Friday, May 21, 2010

Congress' New Clearinghouses

A Wall Street Journal editorial earlier this week exposed some inconvenient truths regarding proposed Congressional so-called 'reform' of derivatives trading. The topic is clearinghouses.

Personally, I find the notion of establishing clearinghouses for derivatives to be progress, if it prevents the valuation panics attendant upon derivatives due to counterparty risk, and the consequent panic over the valuation of the holders of said derivatives.

If, rather than having daisy chains of derivatives existing among various institutions, the bulk of the instruments are traded via an exchange, perhaps counterparty risk will be reduced, thus improving confidence in the risks of potential losses to the various parties.

However, the evolving, awful Dodd bill doesn't seem to have so much confidence in the proposed exchanges for derivatives.

The Journal editorial notes that the fine print of Dodd's effort gives said clearinghouses Fed discount window borrowing privleges.

Pretty scary, eh?

Because that blows the argument about 'no more bailouts' out of the water.

In fact, this provision makes clear that Dodd & Co. fear precisely that even a derivative exchange can't be sufficiently well-capitalized to cover losses, and, thus, needs access guessed it....our taxpayer money.

The editorial points out,

"Also most clearinghouses that operate today set margins based on historic volatility. Everything works well as long as patterns continue as they have in the past, but as we have so painfully learned the worst crises involve assets long considered very safe that turn out to be risky. We now know that regulators at the Treasury's Office of Thrift Supervision signed off on AIG's credit-default swaps because they backed AAA-rated mortgage assets. And everyone knew housing had been rock-solid for decades."

Once again, we are reminded that regulators who are, frankly, less smart than industry practitioners will cause taxpayers losses every time. In the last crisis, our federal regulators proved unable or unwilling to challenge rating agency opinions and/or think for themselves about high ratings on securities backed by whole new mortgage instruments (subprime and Alt-A).

So any Congressional creation that depends upon regulators to get the basics right, such as, oh, say, the derivatives exchange collateral levels, is bound to be wrong.

And that means, as the Journal piece concludes, that this legislation won't do much more for derivatives risk than, first, concentrate it into an exchange, then pass any uncovered risk/losses to taxpayers, via the Fed window.

Makes you want to cry, doesn't it?

Thursday, May 20, 2010

The "Flash Crash" & Market Liquidity

Tuesday's Wall Street Journal featured an article comparing the recent "flash crash" to what it termed "a real one in 1987."

Surprise, we're flirting with another such day today.

A key paragraph in the long piece read,

"Selling pressure became on both days became so intense that any remaining buyers were overwhelmed, creating an "air pocket" in stocks and other securities that led to vertiginous declines.

Many market makers on Black Monday had exhausted their funds, while others were overwhelmed by the volatility. The NYSE later took steps to boost traders' capital."

Here's my question.

It's been 33 years since the 1987 crash. We knew then that small market makers on the NYSE were incapable of withstanding the avalanche of sell orders that what was then advanced technology allowed to occur. Technology has moved on and now dwarfed the volume of that crash.

One of the significant results of that crash was the acquisition of many market makers by larger brokers, as so many of the former had shown themselves either unable or unwilling to fulfill the role, in exchange for which they were given monopolies on trading selected issues.

Why have we not yet decided, once and for all, to either let the chips fall where they may in the rare, but inevitable market free-falls, or to halt trading entirely?

It's not like we haven't had three decades and change to reflect on this important question, is it?

Markets need to be continuous, liquid and able to prevent any one buyer or seller from having pricing power over an issue. If any one of these conditions is violated, it's no longer a market.


Maybe the problem is that the industry hasn't given Congress a sensible, practical approach to what are well-known conditions.

In 1987, there were 2-3 similar 'gapped pricing' upward spirals earlier in the year. But, because fills resulted in higher prices, nobody complained. It was a different story in October of that year, when equity sell orders got filled at prices far lower than the quotes at the time of the market order placement.

We know how equity markets behave in these situations. Simply put, market makers won't step in to catch the "falling knife" of plummeting prices on equities. They will not answer phones, and will institute "speed bumps," in hopes that a pause of 1-2 minutes will fix everything. So, in that situation, it's an implicit closure of markets.

If, instead, as over on the NASDAQ, market sell orders continue to flood a market with no buyers, prices will plummet. If anyone still wishes to enter market orders in that situation, it's buyer beware.

Which do we want to exist in observable situations of market panic, as characterized by trading volumes and index price declines/unit of time?

