Teaching You How to Fish the Markets, Part VII

May 9th, 2013

By Shah Gilani

By the start of the 1960s, banking in America was in a state of flux.

Boundaries were being blurred – especially those separating “commercial banks” and “investment banks” under Depression-era Glass-Steagall parameters. The banking landscape was shifting. In fact, it was about to go volcanic.

The Truman Administration had championed the break-up of bank cartel arrangements, whereby a powerful coterie of commercial-bank bond underwriters controlled how corporations financed debt and who got to distribute bond offerings. Subsequent regulatory changes (requiring bidding for underwriting assignments) broke up the “Gentleman Bankers Code,” which had been code for cartel.

A more competitive landscape drove banks to expand. Branch banking spread through shopping malls and onto prime locations on America’s Main Streets.

The hunt for deposits was on.

And it got ugly fast…

Commercial banks needed more and more deposits to supply funds to rapidly growing corporations. And they wanted to make small business and consumer loans, wherever they could.

Intense banking competition was driving down lending profitability. At the same time, corporations were self-financing themselves through retained earnings and increasingly turning to insurance companies with whom they could directly place their bonds.

Commercial banks were losing their predominant position as providers of capital… while investment banks were growing rapidly.

The investment banks, with insignificant amounts of their own capital, were raising equity capital for corporations and trading blocks of stock accumulating in pension plans, which were mushrooming as a result of 1950s tax law changes and collective bargaining victories by labor unions.

Commercial banks had to grow rapidly to offset declining profit margins in the lending business. And they had to figure out how to compete with more aggressive and more profitable investment banks, as well as their institutional investor clients, who were rapidly becoming suppliers of capital.

So they did.

Under Glass-Steagall, commercial banks were allowed to deal and trade in U.S. Treasury securities, municipal bonds (which were considered safe by virtue of issuers’ taxing authority), and foreign exchange.

Historically, banks didn’t so much trade foreign currencies as they did manage exchanging one currency for another in the spot market and on a “forward” basis. This service, which banks had a monopoly over, facilitated borrowing clients, who were increasingly U.S. multinational corporations, overseas corporations, and foreign governments in need of currency exchange services.

They weren’t supposed to underwrite equity issues, distribute them or trade in them. But they did.

Commercial banks set up trust departments and, in some cases, controlled separate trust banks. The old Bankers Trust, backed by J.P. Morgan’s interests, was a prime example.

Trust departments were “entrusted” with safeguarding client assets. That included equity securities. As securities trading increased, for reasons about to become apparent, banks blatantly circumvented Glass-Steagall prohibitions and actively facilitated trading.

Two seminal events in the 1960s paved a one-way path from traditional banking to casino banking.

First, in 1961, George Moore and Walter Wriston of First National City bank brilliantly sidestepped regulatory prohibitions against banks paying interest to depositors. Their brainchild was the “negotiable certificate of deposit,” simply referred to as CDs.

By structuring a deposit as at least a 30-day “loan” to the bank, interest could be paid to the lender. The word “negotiable” was the magic ticket. Depositors’ CDs and the “liabilities” (deposits) they represented could be traded.

The invention spawned a world-wide hunt for deposits, as banks could raise money virtually anywhere and compete for “hot money” by offering competitive interest rates.

Excess deposits – those that banks couldn’t lend out and those that exceeded regulatory reserve requirements – were traded to other banks in the overnight federal funds (bank to bank) market.

The transition from primarily managing assets (loans) to liabilities (deposits) was almost instantaneous.

Trading floors were built and staffed to speculate on interest rate products. Those instruments, CDs, Treasuries, municipal bonds, and foreign exchange, were all interest rate-based. With the ability to aggressively attract depositor capital – to be used as trading capital – commercial banks embarked upon a hugely profitable new business…

The business of speculation.

Now here’s the second thing that changed.

Commercial banks traditionally offered mergers and acquisition advice, usually as a free service to their bond underwriting clients. But not for long.

