Saturday, October 31, 2009

How About a New Financial Intermediary: Main Street Banks?

The essential function of the banking system is to take money from savers and other holders of capital and lend it to borrowers. Banks serve as intermediaries in this process, taking capital in the form of deposits and deploying it in the form of loans. Without the intermediation of banks, holders of capital would have a harder time obtaining returns and borrowers would have a harder time getting loans. Capital would flow less freely and economic growth would probably be slower. Banking--i.e., the original form of financial intermediation--worked because bankers provided the expertise needed to make sound, profitable loans. Because bankers held the loans, they managed them prudently to minimize loan losses.

A very important innovation in financial intermediation in the last 30 years was securitization of loans. This was a process in which banks bundled together loans into asset backed securities and sold interests in these securities to investors. Through the magic of financial engineering, stodgy residential mortgages, and eventually credit card, auto and commercial loans, often ended up in AAA-rated investments sold on Wall Street. Banks liked securitization because it provided fee income from making and selling loans, and then managing them, while supposedly transferring the risk of credit losses to the investors. Funds obtained from the sale of the loans would be used to make new loans, with more fee income generated. Loan losses would go down because fewer loans would be held. The banks' return on capital presumably could go up as banks became fee earning entities rather than lenders bearing the risk of credit losses. The real lenders, the investors in the securities, were often getting investments that were supposed to be about as safe as U.S. Treasuries.

We know how this story ended. The banks got so good at marketing their financial marvels that everyone and their uncle, including municipalities in Norway, wound up buying America's biggest export: loans. Banks' demand for loans, especially mortgage loans, became voracious and anyone with a pulse and signature could get one. Trillions of dollars were invested in mortgage backed securities and derivatives thereof like the now infamous CDOs. The securitization market became the dominant and unregulated sector of commercial banking. Risk wasn't managed because it supposedly was being dumped on--whoops, transferred to--the investors. Things would have worked out fine if the laws of economics had been suspended and the real estate market had kept rising forever.

But when fantasies collide with reality, it ain't reality that loses. Now, in the aftermath of the mortgage crisis and credit crunch, investors avoid securitizations like the plague, because securitization proved to be a plague on investment portfolios. CPR administered by legions of federal paramedics has raised a faint pulse in the securitization market, but the Fed can't forever continue its role as the buyer of first and last resort in the securitization market. Realistically speaking this patient won't recover. Trillion dollar markets are now billion dollar markets, and that's only for carefully screened bundles of loans to prime borrowers. Subprime loans, to the limited extent they are made at all, couldn't be sold for a nickel.

In spite of trillions of dollars of bailout money, cheap credit and other federal accommodations, the big banks aren't lending. Smaller banks are pulling back, and can be expected to scale lending down even more next year as commercial real estate losses take hold and unemployment rises. The credit crunch isn't over. It's simply shifted from money center banks to consumer and commercial borrowers. In other words, it's gone from Wall Street to Main Street.

New lending is badly needed. Securitization has lost credibility with investors and won't play a major role in the future. A new form of financial intermediation is needed. It shouldn't be complex or novel, because today's holders of capital, afflicted with battered investors syndrome, won't go near anything smacking of financial engineering. Reliability is far better than genius when your retirement money or college fund is at risk. Using familiar, existing structures would be the easiest way to go.

Back in the days when a single black and white TV in the living room and one car in the garage were considered hallmarks of a comfortable middle class life, banks were securitizations. They made a variety of loans, held them in their portfolios (effectively bundling them) and paid depositors interest from the interest paid by borrowers. In effect, the depositors had a de facto interest in the bank's portfolio of loans. Not all banks got AAA ratings, but federal deposit insurance was more than the equivalent so depositors considered their money safe.

A quick way to steer credit back toward Main Street would be to offer regulatory advantages to banks chartered (or rechartered) to lending primarily to Main Street--i.e., to consumers and businesses. For example, let's say we require a bank to lend at least a third of its deposits to consumers, another third to businesses, and a minimum of 90% to consumers and businesses combined (so that if the bank loaned 35% to businesses, it would have to lend at least 55% to consumers). Such a Main Street bank could be allowed to offer federally insured accounts up to $1 million or even $5 million per customer for interest bearing accounts (compared to current limits of $250,000); non-interest bearing accounts today are already insured without limit but that hasn't solved the Main Street credit problem. With heightened federal deposit insurance coverage, Main Street banks could attract larger depositors looking for safety, and the government would funnel more credit to those who today are crunched.

Many of America's smaller financial institutions could probably transform themselves into Main Street banks with relative ease, since they tend engage in traditional commercial banking. Credit unions, in particular, might find Main Street banking familiar. Since federal banking regulators are imposing greater prudence on all banks, raising the insurance deposit limits shouldn't result in a surge of reckless lending. Besides, the fact that there is no securitization market in which to dump dicey loans would make Main Street banks more cautious anyway. The cost to taxpayers of Main Street banking's higher deposit insurance coverage could be ameliorated by the fact that federal deposit insurance is paid for, in the first instance, by premiums charged to the banks. Taxpayers only provide backup. Main Street banks could be required to pay higher premiums for their better coverage.

