Mariner Kemper - We Do Not Need More Regulation

Roubini to CNBC - Yellow Weeds

Interview With Charles Munger (Buffetts VP at Berkshire)

Legal Matters With Munger

Publish at Scribd or explore others: School Work Other Books Non-fiction money world

As we look at the current situation, how much of the responsibility would you lay at the feet of the accounting profession?

Munger: I would argue that a majority of the horrors we face would not have happened if the accounting profession developed and enforced better accounting. They are way too liberal in providing the kind of accounting the financial promot-ers want. They’ve sold out, and they do not even realize that they’ve sold out.

Would you give an example of a particular accounting practice you find problematic?

Munger: Take derivative trading with mark-to-market accounting, which degenerates into mark-to-model. Two firms make a big derivative trade and the accountants on both sides show a large profit from the same trade.
And they can’t both be right. But both of them are fol-lowing the rules.
Yes, and nobody is even bothered by the folly. It violates the most elemental principles of common sense. And the reasons they do it are: (1) there’s a demand for it from the financial promoters, (2) fixing the system is hard work, and (3) they are afraid that a sensible fix might create new responsibilities that cause new litigation risks for accountants.

Can we fix the accounting profession?

Munger: Accounting is a big subject and there are huge forces in play. The entire momentum of existing thinking and existing custom is in a direction that allows these terrible follies to happen, and the terrible follies have terrible consequences. The economic crisis that we’re in now is, in its triggering circumstances, worse than anything that’s ever happened.

Ron Paul's HR 1207 - A Great Idea

Ron Paul is the man:

US to regulate OTC derivatives

This is long overdue. Of course the big banks are going to lobby against these measures, because any type of regulation/clearing house for OTC derivatives (especially credit derivatives) is going to severely cut into their future profits (bid-ask spreads will drop drop 100s of bps): From the WSJ:

Under a proposed raft of reforms, regulators could be given authority to force many standard over-the-counter derivatives to be traded on regulated exchanges and electronic-trading platforms. That would make it easier to see prices and make markets more transparent.

Firms with large derivative exposures or that trade more-complex derivatives would be subject to new reporting requirements. The proposal also calls for all standardized derivatives to go through clearinghouses that will guarantee trades and help cushion the impact of a collapse of a large financial institution.

The regulatory overhauls are in response to growing concerns of outsize risk and leverage among derivatives that trade directly between pairs of firms. Much trading in this market, estimated to total hundreds of trillions of dollars, now happens privately, and contracts are typically negotiated over the phone.

I suspect that if CDOs/CLOs/CMOs and CDSs move to a clearing house or electronic exchange, it will be considerably more difficult for the banks to apply mark-to-model on these assets. As their balance sheets become more transparent (no more Tier 3 assets), the public will regain there confidence.

The move, the latest step to tighten federal regulation of finance, is designed to address markets such as those for credit-default swaps, which many say exacerbated the financial crisis. Any such moves would require congressional approval.

"Reporting those positions will address the primary concerns of the market, about who is trading what derivatives," said Joel Telpner, a derivatives lawyer at Mayer Brown in New York.

Also Wednesday, Mr. Geithner said the Treasury would soon release a separate plan to simplify which agencies oversee financial markets, a move that could bring sweeping change to the alphabet-soup of regulatory bodies.

"I think the president believes we need to have a much more simplified, consolidated oversight structure," Mr. Geithner told the Independent Community Bankers of America trade group.

The plan to move some trades onto exchanges and electronic trading platforms could reduce profits for investment banks, which currently take fees for facilitating the trades.

The long term solution to credit default swaps may be the holder of the derivative has to have a position in the underlying asset. This will take most of the speculators out of the game, and although that will probably negatively affect liquidity, it will prevent speculators from taking down companies (equity prices are highly correlated with CDS rates).

Proposals for new financial regulations ... good stuff

Credit Suisse is forced to the back of the line

I do not really have an opinion on this article, besides the fact that it probably sets a bad precedent for future foreclosures down the road. To make a long story short, it appears CS was found guilty of predatory lending, in regards to the Yellowstone Club Ski resort, which is now in foreclosure. Their punishment is there they are going to have to step behind others lenders (they are now a subordinate debt holder behind the DIP financing) waiting to get their money (CS lent 370 million). From Rueters:

Credit Suisse Group AG (CSGN.VX), which lent $375 million to the exclusive Yellowstone Club ski and golf community before the club's bankruptcy, will have to step behind other creditors, after a judge ruled the loan "predatory".

