The Random Don't Walk Theory
In its ongoing quest to make capitalism safe for human consumption, the Obama Administration has resurrected on the an economic policy concept discredited under President Nixon, whose 90-day wage and price freeze of 1971 morphed into a series of government programs lasting into 1974. Programs being put forward by Team Obama offer price controls in sheep's clothing.
Conservative Republicans - whose concept of Free Markets includes drafting legislation to crush free competition - may have met their match in a liberal Democrat, who appears to favor every aspect of the free market, as long as the market itself is kept under lock and key. The operative factor underlying the recent White Paper's regulatory initiatives is the notion that Someone is doing Something they shouldn't, and it is the job of government to put a stop to it. Having a traffic cop on duty reduces traffic accidents and pedestrian fatalities. And, while the traffic cop who does not permit anyone to move at all will have the highest safety ranking, we demand that the traffic flow nonetheless, because the concept of acceptable risk is fundamental to notions of societal balance, progress, and human happiness.
In the earlier stages of the financial meltdown pundits debated about whether "this" would spill over into "the real economy." But it is devilishly difficult to separate "real" from "not real" in the marketplace, and the attempt to define one group of market participants out of existence - or to sequester their activities - is the cusp of an extremely slippery slope. The policy and social implications of clamping down on broad areas of market activity are broad ranging, and frankly unpredictable.
Trying to define where the market ends, and the "real economy" begins is like trying to find the line separating the air from the sky. Further, since everything meaningful - and market events that cause social shocks are certainly meaningful - occurs at the margins, the activity at the market / real economy interface is sufficient to drive political concerns on a global scale.
As reported in the NY Times (7 July, "US Considers Curbs on Speculative Trading of Oil"), CFTC Chairman Gary Gensler is gearing up for a showdown over speculative trading in natural resources. This was highlighted recently by widely reported "speculative" swings in the price of oil - as exemplified by the story of the world's largest OTC oil broker, PVM Oil Associates, which disclosed unauthorized orders entered by a "rogue broker" that generated $10 million in losses for the firm, after causing an inexplicable run-up in the price of oil (Financial Times, 3 July, "Rogue Oil Broker Triggered Price Spike").
These price swings, by the way, occurred almost exactly one year after the last "unreasonable" spike in the price of oil, likewise attributed to "speculative excess". We recall discussions over the years with energy market participants, many of whom referred to some kind of pricing cycle that peaks in the summer, before prices retreat into the fall. We would welcome a study on this - any one will do, it should not be difficult to determine price moves over time - but the conspiracy theorist in us salivates in Pavlovian glee at the suggestion that there might be a "cycle" that "everyone knows about" in a market that is prone to "speculative excess" and "manipulation."
Indeed, some folks we know have observed this pattern based on insights gained from Goldman Sachs, the firm where CFTC Chairman Gensler was once a partner. This was before he served as deputy Treasury secretary under President Clinton - at whose behest he drafted the language used to defeat the urgent proposals from then CFTC Chair Brooksley Born who pushed, to no avail, for oversight of the derivatives markets.
Has this leopard changed its spots? We are willing to believe that people can learn from their mistakes. Chairman Gensler would no doubt say he was learning from other people's mistakes - specifically, from the mistake publicly admitted by Chairman Greenspan. Whatever the cause, we wish Chairman Gensler well in his quest to force transparency in the derivatives markets. This idea has tremendous merit - it's what market regulation is supposed to do.
Perhaps dancing to the tune of his new political masters, Gensler is doing some muscle-flexing in other areas, and catching some flak for it. We think contract limits for speculative traders is a relatively benign outcome for most participants, though perhaps not for the ETF / ETN business, of which we shall have more to say in our forthcoming screed.
On the other side is the argument that the job of regulation is to keep enough of the playing field open so that "legitimate" market participants can have reasonable access. The issue is: who decides where the borders of legitimacy lie. Many industrial companies have come out against Chairman Gensler's proposals to limit speculative trading. Why, as these are the very markets on which they rely for the key inputs to their livelihood, would they not want speculation curbed?
