The Gathering Storm and waiting for a Dead Canary

China's first bond default is a dead canary coming the from developing economies's mine shaft.  That may break pretty soon.  On the other hand, the strength of the Euro comes from a carry trade sweeping problematic bank to government loans under a huge rug. It's an irrationality outlasting my liquidity.

Flash Boys

MIchael Lewis’s book returns trust as a virtue with value in finance.  This from a blogger who has been ranting about Banks playing games with the public for the past five years.  The optimism comes from a leading bank; Goldman Sachs, a subject of previous evisceration, debating within its ranks their long term survival under the following conditions:  High Speed Trading networks are built to take advantage of customers.   HST is best exploited by small agile firms, not a Goldman, who have no customers but game Goldman’s customers.  Goldman brings to the table customers who are taken as lambs to the slaughter which is a long term loser proposition for the bank. Lewis’s expose puts Goldman in a better light than its competitors for at least acknowledging the problem beforehand and evidently helping to promote a trustworthy solution. The beauty of his expose is that customers being taken advantage of are professional and now understand how they have been gamed so that the market resolves the excesses without depending on a compromised and really useless SEC.

This is How a Lobbyist Operates

There is nothing positive that can be said of a financial network that front runs customer orders, but Philip Delves Broughton's editorial "Flash Boys for the People" certainly tries. Whether the small investor benefits is a laughable side issue as if High Frequency Traders ever had good intentions for them. Not mentioning trust is the fatal flaw in his argument.

A bank that throws customer orders to an exchange that pays them for the privilege of taking the order to front run, buy before the customer and sell back at a higher price is a practice long considered untrustworthy of an agent, is guilty of taking advantage of its client. It is surprising there are any customers left on a Wall Street best described as being in the middle of a giant shark frenzy where the sharks are eating themselves. There is no regulation that fixes this which is proper since regulations are fair game for the untrustworthy. The lesson here is to buy simple instruments, stocks and bonds and not complex ones such as funds and ETFS, for the long term and just stay out of the casino as much as possible.

An Obama Narrative in anticipation of Tim Geithner's Stress Test

Rahm Emanuel, Barack Obama’s Chief of Staff in the first term, famously declared that a crisis is too important to waste.  Unfortunately the newly elected president’s political philosophy is best described as Hamiltonian Federalist versus Jeffersonian Liberal, in the old sense of the term celebrating the individual and distrusting concentrated power.  It was an unfortunate bias for him to have because it left him unprepared to give the bank system the required reset of the century. Andrew Jackson’s reset by not renewing the charter of the Bank of the United States in the 19th and FDR’s with Glass Steagall in the 20th century were long lasting break ups of financial power and concentration.  The Dodd Frank Act, on the other hand, doesn’t and dams the economy to less than optimal growth.  

Fox news and right wing punditry aside, The Administration has many indices headed in the correct direction for those of us wishing for less government and more liberty.  The economy is growing with private employment up and government jobs down.  The deficit is decreasing.  We are disengaged from the war in Iraq and soon will be from Afghanistan as well. Other foreign events have been dealt with a clear head and in partnership with our allies.  Finally the legislative momentum has been brought to a crawl thereby reducing the prospect of further harm being done as the country mends itself.  His legacy will be of competent leadership.

This is from a President who entered office with a challenge for which he had neither the economic nor philosophical framework to understand, much less decide what to do at the cusp of the Great Recession.  That Tim Geithner, his Secretary of the Treasury, was a master mechanic of the broken status quo was not recognized.  Fearing a cascading effect, Treasury did not want to draw blood in Wall Street and decided to protect even the untenable banks.  Unfortunately Bank of America harbored Angelo Mozilo, the great criminal of the recession whose Countrywide Financial operation perpetrated a massive fraud on banks throughout the world.  Citigroup reached its nadir through sheer incompetence but Treasury compelled it’s resentful competitors to prop it up.  By this sweeping of financial misdeeds under the rug the newly elected President’s goodwill turned to ashes within his first thirty days in office.

It ignited Rick Santelli to famously rant on CNBC Business News television against protecting irresponsible borrowers. That the tirade began the Tea Party was really the least of Obama’s problems because Santelli shifted the blame to the borrowers rather than duplicitous lenders. On the other hand, banks that had acted correctly and prudently felt betrayed by the Administration for holding water for those who acted badly and recklessly.  By summer of 2009 the bad feeling in the banking community was so that none of the major players would attend a Wall Street presentation that the President gave. The impression that took over that first year was that Obama abandoned the little guy and let Wall Street off the hook.

Dodd Frank requires a rewrite to one simple precept, that every financial institution, be it Bank, Insurance Company or Investment Firm which reaches one percent of Gross Domestic Product in assets under their control divest into smaller completely separate entities.  The end result is an act that commands rather than micromanages.  It eliminates systematic risk.  Those institutions that game the system are bankrupted by free markets that determine the ersatz services and benefits they offer are worthless. Fewer bonuses for those duping their customers and a slow regression to the mean in the country’s income distribution. Unfortunately with the Financial Lobby’s current vise grip on Washington there is no chance for passing such a simple act until the next crisis.

Bill Clinton wished for the opportunity to have lead in a dire time and thereby put him in the pantheon of the Great Presidents.  Barack Obama’s bad luck in this regard is that he had the crisis but let it slip through his fingers by not having the trust busting instinct of a Teddy Roosevelt who made Standard Oil divest into five distinct competitors, a courageous battle that makes TR a Great President, despite the progressive baggage.  Obama, on the other hand, is the nation’s first President of African descent where he proves American Exceptionalism with his every living breath and for that will be remembered.  