"The only plausible explanation for Credit Suisse's actions is that it was simply driven by the fees it was extracting from the loans it was selling, and letting the chips fall where they may," wrote U.S. Bankruptcy Judge Ralph Kirscher in a preliminary ruling entered on Tuesday.

Credit Suisse lent the money to the club without requesting audited financial statements from Yellowstone Club, among other "curious" decisions, said the judge. The firm received fees of $7.5 million.

"We are disappointed in this ruling and disagree with the court's findings," said Credit Suisse spokesman Duncan King. "We are weighing our options at this time." King declined to comment further.

Credit Suisse has a lien of $232 million, which is now subordinated to the debtor-in-possession financing provided by CrossHarbor Capital Partners LLC, as well as the payment of administrative fees, costs of the bankruptcy and the claims of unsecured creditors.

"The only equitable remedy to compensate for Credit Suisse's overreaching and predatory lending practices in this instance is to subordinate Credit Suisse's first lien position to that of CrossHarbor's super-priority debtor-in-possession financing and to subordinate such lien to that of the allowed claims of unsecured creditors," wrote Judge Kirscher.

Here come the lawsuits

It appears the 60 million dollar Goldman settlement in Massachusetts has the potential to create a windfall of lawsuits by states against the large banks. I causally read this article a few days ago, but didn't really think about the implications of what had taken place. Bruce Krasting had an interesting post on the article:

This means next to nothing for Goldman Sachs. However, a very dangerous precedent has been set. In the critical years 2005-2007 Goldman was ranked 15th in the League Tables for sub prime and Alt-A origination/securitization. Goldman’s management must be pleased as punch with that poor showing today. Those that ranked high on that list are no doubt consulting with their attorneys. 

If Goldman gets its hand slapped for $60mm over 714 mortgages what does this mean for Countrywide Financial? They were very big in Boston. Merrill Lynch was at the top of those securitization tables. That is what got Stan O’Neal fired. If the settlement in Boston is representative of what will be forthcoming then Bank of America is going to be facing a very big number. And that is just Massachusetts. The AGs in the all of the other states, especially Florida, Nevada, Arizona and California must be licking their chops at this news.

This is lining up badly for the banks. The States are broke. They will see this as a source of revenue. Politicians will also like it. They will be able to claim that they are helping their constituents. Word on this will spread quickly from borrower to borrower. Every one of them will be looking for a break.

The settlement makes an important distinction between first and second mortgages. The rights of the second mortgages are clearly subordinated in the deal. This is how a bankruptcy court would treat the two classes of debt. This provides a clue on how these ‘seconds’ will be treated in the future. 

One of the largest sources of these second mortgages is the Mortgage Insurance Industry. They provide a guaranty of payment on the first loss of 20%. This product competed with the second mortgage industry. It created the same result for the borrower, the ability to buy a home with no money down. Precisely what Goldman is paying up for. In this case what quacks, walks and swims like a duck is likely to be treated like a duck.

Fannie Mae and Freddie Mac hold tens of billions of these insured or ‘enhanced’ mortgages. FHFA recently reported that the Agencies collectively held or guaranteed 30.2 million mortgages. Of that amount 16%, or 4.8 million are identified as “Non Prime”. Put differently, the Agencies hold 6,000 times more non-prime mortgages then Goldman originated in Boston.

The Great Government Momentum Trade

"Its a crazy, positive momentum based on zero fundamental improvement, zero fundamental improvement" - M. Whitney

Another Reason Why I am glad I am not French

They think cows are good long term investments. On second thought, maybe they are onto something here. From the NYT:

For Pierre Marguerit, 60, cows make a safe, secure investment, allowing for long-term growth from a renewable resource. The cow contracts are hardly new, but go back to Richard the Lionheart; the French word for livestock, “cheptel,” is the root for “capital.”

