor’s. How about Congress including in their bill on financial reform the requirement that all financial institutions and rating agencies and all other organizations having to do with finance (say the Federal Reserve and the Treasury and Fannie Mae and Freddie Mac…and Congress…and the White House) release all of their e-mails a week after they were written.

This would really provide the financial markets with transparency!

The thing that strikes me so much about the release of these e-mails over the past week or so is their humanity. These Wall Street villains talk like human beings, like you and me.

Gillian Tett, in my mind, has a terrific opinion piece in the Financial Times this morning titled “E-Mails throw light on murky world of credit” (http://www.ft.com/cms/s/0/a9da1aa4-508b-11df-bc86-00144feab49a.html). Her reflection on the e-mails is captured in the following sentence: “It is fascinating, almost touching, stuff.”

But, even more important she states that “Reading these e-mails with the benefit of hindsight, there is little suggestion that rating officials were engaged in any deliberate malfeasance. Many appear conscientious and hard-working.” These people are just human beings trying to do their job.

The same can be said of those people that wrote the e-mails at Goldman. This is captured in an article by Kate Kelly in the Wall Street Journal titled “Goldman’s Take-No-Prisoners Attitude” (http://online.wsj.com/article/SB20001424052748703441404575206400921118356.html#mod=todays_us_money_and_investing.)
Kelly speaks of a world, which Tett describes as “so detached and rarefied”, in which betting applied to almost anything. The scene she presents in her article is one in which mortgage traders from Goldman Sachs “cast bets on a White Castle hamburger-eating contest” in December 2007. (Note that the problems in the subprime mortgage market were so severe at this time that the Federal Reserve announced the creation of a Term Auction Facility (TAF) on December 12, 2007 with the first auction being held on December 17, 2007.)

This behavior, Kelly reminisces, “resembled a scene out of ‘Liar’s Poker,’ a book (by Michael Lewis of the book ‘The Big Short’) depicting bawdy antics of (mortgage) bond traders at Salomon Brothers in the 1980s.” She argues that “It was a lower-stakes version of what went on ever day in the group: aggressive, take-no-prisoners trading.”

To Kelly, the world apparently didn’t change much between the 1980s and the 2000s!

Tett draws some conclusions from the picture present in the e-mails. She writes “by 2007 they (the bond raters), like the bankers, had become tiny cogs in a machine that was spinning out of control. Their world was also a strange, geeky silo, into which few non-bankers ever peered.”

And, Tett goes on, “Indeed, this world was so detached and rarefied it is, perhaps, little wonder that S&P struggled to deal with the press, or that Goldman traders felt free to celebrate the mortgage market collapse.”

“Few expected external scrutiny or imagined their e-mails would ever be read.” They were just being human.

But, something was wrong! Something bigger than the traders or the raters had taken control and was driving the system.

And, this leads Tett to the first of two lessons she draws from the information in the e-mails: “what went wrong in finance was fundamentally structural, as an entire system spun out of control! It might seem tempting to lash out at a few colorful traders but that is a sideshow…”

She concludes: “what is needed is systemic reform that removes conflicts of interest.”

This is the only point on which I disagree with her. To me this whole “spinning out of control” was a result of the credit inflation that had been prevalent in the financial system for the past fifty years or so. The whole effort to inflate the American economy had resulted in the excessive creation of credit during this time period, the almost fanatical drive toward financial innovation (led by the federal government), and the assumption of more and more risk by the private sector in a search to sustain its returns.

The reference to the book “Liar’s Poker” is particularly relevant because the main story in that book is about the trading going on in mortgage-backed securities, something that did not exist until the early 1970s when the federal government created the instrument. Please note that the first mortgage-backed security was issued by the Government National Mortgage Association (Ginny Mae) in 1970. Before then mortgage-related issues were not traded on capital markets. By the time of the writing of “Liar’s Poker”, government-related mortgage-backed securities had become the largest component of capital markets.

As I have stated many times, the purchasing power of the United States dollar declined by roughly 85% between January 1961 and the present time. Although consumer price inflation was kept relatively low over the past decade or so, credit inflation permeated the asset markets as bubbles appeared in stocks and housing. House prices got so out of line with rental prices during this time that the collapse of the housing bubble became inevitable.

So, I agree with Tett in her statement that “what went wrong in finance was fundamentally structural, as an entire system spun out of control!”

But, human beings acted like human beings during this time. Again, to quote Tett: “they (the bond raters), like the bankers, had become tiny cogs in a machine that was spinning out of control.”

And, as Chuck Prince, former CEO of Citigroup, called it: as long as the music is playing, people must keep on dancing. This doesn’t excuse them, but it puts, I think, the behavior in perspective. This was not the well-thought-out plot of evil people.

Lesson: inflation creates incentives that can get out of hand. If the government wants to conduct economic policies with an inflationary bias then they must deal with the consequences at a later time.

I do agree with Tett on her second lesson learned: “the whole murky credit business must be taken out of the shadows. So few people spotted that finance was spinning out of control because the financial system was so separated into silos that its practitioners lost any common sense.”

Tett “welcomes the publication of these emails” but warns us to “keep braced for the next installment.” She “suspects that US regulators and politicians have not finished publishing all those damning e-mails yet.” I look forward to these revelations, as well.