SEC to Rely on FINRA to Monitor Brokerages

"Daddy, read me the story of the self-regulating market again"

If your daddy didn't read you this fairy tale when you were young, maybe your "Uncle" Milton told it to you at university.  Or a kindly professor relayed the Uncle's wisdom to you. 

If this didn't happen, here's a quick recap. 

Even if each businessman single-mindedly pursues his or her own profit to the exclusion of all other concerns, where there is intense competition of the "free" market (note that requirement) salutary outcomes result:

1. individual or overall market excesses are magically curbed 
2. firms offer the best service and prices, eventually competing profits away to zero unless, of course, they make improvements to products.  [Because profits never go to zero (except in bankruptcy) this no doubt proves the creative power of free markets to constantly improve products.]
3. those firms that do not lower their prices or improve their products are forced out of business

Since by definition, the market in the USA is not only "free" but "intensely" competitive, then with such miraculous powers there is little if any need for government regulation.  In fact by interfering with the market, governments are liable to do more harm then good as this quote attributed to Mitt Romney demonstrates. 

The invisible hand of the market always moves faster and better than the heavy hand of government.

This theory seems to be the rationale for this recent SEC decision reported this Monday by Reuters.

The Securities and Exchange Commission is leaning more heavily on partner regulator the Financial Industry Regulatory Authority to monitor brokerages as it devotes extra staff to oversee the rapid growth of independent financial advisers, a top regulator said Monday

What could possibly be a reasonable objection to FINRA taking over SEC duties?

Simply put, FINRA is an industry group and therefore has an inherent conflict of interest. 

Does this mean that it is certain that they will fail to do a proper job or that they have failed in the past?  No.  What it does mean is that a conflict could cause them to fail.

What are some of the potential trouble "spots"?

1. Setting professional qualification standards too low.  FINRA doesn't report the pass rates on its qualification exams (Series 7, etc).  The pass rates for the CFA, CFP, FRM are all reported and suggest these certifications are difficult to obtain.  Why is that?   
2. Restricting information on actions against brokers.  If you'll recall a while back, FINRA was criticized for failing to provide enough information in its Broker Check (BC) tool to allow investors to determine whether to work with a particular broker.  FINRA announced some improvements but just recently the  Public Investors Arbitration Bar Association found those improvements lacking and criticized FINRA because BC doesn't include reasons for a broker's termination by a firm, information about bankruptcies, tax liens and scores on relevant industry examinations.  PIABA noted that some of this information is provided by state security regulators (government agencies) which suggests (but does not prove) that legal liability issues did not motivate these omissions.  
3. Applying a light touch on penalties when perhaps a heavier one is justified.  In the past the maximum fine was $15,000 per "offense" in the NASD days. (FINRA is the combination of the "old" NASD and NYSE separate self-regulatory bodies).   This has changed. Fee levels have increased.   In 2016 FINRA is set for a record year of estimated fines of some $160 million due to some "supersized" fines.  ("Supersized" is defined as a fine $1 million or more).  The estimated 2016 total fines is less than the fines levied against Wells Fargo by government regulators for the "fake accounts" scandal. The last time I looked FINRA's largest 2016 fine was some $25 million against Met Life (2015 revenues $70 billion net income $5 billion).  See the analysis of these "ginormous" fines by Sutherland Asbill and Brennan here.  And here for K&L Gates' analysis of 2015 fines in which it's noted that most FINRA actions are resolved for less than $50,000.  It should be noted that FINRA fines individuals as well as firms and that many of the firms in the industry are minnows alongside the major brokerage firms so $50,000 could be a firm threatening fee. 

Just to be clear, I am not accusing FINRA of improper behavior.  I am merely pointing out a conflict of interest.

During his illustrious career, AA has seen a lot of conflicts of interest turn into conflicts of action. 

Here's one "sweet" story - not witnessed by AA.

Early warning signals of the coronary heart disease (CHD) risk of sugar (sucrose) emerged in the 1950s. We examined Sugar Research Foundation (SRF) internal documents, historical reports, and statements relevant to early debates about the dietary causes of CHD and assembled findings chronologically into a narrative case study. The SRF sponsored its first CHD research project in 1965, a literature review published in the New England Journal of Medicine, which singled out fat and cholesterol as the dietary causes of CHD and downplayed evidence that sucrose consumption was also a risk factor. The SRF set the review’s objective, contributed articles for inclusion, and received drafts. The SRF’s funding and role was not disclosed. Together with other recent analyses of sugar industry documents, our findings suggest the industry sponsored a research program in the 1960s and 1970s that successfully cast doubt about the hazards of sucrose while promoting fat as the dietary culprit in CHD. Policymaking committees should consider giving less weight to food industry–funded studies and include mechanistic and animal studies as well as studies appraising the effect of added sugars on multiple CHD biomarkers and disease development

Why take a risk with this conflict of interest? 

FINRA has a role to play.  

