De-leveraging the Shadow Banking System

What a difference an SEC accusation can make. The once out-of-reach Lincoln bill was approved by the Agricultural Committee 13-8 today, with marginal bi-partisanship. Lincoln's bill calls for the most sweeping overhaul of the financial system to date: the separation of derivative desks from the broader banking system.

Within modern megabanks, there exist the commercial side of activities (which focus on deposit-taking and lending) as well as the investment banking side of activities. Within the investment banks we typically split into traditional investment banking (debt and equity underwriting, mergers and acquisitions), capital markets and wealth management/advisory services.

In a manner of speaking, the Lincoln bill is a tamed-down version of Glass-Steagal. It focuses on separating portions of the capital markets group from the broader financial institution, rather than the entire investment bank. Derivatives are well-considered to be the instruments that create the difficulties associated with "inter-connectedness" and "systemic importance".

Recent regulatory proposals have focused on a combination of consumer protection measures as well as addressing Too Big to Fail. The proposals surrounding the latter have been as tame as requiring companies to create a disaster plan in the event that they collapse (a "living will") and as stringent as the above-stated Lincoln bill. Somewhere in-between is increased regulation (oversight) and further capital constraints (holding more money to protect against losses).

In effect, the large majority of these proposals serve to shrink the shadow banking system (leverage and loans outside the traditional bank realm). Most conservatively, increased capital requirements divert equity away from other investments and into banks (the impact of this would be small). Alternatively, swap desk spin-offs will require some new capital to be raised by the spun-off institutions. Furthermore, the cost of this capital will be higher (as it does not have a government guarantee, nor a form of funding as cheap as deposits). With the higher cost of capital comes a higher cost for leverage, and in all likelihood, a decrease in available leverage. This may be further exacerbated by declines in bridge financing (temporary financing for business or investment opportunities) and other non-traditional forms of lending.

Although it has become increasingly clear that re-regulation is necessary, there are always unintended consequences. I personally think that a decrease in leverage in the financial system would increase stability in the long run. The short-term impacts may be much more significant if executed improperly. It is no small secret that Bernanke views credit contraction as a major cause of the Great Depression. We will need to plan for our own short-term leverage-adjustment for the sake of increasing stability.

The Political Backlash Begins

As if on cue, there are numerous reports about politicians honing in on the Goldman case. Bloomberg's story "Goldman Suit Harnessed by Obama Political Aides for Internet Ad Campaign" indicates that Obama's official political arm, Organizing for America has paid for top advertising in Google searches for "Goldman Sachs SEC".

From the Bloomberg story:

The ad link takes browsers to a page on my.barackobama.com that features a picture of the president and the following quote: “We’ve seen and lived the consequences of what happens when there’s too little accountability on Wall Street and too little protection for Main Street. It is time for real change."

Furthermore, both London and Berlin are following suit. Given the unpopularity of a Greece bailout, Germany has appeared to attempt to stall action until state elections on May 9. Similarly, the UK is facing the prospect of a hung parliament on May 6. London was quick to attack (story here), as was Berlin (story here).

Let me be clear that I think reasonable and appropriate actions should be taken (including the restructuring of current regulations). I just want to highlight the timing and nature of the political responses.

The SEC Strikes At Goldman While the Iron is Hot

On Friday, the SEC charged Fabrice Tourre and his employer, Goldman Sachs, with fraud. It is common to charge the employer, under the doctrine of respondeat superior ("let the master answer") wherein the employer can be responsible for the actions of its employees. This is sometimes known as "going after the deepest pockets".

Also on Friday, Democratic Senator Blanche Lincoln unveiled a sweeping derivatives regulatory bill, which in spite of alleged attempts to craft a bipartisan bill, had no Republican lawmaker support for the legislation.

Without opining on the culpability of Mr. Tourre or Goldman (The Baseline Scenario makes strong arguments against the firm here, while Goldman makes strong responses here), I think there are a few bigger picture concepts to take note of.