Of course, it's likely the big money center banks would be vociferously unhappy about any such proposal, since they couldn't transform themselves into Main Street banks. They're too heavily invested in stock and commodities trading, investment banking and other activities that generate very large employee bonuses. But Wall Street's engineers are looking for lucrative ways to buy up whole life policies, not make loans to consumers or to the small businesses that typically do much of the hiring in an economic recovery. The big banks are not serving the public need for credit, and we need someone who will. Chartering Main Street banks may be a quick way to revive lending to the real economy.

Thursday, October 29, 2009

Why Wall Street Should Oppose Too Big to Fail

The too-big-to-fail doctrine, now at the heart of the administration's proposal to reform financial regulation, might seem the best of all possible worlds to the big banks on Wall Street. They can take all variety of risks, speculating in this and dabbling in that, yet their obligations are guaranteed 100% by the U.S. government. Anyone and everyone will trade with them--and indeed at favorable prices--because they cannot default. Their borrowing costs will be barely above comparable Treasuries, but their profits have no upper limits. Although the administration and the federal banking authorities rumble about pay limits, that's why you have lawyers. There's never been a lawyer who didn't see a loophole or five in the law, and the highly compensated counsellors who serve the carriage trade will burn the midnight oil so that they can find every tiny crack in the regulatory structure, figure out how to drive a tractor trailer of compensation through it, and bill their clients handsomely in the process. And should there be a scarcity of loopholes, the canine-toothed lobbyists on K Street will whip out their checkbooks, already preprinted to be payable to (blank) Re-election Campaign, and make Swiss cheese of previously solid law.

But sometimes, something that looks almost too good to be true is too good to be true. The too-big-to-fail policy, already implemented by the Federal Reserve and Treasury Dept. on a de facto basis, has created a cartel of financial oligarchs. These megabanks derive significant market advantages from their favored status, and have reported commensurate profits. But the backlash has already begun. Their compensation policies are under severe scrutiny. Counter-intuitively, Citigroup had to sell what was perhaps its most profitable unit, the commodities trading operation that was supposed to pay its head trader $100 million this year. Those banks with credit card operations are losing significant revenue streams as new legislation increasing consumer protections restrain the gouging of struggling customers. Leverage is being limited to a debt-to-equity ratio of something around 10 to 1, compared to 30 or 40 to 1 during the halcyon days before Lehman collapsed. Leverage limits will slow profit growth, which will eventually affect employee compensation. The employees that enabled banks to act like hedge funds will gradually migrate to real hedge funds, because the big bucks for MBAs aren't in opening passbook savings accounts. Personnel are the only true assets of any bank that wants to be an investment bank, and this migration will drain away the people who provide the sparkle to bank profits.

The future only promises more government presence among the big banks. The soon to be created federal agency/council/czar/doyen or whatever (hereinafter, the "uber-regulator") that will manage systemic risk may turn out to be much more intrusive than the big banks think. To do the job of systemic risk management properly, the uber-regulator will need shiploads of data, much more information than bank regulators now collect. The federal bank regulators were blind-sided by Bear Stearns, Lehman and AIG--they didn't know how massively these firms were inter-connected and intertwined with everyone else in the world of finance. In order to avoid replaying these really scary videos, the uber-regulator will have to know how deeply intertwined and inter-connected the big banks are. But that won't be enough. One would have to dig into the next layer of counterparties, find out who they are, and how vulnerable they would be if one or more of the big banks went down for the count. The counterparties might not like this, but the uber-regulator would have no choice. The reason AIG got its blank check bailout was that the Fed and Treasury belatedly learned, post-the Lehman bankruptcy, that AIG was deep in a vat of liabilities owed to everyone that mattered in finance. This is information the uber-regulator would need on a regular basis--you can't wait until the toilet is flushing to get the information. You need it now, before the crisis, in order to prevent system-threatening conduct. And going to the first layer of counterparties may not be enough. One might have to look into the counterparties of the first level counterparties, and then their counterparties, and so on, to find out how much liabilities loop back to the big banks and other interesting things. The financial services industry has turned itself into a dense thicket of inter-connectedness that beats Facebook, My Space and the rest of the world of social networking by an exponential factor of 100. The uber-regulator will have to dive into granular details in order to do its job properly. Numerous lightly regulated financial players might soon find themselves receiving routine visits from skeptical federal examiners. That might put a damper on their exuberance.

And if the dicier--and potentially more profitable--stuff moves off shore and away from federal jurisdiction, guess what will happen? The uber-regulator and probably other federal regulators will tell the financial oligarchs to stay away from it. Passbook savings, CDs and credit cards will have to suffice as product lines.

GM might eventually get out from underneath the federal thumb by repaying the money it's borrowed from the government. We taxpayers all hope it does. But the financial oligarchs can never escape the federal grip, because they'll always be too-big-to-fail. Unless they make themselves not so big, such as through strategic divestitures and spin-offs. Or by opposing a federal policy that could easily make them more regulated than they ever thought possible.