But should the SEC cede what is properly a government responsibility?

Metadiscussion on "Are Big Banks Safer?"

Often More Dogmatic and Less Scientific

Natasha Sarin and Lawrence Summers of Harvard published a draft paper for the BPEA Conference in September titled “Have big banks gotten safer?”

The authors use a market-based methodology to answer the question whether banks are safer now than they were before the Great Financial Crisis (or as AA prefers to call it The Almost a Second Great Depression) given global regulatory actions.

This post is not meant as an analysis or critique of their work.  Rather I’m using their paper to pose some larger questions about economics, particularly market-based economics. Think of this post as metadiscussion on themes in their paper. 

Before I begin a few disclosures. 

I think that economics is not a science per se, though a scientific approach is useful as a heuristic tool in approaching the topic, e.g., defining terms carefully and as precisely as possible and most importantly recognizing the limits of the endeavor.  The economy is a complex not a complicated system. Therefore, it cannot be successfully modeled.  All the mathematics in the world cannot change this fundamental fact.

Like many who toil in the financial world, I was raised on the prevailing standard economic theory that invests so-called “free markets” with magical wisdom and efficiency. That theory posits that markets are self-regulating, that is, if left to their own processes, they reach a stable full employment (as defined) equilibrium. Extraneous shocks not anything inherent in the market itself cause economic problems.  Vigorous competition keeps participants in the economy “honest” and largely results in maximizing social benefits. Government regulation and taxes distort these virtuous operations. Market prices represent the best available valuation of assets, if not always, then generally.      

As my language suggests, I am not a true believer.  It’s not that I think markets have no value.  It’s that I do not think they are omniscient.  Markets are also inherently unstable, that is, economic problems result from factors within the markets not just extraneous shocks.  Market outcomes do not always maximize social value.  Market valuations can stray from real value for prolonged periods.  Homo economicus is fiction.   That I suppose puts me in the Minskyite camp. 

To start things off, quotes from the abstract in the Sarin/Summers paper.  The quote is in italics.  I’ve boldfaced a few points that I want to use as springboards for my own comments.

“Since the financial crisis, there have been major changes in the regulation of large financial institutions directed at reducing their risk. Measures of regulatory capital have substantially increased; leverage ratios have been reduced; and stress testing has sought to further assure safety by raising levels of capital and reducing risk taking. Standard financial theories would predict that such changes would lead to substantial declines in financial market measures of risk. For major institutions in the United States and around the world and midsized institutions in the United States, we test this proposition using information on stock price volatility, option-based estimates of future volatility, beta, credit default swaps, earnings-price ratios, and preferred stock yields. To our surprise, we find that financial market information provides little support for the view that major institutions are significantly safer than they were before the crisis and some support for the notion that risks have actually increased. This does not make a case against the regulatory approaches that have been pursued, but does caution against complacency.

We examine a number of possible explanations for our surprising findings. We conclude that financial markets may have underestimated risk prior to the crisis and that there may have been significant distortions in measures of regulatory capital. While we cannot rule out these explanations, we believe that our findings are most consistent with a dramatic decline in the franchise value of major financial institutions, caused at least in part by new regulations. This decline in franchise value makes financial institutions more vulnerable to adverse shocks. We highlight that the ratio of the market value of common equity to assets on both a risk-adjusted and risk-unadjusted basis has declined significantly for most major institutions. Our findings, if validated by others, may have important implications for regulatory policy.

Now to some comments.

When Results Differ from Theory, Question Theory

When results differ from what theory predicts, one sensible approach is to question the theory itself, especially in this case as markets have a history of mis-valuing assets, e.g., the dotcom boom, real estate, etc.     

While the authors do not specifically raise this point, they seem to accept that the market is not always right.  “We conclude that financial markets may have underestimated risk prior to the crisis”.   If markets were wrong then, why should we trust them now?  If markets were carried away by irrational exuberance then, perhaps they are being carried away by rational pessimism now.  

Beyond that how many times does the market have to be wrong before we conclude that standard financial theory on markets is wrong or deficient?  That is of course a dangerous step that could well undermine the bases for a lot of economic dogma and the politics that dogma supports.

If we assume that markets indeed can value assets with reasonable accuracy, it’s prudent to ask whether they can value some assets better than others.  Thus, is the market price for a Picasso as “good” (accurate) as the market price for a US Treasury bond? 

Financial institutions are black boxes of risk unlike a lot of other listed firms.  What gives the market the insight to value them?  

If you believe Mr. Dimon, and I sure hope you do, senior management at JPMorgan had no idea that the CIO was engaged in risky trading (instead of hedging), that risk control was ineffective, and that rogue whales were in London, even apparently when traders at other institutions publicly pointed out that one JPMC trader was significantly moving the CDS market. 

Mr. Stumpf has testified before the US Congress that he “knew nothing” about creation of bogus accounts, despite employees contacting the bank’s compliance and ethics department and some employees mentioning this is lawsuits filed for wrongful dismissal. 

