What Will Tomorrow Bring: Rough Waters

China liquidity crisis. I repeat, China liquidity crisis. Hold on to your hats, kids. I think we're in for a blow. 

Motown Lowdown

As far as I'm concerned, city bankruptcies are good with one possible exception.

The exception is pension funds. If the city changes the pension payments they promised to retirees, that strikes me as pretty evil. People plan their whole life for retirement based on the assumption that they will get certain pension benefits. These should be preserved. If Detroit had been smart, they would have insured or offloaded this liability long ago. It's simple math and stochastics. Let the experts in the financial world make it work.

Bondholders should be aware of the risks of lending money to cities with large deficits, so it shouldn't be any surprise that they'll get a "haircut" meaning less than 100% of their value back. In the mean time, they got interest on the bonds.

Aside from that, city bankruptcies allow cities to renegotiate every contract - suppliers, vendors, unions in a public way (as opposed to back-room deals). I guarantee you that there's plenty of fat to be cut here.

What is sadly missing from most municipal bankruptcies is austerity. Bondholders should really pressure Detroit to not only pay less for what they buy (my prior point) but also to buy less, cut services or at least make them cheaper, privatize or close inefficient departments, etc. These are tough decisions, of course, and can create a negative-reinforcement cycle where the city gets worse and more people move out. Ideally, they offset this by improving the economy and thus increasing revenues.

Greasy Thinking

I love to hate Krugman's one-size-fits-all big-government answers to every problem but today through clenched teeth I have to agree with his op-ed yesterday (partially). Europe and the Euro need to put their big boy pants on and learn some bladder control. Fast. Diapers just aren't appropriate anymore. As he said in the NY Times today:

For the past two-and-a-half years, European leaders have responded to crisis with half-measures that buy time, yet they have made no use of that time.

Not sure how that jives with this first sentence, but anyway I agree with him: The Greece problem is not new. The Economist summarizes well this week:

Greece really has suffered: between 2007 and 2012 its economy is expected to have shrunk by almost a fifth. The economy is being strangled by a severe credit and liquidity crunch, with more budget cuts and tax rises to come. Even if all goes well, Greece’s debt will be 161% of GDP next year.

The Spanish, Portuguese, Italian and Irisih problems are not new either.

The facts about Europe (and especially these retarded countries) which have created the current situation are not new. The EC, the EU, the EMU, the European Parliament, the European Presidency - all impotent, except for farm policy (huh?). National governments, all ineffective, focused on pandering, philandering, scandal (either chasing or running away from). Citizens feel emasculated (at best), despondent and dependent (especially those just out of school), and generally pessimistic. Employers are hamstrung on everything from employment/firing to compensation to innovation to outsourcing. Consequently, employees are lazy (not dumb) and inefficient. The governments have pissed away more than enough livelihoods. They need to get busy.

As Reagan put it,

There are no easy answers but there are simple answers. We must have the courage to do what we know is morally right.

The answer to Europe's issues is simple. It may seem odd to use the phrase "morally right" in this case, but it IS a moral issue for Europeans. It should be if they care about their children, their nation, their place in the world. 

Krugman's focus yesterday was on inflation, but the price level is not the core problem, nor is inflating your way out of debt a silver bullet. Happily, it will make European products less expensive. Here's to more Bordeaux and aged Gouda and European vacations! This, however, just corrects an existing price misalignment. A croissant and coffee shouldn't cost the equivalent of $20. That's just nuts. The reason Krugman is wrong is simple:  prices go up, but productivity per worker doesn't change. Every European becomes poorer. Fewer car/house/consumer loans/credit cards are available. House prices go down. Companies can't as easily justify borrowing to invest or launch new products. Which means less innovation and growth.

And that's exactly what Europe needs, particularly in the south: GROWTH. Even Krugman will agree with that usually. 

The only ways to get there are through INNOVATION, PRODUCTIVITY, and/or DEBT.

The last one is Europe's current favorite: beg, borrow, and steal. From the rich. From the companies. From each other. From the future. Money flows from northern countries through the EU/ECB to southern countries without compensation or realistic ability to earn enough to pay it back. Money flows out of companies' profits and employees' income through high taxes but is not set aside for their own social welfare. Instead, it is used to buy votes from those without jobs and/or those with political power. Quoting Krugman again:

Europe’s central bank is, in effect, financing this bank run by lending Greece the necessary euros; if and (probably) when the central bank decides it can lend no more, Greece will be forced to abandon the euro and issue its own currency again ... This demonstration that the euro is, in fact, reversible would lead, in turn, to runs on Spanish and Italian banks

It's just not sustainable. History is littered with examples of failed currencies and governments who thought they could just borrow their way to success. 