These are not exactly cash cows. But investment in Mr. Marguerit’s Holsteins will bring a 4 to 5 percent return a year after taxes, he said, based on “natural growth” — the sale of their offspring. That compares to an interest rate now of 0.75 percent on the basic French bank account.

Last year, his business went up by 40 percent, and so far this year, it has “practically doubled ,” said Mr. Marguerit, the managing director of Élevage et Patrimoine, a cattle investment firm in this part of eastern France, near the Alps, and president of Gestel, which works with farmers and investors.

The supposed 4% to 5% percent sounds great (especially after taxes, its more like 10%, and in socialist France, maybe even higher) until another mad cow disease comes along. In the US this trade may be even more attractive though because of our agricultural subsidies.

“People have saved money and don’t want to waste it,” he said. “Stocks have fallen a lot, and people see it. We need somewhere to put our money for a long-term investment, something more stable.”

At the moment, there are about 37,000 cows under contract in France at some 880 farms, according to theFrench Association for Investment in Cattle. But the potential market is huge, Mr. Marguerit insists, perhaps as many as one million head in France and six million in Europe as a whole.

A typical couple will buy 10 to 20 dairy cows for about $1,700 each and can decide to sell the offspring each year or keep them as additional “capital.”

“At this difficult time, it’s a much better investment than real estate and much more tangible than the stock market,” Mr. Marguerit said. He then proceeded to praise the new interest “in natural, organic and lasting things” among the French, who have always romanticized the countryside and imagined themselves shrewd peasants at heart. “This is part of the patrimony,” he said.

In the steep financial crash, “we’re having a moment of realization — we’re landing hard and people are asking real questions.” Diversify into cows? Why not?

Interesting Article On Company Balance Sheets

There was an interesting article I found in last weeks Economist talking about company balance sheets.  One of the interesting points it mentioned was how highly leveraged many smaller companies are in the United States, while the largest list firms have very little debt:

Yet the data reveal a striking oddity: the largest listed firms have disproportionately little debt compared with both smaller listed peers (see bottom chart) and private firms. Of America’s ten biggest non-financial firms, no fewer than six, including Microsoft and ExxonMobil, reported net cash positions at the end of 2008. Different accounting conventions make comparisons inexact, but non-financial firms in the S&P 500 index of listed American companies appear to account for only about a third of national corporate net debt, despite contributing a majority of profits. In Europe, with its tradition of bank financing, firms have always been keener on debt, but although overall corporate gearing has risen to “unprecedented” levels, according to the European Central Bank, listed firms have actually steadily cut theirs since 2000.

To grasp why big listed firms are different requires a bit of theory and some history. In theory, chief financial officers spend idle moments admiring charts of the idealised firm’s optimal capital structure. From this they are meant to conclude that debt is only moderately attractive. Since interest payments are tax deductible, but dividends are not, some borrowing makes a balance-sheet more efficient. Too much, though, makes a firm too risky, raising its overall cost of capital. It is a fine trade-off, which at most should add 10-20% to a firm’s overall value.

In the real world, however, many managers burnt their textbooks long ago and steadily increased their firms’ leverage, taking only the occasional breather in tricky economic patches such as the 1970s and early 1990s. This partly reflects their pay, which is often based on measures (such as earnings per share) that are flattered by higher gearing, giving them an incentive to take on more debt than is justified by mere tax planning. More demanding owners and abnormally low interest rates also led firms to take on more risk.

Also interesting but yet still important is how the article talks about how financial deregulation, and the large number of new innovative products that came along with it allowed many of these companies to stay afloat:

Financial deregulation, too, has played a big role, notes Jeffrey Palma, a strategist at UBS. A series of new debt products enabled even the leakiest corporate balance-sheet structures to stay afloat—for a while. In the 1980s junk bonds opened up credit markets for lower profile firms. In the most recent boom, companies bought by private-equity outfits, the corporate equivalent of subprime borrowers, packaged their debt into collateralised loan obligations, a form of structured credit that is now as toxic as it is hard to explain. The rash of leveraged buy-outs may account for as much as half of the rise in American corporate net debt since 2002.

