Regulated leverage, or imposing endogenous market regulation?

Before I start writing todays post, I am glad to announce that I have successfully mastered a milestone in the CFA program, and passed the Level I exam. Due to future career prospects I may get with having passed this exam, I have decided to enroll in the second leg of the curriculum.

The former chairman and CEO of Citigroup appeared on CNBC to share his views on the ailing economy and about prospects for future reform concerning the banking industry. Since I am unable to embed the video file in this blog post, I will write out the main tenants of his monologue.

Sandy Weill said:

- break up investment and commercial banking

- manage a system that will not allow excessive leverage, somewhere in the 15 to 18x debt to risk adjusted capital

- force banks to book derivatives on their balance sheets and not manage risks off balance sheet

- protect taxpayer funds from having to bailout TBTF banks

Now, with all due respect to Mr. Weill, who also stated that the biggest banks were also the main providers of capital and growth in the global economy in the past two decades, he is putting the cart before the horse on some of these issues.

To be fair, he did state that investment and deposit banking should be broken up. I put commercial because in the mainstream, the two coincide with one another. But the problem with this reasoning is that somehow deposit taking and making commercial loans will make the investment banking business much to tied up with the former and the latter will be in a constant conflict of interest which will force the government through regulatory measures to force financial institutions to construct “Chinese” walls between departments so no kickbacks may occur and no hefty commissions be generated. To Mr. Weill’s point, it is not the commingling between these activities that cause the problems, but the fraudulent nature of loan origination that occurs in todays economy through secondary deposit creation.

His second point deals with leverage. Leverage as an instrument of magnification, may boost returns that may not be generated without the debt standing behind it. But capping this somewhat arbitrary number will again not solve the problem. Especially when banks, in response to a low yield environment must be forced to generate returns sufficient enough to satisfy customer needs, as well as not losing their revenue base to alternative investment vehicles or pools of funds. Also, on this point, different industries operate on different degrees of leverage. (To make a point, there is a difference between operating leverage, which shows the effect of fixed assets and gross profits on revenue, as well as financial leverage, which shows the difference that operating profits have on net income).  

Now, in respect to derivatives, I do agree that these instruments, as like any other that abide to commercial law, must be placed on the balance sheet as a source (asset) and flow (income) to the company. The problem with derivatives, is that, any change in price stemming from the contract (variation of the instruments fair value), and especially if the instrument is booked as AFS under IFRS, doesn’t show as an unrealized gain or loss in the income statement, but rather as a change in the OCI component at shareholder’s equity. That is point one, and point two, if companies, wish not to keep it on their books, in the form of a SPE, they can do whatever they want; but if there are guarantees and contingencies, they ought to be represented as a liability when calculating financial ratios.

And finally, to protect taxpayer funds, why bailout anybody? Why the need for this made up TBTF notion? They are a drag to the economy and should be allowed to reorganize and selloff unsound units and business ventures.

But all in all, someone that sat at a ranking position should have had the courage to speak out regarding these problems in foresight, and not in hindsight.

Gun control–a logical a priori or a posteriori by Karl Denninger

 

Even though I like writing my own thoughts, I feel that sometimes, the best thing to do is just paste an article from a fellow blogger because it gets into a more in-depth and solid view of a subject that maybe I lack thereof.

Karl Denninger, from market-ticker.org, wrote a article regarding the recent gun violence in Colorado, USA which ended in the death of more than a dozen and injured considerably more. Here is his blog post:

“I was not going to comment in a political context on this tragedy until I saw the following:

New York Mayor Michael Bloomberg, a long-time advocate of gun control, called on both candidates to address what they would do to help prevent such tragedies.

“No matter where you stand on the Second Amendment, no matter where you stand on guns, we have a right to hear from both of them concretely, not just in generalities --specifically what are they going to do about guns?” Bloomberg said today on WOR Radio. The mayor is founder and majority owner of Bloomberg News parent Bloomberg LP.

Gun control is why this murderous assailant managed to kill 20 people and nobody had a crack at shooting him, as they were unarmed.

