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The Boy In The Bubble

We are interested in policy decisions because they direct the way markets and market participants behave.  Every piece of legislation is anchored in a principle of social philosophy, and sometimes we need to tease apart the policy rhetoric before we figure out what lies beneath.  We have had a bit of fun lately at the expense of Fed Chairman Bernanke, dubbing him “He Who Sees No Bubbles” for his steadfast refusal to acknowledge that his no-interest interest rate policy is stoking market excesses (we can’t say “bubble” – what do we call them?)

We call your attention to the Law of Unintended Consequences.  This is what happens when you planned for nearly everything – but not quite.  Those who fail to plan get to wriggle through another Ivy-League loophole – the Unknown Unknowns.  This is a six-figure way of saying I did a poor job on the analysis, but the graphs looked awesome…

When it comes to the Chairman of the Federal Reserve, the nation and the world have a right to expect that there be no unintended consequences.  Chairman Bernanke is exceptionally learned, intelligent and thoughtful.  We can only conclude that the bubbles occurring on his watch are intended consequences.  To borrow an unfortunate military term, they are Collateral Damage.

The bubble in low-grade debt is a case in point.  According to the Financial Times (16 December, “Distressed Debt On The Wane In US Markets”) debt trading at under fifty cents on the dollar, “is rapidly disappearing from the US financial markets as yield-hungry investors push up prices.”  The article cites high-yield managers as reporting the highest returns on their portfolios in history.  The lowest-grade paper has had the biggest jump: the worst-rated bonds have more than doubled in price this year.

“Bonds trading at less than 50 cents on the dollar account for only 1.1 per cent of the high-yield market” reports the FT.  A year ago, they represented 27.5% of that sector.  In real numbers: today there is market value of $8.9 billion in distressed debt; a year ago there was $202 billion.  Somebody bought an awful lot of it, and bankers have raked it in as “high-yield bond issues in 2009 have brought in $171bn.”

Obviously, the trashing of the world’s patrimony through trillions of dollars of subprime debt securities has neither crimped anyone’s appetite for yield, nor made folks more discerning in where they place other people’s money.  Perhaps we should keep mum and let the Chairman stay on course.  If the world wants to relieve us of the burden of our trash – and pay us a premium for the privilege – that may be the best policy solution.  We recall Chairman Bernanke’s testimony that the Federal Reserve is not responsible for preventing bubbles in other nations’ economies.

Even the Fed can not prevent the proverbial Fool being parted from his Money.  Nonetheless, it appears the Chairman has accomplished what the marketplace could not, which is to uncover the market-clearing price for the worst-rated debt.  Who’d a thought it would be a 100% premium?

Take that, Efficient Market Theory!    

The Epistle Of Paul

In hoc signo vinces.


Our modern-day Saint Paul is an aging giant – a man of great stature, both physically and morally.  No stranger to tribulation and danger, he voluntarily charges back into the fray to save the world.  Having put himself on the chop-chop block when his career truly hinged on it – and having pulled off what the world acknowledges to be a heroic feat of economic derring-do – Paul Volcker has returned to teach us the lesson of history.  He is already suffering the consequences of his choice.

Wall Street is full of smart people.  It is even fuller of smart-asses who, at critical junctures are fond of spouting statements like “Those who can not remember the past are condemned to repeat it” before heading off to print the next trade with someone else’s money.  There’s this to say about teaching lessons: the students have to actually be in the classroom.

Business Week reports (15 December, “Volcker: Financial Fix ‘Like A Dimple’ So Far”) the aging warrior has trekked across five nations, visiting nine cities in the past eight weeks, warning that financial authorities “have not come anywhere close to responding with necessary vigor” to the world’s financial situation.  He scolded a gaggle of financial executives at the Wall Street Journal conference in West Sussex, England, for proposing changes that were “like a dimple.”

Far from being a revelation on the road to Damascus, Volcker came by this knowledge the hard way – he lived every bruising moment of a global fiscal crisis and withstood the shocks largely alone.  With the death this week of Professor Samuelson, “Dimples” Volcker is perhaps the only world-class economist alive who actually was an established economist during past crises.  Harvard’s Niall Ferguson observes that potentially civilization-ending or society-disrupting events happen just far enough apart that those in power today were not around to experience it last time.  Add to this the standard 30-minute (interrupted by commercials) memory span of Wall Street, Washington, and television-addicted America, and it’s a wonder anyone can remember how to use an ATM, much less rescue a damaged economy.