Taking their statements at face value and AA knows no reason not to (I’m definitely senior management material), if the CEO with access to inside information doesn’t know, how does the market?

Regulators get to peer into these black boxes. In the case of large banks in the US they get "invited" (or more accurately invite themselves) to station personnel inside the box.  They get regular detailed reports on assets, trading positions, and can compel the FI to provide more information. If so motivated, regulators can meet with bank officers to raise questions.  Even with this access regulators appear to have trouble regulating banks.  What about the market gives it insights beyond regulators?  Or do regulators "see" but not "see" for other reasons?

The market doesn’t have the same level and detail of information as regulators nor can it force the FI to give it more.  On what basis does the market form an opinion?  If it is operating on less than complete information, is its market price more directional than locational?  That is, it identifies troubled institutions but may not have estimated their true value.  If so, then caution has to be used with results based on market values.

By contrast, it’s much easier, but not easy, to value a manufacturing firm.  These firms generate physical goods whose acceptance by customers can be tracked. Market share is going up or down.  Margins are increasing or decreasing.  Think of the saga of Blackberry.  But even in these cases, value is directional not locational.  That being said, there is always the counter case, e.g., Sunbeam, where “clever” practices can hide the rot in the underlying business. 

If Theory is Sound, Make Sure You Have Met the Conditions

Next are questions about the “market”. 

As I understand standard financial theory, there are some requirements for a market. 

Three guys trading among themselves infrequently is definitely not a market.  A market where participants have colluded (think LIBOR, think FX, think …) to “fix” prices in not a market.

To the extent that these markets’ prices are inputs into the valuation of securities, then one would have to question the accuracy of price determination of those other securities. 

Even where markets are not manipulated, they may not meet the test of a real market.  In which case their price “discovery” may be wildly inaccurate. It’s no secret that the only true bond market qua market is that for USG securities.  Other bonds trade infrequently and in too small numbers to meet the underlying requirement that the market price reflect the outcome of differing views among a multitude of participants.  CDS isn’t a real market.    

Don’t Push Theory Beyond Where It Functions

Related to this is pushing an assumed sound theory too far.  

Some years back, a client showed me an analysis he had received from a competitor.  It was a masterful piece of mathematics applying the Capital Asset Pricing Model etc. to various countries, showing individual country betas and cost of capital. I don’t remember all of the countries, but do remember that Finland and Bahrain were included. 

I noted that Nokia was roughly 70% of the value (market capitalization) of the Finnish market and so it seemed to me that the Finnish market was essentially Nokia idiosyncratic risk.  Since diversification of idiosyncratic risk is a key requirement for the CAPM etc, application of the theory was "dubious" at best.  I expressed doubts that the liquidity of the Bahrain market met the test for a "market".  What does a market price mean when there is no or almost no trading?

Look for Factors that Cause Theory to “Break Down”

But if we do have “real” markets that can generally estimate prices with reasonable accuracy, can there be factors that disrupt price discovery? 

After JFK was assassinated and after 9-11, the NYSE fell dramatically.  For 9-11 it was the largest one day fall since the Great Depression. And the market was closed until 17 September.  While horrific, these events did not wipe out billions in real value.   Liquidity preference, uncertainty, and outright bed wetting fear drove the market down. 

Similarly, there have been markets that imagined value creation e.g., the dotcom boom.   The authors recognize this with their conclusion that markets underestimated risk before the GFC. 

Given that admission, how do we know when to trust the market’s judgment?

It was an article of faith at the highest levels of at least one major country’s economic management apparatus that it is impossible to determine the occurrence of a bubble until after it pops.   I believe that maestro also held that markets self-regulate away excesses.  Views it is clear that worked very very well in theory, but less so in practice.

Are there any factors that could explain a similar pessimism and divergence from real value today?  While the NBER pronounced the GFC ended in 2009, there has not been the usual recovery.  Economic growth is anemic.  Central banks across the world are engaged in unprecedented intervention in financial markets that some fear is distorting markets and sowing the seeds for future busts.  Some are worried that conditions will remain so weak that unwinding intervention will not be possible without plunging the world back into GFC2.  Markets are jittery.    

As a sector, banks have been identified as the key culprits responsible for the GFC.  Thus, against the general worry about the economy, banks have pride of place as more risky than other firms.  If that weren’t enough to drive perceptions of bank risk higher, banks have also been repeatedly shown to be (a) apparently ethically challenged in the conduct of business--not just with respect to mortgage securities, but Libor rate setting, FX trading, and recently the creation of dummy customer accounts--and (b) lax or incapable of applying laws relating to sanctions, money laundering, etc.  Some institutions are serial offenders, “financial recidivists” as Ms. AA calls them.   Additionally note that the unprecedented central bank intervention is directly focused on the financial sector and thus on banks.  