Let's look at the facts of this event.  Metal detectors and searches would have done nothing to prevent this, but would have treated every patron as a felon.  The assailant came in through a back door, which means he tampered with a crash-bar equipped exit at some previous time or had "help."  Those exits are necessary for fire safety purposes.

Reports are that the assailant was wearing body armor.  This would have made him much more difficult to shoot and stop for an armed citizen, but body armor is not "bullet proof"; it is bullet resistant, and if you take a round in the chest while wearing it the energy is still dissipated on your chest -- it just doesn't make a hole.  Continuing to shoot people while being punched in the chest (pretty much what the shooter would be experiencing) would be difficult -- but not impossible.

The presence of a bunch of openly-carried or concealed weapons might have done nothing.  A pistol against a guy toting a rifle or shotgun is not a "fair fight" but it beats nothing, which is what the victims had.  The option to fight back is better than no option at all, whether you can or do choose to use it or not.  Oh, and let's not forget that it appears that Cinemark, the company that owns the theater, appears to prohibit by policy law-abiding citizens carrying concealed weapons.  If the assailant knew this (and it is, apparently, posted on signs at the ticket counter of at least some of their theaters) then he knew that every patron in the place was literally a walking target unable to defend him or herself as law-abiding citizens are disarmed by signs -- but criminals are not.

We do not know what the shooter's beef was with the theater or the people in it.  We will likely learn at least some of that in coming days and weeks.  The alleged shooter is in custody and reportedly has no prior criminal record, so clues are not to be found there.

The simple fact of the matter is that there is a tiny percentage of people who are cracked in the head.  Walking into a theater armed to the teeth and carrying incendiary devices to intentionally drive people to where you can more-easily shoot them is the act of a depraved mind and evidences obvious premeditation and intent.  The criminal justice system will mete out the punishment it is able for this circumstance, which will be wholly inadequate as you can only take a murderous thug's life once with capital punishment.

The Second Amendment and fully-recognized Constitutional Carry is the only means available to mitigate these sorts of events.  Firearms and smoke bombs are neither difficult to acquire nor can they be made difficult to acquire or even construct for someone with murderous intent, and as such the idea that "gun control" will ever do anything other than disarm law-abiding citizens is the worst sort of crap argument from ethically and morally-bankrupt fascists who themselves employ armed security around them at all times.

Mayor Bloomberg can pontificate on whether Constitutional Carry should be prohibited and the Second Amendment amended, which is the only lawful means to alter it, if and when, and only if and when, he dismisses all of his own armed security and turns over his own firearms -- all of them.”

Bashing a company to help expropriate funds to the government

Microsoft is in the headlines again. This time the fuss is regarding its operating system Windows 7. In the following report from WPCentral, the EU commission is looking into punishing Microsoft for the apparent breach of customer service when selling their software. The following bellow is the full article:

“The European Commission announced plans today to open an investigation to determine whether or not Microsoft has failed to comply with its browser choice commitment, which was applied in 2009. The commitment saw the software giant presenting customers of its Windows operating system with a screen listing available alternatives to Internet Explorer. This was put in place due to Microsoft being found guilty of abusing its dominant position with IE in the browser market.

Joaquín Almunia, Vice President of the Commission in charge of competition policy, had the following to comment.
"We take compliance with our decisions very seriously. And I trusted the company's reports were accurate. But it seems that was not the case, so we have immediately taken action. If following our investigation, the infringement is confirmed, Microsoft should expect sanctions"

Competing browsers have previously spoken publicly about the potential antitrust violations Microsoft is dancing around by preventing third party browsers access to the same APIs IE uses in Windows 8. With the down-spiral of IE and the massive increase in users for both Firefox and Chrome, is it worth penalizing Microsoft heavily for a ballot box screen, which arguably adds little value to the user experience?

According to the announcement, the EC believes that Microsoft may have failed to implement the browser choice screen from February 2011 onwards with the release of Windows 7 SP1. It'll be interesting to see the outcome of this investigation, especially from a financial standpoint, with a possible fine of up to 10% of Microsoft's total annual turnover, should it be found guilty of breaching the commitment.”

Now, this is the dumbest case of government expropriation from a bunch of unelected bureaucrats this year. (I am putting aside the shadow banking bailouts, because those concern finance.) 