Instead, the core issues of low productivity, low innovation, and perverse incentives need to be addressed. Europe needs to start acting like a single community rather than a bunch of clans of grumpy neighbors. Europe needs to recognize the limits of socialism in the face of globalization. Europe needs to acknowledge global realpolitik. Protectionism and nationalism are luxuries they can no longer afford. The Euro cannot be a fiat currency - it needs backing based on the power of taxation and reserves.

On Productivity and Innovations:

• Ya just gotta free up the labor market, folks, or productivity is never going to get better. People/roles/trades/companies/industries/countries (including those abroad) which are more productive than others should be allowed to crowd out the less-productive. Languages can be a barrier, but to the extent that, for example, a smart and/or ambitious Pole can speak enough Italian or German to work abroad, this should be enabled, not discouraged. Even in "protected" industries. Spanish companies should be able to put callcenters and operations in, for example, Guatemala.
• Extending that point, you also need to accept that people/trades/industries/countries which are less productive are going to be less wealthy. Socialism hates inequality, but if a Finn can produce 4 cars a day while an Italian can only produce 3, the Finn should make more than the Italian. Similarly, if a Greek or Bulgarian (gasp!) is willing to earn EUR10 an hour to grow grapes while an Austrian insists on EUR25, the Greek and Bulgarian grapes should be trucked to Austria, crowding the Austrian farmers out of the business or forcing them to take a pay cut. 
• Extending the above: Learn from the US (both what to do and what NOT to do) about immigration and foreign workers. Let 'em in! Create a controlled and net-positive process (as explained in my prior blog post) and then open the gates. For one thing, allowing younger immigrants into the workforce is the only way you will be able to pay for your pensions and healthcare systems going forward. There should be no prohibitive barriers against Uruguayans moving to and working in Spain, for example. Just make sure you charge them for it.
• Aside from the ability to hire/fire the people they want and the ability to pay a market-clearing wage, companies need the ability to offer both contract and full-time work. They also need to be able to offer various tiers of benefits for interns, new-to-the-workforce, tradespeople, professionals, executives, etc. It can't be just the one-size-fits-all government-dictated (tarnishing) gold-plated package. A hundred years ago, Hayek correctly described where that road leads.
• Moreover, you can't have your cake (of national champion companies in every industry) and eat it too (expecting them to be globally competitive and profitable without being able to scale). Accept that you are a common market and allow Euro-wide champions to arise in whatever Euro country they may. No longer can the Portuguese government spend money it doesn't have to promote and protect their own national paper, airline, or cell phone companies. It's ridiculous for richly-paid Italians, French, and Germans to produce nearly 10% of the world's steel ... at a loss when all governmental supports are factored in. Buy Turkish or even Indian steel!

On Perverse Incentives:

• Government borrowing needs a revamp. Existing sovereign bond markets need to be priced based on country risk, not currency risk. Separately, the ECB should introduce Eurobonds which are guaranteed by all countries in the monetary union. Individual countries would buy SDR-like rights by either depositing collateral at the ECB or by legislating pledges of future tax receipts. They would then be allowed to request that the ECB issue bonds on their behalf, most of the proceeds going to the national government, but with an adequate reserve withheld by the ECB as collateral against future payment. Overall Eurobond issuance would be capped by the ECB based on market conditions and European Parliament votes.
• More radically, impose, by irrevocable treaty, a 5% Eurozone value-added tax. Simultaneously reduce national VATs by the same amount such that there is no impact to consumers or businesses. These funds go to the ECB and are distributed according to agreed rules. In other words, taxes collected in Spain are sent to the ECB but might get sent right back to Spain if all's well. However, if one country is circling the fiscal drain, this provides a cash buffer to protect the ECB and the other Eurozone countries from getting sucked into the vortex. Most importantly, this creates a "lever" of power by the ECB over individual countries. If you don't live up to your commitments, you don't get your 5% back. The bank NEEDS this power to protect and defend the currency. It also needs it to enforce compliance with treaties and commitments.
• Enforcement of the monetary union's and European Parliament's targets (ex. Growth and Stability) must be strict. Greece has NEVER met the very friendly targets they negotiated. Never intended to, I'm sure. They should be fined. They should not get their 5% back. Their voting rights in the European Parliament should be suspended. ECB transfers should be suspended. International remittances and account balances should be frozen.
• While you're at it - fix the banking system's capital adequacy rules. Sovereign debt is NOT risk free.  

All graphics from Economist.com. 

Goldman needs Privacy

At one point this week, the headline was:

Roiled by op-ed, Goldman loses $2.15 bn m-cap

Goldman didn't get where it was by being a public company. It was a partnership for the first 130 years before going public only 13 years ago. Those have been a pretty awful 13 years for the firm.

The latest round of headline-generators and talking head fodder would have never happened if Goldman were still private. The dude wouldn't have even had the motivation to publish the op-ed. The Times wouldn't have cared to print it. Nobody outside the firm would care to read it.

