Going for Gold in a Dangerous World


Eidesis Capital's Simon Mikhailovich on why physical gold outside the world's banking system is the safe place to be. Understanding the Philadelphia problem.

Simon Mikhailovich knows a thing or two about financial weapons of mass destruction. With a wealth of experience in structured credit, he co-founded Eidesis Capital in 1998 with Michael Sollott, after they completed a buyout of the collateralized-debt-obligation business of St. Paul Travelers.

The new firm focused on distressed CDO investing. Its latest such private equity-style fund, the $180 million Eidesis Special Opportunities III, had a net internal rate of return of 17% from July 2009 through June 2011, when it decided to lock in gains and return most of investors' capital.

Gary Spector for Barron's

"The politicians have no incentive to act...unless faced with some sort of existential threat."

-- Simon Mikhailovich

Mikhailovich, who emigrated to the U.S. from the Soviet Union in 1979 with just $100 in his pocket, issued early warnings in 2007 about the impending collapse of the derivatives market, and the coming financial crisis. Convinced the worst is yet to come, Eidesis, which also is managed by Jim Wang, now invests mostly in gold bullion in various locations around the world outside of the banking system. To understand why, read on.

Barron's: What's your view of the current macro picture?

Mikhailovich: The U.S. has so far succeeded in going slowly to allow an orderly deleveraging of financial assets. But the policy measures—essentially zero interest rates—are like antibiotics. The effectiveness wears off over time, you need to take more and more to achieve less and less, and eventually they stop working. Our concern is that excessive indebtedness around the world is driving governments to try to perpetuate a protracted deleveraging, because short-term deleveraging is very painful. But there are some natural limitations. Interconnectedness in markets—now higher than it has ever been—has been created by disruptive new technologies, which aren't very well understood.

Try us.

One technology is securitization, such as CDOs, where high-risk debt is recharacterized into investment-grade securities. The other is over-the-counter credit derivatives, which are basically grossly under-reserved insurance. When you combine the government policies with the level of interconnectedness in markets, it creates a recipe for disaster.

What are the short-term chances that we see a meltdown comparable to 2008?

Chances are high. Although there's faith in the U.S. and its ability to help Europe navigate this situation financially, the U.S. itself has a big pending problem of the debt ceiling, of automatic tax increases, of the presidential election. There's tremendous uncertainty. Many things have to go right in the short term to delay the eventual resolution, if you will. Based on recent precedent, it's clear the politicians have no incentive to act unless they are faced with some sort of existential threat. A compromise will only delay the problem, because it's a problem of excessive indebtedness and you can't solve a balance-sheet problem without solving it, except by delaying it.

So the risks are greater than 2008?

Yes. The disruptive technologies and government policies have created an extremely highly correlated environment with all financial markets and all financial institutions. The risks were manifest in 2008, but rather than defuse them, government policies have since increased the interconnectedness. Too big to fail is now too bigger to fail. Northern European countries have been trying to figure out how to bail out Southern European countries, which increases their interdependence. The Federal Reserve is opening credit lines to the European Central Bank, and essentially supporting the ECB and providing liquidity to the European banks. Rather than enable a quick but extremely painful deleveraging, Western governments are trying to delay it by borrowing significant amounts to supplement economic activity. Debt increases the risks by increasing the interconnectedness of financial institutions and governments. Correlation is a measure of risk. That poses threats that have never existed before to the stewards of capital.

What can the government do?

My approach is what investors should do to protect themselves from the consequences.

Investors need to examine old ideas about diversification, and to realize that both bonds and stocks have become much more highly correlated than ever. Investors should look for alternative sources of uncorrelated assets or assets whose value is less correlated, as opposed to simply looking at the price of those assets. The hidden cost of deleveraging proceeding without a blowup is that it transfers value from savers to debtors. It creates perverse incentives because it breaks the price mechanism, which is the most important signal in a free-market economy.

We don't know the real cost of misallocation of capital. Meanwhile, people are making valuation decisions based on these bad signals.

Where do you allot assets if you are concerned about correlated risk?

There are two roles of uncorrelated sources of returns, or reserves, in a central banking sense. Reserves are essentially hedges or protections, they're monies or some value that is sitting on the sidelines that can be pressed into service if something happens and you need to rely on these stores of value, for two reasons. One is to protect the value of part of the portfolio, and the other is to have access to liquidity during market disruptions when you can profit by being able to buy when others do not have access to liquidity. We concluded such an asset is physical gold bullion—not paper or derivative instruments—held securely outside the financial system, which is potentially subject to a disruption like we saw in 2008, and geographically diversified to provide access to various markets, where the hope is that at least one or some of them would be liquid. That is a very intelligent way to allocate part of your portfolio to this sort of reserves.

Central banks all have gold reserves, and they've been increasing them. Recently, the Swiss National Bank announced that it holds its reserves in diverse locations around the globe. A spokesman explained that the main reason is to protect against a crisis scenario.

They aren't comfortable storing their assets in their own country?

A cardinal rule of risk management is, don't put all your eggs in one basket. If anybody is an expert in safe-haven assets, it is the Swiss National Bank. The U.S., for example, holds its gold reserves outside the financial system, at Fort Knox and at West Point.

We came up with a vehicle that enables investors to do the same thing. Our specialty is structured credit, and credit derivatives are mispriced because the rates are at zero and are subject to potential significant disruptions. We have just seen an example of that. Despite the fact that JPMorgan Chase was lauded as the most capable risk-management institution, it is facing potentially very large losses.

Their trade wasn't a hedge. It was a very specific bet on a very specific set of outcomes that is not panning out.

Can you imagine another Lehman event?

