Word of the Day: Spin-in

Summary:
Spin-ins are startups founded by people from a more established parent company. They usually work to develop products and technology aligned with the goals of the mothership, but keep track of everything (including venture capital raised) on a separate balance sheet. If certain technical milestones are hit, the spin-in is then absorbed back into the company, which it can then ride to profitability or leverage to raise further rounds. Cisco Systems has long been a major proponent of this strategy, and it’s clearly worked for them.

Notes:
But there’s also another way to do it. A spin-in doesn’t have to be a simple technology play. Instead, the parent company works with investors (since it has the clout) and the management team to build a real company with real revenues of its own. That way, if it gets gobbled back up after two or three years, it can be immediately accretive to the parent company. This is an attractive option for bigger companies looking to balance their investment in innovation against dilution of corporate earnings. Not to mention that it will help both venture firms and management teams address the issue of liquidity in a world where IPOs, mergers and acquisitions are becoming few and far between.

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Quote of the Day

"Buffett once told me there are three 'I's in every cycle. The 'innovator,' that's the first 'I.' After the innovator comes the 'imitator.' And after the imitator in the cycle comes the idiot." -Theodore Forstmann, quoting Warren Buffett

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King's men must put themselves together again - FT.com

Summary:
John Gapper explains why banks and insurance companies got addicted to complexity, through the practice of dicing up cashflows and risk. Origin of practice traces back to Black, Scholes and Merton, 1973. The appeal to financial institutions derives from four reasons: it skews the odds in favour of those who hold the technology; structured finance has been a huge money-spinner; complexity produced yield; and, most perilously, structured finance gave banks and others more chances to take on "tail risk." The future of finance and regulations now looks very uncertain. The crisis has exposed gaping holes in the US regulatory structure. The current system is outdated (devices in the 1930s). The biggest regulatory gap involves over-the-counter (OTC) derivatives. (Published: 19/09/08)

Notes:

• worst financial crisis in US markets since 1929
• the investment banks and insurers that caused the problem did so by taking mortgages and first packaging and repackaging them into bizarrely complex securities, and then topping them off with derivatives
• e.g. AIG had been writing credit default swaps (CDS)
• a form of derivative allowing one financial institution to pass the risk of a bond defaulting on to another
• sold them to banks wanting to protect themselves against defaults on collateralised debt obligations (CDOs), built from sub-prime mortgages
• when these CDS plunged in value because the market stopped trusting what they were worth, AIG came close to bankruptcy and was bailed out by the US Treasury
• dicing up of cashflows and risk
  
• has been a growing part of markets since Fischer Black, Myron Scholes and Robert Merton, three US academics, devised a way to value options in 1973
• over the ensuing three decades, banks and insurance companies got addicted to complexity
• four reasons
1. it skews the odds in favour of those who hold the technology
• rading in markets is essentially a zero sum game, in which you have an equal chance of winning or losing
• but: banks have been able to shift the odds by using computer models that others lack, to trade in volatility, for example
2. structured finance has been a huge money-spinner
• i.e. the practice of using the cashflows from stocks and bonds to create other securities
  
• every institution involved in creating and selling structured bonds, from banks to ratings agencies to insurance companies, gained a big fee every time such a bond was issued
3. complexity produced yield
• in an era of low interest rates, pension funds and insurance companies found it hard to earn much money from cash
• so any instrument that appeared safe but paid a higher interest rate than Treasury bonds, which mortgage-backed securities did, found ready buyers
• the problem was that these securities paid a higher yield than other triple A rated paper precisely because they were complex
• investors got paid more to hold them because they were so difficult to understand
4. structured finance gave banks and others more chances to take on "tail risk"
• this is an insurance-like trading strategy:
  
• one institution writes swaps or options that provide it with regular payments in exchange for taking another's risk of default
• in most cases, this produces profits, but occasionally it is disastrous
• was AIG's downfall
  
• huge uncertainty over the future of finance and of regulation
• risks of financial institutions devoting themselves to the underwriting and sale of complex securities have become abundantly clear
• complexity is a good way to make money, but it also causes bank runs
• crisis has exposed gaping holes in the US regulatory structure
• largely devised in the 1930s and is outdated
• the supervision of banks and investment banks is done by different bodies while insurers are regulated by US states
• biggest regulatory gap involves over-the-counter (OTC) derivatives
• the contracts traded among banks and insurance companies that lie at the heart of the financial crisis
• not regulated at all in the US since they were excluded by the federal government from Commodities Futures Trading Commission oversight eight years ago

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Quote of the Day

"Allowing investment banks to be leveraged to the tune of 30 to 1 is the equivalent of playing Russian roulette with five of the six chambers of the gun loaded. If one adds the off-balance-sheet liabilities to this leverage, you might as well fill the sixth chamber with a bullet and pull the trigger." - Michael Lewitt

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Why global capitalism needs global rules - FT.com

Summary:
Philip Stevens argues that once the financial storm has settled, politicians will need to consider what the crisis tells us about the nature of the world we live in. One thing it revealed is that governments have been left with responsibility without power. The grip of individual states on the levers of economic management decisively weakened, but the loss of control has not been matched by any corresponding diminution of responsibility. Tensions like this, resulting from globalization, are not restricted to just the economy. Voters want the ease of movement across national borders that comes with cheap travel, but they also want governments to control immigration and cross-border crime. They want to buy cheap electronics from China, but they blame politicians when global supply chains threaten job security at home. If the politicians want the liberal market system to work, they will have to make multilateralism work. We need global governance, and a set of credible international rules. (Published: 18/09/08)

Notes:

• once the storm abates the task for politicians will be to ask some bigger questions
• Putting aside the technicalities of collateralised debt obligations, capital ratios and the rest, what does the crisis tell us about the nature of the world in which we now live?
• growing tension between global integration and a shortage of credible international governance
• governments have been left with responsibility without power
• tensions as a result of globalization
  
• grip of individual states on the levers of economic management decisively weakened
• few political leaders outside the US were even vaguely aware of the degree to which their own banking systems were held hostage to the subprime loans made to American homeowners
• but: loss of control has not been matched by any corresponding diminution of responsibility
• voters still hold their own politicians to account for the insecurities that flow from interdependence
• blaming someone else offers insufficient answer to the homeowners trapped in negative equity or to depositors or creditors in a failing bank
• voters want the ease of movement across national borders that comes with cheap travel
• but they also want governments to control immigration and cross-border crime
• voters want to buy cheap electronics from China
• but they blame politicians when global supply chains threaten job security at home
• tensions are not susceptible to neat solutions
• but: all point in the same direction
• interdependence is no longer an abstract noun
• governments need to find ways to reclaim some of the sovereignty lost to globalisation
• means more global governance: credible international rules
• consequences of financial shocks
• capitalism will survive
• but: risk of a retreat to economic nationalism
• if the politicians want the liberal market system to work, they will have to make multilateralism work

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Word of the Day: The Pecora Commission

Commission established by the U.S. Senate to study the causes of the crash of 1929. The hearings lasted for two years (1932 - 1934) and resulted in the U.S. Congress passing the Glass-Steagall Act in 1933, which mandated a separation between commercial banks, which take deposits and extend loans, and investment banks, which underwrite, issue, and distribute stocks, bonds, and other securities.