This “malpractice” coming from Microsoft had to do with an earlier massive fine it had to pay for “monopolizing” the market in browser software. The Commission seized the opportunity to pounce on Microsoft because it violated its commitment to give the option to the customer of choosing an alternative to IE. The Commission is furious because Microsoft neglected making to make this change.

First of all, The Commission should have left the doings of a private company alone. If a customer was dissatisfied with the product he purchased and the service rendered for the amount paid, there are civil courts where these matters are disputed. In my view, I am certain, that the customer couldn’t care less about this option, because Windows 7 allows you to download an alternative to IE.

And even if Microsoft did promise to make this change, and it failed to comply with this regulatory statement, any customer could have complained. I haven’t heard of any complain against Windows for not installing an optional step in the installation process of its software.

The part of the article that struck me most was the following:

“Competing browsers have previously spoken publicly about the potential antitrust violations Microsoft is dancing around by preventing third party browsers access to the same APIs IE uses in Windows 8. (italics added)

It seems that the competition wants a free ride on the back of Microsoft and is using the government to do their bidding. According to Wikipedia:

“An application programming interface (API) is a specification intended to be used as an interface by software components to communicate with each other. An API may include specifications for routines, data structures, object classes, and variables. An API specification can take many forms, including an International Standard such as POSIX or vendor documentation such as the Microsoft Windows API, or the libraries of a programming language, e.g. Standard Template Library in C++ or Java API. (italics added)”

The competing vendors are complaining because Microsoft’s API language doesn’t allow for competing vendors API to be successfully integrated into Windows.

My answer is: And, so what?

Microsoft, as a private company doesn’t need to comply with the whims of the competition. If individuals didn’t enjoy the service provided by Microsoft, it would leave Microsoft and buy a different software provider. Now, the case comes, where Microsoft is accused of being a monopolist. It is too massive and too expensive to compete against them. But this surely is not the case.

Google Chrome, Firefox and others have successfully pummeled IE into the ground. They have successfully integrated their browsers to work with Windows. They have therefore worked around this supposed stranglehold that Microsoft has.

But, to a bigger issue. If Microsoft is fined 10% of yearly turnover, which amounts to about 20*4 billion= 80 billion dollars of revenue according to Microsoft Investor Relations, the fine would be around 8 billion dollars Now, where is this money going to go to? Is it to the competition? Is it to the EU coffers?

In any way, Microsoft will later be forced to contract business, as well as the inability to possibly fund this request by the EU Commission.

This next image is also a revelation that IE cannot be charged of being a monopoly product: Google Chrome has overtaken IE, with Firefox close behind IE. Even if Google or Mozzila had to pay a license to Microsoft, it still managed to create a better product, forcing Microsoft to rethink IE and make itself a better browser.

This would be the equivalent as Apple suing Microsoft for on being able to run their OS Leopard or Lion on any other hardware other than on Mac’s. Which is absurd, because Apple designed their OS specifically for Mac’s.

This is just another attempt for the government to rake in a substantial amount of cash for their dwindling budget. And, since the EU is giving away money to shore up the bankers reckless behavior, they would probably be able to bailout Cyprus with this money:

“The little island of Cyprus became the fifth European country to request a bailout for its struggling banking sector, and the estimated 10 billion euros needed to set things right would amount to more than half its total economy.”

I am sure to get the remaining 2 billion, the ECB will just lower some reserve requirement and get the desired excess liquidity. Wouldn’t it be interesting to see the possible statistical correlation of this possible expropriation and the bailing out of Cyprus? Wouldn’t be surprised if it brought on a p-value < 0,0001 in the tails of the distribution.

President Obama’s speech shows the person behind the Presidency

 

The following quote has been taken from Zero Hedge, which cites the President at a rally who knows where in The US. It clearly shows what’s wrong with the Presidency at the current moment and the feel of politics in America.

“There are a lot of wealthy, successful Americans who agree with me -- because they want to give something back.  They know they didn’t -- look, if you’ve been successful, you didn’t get there on your own.  You didn’t get there on your own.  I’m always struck by people who think, well, it must be because I was just so smart.  There are a lot of smart people out there.  It must be because I worked harder than everybody else.  Let me tell you something -- there are a whole bunch of hardworking people out there.  (Applause.)
 