It's just a matter of time. This financial system is completely unsustainable. The level of interconnectedness, the level of misapplied incentives is again unprecedented in history. If you were offered a game of chance where when you win, you win, and when you lose, you are given another chance to throw the dice, then, of course, everybody would play that game and essentially that is where the financial system is. That isn't capitalism. That creates distortions, misallocation of capital, and mismanagement of risk, and we are seeing it time and time again.

Should the U.S. break up the big banks?

The most important thing for the government to do is admit the truth: that we have all participated in overspending through various means and that our standard of living exceeds our ability to pay for it. As with any emergency, this requires a tremendous amount of leadership.

Before you can solve the problem, you have to admit you have a problem. And it is critically important to restore the confidence of the population in the fact that the system is not rigged.

It's absolutely disgraceful that 2008's consequences haven't been the same as, let's say, savings and loans in the 1990s. Unquestionably, things were done that were illegal in many cases, certainly grossly negligent. By various fiduciary and criminal standards, we should have seen a tremendous number of prosecutions and successful lawsuits. The U.S. system was built on a very simple premise: if you take a chance and succeed, you reap the rewards of your success. If you take a chance and fail, you have to take the consequences of your failure. When you disconnect greed and fear, greed runs rampant.

What's the endgame for the euro?

I don't know; nobody knows. If we step back from everything that is going on in the U.S., and in Greece and Europe, one can say that the endgame ultimately is devaluation of financial assets.

It is almost as if these disruptive financial technologies enabled overproduction of financial assets. They increased productivity and they created oversupply, and that excess supply needs to be liquidated. But the liquidation is what governments don't want to allow. So they are trying to support the prices of goods and services that have been overproduced, which are financials. That is the endgame.

Greece has overproduced credit. There is a huge vulnerability. What about Spain? What about Portugal?

What about Ireland? These are irreconcilable issues, and the only way they can be reconciled is by printing more money for the moment. The ability of governments to sustain the unsustainable ultimately rests on their ability to maintain faith in their creditworthiness, and faith is something that takes a long time to crumble. But once it goes, it can go very quickly. Here is the paradox: Governments are borrowing more and more, and the spreads of government securities are getting tighter and tighter. So the creditworthiness is getting worse and the cost of funding is getting better.

How do you explain it?

Very simple. It is faith. It is muscle memory. It's normalcy bias, a psychological phenomenon that prevents people from seeing unconventional threats. People overestimate their previous experience and they underestimate future experience. But there may come a moment when it doesn't work, and then what's a safe haven? It is gold. It's silver, diamonds, Rembrandts, Picassos, real estate. It's agricultural land. It's the means of production.

But you have to consider the Philadelphia problem. In the movie Trading Places, the hero is trying to sell his very expensive Swiss watch at a pawn shop in Philadelphia, and he is told that in Philadelphia it's worth 50 bucks. The benefit of land and of paintings and other stores of value is that they are not financial assets and they do preserve value over an extended period.

But they are not liquid during times of disruption. You can't get a fair price; they're unique, whereas gold is ubiquitous. It's divisible.

It's measurable. It's testable. There is a global market for it. So you will never have the Philadelphia problem. You may not like the price, but it is never going to be a rip-off.

So, gold is going to rise over time.

The price of gold never rises. It is the value of financial assets that declines. Gold is a store of value. Gold is not an investment.

However, in the current environment, gold can produce tremendous real returns because it's an asset that doesn't produce any cash flow. Its valuation is driven exclusively by supply and demand. In the 10 years through 2010, a study has shown, 80% of physical demand for gold came from emerging markets and only 20% from the developed world, and half of that was for jewelry. Developed markets that are the repositories of most of global financial wealth have had de minimis demand for physical gold. If this devaluation of financial assets proceeds apace and the moment of clarity comes for many investors in the West who realize they need to diversify into assets that can protect against devaluation, demand for physical gold has the potential to rise dramatically.

What about commodities?

It is very difficult to own commodities physically, and therefore you are subject to market disruptions and counterparty risk. MF Global's clients thought they owned commodities. They even thought they owned U.S. Treasuries, and they ended up being paid 70 cents on the dollar for their Treasury holdings. Lehman clients couldn't get full value for assets they didn't think were at risk. They thought they were simply in custody of Lehman Brothers. That raises another problem with financial technology—re-hypothecation—where banks make money by lending out collateral.

Every asset and every dollar that is in custody in a bank, unless specific legal arrangements are made, is re-lent, and as we saw with MF Global and with Lehman, ultimately it is the customer or the investor who bears the counterparty risk.

Do you have any of your money in a bank?

Of course. But I try to diversify. This isn't about the end of the world. Armageddon is a physical end of the world, financial disruption is financial disruption. Many countries have gone through financial disruptions and had their currencies devalued and had all sorts of economic problems, even in the last 20 years. Russia, Argentina, Brazil—it didn't extinguish life in those countries.

But you're talking about a greater correlation between the financial system and these financial weapons of mass destruction.

They destroy money, not lives. Human history ultimately is the history of ebbs and flows of wealth, and the ability to preserve wealth over time requires a very proactive approach. Secular changes that disrupt technologies are traditionally very, very difficult, and many will lose. But some people will win. Tremendous wealth was created during the Great Depression.

The idea is to position oneself to survive financially and potentially enhance one's position.

Copyright 2011 Dow Jones & Company, Inc. All Rights Reserved

Bulls: Nothing Can Stop Us

funny animated GIF 

To my thinking once again, the best bulls can do is take us back to the ugly and unproductive trading range of 2015 & early 2016. Savant, I am not. I adhere to the philosophy of economist Edgar Fielder who stated: “If you must forecast, forecast often”.

There is no economic data or earnings to suggest happy days are here again. The only policy the Fed knows is one is to keep printing more money giving corporations the ability for borrow on the cheap and buy shares back in the open market. That creates a lower amount of float stimulating share prices to rise to the betterment of shareholders. While all shareholders benefit in the short-term, those with lucrative stock options benefit the most. This, in many ways, has created the wealth inequality we here so much about.