The free enterprise system doesn't exist without the possibility of failure. If failure is abolished, we end up somewhere between Socialism and Communism. The federal government should allow major financial institutions to fail but try to limit the collateral damage. Given that AIG's creditors received 100 cents on the dollar, it would have been no more expensive to allow AIG to go down the drain and write checks to its creditors for everything AIG owed them. AIG's senior management would have been out of jobs, and deservedly so. Many and perhaps most of its employees would probably have kept their jobs since the operating insurance subsidiaries of AIG are mostly sound and could have been sold off or established as free-standing businesses. The end result would have been a better outcome, and we would perhaps be having less of a handwringing experience in formulating reforms for federal financial regulation.

Tuesday, October 27, 2009

Allow Insider Trading? Why Not Reduce Inside Information?

With the filing of the government's insider trading case against Galleon Management and diverse and sundry individuals, free market de-regulators have again piped up with time-worn arguments for legalizing insider trading. The essential premise of this thesis is that insider trading moves the market price of a company's stock toward the level at which it would trade if the inside information were publicly known. In this way, the information is "broadcast" through price movements in the stock, and buyers and sellers interact at "fairer" prices.

There are market problems with this proposition. Days or weeks can pass before the accumulated impact of the trades by knowledgeable players pushes prices to the level warranted by the undisclosed news. Along the way, a lot of trading at unfair prices could take place. Trades totaling hundreds of thousands or even millions of shares could be done at prices that favor insiders and disadvantage those left in the dark. Publicly announced news is widely known and produces almost instantaneous price movements. Public disclosure produces much fairer prices much faster, and everyone has the information needed to judge the fairness of the price.

In addition, insiders can have more than one reason for trading. A CEO may sell stock to cover a child's college expenses, or to build a vacation home. Sales don't necessarily mean something negative is happening at the company. Buying stock may indicate optimism about the company's future, or be a defensive measure against short sellers when the company's fortunes are known by the CEO to be dim. The mere fact of transactions, and the price movements they induce, may mislead instead of inform.

A little history is worth noting. Long before the SEC interpreted federal law to prohibit insider trading, state law prohibited it (see Strong v. Repide, 213 U.S. 419 (1909), a U.S. Supreme Court decision that interpreted state law to prohibit a corporate insider from taking advantage of nonpublic inside information in dealings with an uninformed shareholder). The state courts, before the SEC was created, were hesitant about applying this insider trading prohibition to anonymous trading on an exchange. However, it's likely that sooner or later an aggressive state official like, randomly speaking, the attorney general of New York, would convince state courts to enforce the prohibition in exchange-based trades, which today comprise the bulk of securities transactions. Realistically speaking, insider trading would probably be unlawful under state law if the SEC and U.S. Department of Justice ignored the issue.

Even the branch of federal insider trading law called "misappropriation" would probably be illegal under state law if it weren't part of federal law. Misappropriation refers, in essence, to trading by someone who isn't a corporate insider but has a fiduciary or contractual duty of confidentiality to refrain from trading on nonpublic information. The classic example of misappropriation comes up in the area of mergers and acquisitions. Let's say an activist shareholder decides to take a run at a company he believes to need the benefit of his activism. He hires an investment banker to provide advice and, potentially, financing for a takeover offer. The investment banker secretly buys the target company's stock through a foreign bank account in anticipation of the moment when the activist shareholder surfaces publicly (almost sure to be a market moving event). The banker's trades push up the price of the stock. The activist shareholder wants to prevent this kind of trading because it could increase the cost to the activist of purchasing stock, particularly in a potential takeover of the target company (since offers to purchase companies almost always come at a premium to the open market price of the stock). Activist shareholders typically expect and require their advisers and financiers to avoid trading in the stocks they target. If the federal government didn't enforce this obligation as misappropriation, state courts could easily enforce it as a breach of contract. Many millions and even billions of dollars are at stake, so activist shareholders and other potential acquirers of companies wouldn't let the problem rest. They'd enforce their contracts in state court if the SEC and DOJ weren't already on the beat.

Bashing the federal government for pursuing insider trading is misguided and an exercise in futility. But the Galleon case, with its many tentacles, reminds us that insider trading won't die as long as there is inside information. We know from recent experience how volatile the stock market can be. Inside information is about as close to a sure bet in stocks as is possible. That's why market players lust for it. Government enforcement provides some deterrence, but will never stamp it out entirely.

An intriguing and potentially more effective way to reduce insider trading is to speed up public disclosure of inside information. The less nonpublic information there is, the fewer the opportunities for insider trading and the fairer the day-to-day trading in the markets. Public companies today report their financial conditions quarterly and annually on SEC reports called 10-Q and 10-K. A few special events must be reported on SEC Form 8-K whenever they occur. But there is nothing like continuous disclosure. (Stock exchange rules do require listed companies to disclose all "material" developments, but the exchanges use these rules to require disclosure of developments only after funny trading is observed in the company's stock, and not to require immediate and continuous disclosure of all material developments.)