In some cases, regulatory settlements have imposed onerous conditions on businesses and hefty fines while only deferring prosecution – leaving that risk “unsettled”.  In other cases, settlements have yet to be reached.  In one case regulators have opened what appears to be public haggling over the size of the fine –not something that is likely to calm market jitters. 

Compliance issues like trading losses appear all of a sudden.  One day everything is fine the next day the fur hits the fan. 

How does one quantify regulatory risk emanating from a "black box"?

In such an environment investors sensibly would demand higher risk premia.  Since the true risk is unknown and thus unquantifiable, that premium would be large to cover the unknown.  Perhaps larger than necessary?

Investors no doubt are also worried about the uncertain and potentially unfair results of civil suits, e.g., Arab Bank and the one against HSBC and several other major EU banks.   Something the government has little to no control over. And the results of which are left to the whims of judges and impartiality of juries.    

 Are You Conclusions Well Grounded?

Does this mean that bank franchise values have gone down?  

It depends. 

It depends on the accuracy of the two value points being compared. 

If the market underestimated risks before the GFC, then the market overestimated pre-GFC franchise values.  In this case, how can you make a comparison?

But it get worse.  Once you accept that the market made a single valuation "mistake", then you've accepted that it can make others.

So, why should one have more confidence in the current valuation? 

Particularly when economic conditions are not "normal":  a very anemic recovery and extraordinary central bank policies.  Conditions that have obtained for at least eight years despite the NBER's pronouncement. 

Nominal and Real Values

While one might compare nominal values, I think that “real” values (to the extent they might be known) would be more important for policy considerations.

But it has to be a challenge to untangle multiple factors affecting bank security prices to identify the main driver.  Well, at least, it’s hard for AA.

Wrapping Up

At this point, I’ve come back full circle to  where I began: skepticism about economics and market wisdom/valuations.

Don’t read the above as necessarily saying that market prices are “rubbish”, but rather that they are not infallible just as the market is not infallible.   A great deal of skepticism, caution, and humility has to be brought to bear when applying economic or financial theories to the real world.            

Interesting New Blog: Uncensored Middle East Monetary Musings

AA Can See All The Way to Dubai and Even Budapest, But Sadly Not Through The Stargate

An interesting new blog:  Uncensored Middle East Monetary Musings.

Take a look.

Finance is Not the Economy

That's Where the Real Thinking is Done

Michael Hudson and Dirk Bezemer published a great article about a week ago on the net "Finance is Not the Economy".  Well worth a read.

The article focuses on one of AA's favorite topics: how the failure to account for the financial sector means that economic analysis is incomplete and therefore incorrect.  That is not to say the economics will ever be more than a best guess. 

A failure on at least two fronts--impact of the financial sector on the economy and the risk of financialization of the economy.

One thing did catch my eye - lack of a reference to Rudolf Hilferding.

What Does Fitch's Study on CDS Spreads as Predictors of Default Tell Us About Modern Finance Theory?

Fitch released a report "CDS Spreads and Default Risk Interpreting the Signals" which has received a good deal of coverage in the press. One example from the Financial Times.

Analyzing five property-sensitive sectors in USA market in the wake the recent housing crisis, Fitch found that all five of these sectors had wild swings in their derived default risk. For example, USA REITs went from a CDS-derived probability of default ("PD") of 0.7% at June 2007, to 10.1% in October 2008, to 18.0% in March 2009, and then to 4.4% in August 2010. Details on the other four sectors are in the Table on Page 3. Despite these highly elevated PD's, actual defaults did not increase as predicted. The derived PDs were inaccurate. Fitch cites the volatility of CDS markets and the tendency for directional momentum (that is, an imbalance of demand and supply) as the cause of these false positives.

There are two key conclusions.  

1. CDS-derived PDs can give potentially erroneous and costly portfolio management signals. 
2. More importantly, as shown in the Table on Page 9, if the derived PDs are used in Basel II IRB models, financial institutions would be forced to dramatically and needlessly increase provisions at precisely the wrong time in a crisis. A pro-cyclical move which would depress the probability and strength of a recovery.

Fitch's study confirms what various analysts (including yours truly) have been saying about CDS spreads. The market is too thin to give reliable information. These are at best directional indications of PD. Fitch's detailed empirical analysis on this topic is therefore highly welcome and useful.

But there's more here.  Fitch's report raises fundamental questions about current finance theory:  both the construction of models and the use of market data – whether direct or derived –  as inputs to those models during periods of crisis. And so challenges some of the fundamental assumptions of corporate finance orthodoxy about market prices – both at the macroeconomic and microeconomic levels.

The simple empirical fact is that during periods of stress or exuberance, markets are dysfunctional. Prices no longer reflect, if they ever did, intrinsic values. During a crisis, there is a dramatic increase in liquidity preference motivated usually by fear. We see this most clearly in the breakdown of "normal" correlations among markets and asset classes. During a boom, a dramatic decrease in liquidity preference motivated by greed and irrational exuberance. 