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What Should Government Guarantee? - EconLog

Summary:
Arnold Kling says that financial markets are inherently unstable because they are based on trust and inherently lacking transparency. In fact, trust and reputation replace transparency in financial intermediation; if it were perfectly transparent, there would be no need for it, one could do its business oneself. Deposit insurance helps facilitate trust. It removes all motivation for the consumer to worry about the bank's risk management. It is, however, up to the insurer (FDIC) to worry. Any system can be gamed eventually, so it's a challenge for the regulators to stay one step ahead of the banks. Bear Stearns, Freddie and Fannie, Lehman, and AIG were not FDIC-insured banks, yet there creditors are being rescued. Ad hoc-ness of Fed and Treasury causing some resentment. Regulators should try to anticipate crises and prevent them. But almost by definition, the crises that do occur will be ones that they did not anticipate, and the responses will have to be somewhat ad hoc. (Published: 16/09/08)

Notes:

• financial markets are inherently unstable
• because financial intermediation inherently replaces transparency with trust
• if my bank were perfectly transparent, then I would know everything about its loans
• including the underlying risks of the real estate developers, small businesses, and individuals to whom it is lending money
• in that case, I would not need a bank,I could just make those loans myself.
• so if you assume perfect transparency, you assume away the need for financial intermediation
• you have to assume the opposite of perfect transparency, highly imperfect transparency
• with reputation and trust serving as substitutes

• deposit insurance helps facilitate trust
• private insurance pool might work, but people trust government-provided deposit insurance even more
• the consumer loses all motivation for worrying about the bank's risk management
• by contrast: the insurer has to worry a lot
• in the U.S., the FDIC has been getting better over the years, but you can never get complacent
• any system can be gamed eventually, so it's a challenge for the regulators to stay one step ahead of the banks
• Bear Stearns, Freddie and Fannie, Lehman, and AIG
• institutions that are not FDIC-insured banks
  
• question arises about whether some of their creditors ought to be protected by the government
• note: financial blow-up has not come from private hedge funds
• highly leveraged and unregulated business
• having some regulated, insured institutions, like the banks, is good
• we can or should not try to regulate everyone
• regulators should try to anticipate crises and prevent them
• but almost by definition, the crises that do occur will be ones that they did not anticipate, and the responses will have to be somewhat ad hoc

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Quote of the Day

“The rule is that financial operations do not lend themselves to innovation. What is recurrently so described and celebrated is, without exception, a small variation on an established design, one that owes it distinctive character to the aforementioned brevity of the financial memory. The world of finance hails the invention of the wheel over and over again, often in a slightly more unstable version. All financial innovation involves, in one form or another, the creation of debt secured in greater or lesser adequacy by real assets.” - J.K. Galbraith, "A Short History of Financial Euphoria"

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The K-T Boundary - The Epicurean Dealmaker

Summary:
Epicurean Dealmaker elaborates on John Gapper's FT comment about how the investment banking industry got to this stage. The problematic component of i-banking is the capital markets business. Maintaining a credible and effective capital markets operation has always been an expensive proposition, compared to the advisory side of the business. When fixed commissions were eliminated, the huge capital markets business of a typical investment bank could no longer support itself financially. Started using a much larger amount of money trading for their own account, on a proprietary basis. As a result of US's ballooning trade deficit, and low interest rates under Greenspan, capital markets operations became the dominant business line of all major investment banks over the past couple of decades. Compensation systems at investment banks could not deal with this development. Imbalances built up, risk and return became misaligned. But capital markets business has always been an integral part of an investment bank's advisory business. No better definition of market-based advice, and no better example of the type of added value an integrated investment bank can bring to its client. Pure advisory boutiques cannot deliver this sort of advice, because they do not have the capital markets arms to deliver it. Catch-22. capital markets capabilities cannot pay for themselves without proprietary trading operations. (Published: 16/09/08)

Notes:

• how did the investment banking industry get itself into this pickle, and where does it go from here?
• John Gapper, "May Day": the elimination of fixed commissions for stock trades in 1975
• launched the industry onto the path of relentless growth in capital, people and profits
• capital markets business
• securities sales and trading activities
• has always been a key component of the investment banking model
• but: maintaining a credible and effective capital markets operation has always been an expensive proposition
• requires a lot of people, information technology, dedicated real estate, and other doodads that cost a lot of money to install and a lot of money to maintain
• unlike the advisory side of the business
• your typical M&A banker requires very little in the way of infrastructure
• May Day: when fixed commissions were eliminated, the huge capital markets business of a typical investment bank could no longer support itself financially
• banks needed to find another use for all that investment in infrastructure
• Salomon Brothers:
  
• first to make the transition from using relatively small amounts of in-house capital to support underwriting and market-making activities to using a much larger amount of money trading for their own account, on a proprietary basis
• because they were "in the flow" and saw the securities markets from the privileged position of market makers, "prop desks" at investment banks started making money hand over fist
• i.e. they started acting like hedge funds
• ballooning federal deficits of the Reagan years
  
• resulted in huge trading volumes in fixed income securities and related derivatives
• led to an explosion in equity trading
• accompanied the internet boom
• Alan Greenspan
  
• plying the financial markets with liquidity "like a whorehouse madam plies shore-leave sailors with booze"
• result: capital markets operations became the dominant business line of all major investment banks over the past couple of decades
• trouble in paradise
• problems caused by trying to incorporate a volatile principal-oriented business like proprietary trading into an organization that was otherwise focused on agency business like M&A advisory, capital raising, and underwriting
• when the prop traders made a bundle betting for the firm, they brought home annual bonuses that struck even the highly overcompensated bankers in M&A and corporate finance as nothing short of obscene
  
• when their trades blew up in their faces everybody else at the firm suffered big cuts in compensation regardless of how good their individual years had been
• compensation systems at investment banks could not deal with this development
• proprietary traders, CDO structurers, and derivatives specialists began taking and holding positions with longer and longer risk tails
• but still got measured and paid based on systems designed to measure the annual production of a banker conducting traditional agency business, like M&A or equity underwriting
• imbalances built up, risk and return became misaligned, "and various pieces of shit began hitting various fans"
• paying traders, corporate financiers, and M&A advisors with long-vesting restricted stock did create some sort of alignment with the firm's and shareholders' interests
• but: it was too blunt an instrument to contain and control the stresses building up in the new hybrid hedge fund-investment banking model
• why didn't the investment banks abandon the securities sales and trading business when it became unprofitable after May 1975? Three reasons:
1. commissions did not vanish in one fell swoop after May 1, 1975
• competition was introduced, and commissions shrank gradually over a number of years
• investment banks did not necessarily see the writing on the wall for quite some time
• by the time they realized that pure agency capital markets was now and forever a loss leader business, it was in many respects too late to change
2. capital markets businesses were always large
• controlling roughly half the resources of a typical investment bank and sometimes more
• very difficult to kill a business line with so much human, psychological, and political capital committed to it
• plus sharp-elbowed leaders who are committed to fight for it
3. most importantly: the capital markets business has always been an integral part of an investment bank's advisory business
• obvious for corporate finance activities like selling bonds to raise capital for a railroad or underwriting an initial public stock offering for a technology company
• raising capital for corporate clients has always been an extremely important business line for investment banks
• was really the only business investment banks conducted for many years after their separation from commercial banks in the 1930s after Glass-Steagall
• until the emergence of a new business in the late 1970s which came to be known as mergers and acquisitions advisory
• "client bankers" to Ford Motor Company, CSX Corporation, and Netscape did and do rely heavily on their buddies on the capital markets desk to gauge investor demand, structure attractive security offerings, and help sell their clients' securities to new investors
• M&A bankers rely heavily and often on their capital markets colleagues, too
• in the case of corporate clients, there is all sorts of useful intelligence an M&A banker can glean from his capital markets partners
• bears directly on the approach, feasibility, and potential price of doing a deal
• publicly traded corporations want to know how the markets will react to the announcement of a transaction
• CEOs want to know who are the top 20 critical investors they should talk to to explain the rationale for selling a division or buying their biggest competitor
• there is no better definition of market-based advice, and no better example of the type of added value an integrated investment bank can bring to its client
• pure advisory boutiques cannot deliver this sort of advice, because they do not have the capital markets arms to deliver it
• capital markets operations of any consequence are too expensive to support solely with the revenues a successful M&A practice brings in
• Catch-22:
• advisory practices cannot compete with fully integrated investment banks in all situations without capital markets capabilities
• but: capital markets capabilities cannot pay for themselves without proprietary trading operations
  
• we seem to be stuck with the integrated i-bank model, whether we like it or not

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Roubini Misses the Boat on Regulation - Mish's blog