Instead, over the course of a few hours of stock trading, value was "destroyed" to the tune of ... well, more money than 99.999% of the world's population will see in their lifetimes. Actually, add a few more 9's after the decimal. Billions. With a "B." As in Buffett-sized.

Or was it? If a whiny Dear John to a former employer full of news (which, as Forbes pointed out, everybody already knew) can destroy billions of bucks, then maybe that value didn't really exist to begin with. Stepping back from the greater fool theory, perhaps GS should be valued based on the discounted cash flows it can generate. Novel concept, eh? Maybe I should write a book and teach at Wharton.

Then again, maybe my book should take a different approach. Perhaps Goldman should never have become GS in the first place. Perhaps a financial firm with ridiculous leverage ratios, a wacky capital structure, a penchant for mercenary dealings (AIG collateral call ring a bell?)  needs a small, concentrated, captive based of owners rather than a whole "street" of busybodies to answer to.

The only way Goldman's stock has impressed is in its volatility. It hasn't even doubled over the past 10 years. Hardly a good investment. The management has never been able to find an acceptable balance between staff incentives and shareholder value. Perhaps no such balance can exist for more than a few microseconds. Perhaps GS is an unstable element with a short halflife. Maybe they're in a constant state of containing the meltdown, hoping it wont Fukushima on them tomorrow ... or the next day. Perhaps this is distracting them from their "day jobs" of making deals with and on behalf of clients.

Nice adventure, guys, but it's time to take your marbles and go home. Cash in the chips and go private.

Yeah! What HE Said: Buying Stuff that Ain't Yours

As Karl says, the following should be self-evident but isn't.

 In economics, leverage is the use of debt to pretend to have more economic surplus (that is, purchasing power) than you really have. - Karl Denninger, market-ticker.org

Nik's Laws: Mortgage Interest Deductability

Eliminating the mortgage interest deductability on income taxes will have the effect of instantly reducing all house prices by 10-30%. Such an attempt to increase federal tax receipts would have the inverse effect, as it would push the economy soundly into a double-dip recession, would degrade the capital stock of most US financial institutions at a time of increased capital requirements, would push a new tier of homeowners underwater, and would trigger a new round of bankruptcies for those on the margin.

Breaking News: Market Share Stolen by Hackers!

A Wall Street Journal article today carries the following quote:

Chinese state television has broadcast footage of what two experts on the Chinese military say appears to be a military institute demonstrating software designed to attack websites in the U.S.

DailyTech blog captured screenshots including the image below.

This further supports my prediction in a January 2010 blog post What Will Tomorrow (Today?) Bring: Virtual War.

"Make no mistake, this is
Cyber Warfare."

It is now undeniable: we are engaged in a new Cyber Cold War which represents the most unconventional and asymmetric war the world has ever seen. Control is extremely decentralized. Weapons are easily acquired. The risk of retaliation is low. Battles are waged remotely. The prosecutors and victims of the war can be anyone or any group of people. Governments, individuals, and businesses are all players, like it or not.

The WSJ article shows, however, that more conventional power structures are now on the battlefield. Many in the LulzSec group may have simply been bored, over-caffeinated students who wanted some celebrity. However, security insiders increasingly see hard evidence to support the WSJ's case: governments, particularly those of Russia, China, and the US are quietly backing attacks.

Many people would laugh at the notion that a foreign military might wage an online attack on a US financial institution. Consider, however, two factors which might give them motivation:

1. Sovereign Wealth Funds (SWFs) increasingly own debt and equity of governments AND businesses. This gives them a financial interest in the success (or failure) of certain companies as well as economies. Hack a bank, leak a headline, and watch the share price drop until a buying opportunity has emerged.
2. Many emerging market countries have discovered that they don't have to create an economy as big as the US in order to have companies which compete on a global scale. These companies can be jump-started with some quiet government support. As a result, it has become common policy to support "national champions" which successfully compete against the largest and most mature global (though still mostly US-based) companies. Government-sponsored hackers might help these champions by hacking the competition and stealing trade information or by creating bad headlines.
   

Like it or not, we have to acknowledge that certain governments have the means, the motive, and the opportunity to commit cyber attacks against financial institutions. In all likelihood, this has been going on for at least several years. Consider a March 2009 Telegraph.co.uk article:

"A vast Chinese cyber-espionage network, codenamed GhostNet, has penetrated 103 countries and infects at least a dozen new computers every week, according to researchers ... [GhostNet] is the latest sign of China's determination to win a future 'information war'... In 2003, the Chinese army announced the creation of 'information warfare units'."

Fox News added to the story:

"The Chinese government on Monday denied it was behind GhostNet"

Banking has the notion of security at its core. Think of a bank branch and you'll instantly visualize vaults, armed guards and video surveillance. Behind the scenes, banks all have hardened ATMs, teller stick-up procedures, passwords and permissions. In other words, security is tightly integrated with their physical channels.

