9.18.2008

Trust me, it’s all about taking credit when credit is due.

The recent (and inevitable) “credit crisis” and the disaster looming on the eastern seaboard has brought one thought to mind. The amount of consolidation happening in the financial industry is almost shocking. It has brought two major thoughts to the forefront of my mind: Anit-trust, and the paradox of information – as well as perception and reality.

I would like to touch on both of these points.

First, some background. In the current state, the number of independent US Investment banks has, in recent history, been reduced to two. Speculation is that only one will survive – GoldmanSachs. It was not too long ago that BearSterns was on the brink of bankruptcy and was sold the JP Morgan Chase for a bargain. It was like stealing from a flea market – at the end of the day, you are really just a cheap asshole. A few months later, and on the same day, Lehman Bros. declared bankruptcy and MerrilLynch was sold to the Bank of America. The speculation in the current state, is that a major retail bank (namely Wachovia) is very interested in purchasing the likes of MorganStanley. Realistically this is a Cher-esque facelift of the United States financial sector. Seemingly overnight, Wall Street has had the squeeze put on it in terms of the span of control. Remaining there will be 4 major banks, and 1 investment bank.
They are:
CitiGroup (Bank)
Bank of America (Bank)
JP Morgan Chase (Bank)
GoldmanSachs (Investment Bank)

Of course, there are still a number of banks that are kicking it on Wall Street. But realistically, does anyone still drive Fiats? (no pun intended?).

To touch on the first point - the anti-trust situation. In any given market, there are regulatory bodies (both governmental, and bureaucratic) that will investigate all industry consolidation to ensure that it is not creating a situation of monopoly. There are anti-trust laws in the United States that ban both holding companies, and monopoly. Some examples of companies that have been subject to anti-trust legislation are (in both recent and not-so recent history) Microsoft, and Standard Oil. Both were broken up by the government. The irony of the break-up of Standard Oil is that the price of crude had dramatically dropped from its infancy to its rise to power due to economies of scale. The savings were, in fact, actually passed onto the consumer.
In the current situation, I have not heard a peep about the regulatory bodies looking at whether there are infringements on any anti-trust legislation. Given that the span of control in the US financial sector has greatly shrunk as a result of the “crisis”, I would expect at least some words of wisdom from the powers that be.
I conjecture, the reason for this silence, is that it is acceptance. It is not that the regulatory bodies (and should be the public) are not concerned with the consolidation and its effects on free markets, but their hands are tied. The argument that would come from the industry itself (or the players) is that without this consolidation, the market would crash. Those with liquidity needs to save those without. For some of these companies to attempt to liquefy (that’s right) their assets, it would create a situation where the supply of instruments would grossly outstrip the supply. To flood the market with these fire sales would cause an inherent and systemic problem of devaluation. If company A sells an asset at a discount on the market for the purpose of liquidity, and Company B happens to hold an identical instrument, it reduces its value. Given that these companies have more or less mimicked each other in terms of strategy and creating this false market value, when one goes, they all lose value.
The only option for the powers that be (mainly the Fed) is to allow for this consolidation and for assets to be frozen to avoid them being spewed out into the market. The good get to buy the bad for a bargain. Realistically, the Fed is stuck between two choices – assume the liabilities and assets of the organizations (like Fannie and Freddie), or allow for the private sector to sort out its own debacle. Personally, and politically, it is an issue where I am completely torn. I am against big government, but against modern corporate capitalism. Would I rather see the Fed assume these failing banks, or would I rather see banks buy these failing banks. I honestly don’t know. The one caveat is that the Fed is also a private bank. The key difference between the private nature of the Fed vs. for example, Citigroup, is that one has open books, and the other does not. The other key difference is that the cash flow of the Fed is the tax base (and the interest is collects) vs. the voluntary deposits of the citizenry. Ultimately, I would have to (and I mean reluctantly) side with the current industry consolidation. I am against monopoly (unless I’m the one reaping the benefits – what can I say, I’m a capitalist), but I am also against nationalization.

This is a nice segue for my second concern, that being the openness of the books. With the post-Enron legislation led by 2 US Senators, Sarbanes and Oxley (known as SOX), came new mandates for the openness of books and the separation of processes. To summarize SOX in very layman’s terms – the guy that sells the product can’t load the truck and enter then enter the JV. The processes need to separated by individuals to ensure that there is no overlap. With overlap comes the opportunity for sleuth activity.
This question was posed to me by my brother, and that was (paraphrase) “What was the point of SOX if these companies have been padding their books and bottom line in this fashion?” Now, some of you may be saying that SOX has nothing to do with it, which is somewhat true. These banks were not padding their bottom line with fake money, but they were building their bottom line with derivatives and instruments based on their derivates and instruments. This money never existed, although, to be nihilistic for a second, no money really exists. There are three regulatory bodies that theoretically should have been monitoring the banks behaviours. The Fed, the US Treasury, and the SEC. I am not saying that they were not looking at it, but am definitely saying that they did absolutely nothing about it.
The reality is that they likely were not being pre-emptive in actually monitoring what these firms were doing, and by the time they had clued into as to what was happening, there was really no point. The paradox of perception and reality is that they are one in the same. No matter what the source of the information is, or how valid it is, the information is public. The examples are endless. My favourite one is the paradox of the slut. Regardless of whether or not a girl is tramping around and giving it to every man she could hit with the throw of a rock, if the perception is that she does, she is a slut. I am convinced that there is at least one virgin slut in every high school. A friend once reminded me of a famous saying, and that is that a lie told enough times becomes the truth.
Think about the market situation. If the three regulatory bodies were to have stepped in (and there is no choice but to do it publicly), the perception of the street being cracked is the reality regardless of whether or not it is true. The panic would have set in, regardless of its validity. The reality right now is that there is a hairline fracture in its base, but it has been spreading for quite a long time. Those in the know were definitely not surprised, and those who weren’t, were where the concern lay. This is the paradox of the market – perception is reality. The end effects of a crash, verse a perceived crash, are ultimately the same. If I think the bank doesn’t have my money, it’s the same as me being told that the bank doesn’t have my money. The only benefit is that I don’t need actually run to the bank in the latter, unless the bank tells me that they might have my money – then I’m going to run even faster! I think I have made the point pretty clear.