We believe there are several forces at work. One is simply that capitalists see government interference in markets as bad. Governments are notoriously inept at helping markets to improve, and efforts to "fix" markets invariably end in what the Germans call Schlimmverbesserung - an improvement that makes things worse. Call it what you will, the attempt to tamp down speculative trading through legislation is price fixing.
If you want proof of just how rotten an idea it is, you have but to look at the Op Ed piece in the Wall Street Journal (8 July, "Oil Prices Need Government Supervision") co-authored by Nicolas Sarkozy and Gordon Brown, and calling for a controlled pricing mechanism to keep the price of oil within a stable band. Even as these champions of government control of industry mount their soapboxes, Europeans are playing the regulatory equivalent of Beggar Thy Neighbor by considering looser rules on derivatives than those proposed for the US (Financial Times, 12 July, "Geithner Warns of European Threat to Derivatives").
Industrial companies see both edges of the blade: today, the government will be setting the price at which producers can sell key inputs. Tomorrow, the government will be dictating the prices at which manufacturers can sell output. Along the way, the increased costs associated with implementing the new regulations will drive a number of smaller operators out of business. This is regulatory Lysenkoism at its finest.
Secretary Geithner's testimony on Friday contained soothing words, assuring industrial companies that the legitimate use of futures for hedging purposes is not the target of these reforms.
But it seems no one is buying it. The financial companies that take the other side of these bets are the target, and any restriction on their activities will dramatically increase the costs of doing business. Which will be passed directly to You Know Who. The majority of derivative contracts for the world's largest corporations are issued by two firms - JP Morgan Chase, and BofA/Merrill. These are big-ticket operators, and the companies that rely on them for their hedge contracts must permit them to overcharge them for services. In the case of Morgan, they are paying for one of the only really competent risk managements in the world. In the case of BofA they are paying for the implicit ongoing government guarantee and the fact that the firm continues to wield incredible market clout.
This is all based on degrees of trust. Trust in the soundness of the bank, in the judgment of the bankers, and in the soundness of the financial system and those who oversee its smooth functioning.
This reminds us of Paul, one of our favorite brokerage customers - a long-suffering gent with a seemingly endless ability to absorb market abuse. Paul had the same plangent refrain every time a new stock idea was presented. He would listen to the sales pitch, old his breath for a few silent seconds, then invest ten thousand dollars into the idea. Each time, before hanging up the phone, he would sigh, "this better be good..."
But of course, it almost never was.
The Good, The Bad, And The Citi
You see in this world there's two kinds of people, my friend. Those with loaded guns, and those who dig. You dig.
- "The Good, the Bad, and the Ugly"
Some folks believe it should not be a fundamental requirement for financial survival that every private investor be an expert in forensic accounting. Thus, it is with more than our usual dash of skepticism that we look at the number - $1,593 - representing Citigroup's net profit for the first quarter. This comes on the back of a year where the company lost $27.6 billion. One need not be the proverbial rocket scientist to know that this "earnings" number should have an asterisk.
Along with these earnings, Citi issued a press release, explaining that Citigroup has been stripped of its nonperforming and toxic assets, all of which have been bundled into an entity called Citi Holdings. CEO Pandit explains, "The creation of Citicorp and Citi Holdings reflects our strategy to refocus the company on its greatest strength: our global institutional and consumer banking businesses, while exiting non-core businesses and reducing risk assets."
The drama unfolding alongside this financial restructuring is CEO Pandit's juggling of personnel in the inner circle. Friday's release came a day after the public removal of Ned Kelly from the CFO position - a post he occupied for all of four months - to be replaced by Citi's long-serving chief accountant, John Gerspach, who was likely far more suitable for the job in the first instance. The ongoing Night of the Long Knives at the Citi boardroom was "not something the FDIC ordered" (Financial Times, 10 July, "Citigroup Finance Chief In Reshuffle"). While there are clear political motives for this management restructuring, it certainly would appear Vikram Pandit is more concerned with his own agenda than with the best interests of Citi's shareholders.