If you were successful, somebody along the line gave you some help.  There was a great teacher somewhere in your life.  Somebody helped to create this unbelievable American system that we have that allowed you to thrive.  Somebody invested in roads and bridges.  If you’ve got a business -- you didn’t build that.  Somebody else made that happen.  The Internet didn’t get invented on its own.  Government research created the Internet so that all the companies could make money off the Internet.
 
The point is, is that when we succeed, we succeed because of our individual initiative, but also because we do things together.  There are some things, just like fighting fires, we don’t do on our own.  I mean, imagine if everybody had their own fire service.  That would be a hard way to organize fighting fires.
 
So we say to ourselves, ever since the founding of this country, you know what, there are some things we do better together.  That’s how we funded the GI Bill.  That’s how we created the middle class.  That’s how we built the Golden Gate Bridge or the Hoover Dam.  That’s how we invented the Internet.  That’s how we sent a man to the moon.  We rise or fall together as one nation and as one people, and that’s the reason I’m running for President -- because I still believe in that idea.  You’re not on your own, we’re in this together.  (Applause.)”

So, if you did something, it was through the collective spirit, not through the profit seeking motive of the individual.

Brilliant.

Using other peoples money to finance projects of grandeur

 

I am happy so say that after a week of absence (summer vacation), I can resume writing my blog and continue to comment on everyday economic events.

There hasn’t been word of the late “Peljesac” bridge project for some time, so I have decided to touch on this subject for a bit. Browsing through todays online business news, I stumbled upon an article concerning this government project. It was the idea of the previous administration to solve the problem of Croatia’s territorial discontinuity by building a massive bridge that would connect Croatia’s mainland with the Peljesac peninsula, thus enabling Croatians and others to get to Dubrovnik and the rest of the south of the country, and not having to go trough the city of Neum, Bosnia and Hercegovina.

As, the article reads: “HSP Ante Starcevic against the construction of the Peljesac Bridge - The solution for the Peninsula is immersed tunnel”. The HSP Ante Starcevic political party wrote an open letter to the government requesting a tunnel, rather than a bridge, be built to connect the Croatian territory.

Now, I am sure that the political party has good intensions in mind, and they even give the plan a technical feel to it by elaborating that the same practice has been implemented by other nations as well. It would also benefit the domestic construction industry.

Now, not once (at least in the news article) is it mentioned the source of financing for such a venture. How will the government open the bidding for the construction companies is also a mystery, coupled with the fact that, are there sufficient funds in the government coffers to spend on a wasteful project and subsidize the construction industry as well.

I am not going to go into the technical aspects of such a project, since I am not a construction engineer, nor geologist, nor by the look of things (as this political party advocates) a maritime engineer, I am an economist and the economics just don’t work out. Usually, governments build bridges, roads, social infrastructure as a necessity. These projects are placed into the “natural monopoly” category, are deemed as such, because conventional wisdom states that such projects are too large for the private sector to complete.

What is really meant, is that the government can easily and with no trouble expropriate by force (taxation) the funds necessary to build such a project. Why the government doesn’t think that a private contractor and later owner can manage to bridge at a profit, is beyond me.

I do know is that if a study is done on the feasibility of the project, and this usually includes discounting cash flows, finding similar projects that carry proportional risk to arrive at the desired discount rate (delevering asset beta of similar project and relevering project equity), payback periods, WACC estimates and project duration, it will be excepted or rejected. The component leg would include checking for viable materials, natural geological movements which include geological shifts, sea level changes, wind resistance, corrosive elements, and so on.

If massive companies can finance massive constructional endeavors such as the Burj Khalifa, Tokyo International Airport, Wal-Mart, Apple and so on, why such clearly political motivated economic prevail? The largest boondoggle in history must be the interstate highway system built in The US under the auspice of boosting aggregate demand. This system hasn’t been maintained in over forty years. Just in moments of economic recession, the government calls for more public works. It didn’t occur to them that maybe a level of savings had to be generated to maintain such a vast system?

Running a perpetual budget deficit doesn’t really help in such a situation.