1. The timing of the accusation largely coincides with the need for votes to pass financial regulation. Of the handful of financial regulatory bills currently circulating, there is very little in the way of bipartisan support. Although I am fully supportive of implementing prudent regulation to promote long-term stability within the financial system, we must take care not to pass reactionary rather than visionary legislation.

2. These allegations are a big win for the Democratic party. It is no secret that Obama's approval ratings have dropped precipitously. It is also no secret that Wall Street bankers seem to rank with pedophiles and traitors as the most-hated segment of society. While the Republicans have been chasing Wall Street donations (see WSJ article here), Mr. Obama is attempting to position himself as a champion of the people against the banks. The Democratic party is incented to push for an overly restrictive bill in order to discourage Republican support. Come mid-term elections, they may poignantly declare "why vote for so and so when they refused to regulate fraudulent companies…do they really have your best interest in mind?". My fear is that the resultant political banter may take away from the larger issue of an appropriate regulatory backdrop.

3. Where will the money come from? Taken to its logical conclusion, there is simply not enough available money in global financial institutions to make investors whole for the losses that they incurred. If litigation were pursued on all levels, we would see clients suing their investors, investors suing investment banks and ratings agencies, ratings agencies and investment banks suing mortgage lending companies, mortgage lending companies suing the appraisers and the individuals that committed representational fraud, etc. By no means am I arguing that legal recourse should be foregone, but in a room where everybody is shooting at each other, the only winner is the funeral home. We have a messy situation on our hands.

Altogether, this is an unfortunate and complicated situation. Its impact has the potential to be much more far-reaching that the single outcome ("deny and settle" seems to be the mainstream PR response.

China Runs a Trade Deficit?

China reported today that it ran a trade deficit for March, where it imported more than it exported (the last time that this occurred was April 2004). See NYT article here. This is much more complicated that the headline, and does not undermine the piece I wrote previously, Why China Needs the United States. A single month does not change a decade of imbalance, and furthermore, we will see that the underlying causes are not sustainable.

1. Chinese growth has begun to overheat, and appears to be causing Chinese authorities concern. Like numerous countries worldwide, China unleashed large stimulus packages in early 2009 in order to keep their economy growing. Although stimulus packages are often portrayed as "jumpstarting" the economy like a car, "whipping the horse" is probably a more accurate portrayal. When you whip the horse too hard, it can go berserk and run faster than intended. In Beijing, housing prices rose at 8.8% in the month of March and over 60% in the past year! Not only is this fast, it is accelerating.

2. In response to massive demand, residential and commercial construction is occurring at breakneck speeds. In order to achieve this building, China needs to import natural resources, such as oil, iron ore and copper. Record import volumes helped to drive oil up over 5% in March and copper up nearly 9%. Iron ore prices are up some 40% year-to-date.

3. An unwelcome outgrowth of this is large scale speculation. Individuals are purchasing second and third homes in the face of rapidly rising prices (a process that officials are likely to try to discourage). Anecdotal reports suggest that iron ore traders are stockpiling the commodity in anticipation of future demand. As a result, Chinese authorities are trying to limit imports of the raw material.

As we know all too well, rampant asset-driven growth like the housing bubble of 2007 and the crude oil bubble of 2008 is not sustainable. Although China's trade deficit may persist for a few months, it is very unlikely that this will be a long-term shift. Nonetheless, it is coincidentally convenient that this "shift" occurred only weeks before US Treasury Secretary Geithner was originally to decide whether to label China as a "currency manipulator". Sustainable or not, it is all too likely that they will use this data point to defray potential allegations.

How Free is Speech?

The oft-cited First Amendment has fallen amid a bit of controversy lately. As has been well-publicized, the Supreme Court rolled back limits on corporate political donations, deeming this to interfere with freedom of political speech as per the constitution (see NYT article here).

One of the key themes of this blog is to distinguish idealism versus pragmatism. While our linguistic liberties have been legislatively preserved, our first amendment freedoms have been functionally fractured.