We wish our knight errant, Sir Paul, God speed as he pursues the dragon risen from its lair.  On that famous trek to Damascus his namesake, Saint Paul, saw a heavenly vision, the words of which ring down through the ages.  Indeed, part of that same message applies directly to the task Mr. Volcker has taken on, and it is a blazon the US would do well to bear in mind.  We may not yet see the Sign of Victory, but we are surely In Hock.

The Bair Witch Project

Sheila Bair, FDIC Chairman, remains one of our heroes in the world of financial markets regulation.  Her view of the world is vastly different from almost anyone else’s in Washington.

It is all a bit unreal to be sitting in your kitchen sipping your morning coffee and reading about the pitched battles being waged across conference tables in London and Washington over how many trillions will be spent over the coming decade.  When the only bank servicing your community is forced to shut its doors, that’s reality.

According to the Wall Street Journal (16 December, “Bank Agency Boosts Budget 35%”) “more than 130 banks have failed this year, and the agency’s inventory of assets in liquidation has more than doubled” to a current $36.8 billion.  The agency will also share losses on an additional $108 billion of damaged assets from more than 80 failed banks.  It’s no wonder Ms. Bair keeps coming up short in the till.  Indeed, twice this year the agency took down billions in stepped-up fees from its member institutions, as cash drained from its coffers.

The FDIC insures 8,041 institutions (figures from the FDIC website Institution Directory page) with combined assets of approximately $13.3 trillion, and deposits of $9.1 trillion.  Requested staffing and budget increases would bring FDIC manpower to 8,653 employees, almost double its 2006 level.

The math is not encouraging, and the nation desperately needs Chairman Bair’s knowledge and dedication.  The FDIC’s “problem list” of troubled banks is at 552 and expected to rise.  We could be looking at ten percent of the nation’s banks being close to the brink.  Gee, sounds like a crisis to us. 

The FDIC doesn’t announce publicly which banks are at risk of failure – that task is ably handled by members of Congress who precipitate crises by “outing” weak institutions for their own political purposes.  It can’t be easy being the only regulator whose agency actually deals with real people.

FDIC teams are widely acknowledged to be highly professional, and sensitive to the reality that they are taking people’s lives in hand.  They are also efficient.  In the past, Chairman Bair has made a point of bringing in retired bank examiners or professionals who moved on after a decade or more at the FDIC.  Teams often have failed banks up and running in short order, with minimal disruption to the grateful community.

Chairman Bair is managing this full-blown crisis while staging a fight for survival.  The Journal (18 December, “Agencies In Brawl For Control Of Banks”) reports that Senator Dodd “has proposed revoking all of Ms. Bair’s powers to supervise banks.”  Ms. Bair, widely praised for being perhaps the sole financial regulator not asleep at the switch, is now in danger of being unseated and left with nothing more than a dustpan and brush. 

We figure it must be that testosterone thing.  It can not be a coincidence that, for over a decade, no one in a position of authority was troubled by the Lori Richards’ mediocre management of the SEC Office of Compliance Inspections and Examinations.  You know, the guys who didn’t look at Bernie Madoff?  Nor was anyone up in arms about SEC Enforcement Director Linda Thomsen, on whose watch the Pequot Capital investigation went up in smoke.  Chairman Bair is fighting a multiple uphill struggle in Washington: she is a woman, she makes sure she has command of the facts, and she does not back down when Groupthink is the required order of the day. 

We think Chairman Bair is the target of a Capitol Hill witch hunt.  Why does she have to go begging for a $4 billion operating budget and assure Congress that her staff increases will all be temporary workers?  Who will Senator Dodd turn to when Ms. Bair has been sidelined? 

A run on the banks is a scary thing. We urge Congress not to stage a run on the bank regulators.

Stocking Stuffers

Financial industry participants are characterizing this year’s SEC initiatives as an all-out war on the securities industry (TradersMagazine.com, 17 December, “Washington Strikes Back: Washington On The Warpath”) in which the very underlying structure of the markets has come under attack.  Fingering Congress as the driver of this mule team, Traders Magazine observes that the topics currently under attack include over-the-counter derivatives, short selling, dark pools, and co-location high frequency trading operations. 