It is also tightly integrated into their physical products through watermarks, microdot printing on checks, serial numbers on other financial instruments, signature specimens, etc.

Ironically, banks have been dangerously slow to understand how this relates to the online world. Today's banks are dot-coms. Online banking is now a core product. Moreover, it is the "face of the bank" for many customers. It is the gateway or channel through which all other products and services are offered.

Dot-com execs have an advantage in the realm of security and fraud inasmuch as their core product is a piece of technology which intrinsically has a set of permissions and security controls built in. The tools their engineers use also have permissions and security controls at their core. Bank execs need to think like dot-commers. Online security and fraud prevention are just as intrinsic to their core products as signature cards, credit scores, personal relationships, and armed guards once were.

The logical conclusion is that banks need to be organized, staffed, and run more like dot-com businesses to survive in the current Cyber Cold War. Security must be "baked in" to everything they do, just as credit scores and ratings have been baked into lending and trading decisions for decades. Executives should make no mistake: on the current battlefield, market share is not stolen by a bank down the street who might lure customers away with better rates and free toasters. Market share is "stolen" by hackers who ruin the bank's reputation or steals clients' identities and thus causes customers to flee.

It is no longer a sci-fi fantasy that these hackers may be shadow agents of a competitor or even a government intent on manipulating markets, economies, or even specific businesses.

Follow-Up: What Will Tomorrow Bring: Financial Utilities

The FT had more to say this week on the future of banking. Opinionators Patrick Jenkins and Megan Murphy argue in "Banking: Again on the edge" that:

"cuts this time are set to differ from those of previous cyclical downturns. Bankers and regulators agree they may mark a profound change in employment patterns across the world’s banking industry.

The reason is simple enough. At the same time as western economies are teetering on the edge of double-dip recessions, the banking industry itself is caught in the middle of a period of deep structural change – much of it ushered in by the regulatory response to the first wave of the financial crisis three years ago."

Every consultant worth his salt is busy trying to write something prescient on the future business model for banks. GLG Research recently published a report called out the following key parameters, with a focus on retail banking:

1. Peer-to-Peer (P2P) Lending: An advanced technology that eliminates middlemen and directly connects borrowers and lenders.

2. Prepaid General Purpose Reloadable (GPR) cards: In return for modest commissions, a global agency network of convenience stores and retailers are now enabling cards to be “loaded” with cash. When equipped with remote deposit check capture, direct deposit, bill payment and ancillary credit, savings and investment accounts, these cards make traditional bank branching redundant. eWallets such as those touted by ISIS, Google, Visa, Amex, Paypal and FaceCash are the offspring of GPR built on the same infrastructure; similar economics but a different, arguably more convenient, access device.

3. Social Media: Social media like Facebook and LinkedIn can offer insight into customer behavior that can be applied to enhance customer acquisition, retention, and even underwriting (http://www.freepatentsonline.com/20110112957.pdf).

What Will Tomorrow Bring: Financial Utilities

The story of the financial industry is a breathless one. With all that money sloshing around, smart people know that there is profit to be made. Unfortunately, due to that same money (=liquidity) and profit potential, financial products and services get commoditized very quickly. Competitive advantage is fleeting. It's textbook hyper-competition. Constant, hostile, explosive innovation is necessary to survive.

Unfortunately, that also leads smart, sensible people to do horrifically stupid, risky, nonsensical things which relieve immediate (financial or political) pressures but which have been entirely "un-thunk" in terms of their end-state consequences.

Hyper-competition also intrinsically conflicts with hyper-regulation.

Last year I predicted that the weight of new regulations (written and unwritten), political instability, and economic realities would force financial institutions to give up their for-profit status to become utilities:

Financial Institutions will once again be lobotomized. Divided into two classes:
- Utilities (aka retail banking)
- Casinos (aka everything else)

"Utilities" are done for as a for-profit enterprise. Just like Amtrack and Con Ed, they will require permanent and heavy subsidy verging on nationalization to survive the tonnage of regulations which will be piled on.

Evidence continues to pour in to support this including:

• More than 8,000 entries in the OCC's list of sanctions here. They are just one of a half-dozen governmental agencies which take enforcement actions against banks
• 111 bank collapses in the past 12 months per the FDIC's Bank Failure website. Twenty-six banks collapsed between 2000 and the end of 2007
  
• Voluntary closure of a regional bank this week "in an extreme example of the frustration felt by many bankers as regulators toughen their oversight of the nation's financial institutions"
• According to a Marakon report (source of the chart above), "only four US banks, or 10% of banking equity capital, are expected to generate returns above the cost of equity; a staggering 90% of banking capital is not performing"

But you ain't seen nothing yet. The above are mostly smaller institutions. The financial titans (Titanics?) are better at fighting and delaying, but trust me they are also bending under the weight. Their stock prices are beginning to reflect it.