By the letter of the law, as a legal person (corporations, not-for-profits, flesh-and-blood people) I have the right to rent a billboard to broadcast to the world my support for political candidate John Q. Public. Similarly, XYZ corporation has the legal right to rent their own billboard arguing in support of John D. Private. All is well from an ideological standpoint: we both can speak freely in favor of our candidates.

Functionally, however, we may run into problems. Suppose that there are five billboards in my town. As a middle-class citizen, I have $500 to spend on my billboard, which happens to be the current rate for billboard rentals. Hearing of my intention, XYZ corporation (presumably wealthier) decides to rent out all five billboards, driving the cost up to $2,000 per billboard, well outside of my price range. While we both have the same legal liberties, I have been functionally "crowded out" from expressing my view on a billboard.

I am left to either find another means of communication, or to seek out somebody wealthier to join my cause. Extending this line of thought, we see that there is some relationship between wealth and making one's voice heard.

Limits on campaign spending help to alleviate this problem (unless the bar is set too high, in which case it doesn't limit much at all). If, for instance, campaign donations (including money spending on advertisements) were capped at $1,000 (this is somewhat arbitrary), then we needn't concern ourselves with crowding out to the same extent.

Although I tend to lean more towards publicly funded campaigns (more on this later), I do think that it is important to respect people's right to use media to promote their causes. As I see it, a low limit (clearly adjusting for cost of living over time) for campaign donations preserves the ability to speak both functionally and legislatively.

Why China Needs the United States

One of the most common misconceptions that I find in conversations is the view that the United States need tiptoe around Sino-American relations for fear that the Chinese won't fund their burgeoning deficit. This is a timely topic given Geithner's choice to delay his decision on whether to label China a "currency manipulator" (see US delays decision on China currency manipulation in today's FT). More accurately, both countries need each other, and are engaged in a delicate dance of imbalances. This, in a sense, is what "fragile equilibria" are about.

Over the past 30 years, China has risen to power largely through its export-led growth policies (although in recent years, their economy has been gradually moving to being more self-sustaining). Through this period, they have fixed their currency, the Renmimbi, to the US Dollar, as the United States had a more stable economy. Similar growth strategies were pursued by Japan and Germany in the 1960s and 1970s. I would highly recommend Niall Ferguson's piece The End of Chimerica which details these histories.

Under circumstances where a currency is allowed to "free float", market imbalances are assumed to correct over time. For example, when we buy clothing that is imported from China, that merchant would sell the money that he receives from you (US dollars) and buy a currency more useful to him (Chinese renmimbi). Normally, this would cause the renmimbi to increase in value relative to the dollar (because somebody is "buying" renmimbi with dollars). A higher renmimbi would make it more expensive to for our corporations to hire Chinese workers. Most of us are more familiar with this concept via travels to Europe. When the dollar is weak our trips to Europe are more expensive. This is the same phenomenon that corporations deal with.

Now just as our purchase of clothing from China causes the renmimbi to go up (and makes Chinese labor less competitive), China can purchase things from the United States to make the renmimbi go back down (and make Chinese labor more competitive once again). Just such purchases are required in order to maintain their currency peg.

What exactly have they purchased from us? Our debt: Treasuries and mortgage debts. Chinese involvement is one of the primary reasons that interest rates remained as low as they did for as long as they did (the "conundrum" that Greenspan spoke of). These low interest rates permitted (but did not force!) Americans to borrow more money and buy more things (often from China).

A picture is worth a thousand words, and this case is no exception. China's accumulation of foreign reserves (comprised largely of American debt) have increased by 1100%.

Shockingly, at $2.4 trillion, China's foreign reserves are now 50% of its gross domestic product (annual economic output). If the roles were reversed, this would be the equivalent of the US owning $7 trillion of Chinese debt. More remarkable perhaps is the speed at which the chart increases: it shows the ever-growing effort required to keep its labor artificially cheap, and that of the United States artificially expensive.

The problem that China has with boycotting the US Treasury market is that they own so much of it. For every 1% that their foreign reserves go down in price (assume this is an average across the basket of debt they own), their "portfolio" declines in value by $24 billion USD. Although running a profitable Treasury portfolio has never been their intention nor their goal, they have equally backed themselves into a corner.