In fairness to Pandit & Co., the pilot for this long-running series - The Great Global Financial Meltdown - included the first appearance of TARP, wherein then Treasury Chief Paulson floated a version of a good bank / bad bank model. Using the TARP funds to remove toxic assets from the balance sheets of major US institutions would unclog the markets - so went the argument - and permit credit to flow once again. Indeed, that was what got voted on and passed.
But good bank / bad bank did not materialize. Instead, we got Uber-Bank / Lick Your Wounds Bank, as Goldman and JP Morgan pocketed tens of billions of dollars they did not need, and segments of the economy desperate for liquidity (in economic jargon they are called "small businesses" and "consumers") were instructed to pound salt.
Now Citi is bringing the good / bad model to the firm level. The canonization of Too Big To Fail may be Obama's downfall. It shows that he lacks the guts to wrestle the bad guy to the floor, disarm him, then stand over him brandishing his own weapon. President Obama does not seem to understand that perpetuating Very Bad Ideas launched under the Bush Administration does not get him off the hook. We fear that President Obama and Speaker Pelosi think they will get to point to their failures and say "don't blame us - look at the mess we inherited!" As Petey, in the old neighborhood, used to say - someone should tell them what time it is.
Skeptics though we have been, we think institutions like Citi, which bear the formal government designation of 2B2F, may be the only place the good / bad model can be made to work. In a perverse way, Citi's restructuring may be the bellwether of sound economic thinking. It appears to have been structured for the benefit of the shareholders - that would be us, the American taxpayer. (Indeed, the American Tax Avoider will benefit as well, which adds another layer of unfairness to the tax system. But we digress... )
The fundamental problem underlying TARP and its countless begats is that governments can not repair markets. When they seek to do so, it is always a disaster. The only question is the extent of the damage, and the time and cost to recover.
As a side bet, it seems Pandit and Geithner have mounted an effort to shove Sheila Bair out of bounds, just when she is about to run for daylight. Bair has stated publicly that Pandit should not be CEO of a bank. Her convoluted logic holds that people who are not bankers, and who do not understand either the business or the regulation of banking, should not be given free hand to own and operate banks. This led her to clash with Mr. Geithner in the early stages of TARP, and it is setting her on a collision course with the major private equity firms as she insists they post credible protection for depositors and other assets in the banks they seek to acquire (using government money, mind you.)
Ms. Bair has long worn the mantle of Digger In Of Heels In Chief. As even regulatory agencies are suffering hiring freezes, it is interesting that the Fed has increased its bank examiner staff by ten percent, with more growth in the offing. Amidst the proposals to make it the Systemic Risk Regulator, the Fed is arming itself to replace the FDIC.
Similarly, Mr. Pandit's internal reshuffling is clearly designed to keep as many of his cronies as close as possible - Mr. Kelly, a longtime FOV ("Friend of Vikram") remains on in a strategic and dealmaking capacity - while giving up just enough to make colorable the argument that he should stay on as CEO, and have access to FDIC guarantees. We anticipate that Secretary Geithner will beat Chairman Bair over the head with this before too long. In this battle, as in so many others, we are rooting for Chairman Bair, if only as a needed corrective to pervasive Geithnerism.
The ultimate rescue of Citi will be a long and arduous process. Back in the dot-com boom America enjoyed global handshake credibility. This credibility allowed our banks to abuse the goodwill of all our trading partners. When Chairman Greenspan admitted to the UK's central bankers that the losses in the swap contracts - very real ones, at that - had been borne by European insurance companies, he was disclosing a nasty truth: the US, which considered itself 2B2F, had maneuvered its financial trading partners into serving as a landfill for all our toxic paper. This was far beyond Good bank / Bad Bank. It was Good Country / Bad Continent. With our handshake credibility gone, we must now use our own shovels to dig ourselves out.
Perhaps by bringing good bank / bad bank to the firm level, Citi is actually showing leadership. It will take a long time to work out the toxic paper that has been rolled into Citi Holdings, but at least now we know where it is, and there is hope of transparency for both shareholders and the markets. We hate to admit it, but CEO Pandit may have actually engineered Change We Can Believe In.