However, at the same time, this buyback activity robs investors of long term growth as corporate investing for the long-term growth disappears.

So stock markets rose again with the duo of cheap money and no interest rate hikes in the near future gold. Gold and weaker interest rates assured allowed the dollar to fall and commodities overall to rise. Janet probably knew these low interest rate policies meant this would be the outcome.

(I’m still having some issues with writing affecting my hands, please bear with me.)

3-17-2016 2-40-25 PM

Volume pretty much matched yesterday’s level and breadth per the WSJ was positive.

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3-17-2016 2-41-10 PM 
12-17-2015 9-04-44 PM Chart of the Day

Charts of the Day
















    The NYMO is a market breadth indicator that is based on the difference between the number of advancing and declining issues on the NYSE. When readings are +60/-60 markets are extended short-term.


    The McClellan Summation Index is a long-term version of the McClellan Oscillator. It is a market breadth indicator, and interpretation is similar to that of the McClellan Oscillator, except that it is more suited to major trends. I believe readings of +1000/-1000 reveal markets as much extended.


    The VIX is a widely used measure of market risk and is often referred to as the "investor fear gauge". Our own interpretation has changed due to a variety of new factors including HFTs, new VIX linked ETPs and a multitude of new products to leverage trading and change or obscure prior VIX relevance.

Consumer Sentiment Friday may show good readings since it more weighted by stock prices than its rival Consumer Confidence.

Then there’s the  all-important quad-witching which can have an effect, especially on volume.

Let’s see what happens.

The Roots of Trump’s Strength

George Friedman
Editor, This Week in Geopolitics

Donald Trump appears likely to be the Republican candidate for president. This does not mean that he will become president, but it does mean that he might. It also means that the basic dynamic of the American political system has shifted, suggesting the behavior of the United States might change. And that makes Trump a matter of geopolitical interest.

These geopolitical consequences cannot be considered until we have looked at how and why Trump differs from other candidates and why he has emerged as a political power.

Let’s begin with a criticism that has generally been made of him. His supporters tend to be less educated, less well-off, and white. This has become a central, disaffected class in the United States, and while focus has been on other groups, Trump has spoken to this one. He has addressed their economic and cultural interests, and no candidate has done that in a long time. 

This strategy is what has made him effective. Yet it also poses a challenge, as this class by itself isn’t large enough to give him the presidency. And it generates an almost unanswerable question: Did Trump plan this strategy or did it just happen? But let’s begin with why poorer, less educated white voters have flocked to him.

The Invisible Man—The White Lower-Middle Class

In the United States, the median household income is about $51,000. In California, a state with high taxes, the take-home pay would be about $39,000 a year. That translates into about $3,250 a month in take-home pay for living expenses. If we assume that a home in an inexpensive suburb, a car, and some limited annual vacation is what we mean by middle class life, it is hard to see how the middle class affords that life today.

The fourth quintile, the heart of lower-middle class, earns about $31,000 a year before taxes per household. I grew up in a lower-middle class household (my father was a printer, my mother a homemaker, and there were two children). We owned a house and a car and took a vacation.

Today, people in the lower-middle class are bringing home, at best, $2,000 a month, and they will not own a house but instead pay $1,200 a month to rent an apartment, with the rest going to food and other basics. The lower-middle class can no longer afford what used to be a lower-middle class life.

The Democrats have made a huge case about inequality, assuming that the problem is that the rich own too much. American political culture has rarely been triggered by inequality, but by the inability to acquire the basics of American life. The problem with the Republicans is that they have not noticed that the defining issue of this generation is the collapse in the standard of living of the middle and lower-middle classes. This is part of what brought Trump to where he is today, but only part.

The deeper problem was the perception of the white segment of the lower-middle class that their problems were invisible. They heard talk about African-Americans or Hispanics and the need to integrate them into society. However, from the white lower-middle class perspective, there appeared to be little interest in the challenges facing their demographic. Indeed, there was a perception that the upper strata and the media not only didn’t care about them, but had contempt for their beliefs.

The white lower-middle class is divided into two parts. One part has already been shattered by economic pressures, family fragmentation, drugs, and other forces. Another part is under equal economic pressure but has not yet fragmented. It retains values such as religiosity, traditional sexual mores, intense work ethic, and so on.

This is the class that has been deemed pathological by the media and the upper classes. Its opposition to homosexuality, gay marriage, abortion, promiscuity, and the rest (which was the social norm a generation ago) is now treated as a problem that needs to be overcome, rather than the core of a decent society.
The speed of the shift in the values of dominant classes has left this class in a position where those values taught at home and at church are now regarded by the broader society as despicable. Repercussions are bound to happen.

The simultaneous economic disaster and delegitimation of their values marginalized this class. When Mitt Romney referred to the 47% who were parasites in our society, he was referring to these people. When Barack Obama was elected, this group felt that the focus had shifted to the black community and saw itself as invisible (and to the extent seen, contemptible). Economic, social, and cultural evolutions had bypassed them.

Their perception of the political system has become intensely cynical. They see the political elite, bankers, lawyers, and lobbyists as a near criminal and entirely incompetent class. We speak of unemployment after the 2008 recession in terms of numbers. These are the people who were unemployed. They view this elite as claiming rights they haven’t earned. The lower-middle class can tolerate earned wealth, and even respect it, but cannot accept what they see as manipulated wealth and power.

They also see politicians as being dishonest in other ways: saying whatever they need to say in order to be elected. This is not a new view of politics.
However, in this case, what the politicians have said is neither in the language of the white lower-middle class, nor does it address any of their issues. It is not only indifference to the economic problems of the white middle and lower-middle class, but obeisance to a political correctness that delegitimized their values. The politicians are implicitly and explicitly rejecting lower-middle class values.