We need our sector executives, especially on the exchanges, to formulate workable solutions and insist that Congress enact them so that all investors know, a priori, how markets will, or will not, function at times in which pre-defined crisis parameters apply.

The Shadow Banking Safety Net?

A few days ago, on CNBC, guest Steve Crawford, late of Morgan Stanley, advanced the notion that current Senate regulatory efforts to shove risky trading out of regulated banks and into a "shadow banking system" won't keep the federal government from bailing out that sector, too.

This seemed to be an unsubstantiated claim.

Crawford didn't name names, but alleged that "shadow banks" had already been bailed out in the recent crisis, so there was no real discrimination, new legislation, or not.

I wonder which companies he considered to be shadow banks which were saved?

To me, any publicly-held, private sector entity which has material regulation of some sort is not a "shadow bank."

For example, I'd say that hedge funds and private equity groups are "shadow banks." Private equity lends, does leveraged buyouts and, at the upper end, can engage in significant proprietary trading.

Hedge funds clearly meet the trading units of heavily-regulated banks in the marketplace. But the hedge funds enjoy notoriously lighter regulatory burdens than their publicly-held competitors.

I'm not aware of any private equity or hedge fund groups being rescued in late 2008, are you? In fact, a few hedge funds went under, though I can't recall specific names. Other than LTCM, in 1998, no hedge fund, to my knowledge, has been the subject of a coordinated, government-led action to preserve markets.

Even in the case of LTCM, the firm wasn't saved. Rather, there was concern for counterparty losses due to the lack of bids for assets held by the firm, causing financial markets to crater as a by-product.

Counterparties and other large institutions contributed to the orderly unwinding of LTCM positions, but the firm's owners lost everything.

So I confess to not really understanding why Crawford is so worried about shadow banks. Existing hedge funds and private equity firms would pose risks due to unwise levels of leverage. But surely their lenders are capable of judging for themselves what those balance sheets can handle. At least better than an army of civil servants who have yet to forestall a financial crisis due to their exercise of their lawful supervisory powers.

Wednesday, May 19, 2010

Doug Dachille on CNBC This Morning

I caught a fair amount of Doug Dachille's appearance for, I think, an hour this morning on CNBC.

As always, his comments were lucid, powerful and candid.

Dachille crystallized something which has always bothered me about the creation of the Euro.

In effect, Dachille, more clearly than anyone else whom I've heard on the subject, noted that the EU chose to create a currency, but no centralized taxing authority. Thus, unlike the US, the countries share a currency, and some loose federation policies, but have no effective means to back the Euro as a currency.

It really brings to mind something I said just yesterday to a colleague about Alexander Hamilton. Our first Treasury Secretary was truly brilliant. He had the federal government assume the debts of the states and created the dollar, thus seamlessly unifying the nation fiscally and monetarily.

Pity the Eurozone. As Dachille so succinctly put it, they can't take unified measures to support the Euro because there is no federal taxing power. Everything has to be a country-by-country vote to fund actions in support of their shared currency.

This addresses what I had misgivings about so many years ago, i.e., that the Euro countries weren't sufficiently unified in both fiscal and monetary policies. As such, at some point, their lack of federal authority to coordinate the monetary and fiscal aspects of the Euro would come back to bite them. In effect, Germany, with the most stable currency and strongest economy of the EU, had not ceded its fiscal authority to the EU.

You might not be able to clearly define how the monetary and fiscal aspects of a nation's currency interact, but you know it's an important phenomenon. In the Eurozone, it's now clear they just don't have that linkage in a manner that global investors trust or believe.

Taxes & GDP

David Ranson, the head of research for H.C. Wainright & Co. Economics, wrote in Monday's Wall Street Journal on the relationship between US GDP and tax revenues.

The graph from his article appears nearby. It shows real US tax receipts (Y axis) plotted against US GDP (X axis), with the dotted red line representing Y-values equal to 20% of the X-values at each point.
Ranson observes, in his editorial,
"The feds assume a relationship between the economy and tax revenue that is divorced from reality. Six decades of history have established one far-reaching fact that needs to be built into fiscal calculations: Increases in federal tax rates, particularly if targeted at the higher brackets, produce no additional revenue. For politicians this is truly an inconvenient truth.
The nearby chart shows how tax revenue has grown over the past eight decades along with the size of the economy. It illustrates the empirical relationship first introduced on this page 20 years ago by the Hoover Institution's W. Kurt Hauser—a close proportionality between revenue and GDP since World War II, despite big changes in marginal tax rates in both directions. "Hauser's Law," as I call this formula, reveals a kind of capacity ceiling for federal tax receipts at about 19% of GDP."
I confess to being completely surprised at the incredible consistency of this chart. There aren't the kind of significant swings above and below a regressed curve fitted through the actual data.
Rather, it's clear, assuming Ranson's numbers, as sources in his chart footer, are correct, that this relationship is very tight and dependable.
Why is this so? Ranson opines,