The current global money markets is a house of cards built on a fault line. The cards are the derivates on derivates, and the fault line is the lack of reserves to validate the wealth. I am not a proponent of a 100% reserve ratio system, but I am also not a fan of paying profit with debt. There are two types of debt, good debt and bad debt. Example of good debt, is taking on a mortgage to purchase and affordable real estate for the purpose of owning property. Example of bad debt, is the war in Iraq.

I am not saying this system will tumble, but I am saying that we will continue to cycle through these collapses and gains. They are driven by irrationality and greed. Unless a phoenix rises from the ashes (the phoenix being a new system) we will continue to be susceptible to the inevitability of the beast. If you are like me, you can’t wait to see how this will all pan out. Take a number and get in line.

3 Comments:

Blogger Timothy ware said...

First off, City bank operates in Japan and there is no ci phonic in Japanese so over here it is called "shitty bank". Just that.

The reason why it is not necessarily monopolistic is banking markets are quite global. I mean if you live in a small American town you may only be able to go to your local bank but it operates through larger groups which are interconnected world wide. So there may be few American banks left since the world has many it does not have as many monopolistic Tendencies. TD Waterhouse is fairly large, Scotia and RBC (Maybe CIBC) are all important on the world stage. A few banks from England, a couple from Switzerland, two major Dutch banks, the Germans have plenty, Japan has MUFG and Mizuho which are quite international. So at least at the wholesale, investment, bank to bank, and corporate levels there are plenty.
The Wall Street Journal article I posted says some really interesting things about SOX that are related to what you have to say. Essentially it goes on about how the regulation is not too much or too little but just terrible. The banks were built on something not dissimilar to the so called "Enron Accounting". I mean a more reasonable form certainly but still valuating future money streams in current profits. Well Sox essentially forced all of the write downs recently that lead to general market fear, speculators taking short position, hysteria ensued and here we are. Of course I am saying how we came about it in the passed few months without speaking of how we go to the passed few months over the passed few years.
Of course banks and (more shockingly and possibly more disturbingly insurance companies) took on way too much risk during the bullish times as of late. Certainly people were taking on too much debt (you would say good debt in this case) and the banks were happy to lend it to them. So can we say it was also individuals at fault? I don't think so. You tell me I can have a million dollars at 8%, to be paid off over 40 years using an $800000 as collateral and I will say yes. Its likely branch managers being yelled at to drive up sales and having no choice but to approve everything.
I postulated to my girlfriend that if the American government didn't prop up freddie, frannie and AIG the Chinese government may have to essentially buy all of the real estate in America.
Government buyouts are generally stupid but whats the alternative? There wasn't one. In the future we need to react sooner so we have more and better options.

8:30 PM  
Blogger j-rem said...

Clearly I didn't do a very goo job of explaining a couple of points.

1) I refrain from caps lock wherever possible. I meant AFFORDABLE. i.e. good debt is where you are buying a property you own. a lot of this is indirectly driven by 0 down dream houses...
2) i work in an industry where the pressure is very top-down. it doesn't mean i make decisions that are bad for the industry in the long-run. it is no excuse.
3) my point about SOX is oringal.
4) the Yaun is pegged to the US dollar. why would they buy American property? i "postulate" that they will unpeg soon and america will really spiral into turmoil. owning american property (at american valued currency) would be myopic to say the least.

as for the global thing. i agree... but inevitably, every bank is tied to americans. my point actually was global - they all own eachother. if american banks fall, each country/firm you mentioned will face write-downs. as with everything with america, its "go big or go home".. dont think that this global banks are tied to the same risky assets that they are. theya re either directly invested, or they are invested in the companies that are.

11:32 PM  
Blogger Timothy ware said...

your point is original. I was just saying that it is something else that I saw about SOX on the Wall Street Journal. I wasn't implying you stole anything.
All of the banks swap their assets. I agree, but you can also see the depreciation of their stock value and know which countries have the best (read least risky) banks.
I would say the 0 down homes are directly causing this too. Not solely but the fact that the government often gives tax breaks to first time buyers (ie: Take tax-free money out of an RRSP) means they promoted it as we feel construction is so important (not to say it isn't but we do certainly feel that way).
As for China I only mentioned that country because it is so feared in America. The reality is the large sovereign wealth funds would be the likely source of money. Norway perhaps but I would say Qatar really likes those kinds of investments.
Freddie Mac, Frannie Mae, AIG and perhaps more to come are important to the global economy and I stand by the notion that if America didn't bail them out someone else may have.
You may have done a 'very goo' job of explaining yourself.

7:55 AM  

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