The quarterly and annual system of financial reporting was created in the 1930s and 1940s, when accountants used desk calculators (bulkier and heavier than many of today's laptops) to tally up companies' accounts. The sheer amount of time required to manually add, subtract, multiply and divide necessary to produce a company's financial statements made more frequent financial reporting difficult or impossible.

Today, electronic computing power abounds. Laptop computers can create hours of video. That's enough computing power to assemble a company's financial statements. Many companies calculate their operating results on a daily, weekly and/or monthly basis. Fast food and casual restaurant chains, and retailers are especially adept at this, since serving the fickle public is at the heart of their businesses and they need to monitor trends in product sales by the day. Since they use this information to manage their businesses, it must be pretty reliable. Why not put shareholders in the loop?

Companies generally make decisions about bad debts and other asset writedowns and writeoffs on a quarterly basis. But that's because the current system of reporting requires quarterly assessments. There's no intrinsic reason why these decisions cannot be made more frequently than once every three months. Debts go bad every day and recognition of uncollectability doesn't have to be delayed until the end of the quarter. Similarly, depreciation, depletion, and additions to or subtractions from reserve accounts are not intrinsically quarterly or annual determinations. They, too, can be made more often as relevant information permits.

Disclosure by public companies of at least some financial information could be made more frequently--monthly, weekly and even daily. Of course, the more frequent the disclosure, the more preliminary it's likely to be. But the current system of reporting already involves disclosure of preliminary information. The quarterly reports on Form 10-Q are preliminary as compared to the annual report on Form 10-K. A more continuous system of reporting would simply involve a greater degree of "preliminaryness." Just as investors have grown to understand the preliminary nature of quarterly reports, they can adjust to the preliminary nature of more frequent reporting.

Of course, financial reporting is a complex subject and any system of continuous reporting would have to be implemented over the course of enough time for both companies and investors to adjust. But there is nothing intrinsically impossible about it. Indeed, the SEC already requires continuous reporting of potential market moving information in another setting.

Shareholders controlling, individually or as part of a group, 5% or more of the outstanding shares of a public company are usually required to report their holdings on an SEC form called Schedule 13D. This schedule calls for the disclosure of a variety of information items, such as the identities of the shareholders in any group, any and all of their contracts, agreements, and understandings with respect to the stock, their plans, proposals and intentions with respect to the company (which most importantly include any intention of trying to take over the company), and their sources of financing. This is sensitive, market moving stuff, and 13D persons are required to promptly disclose in amendments to their filings any changes to these and other informational items. Promptly generally means no later than the next day--not quarterly, not annually.

Thus, the federal securities laws apply the concept of continuous reporting already, just not to public companies. 13D persons don't have to file financial statements, and public companies do, something that would make continuous reporting a much bigger undertaking for public companies. But lest we obsess over costs, and not benefits, consider a stock market with less insider trading, fewer missed analyst estimates, less stalking of companies by whisper numbers, fewer quarterly surprises for outsider shareholders, and fairer prices on a continuous basis. The current system of quarterly and annual reporting was the Glenn Miller era's response to the paucity of corporate reporting of even earlier times. We no longer use the manual typewriters and desk calculators of the 1930s and 1940s. There's no reason why we should keep using that era's financial reporting system.

Sunday, October 25, 2009

Are the Bankers Pay Cuts Regulatory Short Cuts?

The Federal Reserve announced last week that it will scrutinize pay practices at banks of all sizes for excessive risk taking, especially in the short term. Large banks will receive special attention, but banks of all sizes will be reviewed one way or another. The Fed said banks should compensate for longer term performance and avoid undue risk to themselves or the financial system. In particular, the Fed indicated that incentive compensation arrangements should be adjusted for risk--e.g., a high risk activity might pay a lower percentage of profits as bonuses than a lower risk activity, so that bank executives and traders won't be drawn to betting the ranch at the expense of the taxpayers.

Not even Rip van Winkle would be surprised that bankers are whining. Some predict that the most talented employees will jump to less regulated firms, where they can maintain the high levels of compensation they've been earning. Employees engaged in high risk activity might be particularly motivated to find a less regulated employer. Banks losing key employees may step back from some of the dicier activities that have generated significant profits in recent years. Bank profits might moderate as the banks tone down their risk levels.

This could be exactly what the regulators want. Formal regulatory reform has bogged down in the usual lobbying scrum where efforts to make law that protects the public interest all too often results in law that protects powerful business interests. The beauty of reform through the regulation of incentive compensation is that the banking agencies can implement it using their existing legal power to ensure the safety and soundness of banks, faster than the legislative process, and with greater certainty of getting the reforms they want.