This happens not only in illiquid markets like those for CDS but in the most liquid markets. In the period after 9/11, the NYSE plunged dramatically. While the attack was horrific, our way of life was not under serious threat. Our economy was not in danger of being destroyed, particularly by a relatively small band of cave dwellers in Afghanistan and Pakistan. For that task it would need and subsequently got some timely domestic help.

In such circumstances as in booms, the usual assumption about what market equilibrium means has to be thrown out the window. When markets are not rational, in no sense do their prices reflect intrinsic or fair values. Using the values they give – potential inputs into our "sophisticated" models – makes little sense. Market equilibria are much more unstable than during more "normal" times.

But, even if we assume that markets continue to function in such periods, we are misled by another myth: the imaginary no profit equilibrium derived from microeconomics. As this theory goes, intense competition leads sellers to lower their price until goods are sold at cost. Now, I recognize this is the one sacred doctrine on which all or nearly all the various economic cults agree. They may dispute vociferously with one another over which is the sole efficacious economic sacrament – the gold standard, the quantity theory of money, deficit spending, tongue of Newt, tax cuts etc  But on this issue there is by and large doctrinal unanimity. 

However, back in the real world, I don't know many businesses that price at cost. Or that stay in business if they do. Yet, we derive our financial models based on this illusion.   Often we use it to derive inputs for those models.  As you'll notice from Fitch's report, the standard equation for deriving PD from a CDS is to take the CDS spread in bps and divide it by the presumed loss on default (LGD) in percentage terms. The result is the PD expressed in percentage terms.  So a 100 bps CDS spread with a 50% LGD turns into a 2% PD. 

As you'll notice, this calculation assumes that the seller of risk protection is content to receive as his compensation exactly the amount of his expected loss. This is far removed from the standard microeconomic theory of equilibrium, which would have the seller's price result in an overall break even position. Here the seller does not recover his operating costs – salaries and other expenses which I believe it would be safe to say are not small in most investment banks. One might, I suppose, argue that in normal non crisis or non boom markets we can ignore these costs because they are spread over large volumes of business. Perhaps.

But in a crisis or in a boom where there is excess demand for a product, I'd expect any rational business man or trader to take advantage of supply/demand dynamics and increase his profit margin. which as I've argued above was not at "zero" from "normal" times.  More importantly, in a crisis where an institution and a trader are assuming an ongoing risk (like a CDS), I'd expect there to be a strong incentive - both  for the trader and his firm - to price up to cover that risk taking. The personal and institutional consequences of a wrong bet can be rather serious – just ask AIG.  So we should rationally assume that during a crisis CDS spreads include  not just the protection seller's  objective best estimate of the PD and LGD but also a fear/caution based adjustment of those factors plus a rather hefty profit margin.  It's not hard to imagine a seller demanding profit margin well in excess of 50%.   As before, in line with best doctrinal thinking, we're ignoring costs. Clearly, the profit margin and the additional fear induced safety margin in pricing are going to be a major component of the pricing.  All of which of course explain why often CDS spread-derived PDs are greater than 100%. And why using them in models makes scant sense because the resulting PDs are inflated.  Probably by significant factors. Not percentages that would be considered "normal" tolerances.

We like to think that we are more advanced than our predecessors. We have elegantly constructed apparently "sophisticated" and "scientific" models. Finance theories are expressed with imaginary mathematical precision. 

Yet at the very heart of these models are assumptions that would make a medieval scholastic blush. 

Assume a market with perfect information and no transaction costs and you will discover, perhaps - but hopefully not - to your surprise, that it turns out to be an efficient market. Something I believe has to do more with logic than economics: the principle of tautology.    

Assume that the market price reflects intrinsic value and you are highly likely to input the silliest numbers as variables into your model. 

What's needed at the core of this discipline like any other is a healthy does of skepticism, a constant challenging of revealed assumptions and a cold hard eye on results. 

IMF Working Paper: Recent Credit Stagnation in MENA

The IMF has released a Working Paper on credit stagnation in MENA prepared by four staff members, though it should be noted that IMF WP's do not represent official views of the IMF.

The report provides some interesting statistics on credit growth compared to measure of "normal" credit growth and some decomposition of changes in bank balance sheets post crisis.

I didn't see anything particularly controversial in the findings.  Or findings that would challenge intuitive analysis.  

The country by country data does provide a context for viewing credit growth across the region.

DIFCI to Divest Non Core Assets and Assure Robust Streams of Liquidity

Photo Jimmyjazz Released to Public Domain

 

Today's Gulf News carried a report that DIFCI had decided to get rid of its non core assets.  It has some US$1 billion of them.  Some of which are pictured above.

In the words of Shahli Akram, Acting Managing Director:

"DIFCI may divest certain of its investment portfolio to create robust liquidity streams across the business, whilst maintaining very strong focus on augmenting returns from our core business lines and also creating operational efficiency across the board," he said.