The Champion of the White Lower-Middle Class

Enter Trump. He is rich, but he is perceived, rightly or wrongly, to have earned his wealth—not stolen it through financial trickery. That was one of Trump’s first assertions. The fact that he is a billionaire has helped, not hurt him. The Democratic fantasy of class jealousy doesn’t work where Trump is concerned. The lower-middle class admires his wealth.

Trump spoke against Mexican immigrants (and implicitly a broader grouping of Hispanics). He is not seen as having his statements vetted by marketing people. And he says things the way his supporters would say things. Trump made it clear that he heard their cultural concerns. Even his debating style—pugnacious, insulting, unapologetic and frequently preposterously wrong—is not fundamentally different from the lower-middle class style of arguing.

It is the very lack of polish that endears him to his followers (and makes him seem like a man from outer space to the upper-middle class). His occasional cursing and threats are part of the entire package. Trump maneuvered himself into the position of a man who, though he may be rich, thinks and feels like the lower-middle class. More important, he shows that they are not invisible to him—not because he speaks to them, but because he speaks like them.

The fact that Trump had never run for office is also a powerful factor in his favor. To this group, the political class is the problem, not the solution. The Republican establishment did not grasp that a career politician groomed to run for president has become anathema to this class.

That Trump was successful as a builder also helped him. The claim that he built things is essential to a class who sees construction as real business… and hedge funds as legalized fraud. The bottom half of society is hurting, and Trump is not seen as one of those who helped bring the pain, as Romney of Bain Capital was seen.

And Trump is perceived as a tough guy, who is willing to lie, insult, or threaten to get his way. From the lower-middle class point of view, nothing else will get them the solutions they need. The very idea that he might get the Mexicans to pay for a wall or tell the Chinese a thing or two might not be practical. But the thought that he would deal this way with the two nations they see as responsible for their misery is overwhelmingly seductive.

Finally, and in some ways most important, he says the things they all think but are no longer permitted to say. When he accused Fox News anchorwoman Megyn Kelly, implicitly, of being offensive because she was having her period, observers thought the world would end. For the white lower-middle class, this was a common assertion.

When Trump claimed that John McCain was not a hero just because he had been taken prisoner, he was speaking to the class who has served in the military going back to Vietnam… and never been called a hero for it. Observers thought Trump had destroyed himself. To many of these voters, McCain had carried his burden, but many knew men who had chosen to die for their buddies. Nothing taken away from McCain, they’d say, but let me tell you about a real hero. For the lower-middle class, McCain had done his duty and endured great hardship… but their definition of a hero was more demanding. They were not appalled by what Trump had said.

This is Trump’s strength. It is also his weakness.

Can Trump Win?

The Republican Party is complex. It is more than a party of the wealthy. It is also the party of lower-middle class whites who reject the current cultural tendencies that have marginalized them. Trump got the marginalized white lower-middle and middle class out over cultural issues. But it is difficult to see how this translates into the presidency. This class is not large enough to give him a victory, and his running will energize his opponents to go to the polls.

The culture wars have been won in the Democratic Party, so there are few voters to win over on that basis. Any Democratic candidate will counter Trump on the economic issue. And those in the Republican upper-middle class are no friends of the Republican lower-middle class. It is not clear how he bridges the gap.

I don’t think Trump can win the presidency. But he has revealed a serious structural weakness in the American polity. As Americans who earn below the median income are increasingly unable to live the life they could have expected a generation ago, they will join in with resentment against the upper classes.
That resentment will be built around cultural issues, as well as economic ones.

The issue is not the gap between rich and poor, but the fact that the lower-middle class is becoming part of the poor, and the middle class is moving that way as well. As in Europe, the inability of the political and financial elite to see that they are presiding over a social and political volcano will produce more and more exotic alternatives.

When those people who have skills and are prepared to work can’t get a job that will allow their families to live reasonably well, this is a problem. When statistics show that vast numbers of people are entering this condition, this is a crisis.
When there is a crisis, these people will turn to politicians who speak to them and give them hope. What else should they do?

Whether Donald Trump planned this brilliantly or was simply extraordinarily lucky doesn’t matter. He has found the third rail in American society. The lower-middle class doesn’t make enough to live a decent American life, and the middle class is only a little better off. Whether supporting or opposing Trump, it is essential to understand the foundations of his power and its limits. Trump makes no sense until his appeal to the lower-income white demographic is understood.

Reliance on central banks risks more market volatility

An investor walks past a screen showing stock market movements at a stocks firm in Hangzhou, eastern China's Zhejiang province on February 29, 2016. Chinese stocks fell on February 29 on worries over the weaker yuan and disappointment at the vagueness of a weekend pledge by G20 countries to tackle slowing global growth. AFP PHOTO CHINA OUT / AFP / STR (Photo credit should read STR/AFP/Getty Images)©AFP
There is more at stake for markets than enhancing the value of stocks as the global economy fails to achieve lift-off, and governments struggle in transitioning away from over dependence on central Banks.
The availability of liquidity to support the well-functioning of markets, together with the appropriate balance between regulation and efficiency, are also in play. All of which renders the outlook for markets an important component of the overall prospects for economic growth, jobs, inequality and financial stability; and this at a time when popular disillusionment has fuelled the emergence of anti-establishment movements on both side of the Atlantic.