Lo and behold their prediction of the future was: companies will be more risk-adverse and avoid carrying as much debt:

All this is likely to change the debate on corporate leverage in two ways. First, the gung-ho and largely erroneous assumption that higher debt means higher risk-adjusted returns will be replaced with a more measured assessment of the limited boost to tax efficiency that leverage can provide. One banker in London suggests that for the next few years, managers will be prepared to take on more debt only to the point where they are sure that they can refinance it if another crisis should strike. That suggests that quoted firms could further reduce their net debt from today’s level of about 50% of their book equity.

Second, the psychological scars will run deep for the private firms that bear a disproportionate burden of overall corporate debt. Many face bankruptcy, with the destruction of value that entails. Financial regulators, too, are far less likely to tolerate the sort of capital-market fads that allowed private companies to overload on debt at the top of the economic cycle and infect the banking system as they did so. It used to be that equity, as well as lunch, was for wimps. Not any more.

Bernanke Is A Douche Bag

He reminds me of a parrot reading that monitor ....

The Confidence Game

Back in the early 1900, the renown economist Irving Fisher lost the equivalent of 10o million USD in the crash of 1929. He is also famous for his theory of debt deflation. Almost 100 years later, is there anything we can learn for Fisher? Steve Keen thinks so:

Fisher’s confidence led him to hang on to his margin-financed stocks (worth over $100 million in 2000-dollar terms). Despite his confidence, the stock market continued its plunge from its peak of 31.3 in July 1929 to the nadir of 4.77 in May of 1932, while unemployment rose from zero to 25 percent. Fisher was wiped out financially, and left to ponder how he could have got the behaviour of the market, and the economy, so badly wrong.

Three years later, he reached the conclusion that he had been misled by two core elements of the neoclassical theory he had helped build: the beliefs that the economy was always in equilibrium, and that the debt commitments borrowers had entered into to purchase financial assets were based on correct forecasts of future economic prospects.

On equilibrium, he reasoned, even if it were true that the economy tended towards equilibrium, random events alone would ensure that all economic variables were either above or below their equilibrium levels. Therefore economic theory had to be about disequilibrium rather than equilibrium:

“Theoretically there may be— in fact, at most times there must be—  over- or under-production, over- or under-consumption, over- or under spending, over- or under-saving, over- or under-investment, and over or under everything else. It is as absurd to assume that, for any long period of time, the variables in the economic organization, or any part of them, will “ stay put,”  in perfect equilibrium, as to assume that the Atlantic Ocean can ever be without a wave.” (Fisher 1933)

This realisation in turn put paid to any notion that today’s debt commitments were based on an accurate prediction of tomorrow’s economic outcomes. Instead, he identified over-indebtedness as one of the two key causes of Great Depression:

“two dominant factors [are ...] over-indebtedness to start with and deflation following soon after… these two economic maladies, the debt disease and the price-level disease, are, in the great booms and depressions, more important causes than all others put together.

Thus over-investment and over-speculation are often important; but they would have far less serious results were they not conducted with borrowed money. That is, over-indebtedness may lend importance to over-investment or to over-speculation.

The same is true as to over-confidence. I fancy that over-confidence seldom does any great harm except when, as, and if, it beguiles its victims into debt.” (Fisher 1933)

One would hope that economic theory had learnt from the Great Depression, and in particular from Fisher’s insights. Unfortunately, economics was eager to unlearn these lessons, because the very phenomenon of a Depression was anathema to a profession that had always sought to eulogise the market economy, rather than to understand it. Equilibrium came back again in the guise of the “Neoclassical-Keynesian synthesis” in the 1950s. By the 1990s, all vestiges of Keynes had been thrown away–and nothing of Fisher had been even assimilated in the first place (skerricks of his thought are percolating through now though: see The Economist for a pretty good overview of Fisher).

Today, macroeconomic models like TRYM (the TReasurY Macroeconomic model that is used to prepare the Australian Federal Budget) presume that the economy tends towards a “long run equilibrium”. The apparent dynamics such models display are simply the convergence of the model from an initial starting point to the assumed long run equilibrium.