There's a lot of this going around lately.  Sort of like SARS.  The GCC is beginning to look like a US suburb with all the jumble and yard sales going on.  Adnan and  Ms. Maha up in Kuwait -  are selling so many "non core" assets that in three to five years they may have no assets left.  Not a one.  A Pretty fellow in Bahrain with a load of non core assets - real estate focused.  And now even DIFCI.

Ever wonder how a competently managed careful firm gets loaded up with non core assets? 

Well, Abu Arqala has a theory based on his experience at the university.  I had a friend let's call him "Sam".  Sam had a legendary refrigerator.  It all began innocently enough.  A clean refrigerator.  Some food items - fruit, vegetables, etc.  Over time these were augmented with left over pizza, Chinese food..  As new items were added, the old ones were all pushed further and further to the back until a critical mass and pressure sufficient for a chain reaction occurred.  One month thereafter,  some of the fruit had  developed whiskers - stubble to be sure, but growth nonetheless.  At two months, the Chinese food eyes.   At three months the pizza a proto hand or claw.  After 9 months, many swore they could hear vague stirrings from deep within the  refrigerator - nameless unthinkable shapes moving at night.  After 18 months, voices were heard. but in an unknown guttural language.   A new form of  life had been created.  After a while, the door was kept closed.

At the 24 month mark, during one summer, a "roomie" temporarily subletting opened the refrigerator.  A hardy soul not particularly prone to squeamishness he took charge of the situation.  Robust liquidity streams were mopped up from the floor.  And in some cases scraped from the interior.  Most of the non core assets were disposed of, except for one legendary orange with a long black beard that eluded capture.   They say (and who am I to doubt them) that it has until today and that if one listens carefully, its plaintive cries can still be heard at night. 

I'm guessing the same sort of thing happens in the financial world.  One starts with a collection of perfectly good assets.  New assets are added to the portfolio pushing the earlier ones to the back.  As they sit  there, some of them begin to fester.  Soon infecting others,  Before you know it, you're loaded up with non core assets.

One can well imagine how Shahli feels having opened DIFCI's rather large refrigerator.

Financial Times: The Great (Economic) Debate

Today's Financial Times resounded with more than its usual "plop" when it hit my doorstep this morning.  When this happens, AA knows that the issue is freighted with more than the usual amount of weighty insight and ponderous thoughts.

The FT has opened its opinion page to a one week debate between the advocates of austerity and of stimulus which promises at least five more such issues.  And at least that number of resounding thuds.  Luckily, the doorstep at Chez AA is sturdy.

Wrapped comfortably in their blankets of blind dogmatism (perhaps a bit too tightly wrapped), several learned thinkers have already weighed forth.  There have been the usual appeals to authority, though as of yet we have not heard what Master Aristotle's position is.  Prophets of various economic sects have been quoted along with the lesser works of apostles and disciples.   Holy books have been referred to.    Heretical scriptures and false prophets denounced. 

Today the abject failure of one particular sect to learn from history was noted, perhaps more in sadness than bitterness.  They are, it appears, sadly doomed (and perhaps damned) to repeat it.  One bearded chap was called out for holding a particularly laughable view - at least in the opinion of one economic "scientist".

As of yet there have been no remarks on opponents' paternity nor the virtue of their womenfolk, though like the 2006 World Cup there is still plenty of time.

While many important matters have no doubt been settled in this way, such as the number of wills and natures of Christ,  I expect this debate will prove a vain attempt to enlighten those who are manifestly in error.   

And so AA is preparing for the eventual regrettable recourse to force to secure recantations (or perhaps more precisely "refudiations") from the evil,  the ignorant and those of mixed disposition between the two.  And, if necessary to eliminate the various Great and Small Satans from the "science" of economics before they mislead others from the path of righteousness.

At present, AA is busily sharpening a rather sturdy stave for the intellectual battles to come.  What better way to make a point forcefully?

But which side to choose?  As a young undergraduate, I had fancied one day enlisting in Minsky's legions to do battle with the unbelievers.  Recently though I have considered joining the forces of Arthur Laffer.  A man whose profound insight was with Occam-like economy inscribed on the back of a cocktail napkin.  When I consider the venue, a potent motive for enlisting in his research corps.

The Elixir of Privatization for Infrastructure

 Blueridge Parkway Tunnel Construction 1935 (In the Public Domain)

Along with the nostrum of austerity in the midst of severe recession, the pedlars of financial patent medicines are offering the magical elixir of privatization as the cure for infrastructure needs around the globe. Today's Financial Times carried a lengthy article focused on America's needs, including advice from one famed investment banker who as noted saved New York City some years ago. And just now happens to be working for a firm "which has a big infrastructure business" and, perhaps, stands to make a shipload of money from successfully closing such deals. A bit of signaling from the FT in those six words?

