Tuesday, March 30, 2010

Diary entries of a consummate dollar pegger

2001 - I am now a member of the WTO. Now the whole world will be my oyster. But the US is my favourite market, and I want to sell everything over there. Good thing I am pegged to the US dollar.

2003 – Whee! I’m so flush with dollars! This peg is the best thing in the world. I continue to sell more wares to the US consumer, who doesn’t seem to know when to stop buying. And despite my accumulation of dollars, my wares continue to drop in price, because I keep the peg. I don’t care about my local consumer, I just want him to find work. I will sterilize all these US dollars so they don’t find their way into funding the locals’ taste for foreign goods.

2005 – Okay, I play along because everybody’s getting worried about the rising US deficits. I change my fixed peg to a managed peg. Everybody feels a bit better, though what was the big diff? I manage my peg so its stays fixed to the exchange level I want.

2007 – Uh, oh, my economy’s overheating. Too many people speculating on growth. After all, I’ve managed to grow double digits for more than a decade straight. Money continues to roll in, and more jobs are moving here from that consuming monster, the US, and from all over the world. I now want to move up the production scale. Hmmm, I think I want technical jobs to move over here too. Why not? My peasant workers work cheap, they don’t complain, and I’m still pegged to the dollar!

2009 – The US is printing money like mad! They continue to prop up their false economy, and look what it’s doing to my precious hoard! They’re losing their value! And what am I going to do with all this fixed income government bonds, whose yield is being destroyed by this madness? I better move my investment towards other things…like commodities, and perhaps, I’ll start buying companies abroad. That will help prop up other countries' wretched currencies, and perhaps…… this will benefit my long-term plan of bringing all global jobs here at home.

2011 – What am I going to do with all these commodities? There’s no more demand for my finished goods, and I fear that I may have wasted all that money I put into this junk. And my investment in foreign companies! These foreigners have no respect for the shareholder. They’re just burning through the capital I invested in them. They keep telling me they can’t make money if they don’t get access to my home market. As if!

2013 – The US is still printing like there’s no tomorrow. And they’re using this funny money to pay me the interest and principal on their bonds. They have no shame! I’ll yet show them who’s the boss. But I can’t just dump my US holdings without hurting myself in the process. After all, I’m now their biggest creditor, because of all my accumulated dollars. Oh what an idiot I’ve been! What am I gonna do?

2015 – I’ve been buying real assets in the US, mainly real estate, mines, and all that stuff. After all, they don’t make more of these anymore. I’m hoping this gives me a good hedge to the falling dollar value.

2017 – Shit! There’s another US market collapse! My real estate holdings, gone down the drain. My mining investments, they’re worthless now that nobody can afford to buy anything anymore. This lost decade is turning out to be a real bummer. I’m still trying to figure out how to get a positive yield on my dollar holdings. My local economy is now in shambles. With foreign demand having disappeared more and more these past few years, it would now take a miracle for me to keep pumping out goods. Even if I sell them at 10% of what it cost me to produce, nobody buys. I don’t know what will happen now that more of my own local population is out of work. Not much local demand has been created here, because if I try too hard to stimulate local demand, it won’t be long before these irritating foreigners start selling more to my locals, and God forbid that I start buying more abroad than I sell to them.

2019 – US lawmakers are pressuring me for the umpteenth time to abandon my peg. What do they want to happen? Don’t they realize that if I abandon my peg, their currency will have a meltdown? They won’t be able to rollover their debts. These Americans are so foolhardy, they don’t know what they want.

2021 – Yikes! The US just demonetized the dollar. It’s now issuing an entirely new currency, at a fraction of the exchange for the old one. And they're rationing it just to locals. My whole stash is now worthless! I should have given up the peg years ago, and just given the money to my local people to spend abroad. Now they don’t have jobs, I don’t my US dollars, and the world is now moving on without me. Where has this world gone to? Waaaaaaahh!!

update: Confessions of a consummate dollar hoarder

Thursday, March 25, 2010

100 year plan for unceasing hypergrowth

This lays down our 100-year long term growth plan for the propagation of Corporates USA, Inc. In this plan, we shall lay down the main principles and thrusts that the company shall undertake over the next 10 decades to ensure the continual forward movement of this illustrious company. This being the year 1950, we will endeavour to visualize the necessary steps that will take us into 10 years into this glorious future.