Investment banks in the 1960s went on the offensive. To generate mergers and acquisitions fees, they actively put corporations in play. Soliciting takeovers from prospective clients was part of the new mantra of “conglomeratization.”

Putting corporations into play had become easy.

Large blocks of stock were spread among trust banks, held directly by pension plans and in the hands of institutional investors. Investment banks had access to these blocks of securities through their relationships with their institutional clients, as well as having access to stock residing at brokerage affiliates. Commercial banks had access to blocks of stock through their trust departments and brokerage operations they were setting up through the bank holding companies they manufactured to hold commercial bank businesses and separate brokerage businesses that commercial banks, on their own, weren’t allowed to operate.

Because blocks of stock were held for individuals by their pension managers, the institutional managers got to vote the shares in their safekeeping. M&A bankers used their institutional relationships to maneuver voting blocks of stock to their advantage in the new war games.

Seeing their corporate clients under attack and recognizing the pull investment banks were having over fee-paying corporate giants, commercial banks recast their M&A bankers as swashbuckling, fee-generating do-gooders.

Which, of course, they weren’t.

M&A bankers rode roughshod over and corralled thousands of American corporations in the Go-Go 60s – for increasingly larger and larger fees. More than 25,000 businesses were merged, acquired, or “vanished” in the 1960s.

Commercial M&A bankers and investment bankers had forever been transformed into commando-bankers, acting like generals on the ever-widening casino floor.

And this was only the beginning of “transactional banking.”

Events in the 1970s would act like an accelerant, igniting a fire under bankers that would further their power and lead to the implosion of a tiny shopping mall bank in Oklahoma.

That “off the radar” event, in a matter of days, led to the failure of a single money-center bank. Its losses were greater than all the failed banks in the Depression, combined.

Only, it didn’t fail. It was the bank that directly led to the American banking doctrine of too-big-to-fail.

And you know what happened next…


jueves, mayo 09, 2013



05.06.2013 18:47

The Enduring Glow of Gold

A ripple of skepticism recently hit prices of the yellow metal, but gold remains the ultimate hedge on inflation

By Andy Xie

The global economy has already entered into stagflation with a growth rate of 2 percent and inflation at 3 percent. The inflation rate is likely to rise above 4 percent in 18 months while the growth rate will remain stuck in the same range. With inflation twice as high as the growth rate, the global economy will slip deeper into stagflation.

The recent decline in commodity prices does not signal a reversal in the inflationary trend. It is a onetime redistribution of mining income to consumer purchasing power. The prevailing negative real interest rate channels monetary growth above economic growth into inflation wherever there is shortage. Manual labor in emerging economies, skilled labor in the developed economies, agricultural commodities, rent, healthcare, education, etc., are leading the inflationary trend.

Inflation expectations are already a self-reinforcing influence on emerging economies such as India. It will take root in developed economies. When this occurs, the global economy will run into an inflationary crisis as a result of wrong-headed policies used to deal with the financial crisis.

Multinational companies remain the biggest beneficiaries of the current global environment. The macro instabilities give them opportunities to arbitrage the frequent fluctuations in demand and production costs across the globe. The negative real interest rate has boosted their profits significantly, too.

Speculative capital also profits from the mismatch between economic challenges and policy responses. The global economy needs flexibility on the supply side to handle the dislocations from globalization and technology development. The primary policy response so far is the use of monetary stimulus, in the hopes that a demand kick will snowball into a virtuous cycle in each national economy. For the past five years, it hasn't worked to achieve its main objective. But it has created big fluctuations in asset markets, giving speculative capital a golden opportunity to engage in the biggest wealth redistribution in modern history.

Despite its recent setback, gold remains a big beneficiary of the current macro environment. It could make a new high in the current year and rise much higher in 2014. The gold bull market will end when an inflation crisis pushes central bankers around the world to tighten aggressively.