Not only are the sums required great -- an estimated US$2 trillion. But there is a deeper problem.

"We are almost broke wherever you turn," Mr. Rohatyn said.

 How can we solve this conundrum?

Private investors, including kindly foreigners, stand ready to step up to bail out beleaguered and bankrupt local US governments if only small minded impediments can be removed. If achieved, local governments will be able to sell existing assets and get cash now. To apply the teaching of the famous commercial "It is my money" and "I want it now". And as well turn over costly new projects for private development.  An apparently free lunch, economically speaking.

Imagine the economies and efficiencies of having private industry in charge, not wasteful, spendthrift governments. Or the enhanced sharply focused management of assets and resources. One only has to look at the track record of the private sector in the financial sector, the oil and gas sector (perhaps with a focus on offshore drilling), mineral extraction (coal mining springs to mind) to see how well the profit motive can sometimes be married with careful stewardship.

The price for all this is rather modest. All that's required is the agreement to pay a fair return on the capital provided, a rate set by the "market". What could be fairer than that? Well, maybe just a few extra "bits" to top off things: some tax breaks and perhaps rights to develop adjacent or adjoining real estate. A small price indeed when one considers all the benefits promised to accrue.

Like the chimera of the efficacy of self-regulation, however, the reality is a bit less rosy than promised. Private capital generally is looking for returns in excess of 12%. On top of that one will have to compensate the diligent managers of that capital with management fees and carried interest for their time, hard work, and value creation. Anything less would be unfair. Anyways it will be a "market" rate. Then, of course, some one will have to bear the cost of the services of famed and not so famed investment bankers who help put the deals together. But no doubt (well at least among its advocates) still cheaper than wasteful government spending on a purely public project which is done as we all know on "non market" terms.

Suddenly, that "free lunch" appears a bit more costly than that in the public service diner. With privatization citizens will pay the price in terms of higher usage fees and/or less service. Or will give up value through the sale of "their" existing assets at prices low enough to give private capital its required market based rate of return. "Their assets"? Well, ultimately what are local governments except those citizens? Much as the shareholders of a private company are essentially the company itself.   I am for the sake of economy in my argument ignoring the many and repeated "agency problems" in the public sector.  A sad event which happily does not occur in the private sector.

So the choice is between paying taxes to the Government (an inherently bad thing as any good American can tell you) or paying fees to the private sector (an inherently patriotic and soundly economic thing to do). A remarkably easy choice it seems.

That the fees to the private sector may in the final analysis be higher (because of all the worthy mouths that need be to be properly compensated) is a rather small detail. The provenance of the small minded.  Another real benefit is that these schemes allow politicians to engage in the time honored and election savvy practice of inter temporal shifting. Provide a benefit today and shift the cost burden to the future when it will be someone else's election and problem. A fact which largely explains why investments in infrastructure have been deferred causing the current problem. 50 years or more of neglect. Until the water mains start popping like champagne corks, their condition is out of sight and out of mind. Instead money can be spent on more pressing universally recognized public goods like tax cuts.

Many will no doubt protest that such analysis smacks of dangerously leftist ideas. Indeed!

For such an analysis let's turn to the radicals at Blackstone Infrastructure Partners.

In a guest editorial for Infrastructure Investor magazine, Blackstone's Michael Dorrell, David Tolley and Trent Vichie point out that the Dow Jones Utilities Index could be used as a benchmark of performance for long-term, US-listed infrastructure returns. That index has delivered 9.5 percent compounded returns per year since 1970, and private infrastructure funds should take stock of this return:

"By simply levering the Index to customary infrastructure fund leverage levels, one would increase the return to 12 percent. That is, on a leverage-equivalent basis, private market funds must provide net returns of 12 percent simply to match the historical performance of the Dow Jones Utilities Index," Dorrell, Vichie and Tolley write in their editorial.

To provide a 12 percent net return, Dorrell, Vichie and Tolley point out that funds will likely need to provide internal rates of return in the range of mid-teens, taking into account several different fee structures.

	Carried Interest
Management Fee	10%	20%
1%	14.1%	15.2%
2%	15.2%	16.3%

 

"The analysis demonstrates clearly that a low double-digit return hurdle, which is somewhat common among private infrastructure funds, is too low to generate any meaningful outperformance against publicly-listed infrastructure, and provides investors no compensation for illiquidity," they conclude.

The simple answer is to raise the required return to attract the capital. Those with a belief in traditional economic theories of demand/supply equilibrium might be forgiven for assuming that raising a non trivial US$ 2 trillion might perhaps exert some "slight" upward pressure on the required rate of return.