Congress has complained about the free hand the Fed has had in supporting, subsidizing and bailing out the banking system, with, in the eyes of some legislators, little accountability. Congress now has a chance to make its contribution through the enactment of meaningful reform. We're still waiting for results. In the meantime, the Fed doesn't seem to be waiting for Congress. And a good thing, too, since risks continue to abound in the financial markets and there are plenty of ways for banks to lose money. Taxpayers shouldn't provide subsidized opportunities for big banks to act like hedge funds. If some of the wilder and crazier employees leave the big banks, and the latter consequently have to step back from dicier activities and shrink their balance sheets, becoming the dull depository institutions of the Ozzie and Harriet era, the outcome would probably let taxpayers and depositors breath more easily.

Thursday, October 22, 2009

Is There Less Information in the Stock Market?

The most important principle governing the stock market is disclosure of information. Information is the lifeblood of the financial markets. Investing is basically a bet on the future, and you can't predict the future value of an investment without plenty of information. Leave investors in the dark, and they'll steer clear of stocks, bonds and other financial investments.

The amount of information in the market seems to be decreasing. For example, consider:

Earnings Blowouts. Many large companies are reporting third quarter earnings that significantly exceed previously announced analyst estimates. Caterpillar, Sallie Mae, PNC Financial, Amazon, American Express, Capitol One, Morgan Stanley, and Goldman Sachs are examples. Caterpillar stands out. Analysts predicted that it would earn 6 cents a share, and it reported 64 cents. This is flat out cognitive dissonance. One wonders if there are a lot of inattentive, dumb, undercaffeinated and/or too-busy-texting-for-a-date analysts covering Caterpillar, or if the company gave some seriously inaccurate guidance. Or maybe it was all of the foregoing, with the Major League Baseball playoffs diverting everyone's attention. Of course, there is a game of sorts with earnings projections: companies like it when analysts underestimate their earnings, so they can pop their stock with a seemingly glowing earnings report. And investors aren't taking it lying down. Whisper numbers seem to have returned, putting companies under pressure not to beat just the published analyst estimates, but the "real" wink-wink estimates that the market actually expects. Goldman Sachs may have beat expectations one time too many this past summer when it reported unexpectedly glowing second quarter results. When it reported unexpectedly glowing third quarter results, the market seemed disappointed, evidently because Goldman didn't smack the heck out of the whisper numbers.

More than three-quarters of S&P 500 companies that have reported earnings thus far have exceeded analyst estimates. By itself, that's not unusual, because many companies provide guidance that tends toward the conservative side. But if the disparities between Street estimates and company results widens enough, investors will soon realize that they're not really getting much useful information from analysts. The market and the Street will both suffer if investors lose faith.

Dark Pools and High Speed Trading. A growing amount of stock trading takes place in ways that ordinary investors can't see. Significant volumes of stock trade in so-called alternative trading systems that are available to the big boys on the Street, but not ordinary, long term investors (hereinafter referred to as "sheep"). Also, a lot of trading takes place on a computerized basis, so fast that the sheep may not be able to see the best prices before a computer snaps them up. The sheep get only those prices that the smart money, bolstered by monster amounts of computing capacity, knows to be too lousy to trade with. As more and more trading becomes invisible, sheep (i.e., investor) confidence will lag.

Bank Financial Statements. Earlier this year, the banking industry applied extreme political pressure on the accounting authorities (the FASB) to ease up on interpretations of rules requiring so-called mark-to-market and fair value accounting of dodgy financial assets at the heart of the mortgage mess and credit crunch. Since then, the banks seem to have booked rosy valuations of these assets and kept them, along with the risk of loss they entail. Keeping the aromatic assets isn't exactly the obvious thing to do, with the real estate market mostly continuing to fall. But a bank doesn't have to book a loss by holding them, while it would if it sold them. Investors had better hope that what they don't know won't hurt them.

Insider Trading. The recently announced $25 million plus insider trading case against Galleon Management LP and a potpourri of individuals would, if its allegations prove true, signal that insider trading remains endemic. Although a major government crackdown 20 odd years ago sent some high level Wall Streeters to prison, memories apparently are short, especially when there's money to be made. And inside information is more valuable than gold. It gives you an advantage over the sheep, who will get yesterday's price while you angle for tomorrow's better price. There will be insider trading as long as there is inside information. But the pros on the Street might again be increasingly emboldened, too often taking undue advantage of their privileged positions.

The regulators may be able to do some things to lessen the growing murkiness. But the movers and shakers on the Street can do more, much more. Short term considerations tend to favor opacity over transparency, slaughtering the sheep over giving them a fair shake. But, ultimately, financial markets need outside sources of capital, which means they need investor money. Investors, in turn, don't want to buy a pig in a poke. Large numbers of long term investors have been sitting out the current, all-news-is-good-news rally, because they simply don't believe that things can suddenly turn from really bad to really good. The growing murkiness on the Street may well make them sit tighter.

Wednesday, October 21, 2009

The Cart-Horse Problem of the Currency Debate

The blogosphere and op ed pages are filling up with calls to arms over the recent decline of the dollar. Predictions of the imminent collapse of American civilization abound. Gold sales boom.