Stagflation is Now

The emerging economies exhibit significant symptoms of stagflation. All major emerging economies are facing significant slowdown. But the attempts to stimulate are checked by inflationary problems. The IMF projects a 5.5 percent GDP growth rate in 2013 for emerging economies. The Q1 data suggests a much weaker year. I see 4 percent for the year. The broadest inflation gauge, the GDP deflator, is likely around 6 percent. Emerging economies are easing monetary policy on the whole, just haltingly to demonstrate some credibility on inflationary concerns. But the easing policy remains the main trend. It is likely that inflation will surpass twice the GDP growth rate.

The U.S. economy grew by 1.7 percent in 2012 with GDP deflator, the broadest inflation gauge, at 2.4 percent. In the first quarter of 2013, it reported a 2.5 percent rate, of which 1 percent came from inventory accumulation, and GDP deflator at 0.9 percent. It appears that the U.S. economy is stuck at a 2 percent growth rate and GDP deflator is slightly higher.

The U.S. economy is experiencing a mild form of stagflation. The high unemployment keeps wage under control. But, shouldn't one be concerned about the significant inflation pressure despite such a weak economy? As a mismatch remains a major force in the U.S. unemployment picture, wage inflation is quite possible in many pockets. Energy and agricultural industries already face such pressures.

Both the IMF and the OECD project a 1.4 percent GDP growth rate for developed economies. The Q1 data suggests that this is just too optimistic. I think 1 percent is more likely. While weak growth is disinflationary, momentum and imported inflation are significant forces. The whole OECD block is likely to be similar to the U.S. with GDP deflator above growth.

At current exchange rates, the OECD block accounts for about two-thirds of the global economy and the emerging economies, one-third. This fact suggests that the global economy will grow at 2 percent with inflation at 3 percent.

Global Policy Paralysis

The latest IMF, World Bank and G20 meetings didn't come out with new ideas. The same people were talking about the same policy prescriptions. Despite the massive stimulus by any measurement so far, the global economy remains stuck. The excuse is that the stimulus should be bigger.

I predicted the 2008 Global Financial Crisis on the debt binge in the West to defend its living standard during a prolonged period of declining competitiveness. After the crisis occurred, I predicted that the global economy was heading toward stagflation, as the policymakers around the world would embrace stimulus, the wrong medicine for what ails the world.

The bubble bursting was supposed to be a wake-up call. But it was interpreted as a cyclical event, like a natural disaster, or just bad financial decisions. In the Anglo-Saxon world, the main response was stimulus to jump-start the economy, believing that the economy was like a car running out of battery power. In the euro zone, the main response was to control debt growth, the so-called austerity.

Neither has worked. However, the policy debate remains stuck as stimulus versus austerity.

Technology and globalization have made jobs and production of goods and even services mobile. But people are still confined within national boundaries. Global competition largely determines one's income. But many expenses like housing, healthcare and education are locally determined. The asymmetry is wreaking havoc for a large share of the population in the developed economies.

The second and equally-important mismatch is in local market flexibility versus global competition. The labor market is not as flexible as markets for goods or services under the best circumstances. Hence, the unemployment rate is higher than that for other factors of production. To protect labor, the OECD economies have built up or tolerated many practices to limit businesses from adjusting labor demand in response to demand fluctuations in goods and services. Such well-intentioned market impediments are running into the brick wall of globalization. A business doesn't need to make things where it sells. Apple is the best example in that regard. So countries have lost control over businesses.

The two mismatches must be solved together. Higher living costs justify labor protection. Unless the big ticket items in living costs reflect global competition, the wages that result from global competition are not living wages. Hence, governments should focus on decreasing living costs and increasing supply side flexibility.

Monetary stimulus magnifies the problem. It inflates non-tradables like healthcare, education and housing, increasing resistance to labor market flexibility. In that regard, the stimulus and austerity approach is still the same. The later doesn't solve the growth problem, pushing the central bank into monetary easing.

Everyone for Themselves

Crisis tends to produce strong leaders, as demonstrated by World War II and 1970s' stagflation. The 2008 crisis did not. It may take another crisis to elevate a generation of leaders with the right medicine for nation states to fit into the world of globalization. Until then, people must survive stagflation as best they can.