The politicization of the markets is, itself, damaging the world economy.  The financial markets issue is not a mere question of liquidity, but of societal stability.  Greed rules the day.  For Congress and the regulators, it is greed for grandstanding and confrontation for its own sake.  For the bankers, it is cold cash.  But this is not a confrontation from which anyone will emerge a winner.  Failure to stabilize the financial market will lead to profound social unrest.  In a worst case, neither the Washington elite nor the Glock-toting investment bankers will survive.

Over-the counter derivatives might be moved to exchange-style trading, and can be centrally cleared.  The industry complains that this would put the members of the clearing houses at direct risk for every trade.  This is called Self-Policing and is what those who call themselves Capitalists complain Washington would take away from them.  If the market is in fact all wise, then it will not long tolerate dishonest or inefficient participants, and those left standing will be the better for it.  The alternative to making the entire derivatives marketplace responsible for every trade, is to make no one responsible for any trade.  We already tried that. 

The transparency and standardization offered by exchange trading will have other consequences.  Once derivative contracts are quoted in real-time, firms will immediately retailize them.  In short order, armies of retail brokers will be sent forth to pump derivatives into 401Ks.  This will lead to a bubble of abuses, as there will be a lag between the time these instruments are set among the population, and the time FINRA and the SEC identify them as a risk.  We take as our paradigm the failure on the part of the regulators to require any kind of training or registration of sales people, any special type of account treatment, or any suitability standard or risk disclosure document in putting individual investors’ dollars into ETFs.

Short sellers, the canaries in the gold mine of Wall Street, come under attack whenever there is severe market turbulence.  Regulators the world over dutifully took them to task in 2008-2009, and the cudgels were taken up by those who most profited from the legitimate pursuit of this practice.  It was laughable to watch Dick Fuld, then-CEO of Lehman, shrieking at Washington to reign in the shorts who were “ganging up” on Lehman stock.  Those of us who have spent years in the game recognize that the shorts are, in nearly every case, better informed than the longs – and always better informed than the target companies themselves, as the managements are subject to Groupthink, while short sellers’ only guide is Profit-think. 

As one of the regulators who slapped on a ban on short selling in the market meltdown of September 2008, the London Financial Services Authority (FSA) assessed the effects of its policy and concluded (FSA Discussion Paper 09/1, “Short Selling”, February 2009) that that the greatest risks posed by short selling are lack of transparency, which can be cured through simple reporting regulations, and illegitimate market manipulation during extreme market conditions – which is to say, market fraud.  Notably, the FSA “are firmly of the view that the positive benefits of short selling outweigh the negative impacts.”  Finally, they found the economic impact of the September ’08 short selling ban was negligible. 

Domestically, as we have pointed out, Chairman Schapiro appears to be dispensing a healthy dose of benign neglect to the whole short selling kerfuffle, so perhaps it will die the quiet death it deserves.

One side-note on the short selling story is reported in Floyd Norris’ blog (http://norris.blogs.nytimes.com/, 9 December, “Overstock Claims Victory”).  Norris, NY Times chief financial correspondent, has waged a running battle with Overstock CEO Patrick Byrne.  This time around, he reports a $5 million settlement of Overstock.com’s lawsuit against Rocker Partners, a short selling hedge fund.

CEO Byrne, one of the more entertaining CEO’s, advises shareholders to stay tuned for the lawsuit against the prime brokers, in which Overstock is alleging the major Wall Street firms “facilitated naked short selling through their prime brokerage operations.”

Dark pools are part of a fundamental debate over the nature of the marketplace: should government provide a level playing field, or should government force everyone to play at the same level?

The public marketplace, as exemplified by the NYSE and NASDAQ, is a social contract in which the investing public agrees that this is the proper way for a marketplace to operate.  We submit that few investors have ever given much thought to this, with the exception of those most disadvantaged by it, which are the ones who opt into the Dark Pools.

Dark pools are part of third market trading which has offered investors such benefits as cheaper executions, better pricing on large orders, anonymity of orders, and the ability to work very large blocks without the hangers-around in the crowd picking off their trades.  Professional investors, many of whom handle the retirement money and, through mutual funds, personal investments of a large number of American private investors, have flocked to the dark pools for the solid business reason that they are getting better executions.  We note that the requirement to obtain Best Execution for client trades is a primary market obligation imposed on money managers.