"What's the origin of this limit beyond which it is impossible to extract any more revenue from tax payers? The tax base is not something that the government can kick around at will. It represents a living economic system that makes its own collective choices. In a tax code of 70,000 pages there are innumerable ways for high-income earners to seek out and use ambiguities and loopholes. The more they are incentivized to make an effort to game the system, the less the federal government will get to collect. That would explain why, as Mr. Hauser has shown, conventional methods of forecasting tax receipts from increases in future tax rates are prone to over-predict revenue."
You can guess what the contemporary application of Ranson's version of "Hauser's Law" would be. Ranson considers current federal tax revenue and GDP projections,
"In this form, Hauser's Law provides a simple basis for testing the validity of any government's revenue projections. Today, since the economy already suffers from a large output gap that is expected to take many years to close, 18.3% must be a realistic upper limit on the ratio of budget revenues to GDP for years to come. Any major tax increase will reduce GDP and therefore revenues too.

But CBO projections based on the current budget show this ratio reaching 18.3% as early as 2013 and rising to 19.6% in 2020. Such numbers implicitly assume that the U.S. labor market will get back to sustainable "full employment" by 2013 and that GDP will exceed its potential thereafter. Not likely. When the projections are tempered by the constraints of Hauser's Law, it's clear that deficit spending will grow faster than the official estimates show."
What provides me with some odd comfort is that, no matter how heavily the government taxes us, jointly, we only pay up to about 18-19% of GDP. Thus, recent deficit-financed spending is not going to be repaid out of near-term taxes which rise precipitously.
Rather, it's pretty clear that the only way it will be repaid is through economic growth. And that's going to take a much different economic climate than our current federal government seems to be capable of delivering.

Another Perspective on Financial "Reform"

Harvey Pitt, the one-time SEC chairman, wrote an editorial in Monday's Wall Street Journal discussing how the ability to learn, or not learn, from history, informs the deeply-flawed Dodd bill.

Thought Pitt was never my favorite SEC chief, his recent article reminds us of some inconvenient facts.

For example, he notes that the S&L crisis of the late 1980s didn't feature any one or few large institutions. Never the less, it required Bill Siedman to create the RTC and took many years and billions of dollars to process and ultimately dispose of foreclosed properties.

Another point Pitt makes is that, once again, Congress seeks to add to layers of existing regulatory authority. This has been the trend since, well, anyone can recall. It seems no agency is ever destroyed. At worst, it morphs into something else. Rather like the principle of conservation of energy.

When is the last time you remember an entire federal agency and its workers being simply eliminated?

No, instead we'll get more oversight boards and agencies with more civil servants in lifetime jobs. Does this sound like the crew that will catch the next explicit, deliberate financial excess perpetrated by groups of very bright financial executives with masters degrees in finance and associated quantitative disciplines?

Congress' own FCIC hasn't even finished its job yet, and both Congress and the administration are pushing for immediate passage of a 1,400 page bill.

Where is the sense in that?

Finally, Pitt sagely observes that, almost certainly in any case, and certainly in this case, whatever legislation is rushed through Congress and signed into law will "assure that we will experience anew the law of unintended consequences."

To me, this last is perhaps the most troubling element of the current rush to over- and re-regulated the financial sector.

For once, could someone just assemble a practically-sized group of reasonably-objective experts, sift through the last 50 years of financial disasters, and consider what type of regulatory bodies and rules would have effectively and efficiently minimized said crisis?

Certainly, one aspect involves credit and leverage standards. The S&L's came to ruin from mismatching durations of liabilities and assets. So, for that matter, did Bear Stearns and Lehman. And, very nearly, Goldman Sachs and Morgan Stanley.

On the exchange front, regulatory authorities have allowed, for some time, the NYSE and the NASDAQ to run under vastly different rules concerning circuit-breakers at the level of individual equities. Promises or expectations of liquidity vanish when they are most wanted, triggering sudden elevator-rides down in equity prices.

We know this happens. Do we want to prevent it, or simply make everyone aware of its possibility? Because, right now, we do neither.

Harvey Pitt did a good job exposing several important truths which currently-proposed regulations do not fix.