Summary:
Mike Shedlock argues that the cause of the financial crisis is not lack of regulation, as argued by by Roubini et al., but government intervention in free markets and fractional reserve banking. Government promoted an ownership society mentality and established HUD, FHA, Fannie, Freddie, and hundreds of affordable housing programs. But government promotion of housing put an artificial bid on housing that a free market never would have, raising the price of housing. In addition, the simple reason Moody's, Fitch, and the S&P do such a miserably poor job is government sponsorship. If Moody's, Fitch, and the S&P had to survive based on how good their ratings were instead of a model where the SEC says they have to rate everything, the problem with rating agencies would be cleared up overnight. The Fed is part of the problem too. The creation of the Fed was a blatant intrusion on the free market in the first place, but the Greenspan Fed's allowance of sweeps was economically equivalent to reducing the reserve-requirement ratio to zero for banks with sweep programs. Ultimately, the problems can be blamed on fractional reserve lending and the ability to create money (credit really) at will by borrowing it into existence. (Published: 10/09/08)

Notes:

• Roubini correct about US becoming United Socialist State Republic of America
• but: wrong about what went wrong and who is to blame
• e.g. the "fanatically and ideologically zealot free-market laissez-fair administration"
• e.g. "ideologue regulators who literally held a chain saw at a public event to smash unnecessary regulations"
• true cause: government meddling in the free markets
  
• there does not need to be regulation of Fannie Mae or Freddie Mac because neither should have existed in the first place
• it was government meddling in the free markets that created Fannie and Freddie
• government meddling in the free market will always blow up
• no matter how many government regulators one threw at Fannie or Freddie, both were going to blow up sooner or later
• ownership society mentality
• the HUD, FHA, Fannie, Freddie, and hundreds of affordable housing programs all came out of "ownership society" type thinking
• sponsorship of such entities creates a problem that regulators can never get right
• the bureaucratic mission inevitably takes on a life of its own
• government promotion of housing put an artificial bid on housing that a free market never would have
• that artificial bid had the exact opposite effect of what was intended
• every government sponsored affordable housing program raised the price of housing
• regulation could not fix that basic flaw and eventually the model blew up with ever increasing efforts to keep the ponzi scheme operative
• Ponzi schemes always blow up as soon as but not before the pool of greater fools runs out
• solution to all the above problems is simple
• eliminate government sponsorship of housing
• i.e. abolish the FHA, the HUD, Fannie Mae, Freddie Mac, Ginnie Mae, and every silly program on the books to create affordable housing
• government sponsorship of rating agencies
• many blame lack of regulation for the incredible fiasco at the rating agencies
• the simple reason Moody's, Fitch, and the S&P do such a miserably poor job is government sponsorship
• solution is easy: End government (SEC) sponsorship of the big three
• far past Time To Break Up The Credit Rating Cartel
• if Moody's, Fitch, and the S&P had to survive based on how good their ratings were instead of a model where the SEC says they have to rate everything, the problem with rating agencies would be cleared up overnight
• no amount of regulation can possibly cure flaws that arise out of government sponsorship
• Fed is the problem
• creation of the Fed was a blatant intrusion on the free market
• Greenspan Fed, ever wanting to "help" banks make more profits, instituted a policy of sweeps
• note on sweeps
• retail deposit sweep programs increase bank earnings by reducing the amount of noninterest bearing deposits that banks hold at Federal Reserve banks
• a bank's transaction deposits beyond approximately the first $50 million are subject to a 10 percent reserve requirement ratio, which is satisfied by holding vault cash or noninterest-bearing deposits at Federal Reserve banks
• in contrast, savings deposits are subject to a zero percent ratio.
• retail deposit sweep programs take advantage of this difference by "sweeping" transaction deposits into savings deposits
• that is, relabeling transaction deposits as savings deposits for reserve-requirement purposes.
• this is economically equivalent to reducing the reserve-requirement ratio to zero for banks with sweep programs
• effectively, the end of binding statutory reserve requirements
  
• every penny has been swept out and lent out (10 times over) thanks to the Greenspan Fed and fractional reserve lending
• what cannot be paid back will be defaulted on
• securitization problems
• in a free market with a sound currency, the originate to securitize model, aided and abetted by the rating agencies, would never have occurred in the first place
• None of the problems can be blamed on "free-market laissez-faire policies"
• every one of them can be blamed on fractional reserve lending and the ability to create money (credit really) at will by borrowing it into existence

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After 73 years: the last gasp of the broker-dealer - FT.com

Summary:
According to John Gapper, recent events mark the end of 73 years of full-service investment banking, i.e. buying and selling shares and bonds for customers as well as advising companies and trading with its own capital. In order to generate the revenues needed to match larger institutions, banks such as Lehman scurried into risk-taking that eventually sunk them. Two milestones in the history of IBs: 1933 Glass-Steagall Act (enforced the separation of banks and investment banks) and May 1 1975 (fixed commissions for trading securities were abolished) Despite the latter setting off a squeeze on broking revenues, IBs prospered for the next 30 years, mainly through gambling with their own (and later others') capital. But the gambles were potentially life-threatening: IBs did not have sufficient capital to cope with a severe setback in the housing market or markets generally. According to Gapper, there are two options for Goldman and Morgan Stanley: sell out to a large commercial bank with a big capital and deposit base, or scale back heavily, or abandon, their broker-dealer arms and become more like big hedge funds or private equity funds. (Published: 15/09/08)

Notes:

• Goldman Sachs and Morgan Stanley last hold-outs among Wall Street's independent investment banks
• future also in doubt
• full-service investment bank is doomed
• i.e. buying and selling shares and bonds for customers as well as advising companies and trading with its own capital
• in order to generate the revenues needed to match larger institutions, banks such as Lehman scurried into risk-taking that eventually sunk them.
  
• investment banks in future will be smaller, specialist institutions
• like the merchants of old
• history
  
• 1933 Glass-Steagall Act
• enforced the separation of banks and investment banks
• e.g. Morgan Stanley founded in 1935
  
• May 1 1975
• fixed commissions for trading securities were abolished
• set off a squeeze on broking revenues
• abolition of the system that has enriched them in good times and pulled many of them through during long periods of market slack,
• investment banks had relied on these commissions during the financial doldrums following the 1973 oil crisis.
• following 1975, investment banks went on to enjoy 30 years of prosperity
• grew rapidly, taking on thousands of employees and expanding around the world
• but: under the surface they were ratcheting up their risk-taking
• was increasingly hard to sustain themselves by selling securities
• the traditional core of their business -
  
• because commissions had shrunk to fractions of a percentage point per trade
• so they were forced to look elsewhere for their profits
• started to gamble more with their own (and later others') capital
• Salomon Brothers pioneered the idea of having a proprietary trading desk that bet its own money on movements in markets
  
• at the same time as the bank bought and sold securities on behalf of its customers
• banks insisted that their safeguards to stop inside information from their customers leaking to their proprietary traders were strong
• but there was no doubt that being "in the flow" gave investment banks' trading desks an edge
• also expanded into the underwriting and selling of complex financial securities
  
• e.g collateralised debt obligations
• were aided by the Federal Reserve's decision to cut US interest rates sharply after September 11 2001
• set off a boom in housing and in mortgage-related securities
• catch: investment banks were taking what turned out to be life-threatening gambles
• did not have sufficient capital to cope with a severe setback in the housing market or markets generally
• when it occurred, three (so far) of the five biggest banks ended up short of capital and confidence
• a bank can be highly skilled in risk management and trading, as Goldman has proved
• but: a single big mistake may spark a fatal spiral
• two options for Goldman and Morgan Stanley
• sell out to a large commercial bank with a big capital and deposit base
• e.g. Merril
• could provide them with sufficient backing for their capital markets divisions, which can be revenue and profit powerhouses in good times.
• scale back heavily, or abandon, their broker-dealer arms and become more like big hedge funds or private equity funds
• would involve a switch from sell side to buy side, where most money is now made
• in exchange for becoming much smaller, they might retain their high margins