UCSD professor Frank Partnoy yesterday published his opinion in the Financial Times with a piece titled "The coming world of smaller banks." He highlights not only the unavoidable reductions in share prices and headcounts, but more damningly, the unavoidable extinction (or drastic evolution) of the standard banking business model:

If all of the world’s major banks had failed during 2007-08, and regulators had permitted Apple, Facebook, Google and Microsoft to take over the economy’s capital allocation function, how would employment numbers have changed? Surely any neo-bank would hire smart lenders, traders, analysts and advisers, the people who have the strongest relationships with, and knowledge of, the institutions that demand or supply capital. But would they have hired all of them? Half? How many people would a new bank really need? Hedge funds take on traditional bank functions with a fraction of the employees.

He concludes:

[Banks] will occupy a smaller place in the economy and they will be less profitable. In a decade, there will be fewer professionals working on Wall Street than there are today.

If I map his comments onto my own, it becomes clear where the job losses will be. The "Financial Utilities" will be characterized by a low-skill, low-innovation, low-margin, high-volume business model. Since capital and information are almost entirely digital these days, there is nary a barrier to massive automation. The remaining jobs will be the folks keeping the computers humming and the 'relationship' people in high-touch areas like customer complaints and regulatory relations.

Time for Timmy to Take a Page from the Dick Nixon Book

Three months ago, on April 19, Timmy G flashed that charming nose-flair and scowl as he proclaimed "no risk" of credit rating downgrade. With a Treasury Secretary like that, who needs enemies?




That incredible foresight has created quite a bank of political capital and immense credibility for Timmy. Knowing that his fatherly tone alone can instill confidence in the most dubious heart, he decided today to leverage a bit of his capital, saying, in effect, 'trust me - China will continue to support borrowing habit.' No need to get our fiscal houses in order. That's just too hard. Too confusing. Too complicated for the average dumb voter. Better to just distract everyone by attacking the ratings agencies ... for ... um ... our fiscal mess?


Also based on his incredible Volcker-like, Lula-like track record of securing our country's fiscal future, he shared some friendly advice with his colleagues in Europe, admonishing those pre-pubescent countries to make sure they don't spend more than they make. If only they were as fiscally responsible as we are. If only they were lead by such world-class minds as we.


Investors are expressing their immense appreciation for Timmy's FDR fireside chat moment by voting with their feet ... from equities, debt, swaps, and even energy straight into gold.

Risk Free?

S&P's downgrade of US debt is not the first domino, nor will it be the last.

Traders and Brokers: wear rubber underwear Monday.

Thousands of funds are contractually required to hold a specified percentage of AAA debt. They ALL have a significant position in US Treasuries. Monday they will have to decide whether they go to their investors hat in hand requesting permission to hold non-AAA US debt or whether to dump their holdings. Furthermore, risk algorithms and valuation models used by nearly all financial institutions and investors are based on the US treasuries as the "risk free" rate of return. These models will have to be re-assessed ... and the consequence will be a shift in investments.

The charters of many countries and sovereign wealth funds require their central banks to hold AAA notes (or the currencies of those countries) for their national reserves. Thus, the US's reserve currency status may also be reviewed next week. FX markets, interest rate markets, swap markets ... wow - hold your hats, kiddos.

(update) Don't take my word for it. Mohammed el-Elrian echoed my comments in the Financial Times over the weekend.

The fact that yields on US debt have fallen all week speaks more to our ability to manipulate markets (in the short and medium term) than it does to confidence level. So don't go there.

This could have been avoided. Go ahead and fiddle, Congress. Washington is burning.

Stupid is as Stupid Does

Switzerland has spent over a century building a safe, predictable, stable currency. Sadly, as one of the last bastions of sovereign stability, the nation is now feeling the unintended consequences of their scotch ways. It is teetering on the verge of recession because their currency is too expensive. As a consequence, Europeans are cancelling trips to the Swiss Alps because everything is too expensive there. Swiss are driving across the (0pen) border to buy TVs and food in Italy where their francs go much further.

Thus, the central bank intervened in currency markets today to knock down the franc. Tonight, the franc is trading above where it started the day.

Ditto Japan.

Consequently, the Swiss and Japanese central banks' wallets are a few billion dollars lighter tonight ... and currency traders' wallets are a few billion dollars heavier.

When will central banks learn??

The Zeitgeist of the BearDogs

Sometimes Simple IS the best way to communicate. Here's to the simpletons.

The Word about The Fed and The Plan for the Change

The Fed is powerful. I'm a fan of a good Fed. We currently do not have a good Fed. I'm horrified.

Be horrified.

Talk Amongst Yourselves: Governmental .... Effectiveness??

Unlikely. But they are moving through the agenda at a pace which, adjusted for the fact that they are complete and utter idiots who live on another planet, is nearly mentionable. In fact, they're going so fast, I have not time to drawl on for paragraphs about each item. The following will have to do.