1950-1070 – THE MARKET SHARE PHASE. During this period, we shall endeavour to increase our profits via organic growth. We shall introduce new products and technologies, and internationalize our operations with beachheads all over the world. During the phase, we shall achieve rapid growth by becoming a world-beating multinational organization.

1971-1990 – THE COSTCUTTING PHASE. The previous phase will end when we reach eventual market saturation. Hence, the next phase of our explosive profit growth will come be via cutting excess fat off our organization. We shall streamline and automate any and all processes that we can, to cut off labour costs, which will have become expensive by this time. We shall also outsource whatever work we cannot automate to much cheaper locales.

1991-2010 – THE LEVERAGING PHASE. The previous phase shall have ended, despite the untold influx of riches that accrues to our organization, with the hollowing of the economy, and the decrease in the purchasing power of our end consumers. Hence, the next important evolution in our growth shall be to circumvent the inconvenience this scenario brings by leveraging ourselves, and that of our consumers, and focus on asset trading. The leveraging shall facilitate the continual movement of our products, and the illusion of wealth from shifting assets around shall make everybody continue to patronize our products, which by this time, shall involve a lot of obtuse financial innovations. Everybody who lost jobs in the previous cycle shall be encouraged to become amateur traders, and thereby become self-reinforcing cogs in this well-oiled machine that we shall endeavour to create. Everyone’s leveraged bets in our machinations will lift all markets and hence, the mark to market gains shall be our main source of profits during this phase.

2011-2030 – THE FIAT PRINTING PHASE. The previous phase shall have ended when our machinations have encouraged enough asset bubbles, and greater than serviceable leveraging in the economy. This asset bubble will end in serious financial crises, and have long-term repercussions for the next phase in our growth cycle, particularly when it results in much painful asset and credit writedowns. This will otherwise result in a devastating deflation to out organization, and a general and sustained fall in aggregate demand, which is why our main thrust during this phase will entail the active participation of government, which shall ensure the continual sustenance of our asset bubbles via the printing of fiat money. This printing shall take place via myriad forms of government guarantees, quantitative easing activities, and monetary policy loosening. During this phase, our growth initiatives will be the selling of products, both real and financial, that will facilitate people’s beliefs that they are outracing the continual upward motion of nominal prices.

2031-2050 – THE REBIRTH PHASE. The previous phase shall then end with a general breakdown of the currency, which is why the last phase in this 100-year plan shall involve our initiatives during that period when government eventually scraps the previous fiat currency with a new improved one. Our opportunities during this phase shall come from the undoubtedly myriad activities that will have to be done to rebuild lost livelihoods and broken economies, resulting from there being more currency than productive capacity. This shall henceforth be the new golden age for our company, because this is where we shall repeat all our previous processes right from the very beginning. Big opportunities will come from the need for our country to take over less developed economies (the ones who didn’t profit from our previous imaginative machinations), to take advantage of their oceans of unutilized productive capabilities A.K.A. PEOPLE.

RISKS. These long-term initiatives do not come without risks, primarily during the fiat printing stage, because this is the stage where the forward motion of the economy is outside our organization’s control, and more so in the hands of government. We shall therefore endeavour to ensure that by the time 2010 rolls around, we have sufficient government capture, so that our initiatives encounter less friction. We shall also undertake that by 2010, general consciousness is more open to the idea of monetary easing and government guarantees. It is imperative that we make everybody understand during this stage that propping up asset prices is what it takes to sustain deficient aggregate demand.


Friday, March 19, 2010

The growth of 2B2F banks, and what to expect when they grow much larger

Karl Marx thought that capitalism sowed the seeds of its own destruction. He thought that capitalism destroys itself because of its endless search for surplus value. This surplus value gets reinvested in more capital-intensive means of production, which substitutes for labor. This action decreases the returns on capital, until eventually capitalism turns in on itself.

That is one way to look at it. But Karl Marx’s analysis was incomplete, and therefore erroneous in his inevitable conclusion.

He did not anticipate the cleverness of many capitalists, particularly American financial institutions. He did not anticipate the value of debt, using other people’s money, to increase the returns on capital, when equity capital alone could no longer do the job. He did not anticipate the values of doubling down to win over the market place. After all, when everybody else is shrugging and thinking, “enough leverage already!”, who ultimately grows and eats everybody else’s lunch? That’s right, the one who’s not afraid to grow the most, regardless of the risk.