In their meeting in China 10 days ago, G20 officials rightly pointed to mounting risks facing a weakening global economy that, in certain areas, is still burdened with excessive debt. In assessing their collective policy requirements, they emphasised a need to pivot away from prolonged and excessive dependence on unconventional monetary policy and towards a comprehensive deployment of “monetary, fiscal and structural” measures.
Yet, as critical as these recognitions are the G20 did not follow through with strengthened policy formulation and implementation. The meeting’s policy commitments were a rehash of what has been said before; and these have been largely unimplemented, as political polarisation and dysfunction in key countries act as constraints. Moreover, when China acted just hours after the G20 meeting ended to stimulate its slowing economy it again resorted to monetary policy, injecting an extra $106bn of liquidity.
Continued overreliance on monetary policy is likely to deliver even less in sustainable growth while increasing the threat of damaging collateral damage and unintended consequences. As such, it also puts at risk asset prices that, having already been bolstered by significant injections of public and private sector liquidity, are decoupled from fundamentals. Improved economic and corporate fundamentals are needed to validate the existing prices of risk assets, most importantly stocks, and to take them higher.

A macroeconomic pivot towards a more comprehensive policy response is also required to underpin the well-functioning of markets. On more than a couple of occasions in the past few years, including the May 2013 “taper tantrum” and the more recent concerns with China’s economic wellbeing, the availability of market liquidity has proven insufficient to allow orderly portfolio repositioning. And this has accentuated a more general increase in realised volatility in many market segments.
These days, even small changes to market paradigms cause outsized price moves, contagion, and unsettling correlations among asset classes. The phenomenon is accentuated by today’s lack of “patient capital”, be it investments from sovereign wealth funds or long-term institutional investors in both Europe and the US that were previously able and willing to act counter-cyclically. In such circumstances, broker-dealers are even less inclined to step in, fearing a backlash both from regulators and their shareholders with shorter-term horizons.

The threat of such market instability also assumes another regulatory dimension now that important components of risk-taking have morphed and migrated outside the banking sector.

As such, it could well encourage additional regulatory interest in non-banks and much greater disclosure requirements, be they asset managers, hedge funds or the rapidly growing “fintech” sector.

All this sets up the possibility of a disconcerting cycle of spillovers and spillbacks. Should this materialise, global economic weakness and too-partial a policy response would place renewed pressured on asset prices. Combined with the possibility of market malfunctions and increasing regulation, this would spill back on to economic activity via less robust consumption, more difficult financial intermediation and muted corporate investments.

Without better economic and corporate fundamentals validating existing market prices and providing them with a stronger anchor, the global economy will find itself at much greater risk of contamination from more volatile and occasionally malfunctioning financial markets. The result would be the increased threat of an even deeper downturn in growth that would fuel inequality, add to popular dissatisfaction with the political process and render a sustainable recovery even harder to deliver.

Mohamed El-Erian is chief economic adviser to Allianz and author of the book ‘The Only Game in Town’

Deutsche Bank May Lose Key Power to Run Pension Assets

The U.S. Labor Dept. granted a temporary reprieve but could still impose tougher conditions.

By Jack Willoughby             

Regulators from London to Seoul have sanctioned Deutsche Bank for misdeeds committed over the past decade. The accumulation of crimes has now taken on a life of its own, prompting new inquiries based on previous episodes. The U.S. Labor Department, for instance, is considering whether the German bank’s two recent convictions for fraud in foreign countries should cost it the ability to manage billions of dollars of Americans’ retirement funds.

In a ruling that has gone mostly unreported outside of official filings, the department tentatively denied Deutsche Bank’s (ticker: DB) bid for an exemption from possible money-management restrictions. Because two units in other parts of the bank were convicted of felonies, the money management units have faced curbs on running U.S. pension money. At stake is Deutsche Bank’s official status as a qualified professional asset manager, or QPAM.

The QPAM designation allows an asset manager to assume multiple roles in overseeing government-regulated Erisa pension plans, or those covered by the Employee Retirement Income Security Act of 1974. It’s unusual for Labor to deny an application for an exemption, even temporarily.
But Labor has been under pressure to take stronger action against global financial institutions found guilty of felonies. While most observers believe that it’s very unlikely the department would pull Deutsche’s QPAM status, it is expected to set tougher conditions on the bank. This could further complicate the bank’s efforts to reorganize its U.S. banking operation or, if it were so inclined, to sell its U.S. asset-management units. It’s also another headache for shareholders who have seen their stock lose 86% of its value since 2007, with little immediate chance of a turnaround.

“The QPAM exemption is critical for Deutsche Bank to maintain its business in the United States,” says Charles Field, a San Diego-based attorney for Sanford Heisler Kimpel, a law firm that advises money managers. Pension-fund clients, which filings suggest have roughly $50 billion in assets at Deutsche Bank units, would need to find other managers. More broadly, the bank would find it more difficult to provide pension clients and other customers with investment advice, brokerage, custody, lending, and cash-management services. The QPAM designation is a kind of government Good Housekeeping seal of approval, giving a money manager license to offer multiple services without having to get repeated approvals. The loss of it would make pension funds, even those whose money isn’t at Deutsche Bank, reluctant to enter into a transaction with the bank as a counterparty.

A Deutsche Bank spokeswoman said Friday: “We take the concerns in the tentative denial letter very seriously and have been actively engaged with the Department of Labor to address them.”

Deutsche Bank’s money management units had to seek an exemption because an affiliate was convicted of a felony. Without an exemption, the units would be barred from running certain retirement assets for 10 years. Deutsche Bank has sought to show regulators that problems in another part of the bank don’t affect U.S. pension money and that they will fix them. Because big banks are viewed as crucial to the functioning of the world’s financial system, regulators have been reluctant to yank designations such as QPAM.

There are signs, however, that Labor is getting tougher. Last fall, it gave Credit Suisse Group (CS), which had been convicted of conspiring to aid U.S. citizens in tax fraud, a shorter, five-year exemption, forcing the Zurich-based bank to reapply and to undergo more stringent audits and compliance reviews. Prior to its decision, Labor held a rare public hearing on Credit Suisse’s exemption bid, allowing consumer advocate Ralph Nader, among others, to argue that guilty banks shouldn’t be allowed to handle U.S. pension money.