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Dangerous Economic Territory - The Globalist

Summary:
David Smick ("The World is Curved") thinks that the politicization of globalization is putting a quarter of century of amazing prosperity and global poverty reduction at risk, potentially sending the US back to Seventies-like period of economic devastation. Globalization, free trade and liberalized financial markets have been a bipartisan success story (Reagan and Clinton). Was a tool to break away from the economically suffocating 70s. But this period of political consensus is at risk of coming to an end. Part of the financial market turbulence, and dollar weakness, in recent times stems not only from subprime-related credit uncertainties, but also from uncertainties about the direction of U.S. politics. Growing belief that the financial world, politically speaking, has entered uncharted political waters. Today’s voters look at globalization’s downsides with not enough appreciation of its tremendous upsides, and the political community is at risk of creating the conditions for a global financial disaster. Urgent need to expand the base of financial capital ownership and reduced the wealth gap. (Published: 09/09/08)

Notes:

• last quarter century
  
• relatively seamless, bipartisan political consensus in favor of free trade and liberalized financial markets
• globalization neither a Republican nor Democratic phenomenon
• not much difference in economic policymaking between Bill Clinton and Ronald Reagan
• both Reagan and Clinton grabbed on to globalization as a flawed yet essential tool to break away from the economically suffocating 1970s
• quarter-century of amazing prosperity and global poverty reduction
• period of policy consensus is at risk of coming to an end
• both political parties in the United States backing away from the pro-globalization policies championed by Bill Clinton
• part of the financial market turbulence, and dollar weakness, in recent times stems not only from subprime-related credit uncertainties
• also from the uncertainties about the direction of U.S. politics
• US politicians engaging in populist attacks on capital formation, entrepreneurial initiative and wealth creation
• problem with politicizing globalization
• world financial markets until now have set the price of U.S. financial assets, including the price of stocks
• at relatively high values
• based on the assumption that the Clinton-Reagan model of free trade, liberalized capital markets and long-term robust growth will remain largely intact
• new political universe emerging: less patience for freely liberalized trade
• questions of the hour are:
  
• How will markets in coming years reprice the changing nature of the political environment?
  
• Will an aggressive downward repricing of financial assets happen in a climate of panic?
• threat for financial markets of unwise political change is very real
• growing belief that the financial world, politically speaking, has entered uncharted political waters
• today’s voters look at globalization’s downsides with not enough appreciation of its tremendous upsides
• helped U.S. economy pull itself out of the 1970s period of economic heartache
• 1980s and 1990s produced a renaissance of American confidence and optimism about the future
• level of global wealth creation and poverty reduction that would have seemed far-fetched, verging on pure fantasy, in the late 1970s
• return to the seventies?
• economically devastating period
• politicians flirting with protectionist, class warfare policies that would unravel economic success that a broad international coalition worked desperately to achieve
• in rejecting the free-trade, liberalized financial market agenda of Bill Clinton, political community is at risk of creating the conditions for a global financial disaster
• first we’ll see a steady loss of global investor confidence in the US
• followed by shrinking of liquidity and credit availability
• then a protracted period of stagnant economic growth far below potential
• weaker growth will beget even more protectionist, class warfare rhetoric and policy
• will further shrink confidence in the US throughout the international system
  
  
• need to expand the base of the investor class
• future of globalization is politically unpredictable fundamentally because the base of financial capital ownership is so small
• wealth gap is widening
• as a result, globalization’s political base of support remains tenuous at best

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Ownership vs markets - Stumbling and Mumbling

Summary:
Chris Dillow argues that the traditional capitalist ownership structure is responsible for the credit crunch, not free markets as others have argued. Banks lost money on mortgage derivatives because of principal-agent failings, i.e. bosses (principals) don't know what the traders (agents) are doing. Traders have an incentive to take risk: life-changing bonus; gains exceeds benefits of prudence. Also, little pressure upon banks' executives to be prudent because when shareholding is dispersed, no individual shareholder has much incentive to rein in management. There has been more "bad" financial innovation that good ones. With good financial innovation it is very difficult for anyone to own its beneficial effects, it's a public good. Gains from “bad” financial innovation are more appropriable, hence we get more of it. Finally, banks' reluctance to lend to each other stems from the inability of management of such complex organisations to know everything. Banks should become more like venture capitalists, i.e. using an internal market, allocating capital to semi-independent divisions, which put in their own capital. (Published: 12/09/08)

Notes:

• Samuel Brittan and Anatole Kaletsky: credit crunch is undermining the case for free market capitalism
• but: crucial distinction between free markets and traditional capitalist ownership structures
• credit crunch does more to highlight the failing of the latter than of free markets
• Four reasons
• Banks lost money on mortgage derivatives because of principal-agent failings
• principals (banks’ bosses) didn’t understand what agents (traders) were doing,
  
• traders had incentives to take on excessive risk
• because the gains from doing so - a life-changing bonus - exceeded the benefits of prudence.
• Banks have been reluctant to lend to each other
  
• not so much because each bank fears its counterparty will not repay the money
• but: because they fear they’ll need the money themselves
• because banks just don’t know what sort of losses they are sitting on
• it’s impossible for managers of such complex organizations to know everything
• Banks are under-capitalized because chief executives have traditionally had incentives to maximize earnings by using leverage
• pressure upon them to be more prudent has been absent partly
  
• because when shareholding is dispersed, no individual shareholder has much incentive to rein in management
• [note: is shareholding too dispersed? 70% of all stock in America is now owned by financial institutions; as John Bogle said, in relation to Enron-type scandals, "the problem is that shareholders aren't owners anymore, they're agents of owners, and they do not actively engage in corporate governance, making sure that companies are managed for their shareholders etc.; instead they are more actively engaged in trading pieces of paper back and forth and they don't seem to care much about anything except whether the CEO meets the earnings expectations he's promised or doesn't; sometimes these expectations are met by fair means, but sometimes by foul ones" - like Dillow, Bogle also focuses on the ownership, but he blames it on the traditional owners capitalism having been replaced by managers capitalism]
  
• Good financial innovation has been lacking
  
• because it’s very difficult for anyone to own its beneficial effects;
  
• it’s a public good
• gains from “bad” financial innovation are more appropriable.
  
• so we get more of it
• e.g. overly complex mortgage derivatives
• solution
• not nationalization
  
• bad way of solving principal agent problems
• perhaps instead, banks should make more use of internal markets
• i.e. should become more like venture capitalists
• allocating capital to semi-independent divisions, which put in their own capital
• would restrain traders’ risk-taking
• as they can not so easily hide behind the fact that losses are spread over the whole firm
• would reduce the problem of asymmetric information between banks’ senior managers and trading desks
• as there’s a simpler test of how well the latter do: whether they can hand over enough hard cash to cover their required returns

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Falling Down - The New Republic

Summary:
Jospeh Stiglitz blames the current crisis are the financial system's latest innovations, fee structures that were often far from transparent. Imperfections of information (resulting from the non-transparency) led to imperfections in competition. Allowed banks to generate enormous profits and private rewards that were not commensurate with social benefits. Worst problems (e.g. subprime mortgage market) occurred when non-transparent fee structures interacted with incentives for excessive risk-taking. Too much effort has been devoted to increasing profits, creating financial products that enhanced risk, and not enough to increasing real wealth. Financial markets frequently fail to do what they are supposed to do in allocating capital and managing risk. Painful lesson from the 1930s and today is that the invisible hand often seems invisible because it's not there. (Published: 10/09/08)

Notes:

• Adam Smith: the market leads the economy, as if by an invisible hand, to economic efficiency and societal wellbeing
• Great Depression
• 1 in 4 Americans out of a job
• Smith's self-regulating markets a fallacy?
• some economists: in the long run the market's restorative forces will take hold, and we will recover
• Keynes's retort: In the long run, we are all dead.
  