Although the value of the dollar is very important, it is the result, not the cause, of our economic problems. A currency becomes strong when the nation issuing it is economically strong. A currency weakens when the issuing nation's economy weakens. The strong currencies today--the Japanese yen and the Chinese yuan--got that way because Japan and China became manufacturing powerhouses. Both nations try like heck to keep their currencies weak in order to bolster exports. Over the long course of time, they have failed. Their currencies have inexorably strengthened as their economies have strengthened. The Japanese yen has tripled its value in the last 30 years. The Chinese yuan probably would be considerably higher than its current value, as well, if it were freely tradeable--the Chinese government does not allow full convertibility of the yuan in order to constrain the outflow of capital from China.

Conversely, the dollar has fallen as the U.S. has shifted from being a manufacturing powerhouse to a binge consumer living off the equity of its real estate. The American way of life in recent years was possible only because foreigners were willing to buy dollar-denominated debt, in effect lending us the money for $5 lattes, $3,000 wide-screen TVs, luxury nameplates on all three cars in the driveway, and a house twice as large as the one we grew up in. When things fell apart, the entire nation became like a person with 22 credit cards and $230,000 of consumer debt, looking for a bailout.

A weakening nation cannot, through government intervention, preserve or increase the value of its currency. Calls to the Treasury or the Fed to intervene in currency markets or raise interest rates in order to support the dollar are misguided. The last major economic power to try something like that--Great Britain in September 1992--was blown up by a wolf pack of hedge funds that shorted the pound in the direction it would have eventually gone anyway. It's doubtful that any collection of hedge funds, however large and well-leveraged, could blow up the dollar. But the other major economic powers of the world can. And, gradually, they are, with talk of repricing oil in a basket of other currencies and gradual reallocation of central bank bond portfolios away from the dollar.

There is a way to save the dollar. That would be to institute government policies to bolster the manufacturing capabilities of the U.S. economy. America has a long and illustrious history as a manufacturing powerhouse, and does not inevitably have a dark future in that regard. It also does not have to rely on exports to support a manufacturing sector, since the American consumer, although currently down in the dumps, will probably rise from the ashes if given half a chance (i.e., a full-time job) and a little more reasonably priced credit. But the Federal Reserve, with its all for the banks and none for anyone else distortion of the Robin Hood tale, offers only sermons but not solutions. And the Obama administration's stimulus package has been unfocused and diffuse. A nation cannot spend or consume its way to economic health. It must be able to make things that other people will pay good money for. This should be the goal of government economic policy.

Sunday, October 18, 2009

Computerized Stock Trading: A Grave New World?

The nature of the stock markets is changing. More than half today's trading volume comes from computer-directed transactions. This mostly consists of ultra-fast trades of vast quantities of stocks. Prices can be quoted and transactions completed in milliseconds, before the human eye can begin to comprehend the quote. There are, in essence, two different markets--one taking place on a superfast scale between computers, and the horse-drawn buggy market for those slow-poke humans. In such a scenario, the market pros that own the computers are likely to get the best prices, and mom and pop investors trying to put aside 100K or 200K for their modest retirements may be left with table scraps.

Many of the computerized trading firms are financed with ultra cheap credit provided courtesy of the Federal Reserve. The Fed's zero interest rate policy provides an incentive to speculate, making risk taking appear more attractive. Indeed, current Fed rumblings about withdrawing accommodation may only increase stock speculation. If you know the Fed might take the bargain basement credit away at any moment, you wouldn't invest long term, or even medium term, in something so mundane as, say, America's manufacturing capacity. Lose your cheap financing and the deal that looked so good a few months ago may turn out to be junk. Instead, it's better to jump in and out of stocks on a minute by minute or even second by second basis, laying off your risk before the Fed has a chance to mess up your profit potential. It may be that, in their innermost thoughts, the Fed's governors want an exuberant stock market, since it takes a lot of political pressure off of them. But lasting recoveries won't come from stock bubbles.

Then, there is the possibility that the computers are distorting prices. Back in the days when Leave It to Beaver was broadcast on prime time TV and human beings determined stock prices through their collective desires to buy and sell, there was no limit on the factors that might influence prices. While the fortunes of each company issuing stock most directly affected the price of its stock, politics, war, weather, currency fluctuations, interest rate changes, government policies and a host of other factors affected stock prices. No computer program, however many variables are incorporated into the algorithm on which it is based, can completely replicate the infinitude and variation of factors that humans would consider relevant to a stock's price. Recall the vaunted risk management systems used by Wall Street earlier this decade to evaluate the chances of a downturn in the real estate markets. By all indications, virtually none of these systems got it right. The possibility of downside real estate risk on a national level seems to have been programmed out of the computers. This would have been a human programming error, but computers cannot self-correct for programming errors.