Sadly, they're going so fast, they also haven't time to hire a fancy Madison Ave team to sex up and connect the whole thing thematically. Fear not, Congressmen. I have a name for the whole agenda.

I dub this session: "the hour of our de-embarrassment."

Someone slightly less numb than average must have realized that some US policy is downright embarrassing ... just like good ole Cousin Eddie.

Health care:
Kudos. With universal (well, near as the US government will ever get to such absolutes) coverage, finally, arrogant socialist countries (cough, cough, Europe, cough) have one fewer reason to feel superior. Shame you forgot all about that whole cost containment/efficiency/quality bit. Maybe next time.

Discrimination:
Again, kudos on removing some of the most ridiculously embarrassing bits of 16th-century discrimination still enshrined in US law.

Legally preventing a gay man or woman on their death bed from seeing the one person who they love most was ... well ... maybe not such a solid idea. I know it was supposed to prevent the coming of Lucifer, but now, what with Bunker Busters and Missile Defense, I think he's less of a threat.

Discrimination makes a guy wanna kill someone. What better place to do that than in the Army? So, kudos again for taking the logical step to reexamine Don't Ask Don't Tell. Instead of making recruiters scrape the bottom of the barrel to meet their quotas, just let a few angry gays in. They always spruce up the place!

Now let's get rid of that whole blood donor ban thing.

Financial Regulation Reform:
Without injecting my own opinion (yet), allow me to predict the most likely outcome. Financial Institutions will once again be lobotomized. Divided into two classes:
- Utilities (aka retail banking)
- Casinos (aka everything else)

"Utilities" are done for as a for-profit enterprise. Just like Amtrack and Con Ed, they will require permanent and heavy subsidy verging on nationalization to survive the tonnage of regulations which will be piled on.

"Casinos" will have to escape to the Bahamas, Monaco, or Indian reservations. I would not be surprised to see these firms further subdivided into firms that are allowed to play with other peoples' money ("brokerages") and those playing with their own money ("proprietary dealers").

Over the past 10 years, the US Financial Services industry has made up more than a third of corporate profits, aka a third of the returns upon which the entire US equity market is based. Over the next 10 years, that entire industry will go the way of the Dodo and Bear Stearns.

Witch Hunting:
Exhibit A: the SEC's civil suit against Goldman. This thing is such a political charade. We're gonna end up in the Supreme court debating the definition of "is" again. GS is too smart to get caught red-handed. Even if they were fined a billion bucks, the 17% market cap drop is a ridiculous over-reaction, but they won't pay that either. Their max exposure SHOULD be the $15 million they charged for their services. Sadly, this court case isn't going to be decided in a court of law, but in the court of public opinion.

All of this ... for better or for worse. Talk Amongst Yourselves.

Yeah! What HE Said: Greenspan on the Hill (again)

They just won't let him alone. But Maestro is still too solid to be shaken by a few pols.

The surging demand for mortgage-backed securities was heavily driven by Fannie Mae and Freddie Mac which were pressed by the Department of Housing and Urban Development and the Congress to expand affordable housing commitments.
- Alan Greenspan, Congressional Testimony 4/7/10

Nuff said. If they don't want to know the real answers, maybe they should stop asking the questions.

And I Suppose People Were Not Expecting This ...

From the FT today:

Dubai shockwave hits global markets

Tremors from the shock request by Dubai’s flagship government-owned holding company for a debt standstill spread through global equity markets on Friday, triggering a sell-off in Asia and heavy losses on Wall Street.

While European markets staged a modest but nervous
rally after heavy sell-offs this week, investor sentiment remained jittery amid
a scramble to assess the broader fallout of the problems of Dubai World.
In depth: Dubai in turmoil - Jul-06
Editorial Comment: Dubai reveals the fragility of finance - Nov-27
Lex: Banks’ Dubai exposures - Nov-27
Opinion: Reality catches up with the Gulf’s model global city - Nov-27
Nakheel’s creditors dash to minimise damage - Nov-27
Abu Dhabi expected to prop up smaller brother - Nov-27

Hmm ... a scrap of the most inhospitable, useless land on the planet somehow convinces the world that it's rich simply by fiat. It goes on a spending spree to prove it. It falls flat on its face. I suppose that won't stop people from being shocked and awed.

Merriam-Webster defines a Mirage as:

... 2 : something illusory and unattainable like a mirage
synonyms: see delusion

Get it? A mirage? In the desert?

How's this for a rule, space cadets: nothing times any amount of leverage is still nothing. Remember that next time you are considering what to do with your kids' inheritance.

Yeah, What HE Said: Warren Buffett

From the self-awareness file:

"We learned that a rising tide lifts all yachts."
-Warren Buffett on Charlie Rose last night

I was a bit surprised by his concerns on rising income inequality.