Labor tentatively denied Deutsche Bank’s bid for the 10-year exemption in September. The department said granting it was “not in the interest of affected plans and individual retirement accounts, and not protective of those plans and individual retirement accounts.” The application was necessary due to two factors.

Deutsche’s U.K. unit, and other big banks, were convicted of manipulating the London interbank offered rate, or Libor, a benchmark interest rate; and Deutsche’s Seoul unit was being investigated on allegations of market manipulation.

Instead, Deutsche Bank was given a nine-month exemption that would begin once the Korean case was resolved. In January, a Seoul court found the bank guilty of market manipulation from an incident in November 2010 and sentenced the former head of its equity derivatives trading in Korea to five years in jail.

The executive’s case is under appeal. The bank has to pay a $1.3 million fine and disgorge profits. Although it’s a pittance for a bank with $1.76 trillion in assets, the fine was the highest ever levied on a securities firm in Korea. The bank hasn’t said if it will appeal.
IN GRANTING THE NINE-MONTH exemption, Labor said Deutsche Bank still must show that officers, directors, and employees in its QPAM operations were unaware of or did not receive compensation from the criminal conduct in Korea. Affiliates must develop and implement written policies that assure asset-management decisions are made “independently” of Deutsche Bank. It must also develop training programs, submit to an annual audit, and not impose added fees if clients want to leave.

Although the bank’s lawyers estimated a much smaller $8 billion in U.S. pension assets are directly affected, its QPAM-designated affiliates run larger sums for various clients that could feel some disruption to services. The three main QPAM affiliates seeking exemptions include Deutsche Investment Management Americas, which handles $212 billion, Deutsche Bank Securities, which advises on $5.7 billion, and RREEF America, which runs $30 billion in real estate–related investments, say Securities and Exchange Commission filings.

Federal rules restrict parties “at interest” from handling all of the various activities involved in running pension assets. The QPAM status allows a firm to provide these services without having to prove in each instance that it has no conflicts of interest.

“WHERE ARE THE HEADLINES? I’m really concerned for Deutsche Bank,” says Marcia Wagner, the founder of Wagner Law Group and a pension expert. “The dislocation could create extremely problematic situations, especially when operating as a counterparty and in derivatives markets.”

Deutsche Bank acknowledged the seriousness of the issue in its application. Affiliates would be “effectively eliminated” as asset managers for many Erisa-covered plans and IRAs because “they would be unable to provide the trading efficiencies and breadth of investment choices and potential counterparties” enabled by the QPAM exemption.

The Labor Department issue is part of a cascade of bad news for the bank, whose new co-CEO, John Cryan, has launched a major turnaround effort. Deutsche Bank lost about $7 billion in 2015, when its shares fell 20%. The stock is off 19% this year, more than twice the decline of U.S. financial stocks.

The spreads on its credit default swaps, used by counterparties to insure against a default, have been widening, a worrisome sign. Even at a price-earnings ratio of 12, the shares are unappealing.
Cryan has pledged to simplify the bank’s corporate structure and to streamline products, locations, and legal entities. Deutsche Bank has put about $5 billion in reserves to deal with future litigation—nearly twice that of any other major European bank. It has already settled cases stemming from the financial crisis over mortgage disclosures and is the subject of multiple regulatory inquiries.

In all likelihood, Labor will grant the exemption, but with special audits and compliance guides, as it did with Credit Suisse.

“While the worst-case scenario is unlikely, the gapping out of credit spreads and the softness of DB’s shares manifest real concern in the market” about Labor issues, says Sean Egan, managing director of Egan-Jones Ratings, which tracks corporate credit. “We expect senior management and regulators will be able to address this problem before the franchise is materially restricted.” Oft-burned shareholders can only hope he’s right.