With the flood of computerized trading now hitting the market, we must wonder whether we'll have deja vu all over again. It may be possible for one computerized trading system to miscomprehend prices and send out a torrent of orders that appears to another computer system to be anomalies that provide trading opportunities. The second system then sends out its own torrent of orders to take advantage of the perceived "anomalies," which in turn may appear to other computerized trading systems as "mispricing" that should be hit with buy, sell and short sell orders in the next two nanoseconds before the pot of gold disappears into the maw of another firm's computers. In this mosh pit of computer vs. computer, prices may drift away from fundamentals, and eventually that would turn out to be a bad and painful thing.

There's a chance the SEC will clamp down on some of the most unfair aspects of computerized trading. But it would have a hard time, legally and philosophically, prohibiting high speed, computerized trading. Abstractly speaking, people should be able to innovate through the use of computers. But the large-scale, hyper fast trading that we have today runs the risk of making smaller, long term investors feel like they are simply grist for the big boys' mills. That would only fuel the populist streak in today's efforts at regulatory reform. Wall Street's current short term trading profits could lead to long term increased regulation. We know that many on the Street take the view that while the music is playing, you have to get up and dance. But the last time Wall Street did a collective hokey pokey with mortgage backed securities, things ended badly.

Thursday, October 15, 2009

Bernie Does It Again, But Why Worry?

Recently, Bernie Madoff reportedly got into a strenuous argument with another prison inmate--about the stock market, no less. It's hard to imagine why two guys in prison would argue about the stock market. You'd think the pay phone or exercise equipment would be more important. But the discussion got so heated that a shoving match ensued, with Bernie pushing the other man to the ground. Scuffling is against prison rules, but the guards evidently didn't see the incident. So Bernie broke the rules--and again wasn't caught by the authorities. He also won the fight. At some point, you have to think some people are just plain lucky, even if they're serving the equivalent of a life sentence.

And what was there to argue about? The current stock market never met a news story it didn't like. Unemployment rising? Stocks rise. Oil prices rising, which means gasoline and heating oil will rise? Stocks rise. Consumer spending down. Stocks up. J.P. Morgan Chase, a very big bank on Wall Street that is subsidized with virtually free money from the Fed and guaranteed not to fail reports better than expected profits. Stocks rise. But how could the profits have been better than expected? This bank--and its mega-sized compadres on Wall Street--can do anything and the Fed will make sure they survive. There shouldn't be any level of profitability from them that isn't expected.

Frankly, the stock market will continue to rise briskly from here on forward, and will never, ever decline again. There's nothing to worry about for the rest of your life. You read it here first.

And if you believe that, there's a really nice bridge in Brooklyn I can get you for a song. Payment in cash--unmarked bills and nonsequential serial numbers--is required.

Friday, October 9, 2009

Why Obama's Nobel is Good for America

Despite vast right wing criticism, Barack Obama's Nobel Peace Prize is good for America. The award of the prize recognizes that, notwithstanding its banking debacle, economic distress, foreign policy morass in the Middle East, and debtor-in-chief status to the rest of the world, America remains the most important nation on Earth and must be dealt with.

The Nobel Committee clearly intends to influence the Obama Administration's policies. Its statement announcing the award noted that "Obama has as President created a new climate in international politics. Multilateral diplomacy has regained a central position . . . " The committee cares about whether America is going unilateral or multilateral because whatever America does has an outsized impact everywhere else.

The prize is part of the dialogue the rest of the world is trying to have with America. The European side of the dialogue can, from the American viewpoint, be irritating. When attacked, Americans are inclined to stand and fight. It's part of our tradition, beginning on April 19, 1775 and continuing through December 7, 1941 to September 11, 2001. Many Europeans seem wobbly by comparison. One must remember, though, that recent history remains much starker in their memories than ours. During the first half of the 20th Century, Europe fought two world wars, which were really just one long war. More than 50 million people in Europe died in these two wars (and perhaps another 30 million in Asia). A combined total of around 520,000 Americans died in the two world wars. For every American death, 100 Europeans died. With this in mind, it's easier to understand why Europeans prefer multilateral discussion to the delivery of firepower.

Like it or not, America needs the rest of the world. With massive deficits that the Federal Reserve cannot finance indefinitely, the United States will remain dependent on foreign creditors far into the future. The dollar's long term decline, which cannot be stopped at this point, must be carefully managed by all major economic powers, lest an abrupt drop push the world economy back into crisis.

Foreign cooperation will be crucial as financial regulatory reform progresses. Potential regulatory arbitrage by banks among American governmental agencies could be trivial compared to potential regulatory arbitrage by banks among different nations. It's no accident that Swiss banks became renowned for secrecy--Swiss law provided for it, and banks there exploited this regulatory regime to their commercial advantage.

Addressing environmental pollution and global warming by definition require multilateral effort. So does combating nuclear proliferation. Preventing Iran's use of nuclear weapons, which it surely will have within a couple of years, will require a multilateral full court press. Sniffing out and snuffing out Al Queda remains an important multilateral task.

The Nobel Committee probably thinks it did the international community a good turn by conferring the Peace Prize on Barack Obama. In actuality, it did America a favor, by acknowledging it is so important that its recently elected chief executive should receive the prize for simply changing the tone of international dialogue.