How Large Scale Socialism Puts Capitalism at a Disadvantage

Thus far we have dealt primarily with private sector companies (those not owned by the government). However, it is becoming increasingly important to consider the impact of international competition amongst the private and public sectors.

Historically, we typically address this from the perspective of private companies forming to challenge public services to reduce costs. For example, the US Postal Service has seen competitors such as FedEx, UPS and DHL cut into its early dominant market share. I would contend that this is a natural and healthy interplay. As Milton Friedman discusses in Capitalism and Freedom, certain industries benefits from spreading costs publicly, others from private competition, and still others from some degree of hybrid. Roads and airports are a great example. It would make little sense for there to be two major highways running in parallel, each run by separate companies, and each charging competing fees.

As the world is growing and changing, it is important to consider this from the alternative perspective. Large socialist governments are forming companies to compete with international private companies. PetroChina and Sinopec, China's two largest listed oil firms, consistently receive subsidies from the mainland when oil prices become onerous, putting private sector firms such as ExxonMobil and Chevron at a relative disadvantage. When a country has a large trade surplus, it better equips them to spend money on such "cushions", creating larger and longer-lasting subsidies.

This leaves us with very large state-owned and subsidized companies in China and other command economies competing for resources with privately-owned companies elsewhere. If the privately-owned companies do not pursue mergers and acquisitions to continue their growth, the result is that their state-owned counterparts will become relatively larger, and have more pricing power and influence.

Although I am not advocating the supercorporation (as I hope is evident at this point), I am looking at their incentives. When viewed in light of globalization, large scale socialism incentivizes consolidation within capitalism, as corporates must grow in order to survive. As the number of players become fewer and fewer, the modes of production become more centrally controlled, leaving us with the aforementioned oligopolies.

The result is stunning. In theory, large-scale and widespread persistent socialism encourages more socialist-like behavior out of capitalism. In the extreme case, state-owned companies in countries with large trade surpluses can price away their competitors in the short run. This is a stark counterbalance to the argument that capitalist innovations challenge command economies over the long run. In order for long run arguments to hold, capitalist players must be able to survive the short run.

The Dark Side of Globalization

Given its many benefits (the case is compelling), it's not often that we hear of the deterrents of globalization. It is in many ways, an academician's dream come true: abundant supplies of international labor, a focus on core competencies and competitive advantages, and global competition all working together to, in theory, reduce friction and unfair business practices.

Corporation acquisitions are at the very heart of creating global institutions. However, as each fish is swallowed by yet a bigger fish we are left with a series of very large and very interconnected companies. The financial sector offers the clearest picture of this: through a series of derivative contracts, the well-being of nearly every major financial institution in the world was linked to the well-being of nearly every one of its competitors. This left the government with no choice but to bail out the struggling firms.

However, this does not stop at the financial sector. Both General Motors and Chrysler were deemed "too big to fail", as their many suppliers and dealers would have collapsed under the weight of their insolvency. The simple fact is that global interconnectedness up and down the supply chain, just-in-time inventory management, and round-the-clock production creates hundreds of "too big to fail" companies. Imagine the impact if Walmart faced significant solvency problems, or if Tyson had to dramatically scale back their chicken operations, or if Whirlpool had to halt washer & dryer production.

Starting yesterday, the bond markets began to identify with this (financial markets are very useful in identifying trends before the mainstream media reports on them): investors are demanding a higher yield from ten year Treasury notes than they are for ten years worth of a synthetic bucket of inter-bank risk. Some take this as the market indicating that the US government's debt isn't nearly as secure an investment as it used to be. Today the papers took note: see Debt Concerns Send Treasury Rates Higher in the Wall Street Journal. (I should note that "too big to fail" isn't the only cause of this phenomenon — the markets are expressing discontent with healthcare and broader government spending as well).