What Will Tomorrow Bring: Program Trading for Everyone!

When the stock market (and every other market) is on a one-way trip to the clouds, brokers convince their prey (err, I mean customers) to "buy and hold" via "dollar-cost-averaging" with some nice "rebalancing" from time to time. As the great investor Issac Newton explained: What goes up must continue up. It's simple physics. It's the laws of Mother Nature. Don't you like nature? Of course. In that case, they might have a hot tip on a cool green stock you should sink your children's inheritance into.

Or you could just discipline yourself to sock away 10% of your monthly income in Spiders and forget about it.

Or you could get all control-freak and OCD and get all into options and day trading and lose your shirt.
These days, the markets follow a different law of physics called the Super Rubber Bouncy Ball law. What goes up hits the ceiling, accelerates, shoots downward, hits the bottom, accelerates further, shoots upward, bounces off the furniture and pings sideways into Mom's expensive vase. The vase shatters on the floor and scares the cat, which shreds the nearest curtain and then pisses on the carpet.

In such a world, the only way to grow your kids' inheritance is to be able to make money no matter what direction the market is moving. The only way to do that is to buy and cover low, sell and short high ... and play volatility in between ... all the while hedging against soaring interest rates and inflation.

In short - do what hedge funds and Wall Street have done for years ... Hopefully, with a little more prudence since it's your own dinero ... and maybe within the law.

I suspect you won't have armies of traders and analysts to do this for you like Wall Street does. Fear not. Hedge funds don't have armies either. You just have to learn to invest like they do: with computahs. Over 70% of all US stock trades are executed by computers following rules with no human intervention. Welcome to Program aka Algorithmic Trading. In short: rather than picking specific investments or trades, you define rules for investing and trading. Then the computers do the grunt work of hunting for opportunities that fit your rules and they execute the trades for you.

Yesterday: Have lunch with your broker. Listen and nod for an hour as he ruminates, boasts, rattles off arcane irrelevancies, pretends to see the future, and slips in stock pick recommendations. Then blindly agree, give him a check for another ten grand, and let him pay the lunch tab.
Tomorrow: Have a pre-defined amount of money automatically sent from each paycheck to your brokerage account. Have lunch with your broker. Listen and nod for an hour as he ruminates ... well, you know, they're creatures of habit ... but the difference is that his suggestions should be strategies (aka packages of rules that make sense together) as opposed to prognostication and specific picks.

Yesterday: Pore over stock info online. Read the WSJ. Check Morningstar and Jaywalk. Watch CNBC and Kramer (yuck!). Every day or two, jot down a stock symbol that someone seems to think are going to "pop." Then, log into eTrade or Merrill Online and key in your stock symbol, amount, and price. Then, sit back and watch as that stock inevitably does the unexpected. Finally, freak out and sell the stock. Take the money that's left and repeat.
Tomorrow: Pore, read, check and watch, but much less frequently. Every month or two, jot down a strategy that fits the new market and economic realities. Log on and key in the rules comprising the strategy. Have a pre-defined amount of money automatically sent from each paycheck to your brokerage account. Then, sit back and watch (or not) as the computer buys and sells things you didn't even know existed at prices you don't care about. Some trades go the right way and the computer exits with a nice profit for you. Other trades go the wrong way and the computer applies your stop-loss rules to ensure you don't end up living in a cardboard box. The computer repeats tens, hundreds of times a week without your input. Hopefully, profits pile up. If not ... well, bad strategy. Just like LTCM.

Don't look now, but the future is already here. Folks have been developing trading rules for decades. A growing number of folks are using a growing number of online brokerage sites which offer rule-based trading. It's a bit amateurish still, but getting better ... fast. This time last year, it was a treat to enter a rule requiring more than a stock symbol and a price. Now, the likes of TD-Strategy Desk and Credit Suisse-AES have rolled out platforms allowing folks to effectively build entire entry and exit strategies, taking into consideration multiple asset classes, company fundamentals, and market conditions.

Vague and arcane, right? Here's a simple concrete example:

Assumptions: Short-term, the dollar will continue to slide against Chinese and Emerging Market currencies. The US will buy less from abroad. Emerging market stocks will do better than domestic ones. The US stock markets will be volatile around earnings seasons. Medium-term, drug companies will be pressured by Obama to cut costs, and profits will shrink accordingly. Long-term, house prices will go back up while commercial real estate prices will go down.