• i.e. could not afford to wait
• today, 75 years later: another shock
• unofficially in recession
  
• more than half year since jobs were created
• "If the Great Depression undermined our confidence in macroeconomics (the ability to maintain full employment, price stability, and sustained growth), it is our confidence in microeconomics (the ability of markets and firms to allocate labor and capital efficiently) that is now being destroyed."
• resources were misallocated and risks were mismanaged so severely that the private sector had to go running to the government for help, lest the entire system melt down
• cumulative gap between what our economy could have produced and what we will produce over the period of our slowdown estimated to be more than $1.5 trillion
• had we invested in actual businesses
• rather than e.g. mortgages for people who couldn't afford their homes
• financial markets rightly blamed
• it is their responsibility to allocate capital and manage risk, and their failure has revived several old concerns of the political (and economic) left
• increasing dependence on service sector
• including financial service
  
• decreasing reliance on manufacturing
• is the whole thing was a house of cards?
  
• i.e. aren't "hard objects" the "core" of the economy? And if so, shouldn't they represent a larger fraction of our national output?
• the food we eat, the houses we live in, the cars and airplanes that we use to transport us from one place to another, the gas and oil that provides heat and energy
• answer: no
• live in a knowledge economy, an information economy, an innovation economy
• because of our ideas, we can have all the food we can possibly eat with only 2 percent of the labor force employed in agriculture
• even with only 9 percent of our labor force in manufacturing, we remain the largest producer of manufactured goods
• better to work smart than to work hard
• our investments in education and technology have enabled us to enjoy higher standards of living than ever before
• we would do even better if we had more resources in these sectors
• but: our recent success may based on a house of cards
• in recent years financial markets created a giant rich man's casino, in which well-off players could take trillion dollar bets against each other
• weren't just gambling their own money
• were gambling other people's money
• were putting at risk the entire financial system, indeed, our entire economic system
• now we are all paying the price

• financial markets as the brain of the economy
• supposed to allocate capital and manage risk
• when they do their job well, economies prosper
• when they do their job badly everyone suffers
• financial markets are amply rewarded for their work
• in recent years, they have received over 30 percent of corporate profits
• standard mantra in economics was that these rewards were commensurate with their social return.
• i.e. financial wizards might walk off with a great deal of money but the rest of society is better off
  
• because our capital generates so much more productivity than in societies with less well-developed--and less rewarded--financial markets
• part of the rewards that accrue to financial markets are thus for encouraging innovation
• through venture capital firms and the like

• financial innovation to blame
  
• financial system's latest innovation was to devise fee structures that were often far from transparent and that allowed it to generate enormous profits
• private rewards that were not commensurate with social benefits
• imperfections of information (resulting from the non-transparency) led to imperfections in competition
• helps to explain why the usual maxim that competition drives profits to zero seemed not to hold
• the worst problems (e.g. subprime mortgage market) occurred when non-transparent fee structures interacted with incentives for excessive risk-taking
  
• financial managers got to keep high returns made one year, even if those returns were more than offset by losses the next
• had those in the financial sector allocated capital and risk in a way that fueled the economy, they would have had handsome profits
• but they wanted more
• so established incentive structures that encouraged gambling
• if they gambled and won, they could walk away with a share of the profits.
• if they gambled and lost, the investors would bear the consequences

• current woes in America's financial system are not an isolated accident
• more than one hundred financial crises worldwide in the last 30 years or so
• in each of these instances, financial markets failed to do what they were supposed to do in allocating capital and managing risk
• e.g. in the late '90s, for instance, so much capital was allocated to fiber optics that, by the time of the crash, it was estimated that 97 percent of fiber optics had seen no light
• problem with the U.S. economy is not that we have allocated too many resources to the "soft" areas and too few to the "hard" (i.e. services/knowledge vs. manufacturing)
  
• not necessarily the case that we have allocated too many resources to the financial sector and rewarded it too generously
• but:
  
• too little effort was devoted to managing real risks that are important
• i.e. enabling ordinary Americans to stay in their homes in the face of economic vicissitudes
• too much effort went into creating financial products that enhanced risk
• too much energy has been spent trying to make an easy buck
• too much effort has been devoted to increasing profits and not enough to increasing real wealth
• whether that wealth comes from manufacturing or new ideas
• painful lesson from the 1930s and today:
  
• The invisible hand often seems invisible because it's not there.
  
• at best, it's more than a little palsied.
  
• at worst, the pursuit of self-interest--corporate greed--can lead to the kind of predicament confronting the country today

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Is there an exit strategy? - The Guardian

Summary:
Kenneth Rogoff argues that weak banks must be allowed to fail or merge (with ordinary depositors being paid off by government insurance funds), so that strong banks can emerge with renewed vigour. Efforts to block a healthy and normal dynamic will ultimately only prolong and exacerbate the problem. Number of central banks currently very exposed. Have to ways of dealing with hits to their balance sheet: through inflation, or recapitalisation by taxpayers. Both solutions are extremely traumatic. Fairness issue: why should ordinary taxpayers foot the bill to bail out the financial industry? Poorest will be hardest hit by inflation tax. More regulation is necessary but is not the whole answer. Today's financial firm equity and bond holders must bear the main cost, or there is little hope they will behave more responsibly in the future. (Published: 08/09/08)

Notes:

• becoming apparent that, after a period of epic profits and growth, the financial industry now needs to undergo a period of consolidation and pruning
• weak banks must be allowed to fail or merge (with ordinary depositors being paid off by government insurance funds), so that strong banks can emerge with renewed vigour
• efforts to block a healthy and normal dynamic will ultimately only prolong and exacerbate the problem
• not allowing the necessary consolidation is weakening credit markets, not strengthening them
• Fed, ECB and BOE
• particularly exposed
• collectively have extended hundreds of billions of dollars in short-term loans to both traditional banks and complex, unregulated "investment banks"
• not end of the world if central banks are faced with a massive hit to their balance sheets
• but: history suggests that fixing a central bank's balance sheet is never pleasant
• faced with credit losses, a central bank can
  
• either dig its way out through inflation (inflation tax)
  
• but: raging inflation causes all kinds of distortions and inefficiencies
• inflation has spiked during the past year, conveniently facilitating a necessary correction in the real price of houses
• or await recapitalisation by taxpayers
• but: taxpayer bailouts are seldom smooth and inevitably compromise central bank independence
• both solutions are extremely traumatic
• fairness issue
• financial sector has produced extraordinary profits
• official US statistics indicate that financial firms accounted for roughly one-third of American corporate profits in 2006
• multi-million dollar bonuses on Wall Street and in the City of London have become routine
• financial firms have dominated donor lists for all the major political candidates in the 2008 US presidential election
• why should ordinary taxpayers foot the bill to bail out the financial industry?
  
• why not the auto and steel industries, or any of the other industries that have suffered downturns in recent years?
  
• this argument is all the more forceful if central banks turn to the "inflation tax"
• falls disproportionately on the poor
• have less means to protect themselves from price increases that undermine the value of their savings
• after a period of massive expansion during which the financial services sector nearly doubled in size, some retrenchment is natural and normal
• the sub-prime mortgage loan problem triggered a drop in some financial institutions' key lines of business
• particularly their opaque but extremely profitable derivatives businesses
• some shrinkage of the industry is inevitable
• central banks have to start fostering consolidation, rather than indiscriminately extending credit
• time to take stock of the crisis and recognise that the financial industry is undergoing fundamental shifts
• is not simply the victim of speculative panic against housing loans
• certainly better regulation is part of the answer over the longer run
• but it is no panacea
• today's financial firm equity and bond holders must bear the main cost, or there is little hope they will behave more responsibly in the future

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All in this together? - FT.com