The steps leading here have been tortuous yet measured. A failure to enforce anti-trust rules has allowed for corporate players that are unseemly and large. As is usual, the matter is not as cut and dry as it appears. As we will see, however, many US businesses were responding to outward pressures from foreign competition.

I, Corporation

This next post is on something that is near and dear to my heart: the complications of corporate campaign contributions.

Although each individual has an equal right to vote, we must recognize that who is incented to vote and how they are incented to vote are determined by their social, political, and financial surroundings. Pessimistically, Noam Chomsky posits in Profit Over People: Neoliberalism & Global Order that these opinions are heavily influenced by the media. This "malleability" of public opinion was "discovered" during and post WWII as documented by Edward Bernays in Propaganda. (The concept of propaganda quickly morphed into "Public Relations").

If this line of thinking holds merit whatsoever, we find that those with the greatest financial backing can run the most permeating policy campaigns, awarding them the greatest sway over voters and political decisions. Corporate contributions had been previously limited via the so-called McCain-Feingold law, but this law has been subsequently reversed (see NYT article here). The premise of the ruling had to do with the legal "personhood" of corporations and the freedom of speech under the First Amendment.

My intent in this is not to point fingers, but rather to address the structure of incentives. People by and large behave how they are incented to (Freakonomics is a very fun read on this). As such, we must give adequate thought to creating proper incentive structures.

This becomes vitally important when incorporated with the previous few posts. As discussed, capitalism and democracy provide necessary checks and balances (financial power versus voting power). When corporate campaign contributions are substantial enough to influence voters, capitalism begins to tacitly control democracy rather than wrestle with it. Our current incentive structure encourages corporations and special interest groups to lobby for change that is narrowly rather than broadly beneficial. Furthermore, it enables them to do so. This creates a trajectory that is long-term politically unstable.

Why Capitalism and Democracy Aren't Interchangeable

Capitalism and democracy: two pillars of America that I had historically thought to be one and the same. I had considered this solely on the philosophy of freedom — while capitalism allows freedom to financial prosperity and choices, democracy allows the freedom to vote and basic human rights. However, the two are very different and both vital to function.

Throughout history, power has tended to reside in the hands of one of three spheres: the church (religious), the military (kings, queens and government), and the commercial sector. Jacques Attali addresses this in A Brief History of the Future: A Brave and Controversial Look at the Twenty-First Century: a bit pricey but one of my favorite reads (he summarizes the history of the world very neatly and moves on to social trends shaping the future). We are currently in an arena where the commercial sector is largely manning the power hub.

Now capitalism and democracy are both systems that deal with the distribution of power amongst individuals. In particular, capitalism empowers those individuals that possess greater wealth, affording them investment opportunities and corporate positions of influence. Democracy, on the other hand, empowers each individual equally, providing an important balance of power. No matter how rich you become, you are constrained to a single vote.

When properly functioning, this prevents the ultra-wealthy from taking strict advantage of the underprivileged. In the event that the income gap (the amount of money the top earners make versus the rest of the country) becomes too disproportionate, the lower- and middle-classes will vote for a redistribution of their wealth. Suppose that only 5% of workers made 90% of the income. You would quickly see the other 95% vote to tax and redistribute that wealth.

The recent backlash at the banks is a tangible demonstration of this interplay. The public felt that the bankers had become too greedy and that Wall Street prospered at the expense of Main Street. As a result, the UK has imposed a one-time tax on their bankers, and momentum is mounting to further regulate the international financial industry.

This push and pull, when properly functioning, is what allows individual greed (capitalism) to wrestle with individual freedom (democracy). Over the years, however, our system has broken down, for reasons I will discuss in the next post.

Less Free-Market Than Meets the Eye

As industry power consolidates into fewer and fewer hands, we are left with a “capitalistic” system that is ideologically different, but pragmatically similar to socialism. This is different than Karl Marx's suggestion that a series of crises portending revolution would lead communism to replace capitalism, as well as Joseph Schumpeter's inclination that intellectual climates would become ill-suited for entrepreneurialism.