For example, the figure below shows the TRYM model’s predictions for unemployment from March 1995 till March 2010 (Figure 10: Dynamic Adjustment towards Steady State - Unemployment; Modelling Section, Macroeconomic Analysis Branch, Commonwealth Treasury, The Macroeconomics Of The Trym Model Of The Australian Economy,  Commonwealth of Australia 1996). The model “predicted” that unemployment would fall from around 9 percent in 1995 to just below 7 percent in 2010, simply on the basis that unemployment was assumed to converge to an a long run equilibrium rate of 7 percent over time (the actual level fell well below this, and the  assumed equilibrium unemployment rate–the “NAIRU”–was therefore later reduced to 5.25 percent).

Virtually everyone knows Keynes’s quip that “in the long run we are all dead”. Yet very few realise that Keynes’s target was precisely this approach to economic modelling–of assuming that the economy would simply tend to return to equilibrium after any disturbance:

“ But this long run is a misleading guide to current affairs. In the long run we are all dead. Economists set themselves too easy, too useless a task if in tempestuous seasons they can only tell us that when the storm is long past the ocean is flat again.”   (Keynes, 1923)

Hobbled by this naive belief in equilibrium, the economics profession was as unprepared for today’s crisis as it had been for the Great Depression. Now that the crisis is well and truly with us, all conventional “neoclassical” economists can offer is the hope that the crisis can be overcome by a good, strong dose of confidence.

From Fisher’s point of view, such a belief is futile. In an economy with an excessive level of debt and low inflation, he argued that confidence was irrelevant–and in fact dangerously misleading, as he knew from painful personal experience. Given over-indebtedness and low levels of inflation, a “chain reaction” would occur in which: 

“(1) Debt liquidation leads to distress selling and to

(2) Contraction of deposit currency, as bank loans are paid off, and to a slowing down of velocity of circulation. This contraction of deposits and of their velocity, precipitated by distress selling, causes

(3) A fall in the level of prices, in other words, a swelling of the dollar. Assuming, as above stated, that this fall of prices is not interfered with by reflation or otherwise, there must be

(4) A still greater fall in the net worths of business, precipitating bankruptcies and

(5) A like fall in profits, which in a “ capitalistic,”  that is, a private-profit society, leads the concerns which are running at a loss to make

(6) A reduction in output, in trade and in employment of labor. These losses, bankruptcies, and unemployment, lead to

(7) Pessimism and loss of confidence, which in turn lead to

(8) Hoardinq and slowing down still more the velocity of circulation.The above eight changes cause

(9) Complicated disturbances in the rates of interest, in particular, a fall in the nominal, or money, rates and a rise in the real, or commodity, rates of interest.” (Fisher 1933; The Debt Deflation Theory of Great Depressions)

What will finance look like after the global financial crisis?

Satyajit Das,  author of the Traders, Guns, and Money has made his prediction:

Das seems to be echoing the common themes here: giant trade imbalances (China/USA), deregulation (financial and telecomm), cheap labor from the emerging markets, and low inflation with debt induced consumption:

Recent global prosperity derived from a fortunate confluence of low inflation and low interest rates. In the 1980s, brutally high interest rates and recessions squeezed inflation out of the economy facilitating lower interest rates. Low energy prices, following the first Gulf War, helped keep inflation low and fuelled growth.

The fall of the Berlin Wall in 1989 and the reintegration of the command economies of Eastern Europe, China and India into global trade provided low cost labour helping maintain the supply of cheap goods and services. Emerging economies provided substantial new markets for products and capital driven by the very high levels of savings in these countries.

Deregulation of key industries, such as banking and telecommunications, fostered growth by increasing access to finance and improved essential infrastructure. Adoption of new technologies, such as information technology and the Internet, improved productivity and assisted growth, though the extent is disputed.

Many countries switched from employer or government pension schemes to private retirement saving arrangements underwritten by generous tax incentives. Rapid growth in this pool of investment capital was also a factor in growth.

Governments, irrespective of political persuasion, benefited from the favourable economic environment. The ability of governments and central banks to control and "fine tune" the economy with a judicial mixture of monetary and fiscal policy became an article of accepted faith. Voters were lulled into false confidence by a mixture of rising wealth, improved living standards and stability.