The real interest rate is probably minus 2 percent in the world today. It should be in line with the per capita income growth rate or 1 percent. The difference is 3 percent. This environment redistributes wealth from savers to debtors on a scale of over US$ 2 trillion per annum or US$ 55 billion per day. This must be the biggest legal robbery ever in human history. But it is always coded in arcane academic lingos spoken by respected central bankers with impeccable CVs. All that is just packaging; it is robbery nevertheless.

The Fifth Column

The world is composed of sovereign nation states. Today's multinational corporations (MNCs) are really the fifth column of instability. The IT revolution has spawned today's MNCs. They can shift production and sales to anywhere with low costs. They can locate their staff anywhere for doing any job. As commercial organizations, they can of course arbitrage differences across nation states for profits. As nation states have evolved independently, the differences among them are big. Hence, the profit opportunities for MNCs are abundant. When the global crisis hit, the affected countries adopted different policy responses, creating more profit opportunities for MNCs. Despite sluggish global growth the MNCs have reported strong profit growth since the crisis.

Globalization has made most markets global. This increases the stake of winning but also its hurdles. This is why there are virtually no new global companies in the past decade. This factor makes the existing MNCs more valuable. I believe that pension funds should invest most of their money into MNCs.

Not all the MNCs are the same. Big isn't necessarily a guarantee for success. One must have something difficult to duplicate. Brands are the best asset in the world today. Food brands, in particular are well positioned to profit from income growth in emerging economies. Luxury brands, despite their recent setbacks, are also well positioned.

Technology is not a good long term investment in general. In the IT world, sooner or later, someone will come up with something better. In mature industries, however, some technologies are hard to duplicate. Energy, chemical and machinery are better bets.

Financial markets believe that corporate credit shouldn't surpass sovereign debt. Such thinking no longer applies in today's world. A balanced MNDC has revenue evenly spread across the world. Its income volatility is less than a country's tax revenue. MNCs have lower leverage and higher income growth than nation states. I believe that, if one invests in bonds, MNCs are better than government bonds.

A Speculator's Paradise

Whenever growth rate disappoints, demanding more monetary stimulus is always the outcry. A central bank will predictably release dovish statements to satisfy the market. Even though the monetary stimulus, even when it works, takes a long time to kick in, it affects asset markets right away. When countries adopt the same policy – but at a different times – global speculators are presented with fantastic opportunities in all liquidity assets.

Economics is not good at studying speculation. It assumes it's not important. But the speculative capital, when fully leveraged, is probably half of the global GDP. It can magnify volatility to such an extent that mass panic results, changing the equilibrium path for a country of even the world. To some extent, macro policy making is held hostage by global speculative capital.

When you can't beat them, join them. It may not be moral but quite profitable to join the global speculative capital. One can invest in some of the funds or mimic their trading patterns. Monetary policy essentially redistributes wealth from clueless savers to debtors and speculators. You can fight back by joining the dark side.

Gold Still Glitters

The recent sharp decline in gold prices has shaken the confidence of many people. Don't worry. The price of gold has dipped, but will rise to new heights soon. In the long term, gold prices will rise far more than inflation. For the masses, gold is the best inflation hedge. It is the best weapon for the little guy to fight central banks that help a few to rob many.

Yes, gold doesn't bear interest. Many, including Warren Buffett, belittle its investment value. But, paintings or antiques don't bear interest either. When money supply is rising, anything scarce tends to rise in value. Gold is the best scarce commodity in the world. There are more artists that can paint more paintings every day. Eighty percent of the world's gold has already been extracted. The remaining 20 percent will be dug up in the next 20 years. The money supply will grow forever. But the gold supply can grow only by 25 percent and no more.

The income growth in emerging economies will vastly increase with gold demand. When people realize how little gold the world has left, the price will skyrocket. If you don't know how to preserve your wealth in an inflationary environment, you should accumulate gold. When the price comes down, just as it did two weeks ago, just buy more.