Now AA is not advocating that private capital has no role in helping fund public infrastructure. It has but in the context of the proper understanding of what a public good is. And the value – both direct and indirect – of service franchises. Plus critically their importance in the wider context. One only has to think of the myriad of benefits and the knock-on effects that accrue to a locality from improved transport. So-called positive externalities. Sadly often overlooked by those selling public assets and public franchises. With the result that no examination is made of how higher private market pricing might in itself adversely impact those externalities to the detriment of aggregate wealth.  If I'm not mistaken, a famous Austrian political and economic thinker attributed such rent seeking behavior to "girly men" capitalists.  But then I suppose I could have the citation wrong.

Anthony Shorris, former head of The Port Authority of New York and New Jersey, discusses some of these issues along with others in this rather useful article. As above, this is a good juncture to note that as a former public employee, his agenda might reflect some personal interest just as that of famed and not so famous investment bankers might.

Finally, to complete the discussion, it might be worthwhile to muse on relative rankings of government expenditure. Some expenditures it seems are by common agreement and definition more worthy than others. More worthy of spending. More worthy of incurring debt to be paid by one's grandchildren.   And perhaps in some cases one's grandchildren's grandchildren's grandchildren.

Perhaps the simplest solution to the infrastructure crisis in the USA is to redefine the need as an integral part of national defense. From potentially futile attempts at nation building in inhospitable foreign climes to a bit of nation building "at home".  A new twist on "Homeland Security" if you will – a phrase that just might catch on.

AT Kearney: Reinventing Investment Banking in the GCC

An interesting report from ATK on the GCC investment banking sector.

The key issues that GCC investment banks face are:

1. Competition from more established firms - who are opening offices in the region.
2. Local investment firm's business models which focus heavily on private equity investments.  That in part reflects the state of local capital markets.
3. A debt capital shortage which constrains the ability to build asset intensive businesses.

To that I'd add:

1. A reluctance by clients to pay for advisory services unrelated to fund raising.
2. Relatively modest volumes.  This in part explains the focus on proprietary investments where the gross margins are higher than on capital markets and advisory business. 
3. Market deficiencies.  An absence of sophisticated institutional investors.  Local equity markets are largely driven by irrational exuberance and pessimism of retail investors.    Constrained free float on many major firms.
4. In general weaknesses in corporate governance and disclosure.   
5. Lack of skills and shortcomings in professionalism/ethics.

Central Bank Regulation - John Lipsky

John Lipsky, First Deputy Managing Director at the IMF, delivered a speech on deficiencies in central bank regulation prior to the recent crisis plus some prescriptions for correcting shortcomings in Moscow last Friday. "The Road Ahead for Central Banks: Meeting New Challenges to Financial Stability".

He identifies a central failing which might be described as simple minded credulity.

Prior to the crisis, for instance, supervisors relied excessively on financial firms’ own risk analysis and internal controls. In broad terms, they relied heavily on the self-disciplining qualities of markets. In other words, supervisors were insufficiently intrusive and skeptical.

What could possibly go wrong with allowing firms to police themselves?  Not just allowing them to judge when they had "broken" a prudential limit, but allowing them to measure whether they had broken it or not.  And, we hear yet again about the self disciplining qualities of markets - which is the regulators' equivalent of the implicit guarantee. 

In fact if you read the speech carefully, you'll see that this failing is the root cause of most of the other shortcomings he identifies. 

Dubai Debt Problems - Someone Else's Fault

As per this article from The National

Dubai’s financial slowdown should be treated as a “special case” caused by the downturn in world trade and had nothing to do with the intrinsic productive capacity of the emirate’s economy, the UAE economic report says.

It seems the culprits were:

1. Banks and investors who didn't provide sufficiently long-dated capital to finance Dubai's real estate projects.
2. Foreign investors whose tremendous and apparently imprudent large capital inflows contributed to a form of the "Dutch" disease causing rampant inflation.
3. The global financial crisis.  Long time readers of this blog will appreciate our standing comment that this is a "global" and not a "Global" crisis.

Despite the short-sighted actions of these external parties, there are a few bright spots:

“The case of Dubai is ‘special’ also because very large investments have been made in its soft infrastructure, in both industry and government, which will have highly positive effects on the long-run development of the emirate,” the report says.

Besides being "special", and I trust you'll note the comparison here is Emirate-wide:

“But perhaps the biggest improvement in the overall productivity of the UAE in general, and specifically in Dubai, is the high efficiency of Dubai government agencies and departments which adopt first-best policies and international best practices …,” the report says.

 And

When these factors are recognised, it will position Dubai as one of the “most competitive cities in the long run”, the report concludes.

A hat tip to The National for helping to set the record straight.

Capitalism and Bad Investments

An absolutely brilliant letter in the FT today from Mr. Peter Berchtold.

Investors know there are two opposite sides to every transaction. If you fail to understand what you are buying don't go blaming the seller. I am always amazed to see big, so-called sophisticated investors try to litigate themselves out of a bad investment.

Or sometimes look for the Shaykh up the road to bail them out.   Or request a bail-out from their governments not mind you to save their profits but out of a selfless concern for the good of their respective national economies.