Many fall by the wayside because of the risks of leverage. But not if you know the tricks of the trade. Wall Street knows the tricks, which mainly involve accounting deception, using various derivative and off-balance sheet transactions.

Accounting gimmicks may actually just be a symptom rather than a cause of financial instability. It is a symptom of an economy where everybody is looking for yield, for investment return, where everybody thinks firms should either grow at a constant 10%, 20%, or 30%, otherwise, investors will flock in droves to the next hot entity.

How silly is it to expect a perpetual 10% increase in return? A one million dollar profit today, growing by 10% annually, will be a $2.4 million profit expectation in ten years. In twenty years, it’s $6.1 million. And if the growth expectation is 20% annually? $1 million today will grow to $5.2 million profit expectation in ten years, and $32 million in twenty years. What if it's 30% growth?

Before long, those little companies that met your 20% annual growth expectations could already make up 40% of the entire economy. Now is that realistic?

But if through the use of leverage, a firm is able to grow - much, much bigger than its competitors, it is now in a position to either: beat them down, eat them up, or take them to the cleaners.

There is another secret power that leveraging up provides the firm, particularly a capital intermediary, whose market positions affect the over-all valuation of the entire capital system. It gives them the power to realign the system. Eventually, if they grow overly big, overly leveraged, and overly connected to the system – they become too big to fail.

Too big to fail firms know this. Their failure can never be as clean as any other firm’s, because they are a pipeline of capital to the economy. Financials can take the entire economy hostage if they fail. So the goal is to become overly big, overly leveraged, and overly connected to the system.

The rules of capitalism are the rules of the jungle. The simple over-arching rule is: the biggest, strongest, fastest , will survive and thrive. But we are not animals. And not everyone can be the biggest, strongest, or fastest. If the competitors in the capitalist jungle are all thinking, scheming humans, who eventually thrives?

That’s right. The one who can credibly convince everybody else that his demise will result in the demise of the jungle itself. This is where the forward motion of capitalism will end. Not with the end of surplus value. Humans proved too clever to be stuck with a dreadful law such as that. It will end when the only remaining key players all have the ability to blow up the capitalist jungle all by themselves.

Financials can take the entire economy hostage if they fail. Remember that the next time you expect your investment in financial firms to perennially grow by double digit rates. Remember that in the next leg up in the growth of already too big financial firms.

Tuesday, March 16, 2010

Lehman in Wonderland

Now I don’t know about you, but I think the Valukas report will make for adventurous reading. For now it can be told - Lehman Brothers’ balance sheet is FULL of fascinating mysteries.

Let’s look at the liability side. Now we know that unicorns* exist on Lehman’s liability side. They disappear when you start looking for them, but they irritatingly reappear at the most inconvenient of times. Now we know what happened to Lehman’s equity – the unicorns ate it!

Now how about Lehman’s asset side? Now we know that Valkyries** exist on Lehman’s asset side. The more we look, the more beautiful they are. But watch out. They‘ll take the life out of you.

And I’m pretty sure that if you look hard enough, you’ll also find Gorgons on their asset side. If you look straight into their eyes, it turns them into capitalized gain.

Now, I haven’t actually read the report, but how come there seems to be no mention of the possibly numerous Elvis sightings*** on the income statement?

* Liabilities that disappear via the magic of Repo 105 and total return swaps.
** Assets whose risks are obscured, via the magic of mysterious valuation techniques.
*** Items which are not exactly what you think they are. These sightings were also numerous in a previously famous company.

Friday, March 12, 2010

Just how important is it really to the world financial system to prop Citigroup up?

This is a question I’ve always wondered to myself, ever since the US financial system first teetered on the brink of mass bankruptcy in the fall of 2008. We know that the US Federal Reserve was ready to bail out some banks (not all banks), but many banks. We don’t know what the real criteria was for choosing which bank to save, but we do know some banks were too systemic to let fail.

Citibank is my first candidate for a bank too systemic to fail. Not just for the US system, but for many other countries as well. Unlike UBS or Credit Suisse, which source much of their deposits via their Switzerland operations, or BNP and Soc Gen, which source most of their deposits in France, Citigroup sources its deposits from all six continents.

It is the most transnational of all banks as far as setting up branches is concerned. So how does a systemic failure of a bank of this magnitude (and this geographical breadth) affect the world financial system? Very seriously, I would believe.

So if ever its US operations will have to face the music for all the dancing it’s done all these past years, will Citi’s foreign branches have to dance along?

