Wednesday, April 21, 2010

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.

Sunday, April 18, 2010

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 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.

Saturday, April 17, 2010

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.

Saturday, April 10, 2010

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.

Wednesday, April 7, 2010

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.

Sunday, April 4, 2010

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.