And Now For Something Completely Different
"Banks Reinvent Securitisation To Cut Capital Costs" reads the Financial Times headline (6 July). The story describes efforts at "smart securitization" by Goldman and Barclay's to package billions of dollars' worth of customer assets in vehicles that can be rated by credit rating agencies, then sell them on to third parties. This brilliant new strategy will enable the originating banks to reduce their capital requirements, by taking the assets off their books, and replacing them with cash.
Call us cynical, but we suspect they will be fast-tracked to the market with their products before second and third-round me-too-ers find the door has been slammed shut.
On the face of it, Barclay's is offering a clearing system for banks to factor productive assets, swapping balance sheet liability for cash today, thereby freeing up regulatory capital.
Observers of the current crisis generally agree that bank capital needs to be increased to prevent repeats of the current dismal scenario, and that the quality of that capital should be more robust. This means holding larger reserves - which means lower returns. It also means retaining more of a bank's liabilities on its own books, not shunting them off to third parties. This means less liquidity.
What we find impressive is the acceleration of the pace of innovation in the capitalist model. No sooner has the world gotten comfortable with the "R" word - "Recession" - than serious market pundits are talking about a new bull market, and governments and global economic organizations are talking about "already being in a recovery." Global powerhouse banking firms (Merrill, Morgan, Goldman...) are putting out bullish reports urging folks to Buy China (up some 70-80% since January) - if the recovery is to gain steam, the banks will have to sell their inventory to someone...
And now, the ink not yet dry on President Obama's white paper, the bankers are getting back into the securitization business. Factoring assets is a simple business. Factoring assets, as presented by Barclay's, is sure to become complex. Even a small wrinkle - one single swap in lieu of actual cash - will create an opening for follow-on participants to wreak havoc. We wonder when that first loophole will be probed. We wonder whether any regulators are actually watching.
We are staying tuned.
stopped into a church I passed along the waywell, I got down on my knees and I pretend to pray
The downside of posting this column weekly is that we get no credit for being right when things move fast.
On Monday (Financial Times, 6 July, "Opportunistic Wall Street Gears Up To Trade In California IOUs") we jotted Note To Self predicting that the SEC would deem the State of California scrip to be securities. By the end of the week, that had come to pass.
Next, we believe, will be an SEC action against Craigslist. Like the cop on the beat who assiduously writes out parking tickets, turning his back on the armed drug dealers at the other end of the block, various courts and government agencies have tried to enjoin, censure, fine, or just plain close down Craigslist over criminal activity - real or alleged - connected to postings on this service.
The ink on the first California IOUs was not yet dry when postings appeared on Craigslist offering to buy and sell them. Collectors were bidding as much as twice face value, in hopes of getting a piece of history, and speculators got into the game, offering instant cash for the IOUs at a discount. The State promises to pay them off at face value when they mature, in October, plus an interest rate of 3.75%. At the right price, there are those who deem that acceptable risk/reward.
Rather than going after Craigslist, we urge Chairman Schapiro to explore ways to bring social networking venues into the mainstream of the markets. Deals are already being done away from the eyes of the regulators - deals that the SEC would probably deem securities transactions. The combined resources of FINRA and the SEC could not catch Bernie Madoff - even when he was delivered on the proverbial silver platter by highly qualified professionals who provided extensive analysis. We do not hold out much hope of them catching someone trading limited partnership interests via Twitter.
If the Commission goes after Craigslist, they will be launching a frontal attack on market transparency - the one thing market regulators should seek to ensure. On the other hand, regulators might learn something from watching the way a marketplace evolves.
This model of a self-regulating marketplace, where buyers must beware by definition, and where information is freely shared across all segments, should be explored by Schapiro & Co as a paradigm for rethinking the regulatory framework. In a world where Facebook effectively faced down the FARC in Colombia, and Twitter combines with iPhone to tweak the Ayatollahs, we suggest the US regulators would be ill advised to go head to head with the social networking phenomenon - itself the most dynamic emerging global marketplace. We don't give this much of a chance - but we can dream.
Chief Compliance Officer