Rather, this is the natural progression of an ill-regulated system of capitalism. Corporations compete with one another in a style similar to the March Madness tournament. Over time, victorious companies acquire or defeat smaller companies. As the victors grow, the barriers to entry for new participants becomes larger and larger. In the end, we are left with each industry dominated by a handful of major players. Barry Lynn addresses this nicely in his book Cornered: The New Monopoly Capitalism and the Economics of Destruction. He highlights that nine of the top ten brands of bottled water are sold by three major players: Pepsi, Coca-Cola, and Nestlé. Whirpool’s Maytag acquisition leaves them with a 75 percent share of the U.S. washer & dryer market. Meanwhile, since the 1990s, the number of large defense firms has consolidated from 107 to 5.

The result is what economists refer to as an oligopoly within industries. Whereas a monopoly consists of one key decision-maker calling all of the shots, oligopolies consist of “a few” decision makers. These oligopolies (sometimes thought of as cartels) encourage the key players to join forces (either implicitly or explicitly) in order to serve their own best interests.

What we find is that, practically speaking, American capitalism is largely characterized by the centralized planning at the heart of socialism. Wherein socialist economies this planning is executed by the state, in cartel economies this planning is executed by a few strong industry players.

This leaves us in a hybrid form of capita-socialism, with important implications for democracy.

The Rise of the Supercorporation

The tech bubble would be proud if it were still alive.

Everything we promised has come true, and more. The dreams we had. That one day you'd be able to buy your groceries from home (Fresh Direct), clear your shelves of the Britannicas (Wikipedia), and make a "video phone call" with your friends across the globe. That transparency and a hyper-competitive landscape would pave the road for an empowered and knowledgeable consumer and usher in a new wave of American entrepreneurialism.

Yet the same medium which has given rise to re-birthed capitalism in a few industries has created oligopolies (sectors dominated by only a few key players) in many others. For these supercorporations, the Internet has offered a degree of connected that facilitates coordination and round-the-clock production that heretofore was impossible. While the eighties and the nineties began domestic waves of consolidation, the noughties ushered in international mergers and acquisitions blessed by tremendous technological progress.

The result is that many corporations have productive capacity which challenges even medium-sized nation states. For example, in 2008, Exxon Mobil's gross revenues were $477 billion while Walmart had gross revenues of $379 billion (they were the two largest corporations internationally by revenue). Taken together, there were the 17th largest GDP in the world, ahead of Poland, Belgium, Switzerland and Thailand.

The point of this is not to necessarily disparage the rise of the supercorporation, but rather to highlight that companies of this size portend structural shifts of power away from the hands of the government and into corporations.

I hope to, over the next week, discuss the implications that this has on labor, governance and centralized planning. Happy reading.

La Raison d'Être

Believe it or not, there are blogs about the reasons to start a blog. Surprisingly, "because you're important and everybody should know what you think" is not on that list.

It is for just such reasons that I've hesitated for years in starting my own. I worked for a very large bank throughout the financial crisis (albeit not in a decision-marking role) and remember well the bloodbath of the equity markets into the close each day. I remember colleagues with bruised tailbones after working twenty-plus hour days through the thick of the Lehman bankruptcy. We worked hard, because we genuinely believed that we were keeping the system from collapse, each playing our part.

Through open brainstorming with friends over the years, I was one of the few that saw the crisis coming. Within weeks after the string of corporate bankruptcies in the fall of 2008, I had put together an alternate bailout package addressing the structural problems America was facing, as well as what I felt were the most cost-efficient solutions to our problems.

I sent them to many members of Congress, as well as many Senators, Republican and Democrat alike. Everything fell on deaf ears.

Over subsequent months, I found friends and family to be fearful of the future, desperately needing a framework by which to make things make sense. It is out of these conversations that this blog is born. It seeks to be both forward- and backward-looking. It will contain a compilation of current events, pertinent reads and my personal commentary.

It is my hope that through this readers will have a resource that helps them understand what they've been through, what is really going on in financial markets, and what they can expect going forward.