US branches notwithstanding, Citibank branches the world over are among the most profitable of all banks. They tend to serve the biggest multinationals. In whatever pat of the world there is a Citibank, they serve the local elite, both on the deposit side, and on the borrowing side. And Citi branches usually have the most repertoire of profitable services of all banks in any jurisdiction. Most local banks are usually just playing catch up each time Citibank comes up with a new product offering.

Now each Citibank branch, having its own complete banking operations (including deposits) in many countries, definitely is accountable to its own set of regulators. The US parent cannot just transfer capital from its far flung branches, if ever the US arm starts experiencing hyperventilating bouts of insolvency (or could they?) Alert Central bankers the world over will probably sit up in attention if they notice their local Citibank repatriating large sums towards the parent. Capital controls (if they did not already exist in that jurisdiction) will surely dam the outflow before you can say ‘bank run’.

Is it possible that if the US parent becomes insolvent, it becomes insolvent by itself?

Now of course, the US parent retains majority equity ownership of its foreign branches. Even though these foreign branches may not be allowed by their respective central bankers to close, they will surely be tapped by Citibank as possible sources of funding to pay off any creditors in any theoretical insolvency.

And as sources of funding, these branches (I haven’t run any numbers) will surely prove rich pickings. I’m pretty sure, in many jurisdictions, local banks will salivate at the prospect of buying their local Citibank competitor, and subsuming it into their own operation. They will probably be willing to pay an arm and a leg in some cases (I am making a bold assumption here). After all, Citibank has a client list of the wealthiest retail clients (Citigold), the biggest companies, and the most multinational organizations. This beachhead should be worth a lot, and even more so, for a newby wannabe transnational bank. (You can list the banks I mentioned above in this group, plus JP Morgan, Deutsche, BofA, Barclays, etc.) The only other bank I know that has Citi’s retail footprint world-wide is HSBC. Because of the possible synergies that can be realized here, these branches have got to be bigger gems than what AIG’s foreign subsidiaries proved to be.

You might say that Citi’s huge global footprint serves as its insurance in a possible insolvency. Bundled altogether, or as separate regional bundles, they gotta be worth at least what Citibank currently seems to owe anyone (again a heroic assumption here). And I could see their value in more ways than one. Because, if your little boys are all systemically important in their respective bases, wouldn’t you think all central bankers the world over will stand at attention in case you, the parent, will ever need help? They’ll probably be forming into ad hoc action committees faster than you can say ‘moral hazard’.

In short, a Citi problem is a global problem. If Citi needs help, we may probably finally see that a global coordinated action is not entirely impossible. You’ll probably see reserves flowing from all central banks concerned (!) to help Citi out. (maybe they’ll even form a Citi global reserve fund) After all, if Citi closes in their jurisdiction, it probably will affect other parts of their system, rather than just Citi’s own retail clients there. Maybe in their jurisdiction, Citi acts as a central clearing authority of some sort, or maybe it’s the chief market maker in some vital sovereign issue. Maybe it’s not even hard to fathom that its local branch could be the main depositary bank of members of the central bank board of governors (Now wouldn’t that get them into code red alert at the first sign of Citi trouble).

Now I don’t claim to know much about the internal workings of Citibank, or have crunched a realistic recreation of its real and actual financials (who knows how they really look like). But as I have been a detached observer of Citi in several places, I could say that Citi is a close enough proxy for the global financial system.

If we ever let Citi fall down to its knees, we may very well have to figure out how to remake a new financial order from scratch. Now that’s a Citicatch22.

Friday, March 5, 2010

Why do bank regulators seem toothless?

Felix makes a valid observation: The problem of non-bank lenders is a huge one: most existing regulatory institutions were created to protect depositors, rather than borrowers, and as a result just about anybody can lend however much they like to whomever they like on whatever terms they like sans any real regulatory oversight at all.

The reason for this I think is that Central bank regulators have yet to catch on to the idea that banks can victimize more than just the depositor. Historically, it’s always been the depositor who was fleeced whenever a bank misbehaved. It was his money that the bank played with, and that the bank lost. The borrower , on the other hand, was someone that everyone thought could take care of himself.

When a bank provided a no-doc, no down payment loan to anyone who did not exhibit the ability to repay it at some point in time, the automatic assumption has been that that borrower must be the bank owner, one of his affiliates, or one of his cronies. He was never thought to be the ‘victim’ but a parasite instead.