Summary:
Overview of the economic situation and outlook for the UK, Eurozone, US and Japan. The global slowdown is the result a of a number of simultaneous shocks (the commodities shock, the housing shock and the credit shock) that have hit countries in different ways. In the US the focus is on the credit crunch, and the economy has proved resilient in the face of the commodities and housing shocks, whereas the UK and the Eurozone appear more affected by the commodities shock. The UK appears particularly vulnerable, with utility price rises feeding through fast. The ECB is mainly concerned about sticky prices and inflation. The US may be experiencing a Road Runner moment, and plummet as of yet. Doubts as to whether the credit crunch or the commodities shocks dominates the slowdown. Different outcomes depending on the true cause. (Published: 07/08/08)

Notes:

• UK: Utility price rises feed through fast
• UK has replaced the US as the economy seen to be at greatest risk of a severe downturn
• economic outlook has deteriorated more rapidly over the past quarter than that of any other advanced economy
• OECD now expects the UK economy to shrink for the rest of this year
• unlike any other Group of Seven economy
• Darling: economic circumstances facing Britain may be the worst in 60 years
• Bank of England:
  
• "sluggish real income growth and constraints on the ability of households to borrow dampen consumer spending, while the weak outlook for demand and the housing market [will] lead to falls in business and residential investment"
• so far, the dominant effect has been the squeeze on household and corporate incomes from higher global commodity prices
• has been exacerbated by a sharp depreciation in sterling
• which raised import prices
  
• and a liberalised market in gas and electricity
• has fed higher utility prices through the economy faster than in continental Europe
• fear is that, looking forward, tight credit conditions combined with Britain's high levels of debt and rapidly falling house prices are likely to prove more troubling than in many other countries

• Eurozone: Concerns surround 'sticky' inflation
• eurozone slowdown
  
• mainly the result of higher commodity prices
• have hit consumer spending
• should gradually revive if commodities now remain stable or decline
• as well as slowing global demand for exports from the 15-member bloc
• i.e. appreciation of the euro against the dollar
• until very recently has sharply aggravated the effect of slowing US growth on eurozone trade
• ECB sees price-setting mechanisms as working differently in the eurozone and the US
• requiring it to operate a more hawkish policy
• prices in the eurozone are "stickier":
  
• once inflation has become elevated, it stays there for longer
• financial turmoil a risk to growth
• but ECB insists that there is little evidence of a eurozone credit crunch
• surveys suggest banks have tightened credit standards significantly
• but lending to the private sector has continued to grow strongly
• housing markets in Spain and Ireland have weakened sharply but corrections there are not seen as a big problem at eurozone level

• US: Credit pain may yet reach its worst
  
• markets surprised by the strength of US growth in Q2
• but: this growth came almost entirely from net trade
• fear is that with the rest of the world weakening, the US will receive much less support from trade in the months ahead
• US economy has so far proved resilient to its house price crash, the credit squeeze and higher oil prices
• question is whether the economy is not very vulnerable to financial disruptions - or whether time lags are just longer than originally thought
• Fed thinks it is mostly a question of lags
• e.g. unemployment jumped unexpectedly to a five-year high of 6.1 per cent in August
• many experts fear that the peak impact of the credit crisis on real activity is yet to come
• most expect a very weak second half
  
• with the possibility of a quarter or two of negative growth around the turn of the year, as the effect of tax rebates wears off
• Fed cannot rule out a deeper and more protracted downturn
• officials increasingly downbeat on the outlook for growth outside the US
  
• one reason why the Fed now appears more comfortable keeping interest rates at 2 per cent for an extended period

• Japan: The contribution from exports goes
• economy contracted by a sharper than expected 0.2 per cent in Q2
• does not have the luxury of a high-growth cushion to help it absorb shocks
• net exports contributed nothing to growth
• for years Japan's main economic driver along with export-related capital spending
• until few months ago, falling exports to the US had been largely compensated for by rising shipments to Europe, the Middle East, Russia and other emerging economies
• but while exports to some developing countries are still robust, they are no longer enough to plug the gap left by falling demand from the US and, now, Europe
• no improvement in domestic consumption
• unlikely in light of weak wages and a softening jobs market
• Japan will have to wait for a recovery in global demand before growth picks up again

• cause of the global slowdown
  
• recent sell-off in global commodity markets
  
• signals growing concern that economic weakness could continue to spread in the months ahead
• many investors have gone from believing in a "decoupling" story to seeing a globally synchronised downturn
• prompting a bounce in the dollar
• seen as a safe-haven in a global downturn
  
• but: may be that just as the "decoupling" hypothesis was naive, the notion of a globally synchronised downturn may also be simplistic
• world's economies are battling a set of roughly simultaneous shocks that differ in their scope and reach
• commodities shock
• hit all economies more or less equally through sharp rises in food and energy prices that preceded the latest partial retreat
• credit shock
  
• global in reach but uneven in its impact
• effects greatest in the US and UK and least marked in Japan and the emerging world (the eurozone lying somewhere in between)
• housing shock
• residential prices crashing in a number of economies including the US, UK, Spain and Ireland
• all have been accompanied by economic spillovers from events in each economy
• effect is like seeing several large rocks thrown into a pond at once, each sending ripples that run across each other
• different interpretations of global events in different parts of the world
• US: tendency is to emphasise the credit squeeze
• not just domestically, but globally too
• other industrialised nations: experts attribute the Q2 global slowdown to what was then a surge in oil prices
  
• aggravated by the swing in trade
• (un)importance of the financial crisis
• some think US experience suggests that the global economy may just not be very vulnerable to financial disruptions
• could be that the credit shock was less important and the commodity price shock more important to the world economy than we thought
  
• or a Road Runner moment?
  
• possible US economy, having scuttled off the edge of a cliff and kept going for a brief while, looks down and plummets
• Fed thinks financial stress will have a big impact on growth in the months ahead
• credit squeeze appears to be most potent when it is combined with falling house prices and strained household balance sheets
• as in the US and the UK
• but: falling house prices may turn out to be a broader problem
• early 2000s saw a house price boom in dozens of countries
• OECD: real house price gains are now "decelerating nearly everywhere"
• commodities and consumer and business confidence
  
• has fallen sharply in non-US industrialised economies
• bodes ill for consumption and investment
• suggests that confidence may be an important channel in its own right
• transmitting weakness that originated in the US
• possible that the main cause of poor confidence was the surge in commodity prices
• if so, confidence should recover as commodity prices subside
• if the slowdown outside America was primarily a story of commodity prices - and not a global credit squeeze
  
• then after a weak period mid-year the world economy should pick up again
• US would by year-end again underperform relative to its peers but would continue to see support from exports
• even if the commodities story is right, there are risks ahead
• the oil market in particular remains tight and could rebound if the global growth scare abates
• credit squeeze
• if the credit squeeze is the key, weakness could spread as global banks cut lending
• non-US industrialised economies may anyway still be incapable of sustaining autonomous growth
• much depends on the performance of the big emerging economies
• above all China
• some experts still doubt the ability of the big emerging economies to substitute domestic demand for exports.
• China and its peers may either slow more sharply than anticipated or reaccelerate too quickly, igniting inflation at home and in commodity prices, before they are forced to slam on the brakes again, with potentially global consequences

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Is the Market Still a Future Indicator? - The Big Picture

Summary:
Barry Ritholz with some thoughts on the Efficient Market Hypothesis, or the idea of markets efficiently reflecting future corporate earnings. Clearly not the case. Some examples: credit crunch; dotcom crash. Note in later case, markets were initially pricing stocks as if earnings didn't matter, whereas three years later some profitable, debt-free tech firms were trading below cash on hand. Stockmarkets now more likely to move in tandem, even lag the trajectory of profits. Blamed on the proliferation of hedge funds. Is making markets increasingly focused on breaking news and short-term swings, rather than longer-term fundamentals. Yet, to an EMH proponent, hedge funds should make markets more, not less efficient. Robert Schiller: The huge mistake EMH proponents have made: just because markets are unpredictable doesn't mean they are efficient. That false leap of logic was one of the most remarkable errors in the history of economic thought. (Published: 11/08/08)

Notes:

• Efficient Market Hypothesis:
• the markets constitute a future discounting mechanism
• i.e. efficiently reflects future corporate earnings
• makes sense, as one ostensibly buys stocks in companies to claim bucketfuls of their future profits
• i.e. behaves like a crystal ball
• should have died a quite death
• but on Wall Street, myths, bad theories, and old information linger far longer than one would expect
• WSJ: "For decades, turns in the stock market typically led earnings by roughly six months. But during the past decade or so, stocks have moved roughly in tandem with, and occasionally lagged, the trajectory of profits, notes Tobias Levkovich, Citigroup's chief U.S. strategist."
• plenty of examples of where markets simply get it wrong
• exhibit A: credit crunch
• began in August 2007 (though some had been warning about it long before that)
• despite all of the obvious problems that were forthcoming, after a minor wobble, stock markets raced ahead
• by October 2007, both the Dow Industrials and the S&P500 had set all time highs
• so much for that discounting mechanism!
• dotcom crash
• March 2000: the market was essentially pricing stocks as if earnings didn't matter
• growth could continue far above historical levels indefinitely
• value was irrelevant
• How'd that work out?
• 3 years later:
• some of the most profitable, debt free tech and telecom names were trading below their book value
• some were even trading below cash on hand.
• the market had "efficiently" priced a dollar at seventy-five cents
• most fascinating aspect of this is the opportunity for anyone in t he market to identify inefficiencies
• discover where the market has a non random error -- we've called it Variant Perception over the years -- and you have a potentially enormous money making opportunity
• is the reason why everyone doesn't simply dollar cost average into index funds
• its the lure of the big score
• proliferation of hedge funds
  
• is making markets increasingly focused on breaking news and short-term swings, rather than longer-term fundamentals.
• contribute to this phenomenon are the narrow niche focuses used to differentiate amongst funds and raise capital
• but: to an EMH proponent, hedge funds should make markets more, not less efficient
• their long lock period (when investors cannot take out cash) means they should have a longer time horizon for investment themes to play out.
• Robert Schiller
• "The huge mistake EMH proponents have made: just because markets are unpredictable doesn't mean they are efficient. That false leap of logic was one of the most remarkable errors in the history of economic thought."
  

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Greenspan: Housing Stabilization Key to Crisis End - WSJ

Summary:
Greenspan: A necessary condition for an end to the current global financial crisis is the stabilization of the price of homes in the U.S. Stable home prices will clarify the level of equity in homes, the ultimate collateral support for much of the financial world’s mortgage-backed securities. We won’t really know the market value of the asset side of the banking system’s balance sheet — and hence banks’ capital — until then. Public policy can hasten this process by not prematurely propping up housing starts and by expanding the underlying demand for homes generally. The most effective initiative, though politically difficult, would be a major expansion in quotas for skilled immigrants. Skilled immigrants tend to form new households, by far the most important source of new home demand. (Published: 13/08/08)

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Word of the Day: Haircut

The percentage by which an asset's market value is reduced for the purpose of calculating capital requirement, margin, and collateral levels, or the difference between the actual market value of a security and the value assessed by the lending side of a transaction.

Notes:

• The term haircut comes from the fact that market makers can trade at such a thin spread.
• When they are used as collateral, securities will generally be devalued since a cushion is required by the lending parties in case the market value falls.
  

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Credit Crisis 'Only Now Beginning' - Bloomberg

Summary:
David Goldman, a portfolio strategist at Asteri Capital, talks about the outlook for the U.S. financial-services industry, the impact of the hedge-fund model on market volatility and his investment advice. This is not a mere recession, it's a change in the lives of Americans. We're still in the credit bubble, because of contractual obligations the banks have. The credit crunch hasn't started yet, merely a mild indisposition so far. The credit crunch is what comes next, and it will be brutal. The hedge fund business is very vulnerable. All in the same trade all the time and every turn is like a stampede out of a crowded theater. Only the big funds that have a lock on capital may do well. If you marked everyone to market now, the banks would be in very bad shape, many insolvent. Isn't going to happen and banks will try to generate enough earnings in order to bring in the capital back while they pretend that they're still solvent. But losses from consumer lending may pile up faster. We may have a deflationary outcome, destroying huge amounts of wealth in the form of homes and equities and companies is in principle inflationary. (Published: 14/08/08)

Notes:

• not a recession, not a blip: it's a change in the lives of Americans who've spent the last 10 years in the delusion that they'd fund their retirement by selling homes back and forth to eachother at higher prices
• the financial industry enabled them by sustaining this delusion
• delusion is now coming unravelled
• no one is going to retire, entire neighborhoods will turn into slums and financials will trade at 50% of book
  

• a year from now we're still going to have a very weak economy;
  
• that may be long enough to find the bottom;
• but it's going to take a rebuilding of household balance sheets, ie a lot of saving
• what we have now is a lot of dis-saving
• Mr Market is going to have to kick their teeth down their throats to change their behaviour

• hedge fund business now (compared to 1998) is much bigger and much more vulnerable
• with everyone forced to take the same trade, volatility intra-month so great that those investors who are committed to a month by month sharp ratio low volatility strategy will be forced to redeem and you get wild swings and illiquidity and inability to liquidate positions
• we're going to have a serial catastrophe of hedge funds
• particularly the type of fund that thought it was a great idea to buy loans at 90 cents to the dollar and won't be able to sell them at 80 later this year
  

• private equity can make money in this kind of market, if you're right and you willing to take massive volatility intra-month, and hang on for a year or two; you can do extremely well
  
• but if you have to grind out returns month by month, which is the conventional hedge fund model, you end up creating volatility because you're all in the same trade all the time and every turn is like a stampede out of a crowded theatre
  

• hedge funds are one of the major sources of volatility, and have become one of the major sources of risk
  

• the most important thing to keep in mind is: we have not had a credit crunch yet; we've had a 20% annual rate of increase of bank lending to corporations, and an even faster rate of securities purchases; we've had a credit bubble continuing
• this is because banks are contractually locked into make loans, largely revolving credits, which they can't get out of
• so the credit crunch is only begining to start
• we're now seeing banks cut off home equity lines to consumers, we're seeing the beginning of cut off credit card lines;
  
• but we had a spike in credit card usage because since the home equity lines were cut off, consumers used their credit cards
• the credit crunch is only now beginning because bank capital is so restricted by losses to date that they will have to begin shutting of credit to households and corporations
• and that's when we're going to get the defaults
• what we have had in aggregate is a credit bubble till today; a credit crunch is technically the wrong expression;
  
• the credit crunch is what comes next, and will be brutal compared to the mild indisposition we've had for the past 12 months
  

• financial institutions would be well-advised to try and clear their books as quickly as possible
• take the pain now because it will be more painful later
  

• SIVs are essentially a corpse waiting to be buried;
• you now have a highly ambiguous situations regarding all of the off-balance sheet assets of banks;
  
• the Federal Accounting Standards Board (FASB) was supposed to have ruled in a way that would force banks to take several billion dollars of asset-backed securities and take them out of off-balance sheet structures and consolidate them back on their books, which would increase the capital demands on the banks
• that was one of the reasons that financial stocks were in such hot water during May and June;
  
• the FASB turned around and postponed that ruling;
  
• obviously they looked at the distressed state of the banks and decided that it was a bad time to stress their capital base again;
  
• so a great deal of this remains under negotiation or in complete unclarity because the regulators, the FASB and the SEC, have not decided what to do about it
  

• if you marked everyone to market now, the banks would be in very bad shape;
  
• they certainly would have inadequate tier one capital, many of them would be insolvent
• wouldn't be the first time, the banking system might have been insolvent in 1990, also might have been in 1981
• so no one is going to mark the stuff to market;
  
• the question is can they generate enough earnings in order to bring in the capital back while they pretend that they're still solvent;
  
• but the problem is, as the rot gets into the consumer sector and the losses pile up from consumer loans and high yield loans, my view is their capital is going to be decreasing; instead of earning their way out of it, they're going to be piling up fresh losses
  

• the only hedge fund model that will work now is to be huge and have a lock on money for a long period of time;
  