The vested interests are clamoring for relief.  But they also are believers in self-help.  The NYSE has constructed a football stadium-size facility at an “undisclosed” location to house high-frequency traders whose strategy hinges on being physically closer to the exchange floor than their competitors, thereby giving them an edge in timeliness of execution.  To the lay person, this expresses itself as

E = MC2 + 100 yards

where “E” is “Superior Execution.”

Can it really be that transactions that are already being processed at the speed of light can be bested by a technology that moves… er… faster?  In the warp-speed world of high-frequency, low-latency trading, firms are lining up for a literal front seat at the exchange floor. 

The exchanges have attacked the dark pools for creating a “bifurcated market.”  Bifurcating the market used to be the sole prerogative of the registered exchanges, which are striking back by creating their own private trading venues.

FINRA, which inexplicably mustered out 300 of its most seasoned regulators in an early retirement program this year, has flexed its remaining muscles in going after the First Call practice.  The Wall Street Journal (18 December, “Wall Street Trade Huddles Probed”) reports FINRA has requested information regarding the practice of giving certain trading indicators to certain customers, and not giving them to others. 

There can only be one “first call.”  That is not a Wall Street fiction, but a physical reality, and the biggest commission dollar always comes from the customer who gets that first call.  If FINRA wants to change the fundamental character of Wall Street relationships, this is a good place to start.  As they get closer to undermining the way Wall Street works, they may find Congress suddenly uncooperative when they realize how much it will cost them in future campaign contributions.  

Which brings us to the Usual Suspects in Washington, headed by the Usual Suspect In Chief.  We were not the only ones who found our President less than Presidential when he addressed the CEOs of three of the nation’s largest financial institutions as “you guys.”  These executives, unlike Jamie Dimon, did not take the corporate jet to the Monday Morning Massacre.  Goldman CEO Blankfein, John Mack of Morgan Stanley, and Citigroup’s Richard Parsons were grounded in New York due to fog.  Instead of spending an entire day shuttling back and forth to Washington to participate in a public Presidential woodshedding, they called in, took their lumps telephonically, and reported back to work at their desks.  Their investing acumen notwithstanding, Goldman Sachs apparently can’t get a reliable weather forecast.

President Obama’s remark “I did not run for office to be helping out a bunch of fat cat bankers on Wall Street” had us thinking of the millions contributed to Obama’s presidential campaign by Wall Street.  According to “opensecrets.org”, contributions from Goldman Sachs employees in 2009 were just shy of one million dollars.  The Top Twenty also feature Citi ($701,290), JP Morgan Chase ($695,132), and Morgan Stanley ($514,881)

As far back as the primaries (LA Times, 21 March 2008, “Democrats Are Darlings Of Wall Street”) the giving was clearly skewed, and the press raised the specter of Wall Street buying the Democrats’ acquiescence in softening financial regulatory reform.  What a silly notion, since these were the same Democrats who sent Glass Steagall to the gallows.  One, in fact, the spouse of the very President who kicked away the stool.  We are tempted to make a joke about Getting in bed with the Powers That Be, except in the case of President Clinton that does not appear to have been such an exclusive venue.

President Obama may not care to help out the Fat Cats, but the Fat Cats certainly helped him.  Riffing on Matt Taibbi’s characterization of Goldman in Rolling Stone, we think Goldman might be entitled to a “Squid Pro Quo”. 

Anyway, the President announced that he impressed upon the bankers that they need to start lending money to business – at the same time the banking regulators are admonishing them to tighten lending standards.  And perhaps most important – and most meaningless of all – he was able to show that the bankers of America are at his beck and call.  Well, a lot of them, anyway.

On the regulatory front, under the leadership of Chairman Schapiro, the SEC has made visible progress.  It now appears to be able to identify Shinola – something it significantly failed to do for a decade.  The present insider trading cases have much riding on them.  If new Enforcement Chief Khuzami manages to bring the Galleon case over the goal line, it will go far towards asserting a new age of credibility for the agency.

The  stage is set for what should prove an interesting year.  What we don’t yet know about 2010 is what regulatory bungles, what Wall Street scams, what international criminal transactions, what collusion between lawmakers, drug dealers, prostitutes and financiers have not yet been uncovered and will come to light next year.  We are rubbing our hands in anticipation. 

What’s under your tree this year?

Wishing you Happy Holidays, and a healthy, prosperous 2010.

Moshe Silver

Chief Compliance Officer