We all know that the US experience shows that this is not always going to be the case. Their experience, in a society where there are more net borrowers than there are net savers, a ‘corrupt’ banker’s attentions can in fact turn towards the borrower. The pickings are just more abundant on that side of the business. And now that the we understand that the bank need not be lending its deposits when it makes loans (there are numerous ways banks can raise their loanable funds), there need not even be sufficient deposits for mass gouging of the consumer to occur.

That in turn creates a disastrous race to the bottom as banks try to compete with unregulated lenders, and in the end everybody — banks, consumers, non-bank lenders, the lot — finds themselves heaped up, broken and crumpled, in the corner (solution).

I have always wondered why the move in the US towards universal banking (allowing banks to operate both as commercial and investment banks) did not result instead, in stifling risk-taking at the investment banking arms of the unibanks. After all, if you have all these units under the same roof, they all automatically fall under the regulatory umbrella of the central bank?

So if a certain type of investment is not allowed for a commercial bank, it should automatically be disallowed for the investment banking unit. After all, it’s not hard to imagine that the ultimate backstop for any investment banking loss resulting from excessive risk-taking is always going to be the depositor. Hence, any i-bank coming under the roof of a commercial banking parent ought to have been effectively neutered of its risk-taking impulses. And any self-respecting bank examiner doesn’t even have to fully understand what it is that the i-bank is doing, because that fact of complexity alone would have raised flags immediately. He could have easily just either disallowed it, or simply counted the whole position 100% against the capital of the commercial bank (which would have immediately led to the parent disallowing the position itself).

So if you understood how unibanks are supposed to be regulated, their mere formation should have suggested to you that it leads to more investment banks competing on the same playing field, and same level, as the commercial banks.

…while non-bank lenders can act more or less with predatory impunity unless and until they grow above $10 billion in size, stealing customers from banks and gouging them freely. As for non-banks (including check cashers, payday lenders and title insurers in Felix’s argument) some central banks even put all these entities under their supervision, merely because they engage in a bank-like activity with the general public. Any sign of misbehaviour and they lose their intermediary license.

My guess is that this is easier to say than do, especially in a large capital market such as the US. But then…

And this from Joseph Stiglitz may simply be the most logical reason for the seeming toothlessness of regulation in the US. "It's time for us to reflect on our own structure today, and to say there are parts that can be improved." The core issue is that regional Fed banks, such as the New York Fed, have clear conflicts of interest -- a result of the banks being partly governed by a board of directors that includes officers of the very banks they're supposed to be overseeing.

Monday, March 1, 2010

Private loans and government guarantees

Felix Salmon adds more voice to the ‘loans growth is not affected by the size of deposits’ meme: The size of a bank’s deposit base is not a meaningful constraint on the amount of lending it does. And what’s more, if you have an adequately-capitalized bank, like say JP Morgan Chase, then throwing money at it either through fiscal policy (Troubled Asset Relief Program) or through monetary policy (cutting interest rates) is by no means guaranteed to change the amount of lending that the bank engages in.

If you want to get banks lending again, governments can try a bit of moral suasion, but ultimately it’s a decision that any bank is going to have to make on its own economic merits….When the government guarantees loans, for instance through the Small Business Administration, that might do more to help increase lending — but only by transferring credit risk out of the banking sector and onto the taxpayer.

If a bank is long on loans but deposits short, it has alternative funding channels, so it can go ahead and make the loan. But if it’s deposits long but loans short, there is nowhere it can go to get that creditworthy alternative (except in the government bonds market, or yes, loans guaranteed by government)

So if government wants lending to be more robust, focusing accommodating policies just on the banking side is not going to be very enough. More focus on supporting private industry and the consumers is needed (But yes, government guarantees will likely be a necessary component in this, to boost the economic merits of lending to these sectors.)

There is currently a large pent up opportunity globally just waiting to unrestrained (if the proper supports are in place). I said it before, I’ll say it here again: Global rebalancing will be the greatest source of growth, as well as the greatest challenge, for capitalism in the coming decade. The developed world needs to rebuild its manufacturing base, while the developing nations need to develop a thriving consumer economy. Much capital investment for production needs to be rebuilt in the developed countries, while much more advanced distribution chains and financial networks need to be established in the developing nations. The best guarantee is a government commitment to this rebalancing. Government has to support the profitable growth of manufacturing in previously hollowed out economies, and to support consumer social safety nets in previously export surplus countries.