A strategy might include a set of rules like:

• Constantly assess cash available and asset allocation
• Constantly assess current interest rates, dollar prices, relative yuan prices, etc
• Constantly assess prices of bazillions of assets and fundamentals of bazillions of companies around the globe
• Always maintain a certain cash balance, subject to a hard minimum plus some extra when market volatility increases ... and at Christmas times
• Slowly build up interest bearing assets which mature in about June 2012, because that's when you'll be ready to buy your next fancy new car
• Always maintain asset allocations within a few percentage points of the target pie-chart you've defined. If this appears to be limiting your profits because of missed opportunities (meaning another rule would have fired in the past and would have made you money, but it was prevented from doing so because of the allocation limits), alert you to reassess the allocation strategy
• Auto-buy into dips in the market, especially around earnings seasons
• Auto-sell when the asset reaches a relative target, either a % gain or crossing a certain statistical threshold like a moving average
• Auto-exit if any trade goes south by more than a few percentage points
• Auto-exit if a better opportunity presents itself
• Keep an eye out for opportunities to buy residential real estate and related assets (like homebuilders, landlords, and residential REITs) when the asset's fundamentals look better than the average for the market and its price is below its 3-month moving average. Exit these positions once the price has jumped more than 10% in a day, risen by at least 20% overall, dips more than 3% below acquisition price, or 6 months have passed, whichever comes first.
• Keep an eye out for opportunities to sell commercial real estate and related assets whose debt levels look particularly ugly and prices are above their 3-month moving averages. Exit these positions once the price has fallen more than 10% in a day, fallen by at least 20% overall, drifted up by 5% above acquisition price, or 3 months have passed, whichever comes first.
• Ceterus paribus, slowly transition from US, dollar-denominated assets to those from China and other emerging markets. When the dollar temporarily spikes against these currencies, exit some laggard dollar-denominated assets and move the money into attractive Chinese and other emerging market assets. Avoid companies that export a lot to the US
• Ceterus paribus, watch for opportunities to slowly move from investments in companies with non-dollar-denominated debt into those of similar companies with more dollar debt
• If a headline turns up for one of the assets in your current portfolio, analyze the price vector (direction of change) after the headline and buy more or close out in order to beat everyone else to the punch.
• Always maintain an appropriate level of rate hedge (for example, shorting treasuries, selling dollar futures/options, etc) in proportion to overall exposure, especially around significant announcements about the economy or the FOMC. If rates surge over a decent period of time, alert you to re-assess the strategy
• And, of course, the security blankey: tell you if the model seems wrong compared with other peoples' behavior. Before accepting new rules from you, back-test them over some previous, similar time period to tell you you're being dumb. Oh, and slam on the brakes if the portfolio starts hemorrhaging money because of a flawed rule.

And Bob's your uncle! Ten years forward, investing like this will be commonplace. Believe me: I can see the future!

Illustrations Copyright http://www.niquette.com

Yeah, What HE Said: Peter Peterson Edition

Pete Peterson is Former Commerce Secretary, CFR Chairman, Founder of Blackstone Group, Former CEO of Lehmann Brothers, Former Chairman of the NY Fed, 150th Richest American, Donor of over $1billion, Founder of the PGP Foundation for fiscal sustainability, Husband of Sesame Street creator Joan Ganz Cooney. Last week, he was on Charlie Rose to remind us we can't just borrow our way out of this mess, personally OR Federally.

My father was a Greek immigrant, comes over at age 17, has a few pennies in his pocket, doesn't know a word of English, 3rd grade education, goes to the middle of Nebraska and takes a job nobody wants, namely washing dishes in the caboose of a railroad. He takes that job in that steaming kitchen. He sleeps there, he eats there, and saves almost everything he had. And then he opens up the inevitable Greek restaurant. 24 hours a day, 7 days a week, 365 days a year for 25 years and when he finally shortened the hours, he had no key to the front door 'cause it had never closed. And he was kinda my model of the workaholic.

And then he addressed our current situation:

Paul Volcker thinks the chances are 75% that there will be a dollar crisis in 5 years ... and what does that mean ... the dollar falls suddenly, interest rates go way up, inflation, recession, housing problems all over again and so forth. And that's the vulnerability and this country's just got to learn to save more, which means the government not dissaving and more personal savings. We just can't continue.

A few months prior, in an EXTREMELY highly recommended op-ed for Newsweek, he explained (emphasis mine):

The moment is overdue for us to become moral and worthy ancestors ... For years, I have been saying that the American government, and America itself, has to change its spending and borrowing policies: the tens of trillions of dollars in unfunded entitlements and promises, the dangerous dependence on foreign capital, our pitiful level of savings, the metastasizing health-care costs, our energy gluttony. These structural deficits are unsustainable ... Underlying these challenges is our broken political system. Our representatives, unlike our Founding Fathers, see politics as a career. As a result, they are focused not on the next generation, but on the next election. When the long-term problems are large and real, they anesthetize us, mislead us, divert us—anything to keep us from giving up something or having to pay for it ... Our problem is not a lack of options. It is a lack of will to do something about them.

Here's one last quote from him, said back in 2004:

I remain a Republican, but the Republicans have become a far more theological, faith-directed party, not troubling with evidence.