An attempt to soak the rich on the global level

 

The United Nations, as reported by Reuters, and rereleased by index.hr, has committed to a massive redistribution plan to “aid” the most poorest countries. It is asking for a global tax on billionaires (some 1226 of them) to pay for this “aid”.

Well, the IMF has given a trillion or so more to sub-Saharan countries in the past decades and nothing much has changed. The only thing that might have changed is the debt level of these countries. How is this money really lent out? Who gets it first and for what endeavors? We may be inclined to ask the simplest of questions: Why are the poor, well, poor?

Even tough this may seem as an easy question which contains an even simpler answer, the mass science of modern “new” economics has dumbfounded analysts, researchers and the rest to explain why such poor performance persists in the presence of such grandiose ventures. Reading von Mises, it is easy to unlock the answer of wealth creation versus wealth destruction. A poor country is one which has a low capital base. I.e., it doesn’t have sufficient savings to bring forth a larger and more roundabout capital structure. The individuals living in some of the remotest areas, are unable to accumulate capital because their time preferences are so high, that they survive by living day by day.

Now, it is true, that some regions of the planet are more abundant in resources, than others and the know-how isn’t capable of delivering sufficient results, but that doesn’t negate the fact that, in order to be wealthy, one has to sacrifice and sustain form present consumption. In the “Third World”, if there is capital formation, there is no real system of private property to ensure a viable and peaceful exchange of goods and services. Europe, nor America weren’t rich in the 1100’s as they are today, but the natural resources were still there, people still lived, technology improved and so forth, but the absence of a cohesive legal and economic structure, the “Third World” can resort to nothing but barbarism.

Taxing the wealthy will just mess up,in the margin,time preferences between their wishes and consumption/investment patterns with one of coercion and anti-entrepreneurialism. If the tax is marginally high, why keep the capital structure intact? Why not consume present goods, as they will bring about a lesser tax burden. Let socialism prevail and all we be well. Not to mention, the ability to  create fake “aid” through inflation and redistribution to the privileged few.

A global tax won’t fix the problem, it will only aggravate current unsound financial positions, wherever they may be located, whether geographically or on an industry basis. Soaking someone with aid, rises the price of those goods at home and creates a disincentive to produce on your own and built up a viable capital structure in the process.

This is however, not the first call, for such a feat. There has been, over the past few years, of a global derivatives tax, dubbed the Tobin tax. Instead of recognizing that the problem of a massive global derivative position, notionally, many times larger than the GDP of planet Earth, is a function of rapid credit expansion and fractional markets in the stages furthest from the initial expansion taking place at the commercial banking level, as well as the negative real interest rate loans provided by the central banks, subsidizing the very originators of fraudulent debt.

If the UN wants to help, it should start by looking itself in the mirror and explaining why their employees are exempt from paying income taxes in their home districts, as well as special subsidies for housing and medical costs…

How the privileged few have access to a massive subsidy

 

Remember, how in life, people say: “it’s the little things that make life great”. In this case, it’s the little things that make life a complete clusterf*ck. If the next picture is so blatantly shown to the public, just what happens behind close doors?

The next list shows bus fares from the city of Zagreb to the town of Novalja on the Adriatic Coast.  The foremost right numbers are the prices represented in the local currency – HRK (1$ = 5,5 HRK). The “J” stands for the price in one way, while the “AR” stands for a return ticket. 202 HRK is a one way ticket to Novalja, while students, the blind pay 134 HRK and small children 104 HRK for one way. 202 HRK, 300 HRK and 241 HRK are paid by children, adults and students and the blind respectively. The bus ticket purchased for a return trip is valid for 180 days.

This is all fine, if not for the yellow bolded part I highlighted. The highlighted part reads: Parliament members pay 6 HRK= 1,2 dollars. And this was decided by the Parliament.

So, I wonder, in the aggregate and in at the margin, how much am I subsidizing these royal individuals? Well, it depends on the average price on the average bus fare for all citizens. And, since its law, all carriers are FORCED to subsidize these passengers. This means an explicit marginal loss for the carrier.

Brilliant.