It matters whether the investment is good or bad

Regarding Paul Krugman's editorial "Bits and Barbarism" I'll leave it others to comment on Gold and Bit-coins and dwell on the Keynesian idea that it doesn't matter how the money is spent for the economy to grow. While World War Two did pull us out of the depression and war is pure consumption, this economic notion of Keynes needs testing in other settings. The recent global mal-investment in real estate is a drag that would not be reversed by additional spending in housing. Japan's inability to pull out of it's lost decades comes in spite of huge infrastructure expenditures tried in the 90's. Nor should we expect the forthcoming clean up spend on nuclear waste and plant dismantling will help out, especially if every nuclear facility lays dormant as another of the country's mal-investments.

 

An example of what an investment Bank could do

Europeanutilities have on occasion had to pay a penalty for excess power put on the grid. This penalty phase comes about when wind and solar power is filling the grid and the less desirable nuclear and carbon based power can not be shut off.  Hydrogen powered automobiles that are about two years away from commercial deployment and where the problem is distribution of hydrogen gas to filling stations. What could an investment bank do with sort of information?

First, secure a long position in depressed European utilities, then sell the idea of making the electric grid the means of conveying hydrogen gas to the various filling stations for automobile use. Filling stations would convert electricity into hydrogen thru electrolysis on the spot. The electrolysis would happen when sensors on the grid inform the various stations that excess capacity needs to be sopped up. Usually post midnight to 6 am and of course anytime high wind and good solar collecting is filling the grid. Such a system would tolerate waste in electric transmission and conversion to hydrogen as it would be preferable to paying a fine. Since the utility wires are already in place, infrastructure costs are minimized. Safety is enhanced because of the small volumes of hydrogen gas of this scheme versus any other.

The scheme solves the utility battery problem as well as promoting a clean energy solution that is safe and distributed for auto and truck transport. Utilities will price their power more optimally and improve their valuations in stock and bond portfolios. This is an example of a long term win win type of proposition that investment banks were made for, versus Goldman Sach's scandalous rent seeking intrusion in the aluminum trade exposed early in 2013.

Volcker rule is irrelevant

The Volcker rule of the Dodd Frank Act, named after former Federal Reserve Chairman Paul Volcker, is an attempt to re-instate in some form or another the Glass Steagall act of 1933 where commercial banks and investment banks were separated. The separation allowed government regulation of commercial banks using a self funded FDIC insurance program to guarantee deposits. Investment banks on the other hand were allowed to act freely and practice unprotected capitalism. The Volcker Rule is a modern yet muddled attempt to micro manage between commercial and investment banking. Well paid lobbyist are eviscerating it, but the market's current aversion to dicey financial instruments will keep abuse to a minimum in the near term. The why of this observation requires a short history.

Investment banks used to raise capital for factories, transport and the public infrastructure required to promote and maintain useful activities to generate an economic good. As more debt was sold, these banks developed trading desks to keep a liquid market for the bonds that were issued. This market activity was a low level low pay operation that was understood to be operating in a zero sum environment. Traders began to assert their importance when the crumbs falling their way were millions of dollars. Harvey Golub's rise at Lehman Brothers in the late 70's is a well documented example of this change in banking.

As systems improved among competitors and customers the trading desks developed artificial products, derivatives, to hedge various positions. These instruments were hard to figure out and price so that firms issuing them found extra profit. An egregious example of bad faith with these derivatives was in 1993 when Bankers Trust sold their customer, Proctor and Gamble, a particularly one sided deal. Years later in a hard fought suit it was revealed in audio tapes that the traders were high fiving themselves for having made a huge windfall by duping their customer. Bankers' reputation did not long survive that revelation, but the casino mentality of milking the customer completely took over Wall Street in that decade so that the raising of capital became secondary. A current sickening example of a worthless manipulation is Goldman Sach's aluminum trading operation exposed recently. The scheme moved inventory from warehouse to warehouse to justify price increases. To reap the fullest price the stock of aluminum ingots had to be inventoried and moved around for eighteen months, solely for the purpose of taking advantage of customers such as Boeing, a large user of aluminum in the manufacture of aircraft.

The investment community has taken notice of Wall Street shenanigans by pricing the stocks of too big to fail banks with low valuations, low price earnings ratios in finance parlance. The lowest PE ratios are with those with the most opaque business model. Bernie Madoff, for example, had an opaque business model. Ironically some firms are spending big money for legal talent in Washington for the right to write opaque money losing contracts. That banks are currently minting money hand over fist is in spite of their trading desks, not because of it. With the current Federal Reserve Bank policy of lending at practically zero and banks lending back to the government at a few points higher does not require exceptional bonus generating talent.

That Goldman Sachs just was added to the Dow Jones Industrial Index is an indication of how far it has coasted on it's reputation for excellence. The aluminum scheme described previously not only shows that Goldman currently is an impediment to industry but it also shows a business model bereft of purpose. For it to be honored as an “Industrial” is an Orwellian use of language that real investors see through. Currently GS is valued with a PE of 10, a C-. Imagine that, GS is the dummy in the room,

 The Volcker Rule will not be abused in the near term because no financial officer wants to over pay for a tax fiddle that will blow up on them. Considering the legal and structured investment fees required, many companies select more transparent schemes, such as not repatriating foreign income. It will take generations for the financial idiocy perpetrated by too big to fail banks in the first decade of the millennium to be forgotten. When it is, then the rule will be trampled over by a herd of credulous bulls which will bring forth another financial crisis.