Wednesday, October 7, 2009

ETFs: The Bloom is Off

Two years ago, exchange traded funds were like the hot, new car model for which buyers would pay a $3,000 premium over list price, all for the privilege of being waited listed for months before the gotta-have-it vehicle was delivered. Asset management firms charged into the fray, registering hundreds of new ETFs based on all varieties of indexes, including some never before seen in the wild, and threw them at investors to see what would stick.

That was 2007. We know what's happened to the financial markets since then. A turbulent market reveals a multitude of sins, defects and other undesirable features, and no exception was made for ETFs. Here are some of the problems that have emerged.

High Trading Costs. Although ETFs often have comparatively low management fees, the costs of investing also include the "bid-ask spread," which is the difference between the higher ask price at which you buy ETF shares and the lower bid price at which you sell them. Management fees, on average, have been rising as ETFs have become more complex, now often exceeding 0.5% of assets per year. But, for the smaller, less liquid ETFs, trading costs can add an additional 1% to the costs of ownership. This trading cost isn't an annual charge. But it is effectively imposed each time you make a round trip in trades (i.e., buy and sell). Since many investors trade ETFs on a short term basis (a bad idea more often than not), these trading costs can become a major expense.

ETF Value Strays from Underlying Values. Sometimes, the value of the shares of an ETF can deviate from the value of the underlying holdings. The reasons for this vary. Sometimes, the index on which the ETF is based contains illiquid investments (like some bonds) that the ETF has trouble actually buying. In such cases, you're not getting what you probably thought you were getting. Other times, the ETF trades at a premium because investor demand elevates the ETF share price. For example, a relatively easy way to participate in the recent rally in corporate bonds is to buy shares of a bond ETF based on a corporate bond index. But that advantage can be reduced if everyone else has the same idea and bids the price of the ETF above underlying asset values. It's usually not a great idea to pay $1.02 for $1.00.

Leveraged ETFs give an unpleasant surprise. Leveraged ETFs promise to give you a multiple of the price movement of the underlying index. In other words, if the underlying index increases by x, the leveraged ETF is supposed to deliver a return of 2x. If the the underlying index drops by x, the leveraged ETF would show a loss of 2x. Short or inverse ETFs deliver the leveraged opposite of the movement of the underlying index. Some leveraged indexes have sustained significant losses even though the underlying indexes have, over time, gone in a direction that would appear profitable. For example, an underlying index might rise, but the leverage ETF sustains losses. Perhaps the most common reason for this deviation is that leveraged ETFs calculate gains and losses on a daily basis. Even if the underlying index rises over the course of several months, the daily ups and downs can create a compounding effect that generates net losses where a casual observer or investor would have expected gains. Moral of the story: stay away from leveraged ETFs. These things are for full-time investment professionals who are used to walking on hot coals with their bare feet.

The early version ETFs, based on well-known broadly based indexes, continue to be useful and valuable investments in many circumstances. See But the fancier and faster-talking the ETF, the more you should put your hand on your wallet.

Saturday, October 3, 2009

Why It Feels So Rough in the Stock Markets

If investing in stocks feels like you're riding through white water, you're not imagining things. It is rough in the market. Let's look at the data.

The 1920s were a period of secular, or long term, market rise. Then, the 1929 market crash knocked the market for such a loop that it did not recover on an inflation adjusted basis until 1953. Then the market enjoyed a secular rise until the end of 1972. However, with the malaise of the 1970s setting in, the market fell and did not recover on an inflation adjusted basis until 1991. Between 1991 and early 2000, the market rose on a long term basis. However, after peaking in March and April 2000, the market has never fully recovered. Currently, adjusted for inflation, the market is at 1997 levels; it's gone nowhere for the past 12 years.

In all, since 1920, the stock market has, on a long term basis, risen a total of 37 years. It has been in a losing position (compared to the preceding peak and adjusted for inflation) for a total of 50 years. No wonder stock market investing makes a lot of people seasick.

Of course, the good years saw gains that greatly exceeded the losses in seasick years. Overall, since 1920, the market has been a very good investment on a long term basis. But, as John Kenneth Galbraith put it, in the long term we're all dead. If your time horizon is about 15 or 20 years, you should be cautious with stocks. Some equity exposure is prudent, because there will be mid and short term rallies even during long term downturns. But you should use bonds or comparable investments to stabilize the value of your portfolio. If your time horizon is short, like a few years or less, it's best to step back from stocks. You may miss out on some gains. But you don't want to lose your child's college tuition money, the down payment on your house, or the funds for Mom or Dad's assisted living expenses.

Even though diversification isn't a bulletproof investment strategy, it still makes sense for many people on a long term basis. If you're taking too many painkillers because of your stock investments, reduce your equity exposure. Put it all in bank CDs if that let's you sleep. Keep your portfolio simple. (See Whatever you do, don't stop saving. People who don't prepare for the future won't have much of one.