• if you can take the courage of your convictions and ignore 10 or 20 or 30% down months in order to get 50% up years, then this is a good thing to do;
  
• and if you want to invest in hedge funds, find managers whose convictions you believe in, who are willing to swing for the fences, and will insist on taking your money for a period of time and have the courage to do it
• or keep it in treasury bills

• I believe that we're going to have an enormous taxpayer bailout for the GSEs and for a number of banks; i think it will look like the 80s, when we had a $700b bill for the S&Ls, but it will be larger

• in an economy where there aren't enough hedges, the price of hedges can be arbitrarily high
• what's the price of a last ticket on the Paris-Marseille express on the night of that the Germans march into Paris? The answer is how much do you have in your pocket;
  
• we may have a deflationary outcome, destroying huge amounts of wealth in the form of homes and equities and companies is in principle inflationary;
  
• the hedge against this in the form of commodity investing has turned out not to work that well in the last several weeks,
  
• and the signals that we're getting from the TIPS market - the break-even inflation rate between TIPS and coupons - has actually come in to the lowest in years;
  
• so we may have an inflationary environment

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Globalisation and the costs of international trade from 1870 to the present - Vox EU

Summary:
Many analysts suggest that rising oil prices will sharply reduce international trade. This paper argues to the contrary, noting that transport costs constitute a limited share of trade costs (about 1/3rd). Instead of transportation costs, the biggest reversal of international trade in recent history is linked to large increases in protectionist measures. Moreover, evidence from the first wave of globalisation suggests that higher shipping costs are unlikely to significantly dampen international commerce – only protectionism would seriously threaten trade. Compared with historical patterns, the level of bilateral trade costs is still high for many country pairs, especially for those that are far away from each other. This means that there is scope for trade costs to fall further. Unless there is a backlash in the form of rising protectionism, world trade has the potential to keep growing strongly over the coming decades. (Published: 16/08/08)

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Back to bust? High technology on course for harder times - FT.com

Summary:
The IT industry may be about to face its toughest period since the dotcom bust due to the slowdown in the economy. Corporate demand, the IT industry's main source of prosperity, will fall significantly. Instability in the financial markets, declining new hires and weakening corporate profits will result in a lowering of capital expenditure and a premium being placed on operational efficiency. This is likely to play out over the next 9 months, with tech stock, already down 19% over the last 12 months, to fall further. Other recent trends that will compound the impact of the economic slowdown are the increase in choice leading to price deflation; the rise of software as a service and virtualisation. Consumer spending and spending on advertising, an important source of revenues for many Web 2.0 startups are also in decline. The downturn, however, may be less painful than the dotcom crash. There is less overcapacity in the industry, and increasing demand from the emerging world for IT services is compensating for the slowdown in the US and UK. (Published: 14/08/08)

Notes:

• information technology industry may be about to face its toughest period since the dotcom bust
• forgotten side of the technology world: industry's main source of prosperity is the corporate customer
  
• the engine that powers Silicon Valley and the rest of the technology industry
• "flashy gadgets such as Apple's iPhone and online consumer services such as Facebook may have captured the popular imagination and created new technology fortunes, but they are not the industry's main source of prosperity"
• companies account for 60-65 per cent of the end-market for technology
• consumer technology represents only about 20-25 per cent
• governments make up the rest
• with a pronounced economic slowdown in the US and the UK, this engine has started to sputter:
1. weakening corporate profits
2. decline in new hires
   
3. instability in the financial markets
   
• these have historically all been warning signs of lower capital spending ahead
• based on the usual lag, the turmoil in credit markets of the past year virtually guarantees that corporate spending on technology will fall over the next nine months or so
• technology demand, which has been growing recently at an annualised rate of 5-6 per cent, could decline by 10 per cent
• tech stock investors
  
• investors in tech stocks are invariably drawn by the promise of superior growth
• made the sector a stock market stand-out for much of last year, as a slowing US economy made growth stocks rarer
• industry's seemingly endless hype cycle feeds this optimism
• there's always a new computing architecture about to go mainstream, a new must-have gadget, and a Next Big Thing
• optimism is often justified given the big markets that new technologies can create
  
• but: investors frequently pay dearly for that potential
• "If it doesn't work, you get your neck broke"
  
• tech stocks have fallen 19 per cent over the 12 months to the end of July
• nearly double the rate of the overall market
• operational execution at a premium
  
• "I expect the slowdown to profoundly impact Silicon Valley internet, networking and technology companies over the next 12 to 18 months"
• "Technology start-ups should already be tightening their cost controls and turning their attention to the nuts and bolts of operational efficiency."
  
• "There are still numerous long-term growth opportunities across Silicon Valley, but operational execution is at a premium and much more of a differentiator than it has been in many years."
  
• Jim Breyer, partner in VC firm Accel Partners
• recent trends in the technology industry compounding the impact of the worsening economic environment
• availability of choice -> price deflation
  
• thanks to the rise of the internet and other standards-based technologies
• made it easier for buyers to shop around
  
• many corporate buyers have come to count on these to help them continually reduce the overall size of their tech budgets
• When the 1990s tech boom reached its peak, corporate buyers were often tied to proprietary systems from single suppliers
• that is no longer the case
• result: a severe price deflation has taken hold in some corners of corporate technology
• rise of "software as a service" and virtualisation
• two of the most powerful recent technology trends that exemplify this change
  
• software as a service (SAS)
• involves shifting corporate computing tasks to online services
• e.g. using a company such as Google to provide an e-mail service
• "I don't have to buy servers, I don't have to buy storage, I don't have to do back-ups"
• many of these service companies have priced their services at rock-bottom rates
• relying on attracting large volumes of customers to spread their large fixed costs
• "We're talking about products that are one tenth the cost of things that were hawked in the last recession"
• virtualisation
• makes it possible to run several computing workloads on a single server,
• greatly reducing the number of machines that companies need to buy and maintain
• trends like these have created new markets and supported the rise of new companies
• but 1: they have also exposed those whose technologies or business models are not suited to the changing times
• e.g. Sun Microsystems
• soared in the dotcom boom as its proprietary servers became the mainstay of Web 1.0
• but has struggled to adapt to the latest generation of low-cost, standards-based machines and open-source software
• but 2: even tech companies that have been better positioned to ride this wave are starting to feel the pinch.
• due to weaker corporate demand
• companies taking a more "pragmatic" approach to their tech budget
• putting off buying new services
• not just weaker corporate demand
• consumer spending on tech, though far less significant overall and traditionally less prone to big dips, could also be hit in a wider downturn
• another big source of growth, the rapid rise in online advertising, has slowed notably this year in the face of a wider softening in consumer advertising
• after growing nearly 26 per cent in 2007, online advertising in the US, is predicted to grow by only 17.5 per cent this year and 14.5 per cent in 2009, before growth eventually pushes back above 20 per cent in 2011
• search still dominates
• people are cutting back on typical display ads
  
• this slowdown in advertising could not have come at a worse time
• many of the consumer web companies created since the dotcom crash have been avidly building an audience in the expectation that they will cash in through advertising

• downturn will not be anywhere near as painful as the one that hit the industry at the start of this decade
• late-1990s tech binge was more than a bubble in stock market valuations:
  
• it also reflected a massive bubble in tech spending
• internet euphoria
• fear that many older IT systems would not be able to handle the date shift at the turn of the millennium
  
• combined to produce a boom in corporate spending
• we don't have the overcapacity in IT systems we had going into the last downturn
• capital spending in the US has been low by historical standards for the past four years
• will cushion the blow from any fall now
• demand from emerging world growing
  
• after many years of investment, these markets are finally on the brink of becoming significant money-earners for some of the industry's biggest players.
• at its current growth rates, these "growth markets" may account for nearly 30 per cent of its revenues in five years' time
• Silicon Valley is once again turning into a place of "haves" and "have-nots"
• those start-ups that raised a comfortable cushion of cash from investors to see them through this more uncertain period and those that risk being left high and dry if business turns down
  

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