Elegant theories about the "Great Moderation" or "Goldilocks Economy", with the benefit of hindsight, seem to be little more than narrative fallacies where a convincing but meaningless story is shaped to fit unconnected facts and coincidence is confused with causality.

Das is supposedly a derivatives expert, and I find it to be interesting that he is sitting here saying that "financial innovation" is really a misnomer, and that all they really do all day is change a product a bit (usually making it more unstable), and then market it and make fees.

First came the Mortgage-Backed securities, then came the CDO, then came the credit default swap, etc .... I guess he may have a point

"Financial engineering" replaced "real engineering" in many countries. Entire cities (London and New York) and economies (Iceland) become dominated by the rapidly growing financial services industry. In the US, financial services’ share of total corporate profits increased from 10% in the early 1980s to 40% in 2007. The stockmarket value of financial services firms increased from 6% in the early 1980s to 23% in 2007.

The reliance on financial innovation proved disastrous. In A Short History of Financial Euphoria (1994), John Kenneth Galbraith noted that: "Financial operations do not lend themselves to innovation. What is recurrently so described and celebrated is, without exception, a small variation on an established design . . . The world of finance hails the invention of the wheel over and over again, often in a slightly more unstable version."

Financially engineered growth extended into international trade flows. Since the 1990s, there has been a substantial build-up of foreign reserves in central banks of emerging markets and developing countries that became the foundation for a trade finance scheme.

Many global currencies were pegged to the dollar at an artificially low rate, like the Chinese Renminbi, to maintain export competitiveness. This created an outflow of dollars (via the trade deficit driven by excess US demand for imports based on an overvalued dollar). Foreign central bankers purchased US debt with dollars to mitigate upward pressure on their domestic currency. The recycled dollars flowed back to the US to finance the spending on imports.

The process relied on the historically unimpeachable credit quality of the USA and large, liquid markets in dollars and dollar investments capable of accommodating the very large investment requirements. This merry-go-round kept US interest rates and cost of capital low encouraging further borrowing to finance consumption and imports to keep the cycle going.

Foreign central banks holding reserves were lending the funds used to purchase goods from the country. The exporting nations never got paid at least until the loan to the buyer (the vendor finance) was paid off. Essentially, growth in global trade was also debt fueled.

And the solution to our problems are: de-leverage and reduce debt overall. Ironically, Obama and Geithner are just fighting de-leveraging with more debt. This is one of the reasons I am pessimistic about the recovery.

The initial phase of the cure is the reduction in debt within the financial system. Some of the debt created during the Ponzi prosperity years will not be repaid. Non-repayment of this debt, in turn, has caused the failure of financial institutions. The process destroys both existing debt and also limits the capacity for further credit creation by financial institutions.

Total losses from the GFC to financial institutions, according the latest estimates, will be in excess of US$ 2 trillion. Banks need additional capital to cover assets that were parked in the "shadow banking system" (the complex of off-balance sheet special purpose vehicles) but are now returning to the mother ship’s balance sheet. The global banking system, in aggregate, is close to technically insolvent.

Commercial sources for recapitalisation are limited as losses mount and the outlook for the financial services industry has deteriorated. Government ownership or de facto nationalisation is the only option to maintain a viable banking system in many countries.

Even after recapitalisation the capital shortfall in the global banking system is likely to be around US$ 1-3 trillion. This equates to a forced contraction in global credit of around 20-30% from existing levels.

The second phase of the cure is the effect on the real economy. The problems of the financial sector have increased the cost and reduced availability of debt to borrowers for legitimate business purposes. The scarcity of capital means that banks must reduce their balance sheets by reducing their stock of loans. Normal financing and loans are now being effectively rationed in global markets.

This forces corporations to reduce leverage by cutting costs, selling assets, reducing investment and raising equity. This also forces consumers to reduce debt by selling assets (where available) and reducing consumption.

"Negative feedback loops" mean reduction in investment and consumption lowers economic activity, placing stresses on corporations and individuals setting off bankruptcies that trigger losses for the financial system that further reduces lending capacity. De-leveraging continues through these iterations until overall levels of debt reach a sustainable level determined by lower asset prices and cash flows available to service the debt.