0     Rezervacija.     6,00
1     Karta za 1 SMJER     202,00
1000     ZASTUPNICI u HRV.SABORU ! ( odluka Sabora )     6,00
1035     J / 35% / STUDENTI, +65 god., SLIJEPE OSOBE!     134,00
1072     J / 50% / DJECA 5-10 g.     104,00
5072     AR / 50% / 60 D/ DJECA 5 -10 g.     202,00
5329     AR / 25% / 60 DANA     300,00
5330     AR / 40% / 60 D/ STUDENTI,+ 65 go.,SLIJEPE OSOBE !     241,00
LEGENDA: J - Jedan smjer, AR - Povratna karta, 180 D - Vrijedi 180 dana, X-ica - Studentska iskaznica

Unemployment in Europe as a precursor for more stimulus

 

BRUSSELS (AP) — Unemployment in the 17 country euro currency bloc hit another record in May as the continent continued to be buffeted by its debt crisis, official figures showed Monday.

Eurostat, the EU's statistics office, said unemployment rose to 11.1 percent in May from 11 percent the previous month. That's the highest rate since the euro was launched in 1999, and compares badly with an unemployment rate of 8.2 percent in the United States and only 4.4 percent in Japan.
In total, 17.6 million people were out of work in the Eurozone in May, 1.8 million higher than a year earlier.

Unemployment has been edging higher for over a year as concerns over the debt crisis and the future of the euro currency itself have weighed on economic activity.
There are huge disparities across the Eurozone. The labor markets of those countries at the front line of the debt crisis, such as Greece and Spain, are suffering in the wake of stringent austerity measures and recession. The highest unemployment rate across the Eurozone was recorded in Spain, where 24.6 percent of people were out of work in May. Even more dramatically, 52.1 percent of the country's youth were unemployed.

Other countries in the Eurozone are faring fairly better. Germany's unemployment rate, for example, stood at only 5.6 percent. However, a raft of surveys in recent weeks have pointed to tougher times ahead in Europe's biggest economy.

Across the wider 27-country European Union, which includes non-euro countries such as Britain and Poland, unemployment edged up to 10.3 percent in May from 10.2 percent the month before.

Does the ECB need to intervene while the EUR is at 1,226?

There has been talk lately, coming from analysts in the financial district for the ECB to continue easing. The ECB has already been active in the market for the past two year by propping up the sovereign markets and buying wholesale government debt loads.

The goal was to make the term structure of the government debt in the Eurozone periphery more manageable. It also induced a short stock market rally. But with every new dose of stimulus, the hangover is ever so greater. In my opinion, it is not the government that need the bailout, but the banking industry that has been supplying cheap credit to the governments are let holding a lot of illiquid debt on their books.

The ECB is risking the fallout of its interventionist policies, that will be in the form of additional moral hazard, higher interest rates and more TBTF banks. You cannot shore up unsound positions by accumulating more debt in the same positions. Bad debt must be liquidated and the nominal price levels must reflect pricing realities.

As the amount of leverage in the system grows, and as the implicit guarantees by the ECB to peripheral debt continues, there will be GDP growth, financed with ex nihilo deposit origination. Any uptick in the GDP will be followed by further capital consumption and a lower standard of living.

The ECB is trying to stimulate its way out of a problem it itself created. You cannot forcefully feed money in an unsound position if there is no demand at the other side. And, even if there is demand, the government will have to redistribute resources from somewhere else to manage the implicit or explicit guarantees. If rates fall for instance as the central banks ease to support the real estate market, rates will rise elsewhere. Pushing rates toward the ZIRP boundary will encourage speculation and consumption, but not rebuild the capital stock which is desperately needed. The ECB is here to help the banking community avoid any losses they might occur, while at the same time devaluing the currency, subsidizing borrowing costs to the banks.

So, no. The ECB has to retrench and take the hit now on its asset side. Will the ECB manage this shortfall with printed Euros it will ignite the shadow inflation currently in the system. What is also needed is a structural reform of the labor market. Minimum wage laws, price floors on wages must be abolished. The notion of a fiscal union is just absurd. If the monetary union wasn’t a transfer mechanism in of its own, do we really need an automatic stabilizer on a supranational level? A stabilizer put in place to shore up the problems the monetary system will continue to produce?

No thank you.