I regret to conclude that, as usual, we'll end up with more, more expensive, cumbersome and unwieldy regulatory authorities and processes, but no greater protection from the financial excesses which we deem unacceptable.

Tuesday, May 18, 2010

Meredith Whitney On Financial "Reform," Small Businesses & State&Local Governments

Meredith Whitney wrote a simple, elegant editorial yesterday in the Wall Street Journal entitled The Small Business Credit Crunch.

In it, she drew a fairly short, straight line from the current Senate financial sector regulation bill to higher-cost or even unavailable consumer credit for use by small businesses. Added to that, Whitney noted how lower housing values have wiped out their use as a traditional small business financing source.

Thus, in her opinion, small business-based job creation, a traditional source of US economic expansion, will be crippled, as the small businesses face financing difficulties, as and should they desire to expand or be created.

To this already dark picture, Whitney added her prior views on municipal and state government budget shortfalls and, eventually, job cuts.

Whitney and former Merrill economist David Rosenberg each shared these views last winter on CNBC, from which I wrote the two linked posts.

Now, it seems that at least Whitney sees evidence of her predictions coming true and having meaningful consequences.

The punchline of her article is that the government job cuts will result in up to two million newly-unemployed at a time when Congressional legislative action will help dampen small business formation and/or growth.

Whitney believes it unlikely that large US businesses will turn around and hire nearly the same number of workers- three million- they just got finished laying off in the past three years.

Missing from the picture will be small businesses growing to take up the five million jobs they have cut in the recent recession.

Putting the pieces of the picture together, Whitney sees continuing jobless 'recovery,' with large businesses continuing to enjoy jobless productivity gains, small businesses crippled by consumer credit contraction, while municipal and state governments finally shed workers larded on in earlier expansions.

Hardly cause for optimism for a robust, high-employment recovery, is it?

Monday, May 17, 2010

The Ratings Agencies' Turn "In The Barrell"

With Moody's being assailed for misleading statements in a regulatory filing, and two opposing amendments to a Senate financial 'reform' bill dealing with the rating agencies, it looks like Moodys, Fitch and S&P are finally getting their turn for scrutiny from the fallout of the mortgage-backed securities-induced financial sector meltdown.

One of the amendments to Dodd's disastrous regulatory "reform" bill would strip the rating agencies of their special, government-designated status. Another amendment, by comedian, now Senator Al Franken, would wrap even more red tape around the ratings agencies, cocooning them under yet another special oversight board.

Guess Franken hasn't left the comedy field just yet.

Paradoxically, both amendments have passed votes to attach them to the Senate bill.

If you have much exposure to the financial sector, then you probably will be rooting for the 'less is more' approach that removes the agencies from any federal imprimatur of credibility. S&P, for the record, backs this step.

Back in the days of little information and poor communications, ratings agencies provided low-cost, widely-disseminated creditworthiness judgements when most investors lacked the resources to undertake their own due diligence.

That's no longer the case. The ratings agencies enjoy monopolies from a long-ago era, much like the airlines before Alfred Kahn liberated them from their anti-competitive industry structure.

It's high time institutional investors quit hiding behind the rating agencies, yet also taking money for allegedly making hard choices concerning investment instruments.

It's not clear there's even a role for the agencies anymore. If so, it's probably not going to be rating instruments for pay from the originators.

Something else will have to replace that now-tainted model.

It's long overdue.

Wealth In China

I read the details of a story in the Wall Street Journal concerning the murder of many young school children in the small provincial town of Lincheng.

The story is heartbreaking. An embittered man who had leased a building for the local school was angry at not being able to recover use of the house. In spite, he attacked the children and school teacher, hacking them to death, then killed himself.

What struck me, however, was the Journal piece's description of the town as "one of the poorer villages in China."

I can't locate the article, published last Thursday, in the Journal's online site. But it seems, at least to me, to belie the notion of what now constitutes the one of the poorer villages in China.

Centered in the image accompanying the article is a decently-dressed woman chatting on a cellphone. To the right, in the back of the photo, sits a man in a dark blazer, well-coiffed, in a collared shirt and loafers, his face grim. Next to him is a casually dressed woman, her face buried in her hand, in a tasteful, slim pair of jeans and dark top with metal buttons.

Other grieving parents, all waiting in a hospital or medical clinic, are surprisingly well-dressed, -groomed and modern-looking.

They'd put the people in the poorer sections of New York City or Chicago to shame.

I guess economic welfare in China is truly widespread and rising.