China’s Thirst Threat

Brahma Chellaney

Bottled war cap sealed

HONG KONG – When identifying threats to Himalayan ecosystems, China stands out. For years, the People’s Republic has been engaged in frenzied damming of rivers and unbridled exploitation of mineral wealth on the resource-rich Tibetan Plateau. Now it is ramping up efforts to spur its bottled-water industry – the world’s largest and fastest-growing – to siphon off glacier water in the region.
Nearly three-quarters of the 18,000 high-altitude glaciers in the Great Himalayas are in Tibet, with the rest in India and its immediate neighborhood. The Tibetan glaciers, along with numerous mountain springs and lakes, supply water to Asia’s great rivers, from the Mekong and the Yangtze to the Indus and the Yellow. In fact, the Tibetan Plateau is the starting point of almost all of Asia’s major river systems.
By annexing Tibet, China thus changed Asia’s water map. And it is aiming to change it further, as it builds dams that redirect trans-boundary riparian flows, thereby acquiring significant leverage over downriver countries.
But China is not motivated purely by strategic considerations. With much of the water in its rivers, lakes, and aquifers unfit for human consumption, pristine water has become the new oil for China – a precious and vital resource, the overexploitation of which risks wrecking the natural environment. By encouraging its companies to tap Himalayan glaciers for premium drinking water that can satisfy a public skeptical about the safety of tap water, China is raising the environmental stakes throughout Asia.
Though much of the bottled water currently sold in China comes from other sources – chemically treated tap water or mineral water from other provinces – China seems to think that the bottling of Himalayan glacier water can serve as a new engine of growth, powered by government subsidies. As part of the official “Share Tibet’s Good Water with the World” campaign, China is offering bottlers incentives like tax breaks, low-interest loans, and a tiny extraction fee of just CN¥3 ($0.45) per cubic meter (or 1,000 liters). According to a ten-year plan unveiled by Chinese authorities in Tibet last fall, extraction of glacier water will increase more than 50-fold in just the next four years, including for export.
Some 30 companies have already been awarded licenses to bottle water from Tibet’s ice-capped peaks. Two popular brands in China are Qomolangma Glacier, sourced from a supposedly protected reserve linked to Mount Everest, on the border with Nepal, and 9000 Years, named after the assumed age of its glacial source. A third, Tibet 5100, is so named because it is bottled at a 5,100-meter-high glacial spring in the Nyenchen Tanglha range that feeds the Yarlung Tsangpo (or Brahmaputra River) – the lifeblood of northeastern India and Bangladesh.
Ominously, the Chinese bottled-water industry is sourcing its glacier water mainly from the eastern Himalayas, where accelerated melting of snow and ice fields is already raising concerns in the international scientific community. Glaciers in the western Himalayas, by contrast, are more stable and could be growing. Even the Chinese Academy of Sciences has documented a sharp decrease in the area and mass of eastern Himalayan glaciers.
One of the world’s most bio-diverse but ecologically fragile regions, the Tibetan Plateau is now warming at more than twice the average global rate. Beyond undermining the pivotal role Tibet plays in Asian hydrology and climate, this trend endangers the Tibetan Plateau’s unique bird, mammal, amphibian, reptile, fish, and medicinal-plant species.
Nonetheless, China is not reconsidering its unbridled extraction of Tibet’s resources. On the contrary, since building railways to Tibet – the first was completed in 2006, with an extension opened in 2014 – China’s efforts have gone into overdrive.
Beyond water, Tibet is the world’s top lithium producer; home to China’s largest reserves of several metals, including copper and chromite (used in steel production); and an important source of diamonds, gold, and uranium. In recent years, Chinese-controlled companies have launched a mining frenzy on the plateau that not only damages landscapes sacred to Tibetans, but also is eroding Tibet’s ecology further – including by polluting its precious water.
These are precisely the kinds of actions that caused China’s water crisis in the first place. Instead of learning the lessons of its past mistakes, China is compounding them, forcing a growing number of people and ecosystems to pay the price for its imprudent approach to economic growth.
Indeed, China has implemented no effective safeguards against adverse impacts from intensive water mining. Bottled water is being sourced even from protected reserves where glaciers are already in retreat. Meanwhile, the glacier-siphoning boom is attracting highly polluting ancillary industries, including manufacturers of plastic water bottles.
Make no mistake: Glacier-water mining has major environmental costs in terms of biodiversity loss, impairment of some ecosystem services due to insufficient runoff water, and potential depletion or degradation of glacial springs. Moreover, the process of sourcing, processing, bottling, and transporting glacial water from the Himalayas to Chinese cities thousands of miles away has a very large carbon footprint.
Bottling glacier water is not the right way to quench China’s thirst. A better alternative, both environmentally and economically, would be to boost investment in treatment facilities to make tap water safe in cities. Unfortunately, China seems determined to remain on its current course – an approach that could do irreparable and severe damage to Asia’s environment, economy, and political stability.

Up and Down Wall Street

Global Currency War Gets Some Relief From the Fed

While not Yellen’s explicit aim, a lower dollar helps ease trade tensions during the presidential campaign.

By Randall W. Forsyth                

The Federal Reserve is completely non-partisan. Janet Yellen, the central bank’s chair, unequivocally asserted the Fed’s independence from political influences in her press conference Wednesday.

It also is a fact that the strongest impact of the Federal Open Market Committee’s signal that there are fewer interest-rate increases looming was to push the dollar sharply lower.

It also is a fact that the likely Republican nominee for president and both contenders for the Democratic nomination all have pointed to trade as what’s ailing the U.S. economy and the stagnant incomes of American workers.

In particular, Donald Trump, who remains the likely GOP candidate for the White House, has accused U.S. trading partners of currency manipulation to boost exports at the expense of U.S. jobs and wages. The Democratic front-runner, former Secretary of State Hillary Clinton, has adopted some of the anti-trade rhetoric of her challenger, Sen. Bernie Sanders of Vermont.

I want to be emphatic here: There is no evidence that the Fed has shaped its policy in accordance with politics of this presidential campaign, which is the most fractious in recent memory.

At the same time, the Fed does not operate in some vacuum sealed off from the world, let alone the winds blowing within the Washington Beltway.

In holding its current target for the federal funds rate unchanged at 0.25%-0.50%, and more importantly, by lowering the expectations for further rate hikes, the FOMC’s policy statement referred to “global economic and financial developments” not once but twice.

In its famous so-called Dot Plot graph, which charts the FOMC members’ guesses of where the fed funds rate target will be at the end of 2016, 2017 and beyond, the forecasts for this year-end and next were both lowered by 50 basis points (one-half percentage point), to 0.90% and 1.90%, respectively.

The most immediate and important implication was that the Fed is penciling in two hikes for 2016, instead of the four boosts indicated by the previous Dot Plots published after the December FOMC meeting. The expectations for the latter were bolstered further by Fed Vice Chair Stanley Fischer’s statement a month later that forecasts of four hikes in 2016 were “in the ballpark.” That added to the slide in global commodity, credit and equity markets then underway.

The fed funds futures market never bought the idea and was placing just a 50% probability of a single hike and only then in December while markets were in retreat in January and early February. Those declines effectively acted as a credit tightening, obviating the need for Fed action.

Since then, however, with some better jobs numbers and crude oil’s recovery from its low leading risk markets higher in the past five weeks, fed funds futures had begun to price in the possibility of two rate hikes. A June move was seen as an even-money bet with one-in-three chances of a second hike in December.

