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

Follow Up 2: Less is More

The lead story in the August 6, 2011 Economist minces no words in their opinion of US politicians' "current uselessness" which the paper fears will be responsible for a double-dip recession. They specifically highlight the negative impact of the growing US governmental unpredictability:

Any hard decisionshave been given to a commission--a cop-out that condemns workers and firms to more crippling uncertainty about how the country's fiscal mess will be tackled. Would you build a factory today if you knew that taxes had to rise eventually, but had no idea which ones?

Worse, the poisonous politics of the past few weeks have created new sorts of uncertainty.

This was precisely my message in a January 2010, blog post:

Risk is equivalent to unpredictability. The more able one is to predict the future, the lower the risk and the more confidently one can make moves today which create a nice return tomorrow. Conversely, when the rules of the game may significantly change tomorrow or next year, risk is dramatically increased. This raises the risk-vs-reward bar such that fewer investment options are viable.

Its no wonder that corporations and banks are choosing to sit on "piles of cash" instead of launching big, strategic, long-term investments which would support long-term and largely high-skilled job creation ... and hopefully long-term profitability for the investors.

No, US federal policy currently discourages that type of thing. More precisely, it forces such investment offshore. When US businesses choose to NOT use their cash for investment in their own commercial projects, they must find something else to do with the cash. People say that Apple has umpteen-hundred-billion dollars "in the bank" but more accurately, Apple has this cash invested in non-apple projects in that Apple owns shares, CDs, bonds, and IOUs from other banks and companies who are not subject to the unpredictability and caprice of the US government.

As my blog post continued:

Governments can increase or decrease this risk. Those with the discipline to stick to a stable, sensible, transparent industrial policy over a long period build tremendous "trust equity" with investors ... Ideas become businesses become economic value ...Unfortunately, being based entirely on intangibles (consensus expectations), this trust equity is a very fragile thing. Governments can quickly sabotage themselves, their economies, and thus their citizens by giving off even the whiff of erratic or ill-advised behavior.

 The current lot in Washington reek of it. Like Renaissance French nobility, they slather themselves in ever-increasing amounts of perfume to cover it up, but the flies still swarm. Here's David Brooks:

"If you ask people, 'why aren't you investing? Why aren't you lending?' it all comes down to uncertainty ... If bankers and entrepreneurs don't have any sense of certainty, they're just not going to invest ... We've not only got this economic problem, but its compounded by a psychological problem, magnified by the fact that distrust of institutions is at its highest level in history." - David Brooks, Meet the Press 1/31/2010

The answer? Of course, it's complicated but a good start is in the title of this blog. The Economist is concerned that immediate fiscal austerity would thrust the economy deeper into trouble. They suggest that we wait a bit. They're half right. I'd listen to Greenspan, who has been a long proponent of using the economic power of "signalling." Without changing a single regulation or appropriation today, the government can clearly communicate what changes are coming when. If the message is credible, people will respond as though the change had happened today. Markets will rapidly price in the new information, and the trajectory of the whole economy will shift.

IF the government's message is credible. This is the rub, given the extent to which Washington has squandered that intangible "trust equity." Given this situation, I'd suggest Obama and Congress see a psychologist ... to better understand how to psychologically build trust in a population.

I'd suggest follow-though is key.

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.

Staged.

Does the White House really think that all it takes to control public opinion is having the US people watch Congress clap for the President for 3 minutes straight? Last time I checked, the only people less liked than the President were the Congressmen.

Yeah! What HE Said: Labor Day

"Capitalists of the world UNITE!"
- Banner at Forbes Magazine HQ

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).

Yeah, What HE Said: Limited Government

Quote shamelessly borrowed from the Cato Institute's blog today:

"Limited government is one of the greatest accomplishments of humanity.
It is imperfectly enjoyed by only a portion of the human race, and, where
it is enjoyed, its tenure is ever precarious. The experience of the last
century is surely witness to the insecurity of constitutional government
and to the need for courage in achieving it and vigilance in maintaining it."
- Tom G. Palmer, Cato Institute Fellow and Humanitarian

Nik's Laws: Profit

If profit is outlawed, only outlaws will profit.

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.