Short-term Treasury yields similarly rose with the odds of more Fed hikes. The two-year note, which traded below 70 basis points when the stock, oil and junk-bond markets were in full retreat back in January and early February, jumped to just over 1% ahead of the FOMC announcement Wednesday at 2 PM EDT. After the maturity most acutely attuned to Fed expectations saw its yield plunge an extraordinary 14 basis points by close, to 86 basis points.

Far more importantly, the greenback fell sharply as a result. The U.S. Dollar Index plunged 1%, about twice as much as the U.S. stock market rose in reaction to the Fed’s move.

What’s more, the Fed backed away from more rate hikes just as inflation is picking up. The previous shortfall from the central bank’s 2% inflation target has been a major factor in keeping policy ultra-accommodative—even as the jobless rate has fallen below 5%, which the Fed has deemed full employment or nearly so.

Torsten Slok, chief international economist at Deutsche Bank, wonders in an exchange of emails about the Fed’s apparent worry about the rest of the world when U.S. prices are moving up, which he calls “a significant deviation from their previous view that they would move once inflation was moving toward 2%.”
While the consumer price index fell 0.2% in February, owing to continued declines in fuel prices (which since has that have begun to reverse), the core CPI excluding food and energy rose 0.3%. On a year-on-year basis, core CPI is up 2.3%. To be sure, the Fed tracks a different inflation measure, the personal consumption expenditure deflator, which remains below the Fed’s target. But, Slok points out, the trend is clearly higher in any number of other price gauges.

So, why the continued emphasis on “global economic and financial developments” when U.S. official data show full employment and rising inflation?

Slok observes the U.S. has fared better than other economies owing to the “resilience” of its economy and the flexibility of its labor force. At the same time, the U.S. economy is less shielded from international influences than the numbers imply.

The political season suggests that flexibility is becoming strained. Trade is one of the targets of Americans’ frustration over stagnant or worsening standards of living, thus making an easy target of political candidates.
Arguments in favor of free trade and comparative advantage, voiced by adherents of classical free-market principles going back to David Riccardo, are shouted down by calls for retaliation against other nations.

Donald rails against currency manipulation by U.S. trading partners. Bernie argues against trade pacts he says hurts U.S. workers. Hillary joins in the criticism even though husband Bill’s administration saw the economy soar by backing free trade, achieving a balanced budget and asserting U.S. policy for a strong dollar.

Times are different. A strong dollar now is seen as being on the losing end of a currency war.

None of the presidential contenders want to endorse that.

Rather than escalate that conflict, the Fed’s decision to hold rates steady and suggest fewer increases down the line has the practical effect of not worsening the trade tensions that figure importantly in this most contentious political seasons. It may not have been the FOMC’s explicit intent but that is the effect of its decisión.

Calling an Audible

Jared Dillian
The 10th Man

I had something else planned for The 10th Man today and scrapped it because of the stupendously amazing Fed meeting yesterday.

There are some things we need to talk about—immediately. I’ll save the other piece for another time. I know you’re accustomed to my grandiloquent prose, but today I’m just focused on getting words down. And I’ll have a special announcement at the end.

So let’s review.

First we thought the Fed was going to hike four or five times in 2016.

Then we changed our mind and thought the Fed was not going to hike at all.

Then we changed our mind again and priced in four Fed hikes.

The rates market has been really schizophrenic about this, and the guidance from the Fed has been less than clear.

So going into the FOMC meeting yesterday, a consensus was building that inflation was starting to ramp and the Fed was going to have to address it. Nobody was expecting a rate hike yesterday, but people thought the Fed would be pretty hawkish and maybe start pricing one in soon.

Didn’t happen—it was the most dovish directive I have seen in some time. They explicitly took out two of the four rate hikes, moved down the dots on the dot plot, downgraded their assessment of the economy, and most important of all—expressed little or no concern whatsoever about inflation.

I have seen a handful of sea changes in Fed policy over the years, and this was a big one. This was a Fed that went from being concerned about inflation pressures building to being fairly glib about it. And the market did pretty much what you’d expect in response to a central bank being glib about inflation:

  • Gold went up
  • Emerging markets went up
  • The yield curve steepened dramatically
  • Base metals went up
  • Commodity currencies rallied

In other words, the inflation trade is back and bigger than ever, just like we’ve been talking about here and elsewhere.

This is no small thing. Pretend for a moment that I were credible. I am telling you that there is going to be inflation. How do you prepare?

The first question I would ask is: What percentage of your portfolio is in fixed income?

Let me parse this for a moment. Earlier, I said that the yield curve steepened dramatically yesterday, which means the spread between short-term interest rates and long-term interest rates increased. That is because short-term interest rates are driven by fed funds expectations and long-term interest rates are driven by inflation expectations. Two-year notes rallied hard, ten-year notes less so, and bonds were almost down on the day.

The curve has been flattening pretty steadily for a year now, so a six-basis-point steepening is a big deal.

This might sound like mumbo-jumbo to someone who isn’t all that familiar with the bond market, so let me be succinct: You do not want to hold long-term bonds when inflation expectations start to ramp up. I have a feeling that people are going to find out the meaning of duration.

I have said this before in Street Freak. We are going to look back at negative yields and say, “Yup, that was a bubble.”

It’s a bond market bubble—complete silliness. Holding paper with no or negative yields when inflation is steaming ahead flank speed is unwise, to say the least.

Admit it: the risk-reward ratio here is terrible. What do you think will be the real rate of return, after inflation, on a 30-year bond yielding less than 3%? 30 years is a long time.

If you asked me what the dumbest thing in the market is today, this is it.

All the Evil of This World

I am very pleased and thrilled to announce the publication of my second book: All the Evil of This World.

I believe that this is the first book of its kind: a Wall Street novel of real literary quality. There exists Wall Street fiction, but it tends to be of the financial-thriller genre. And the rest are non-fiction and memoirs. Here is the cover copy, which will tell you what it is about:

There are humans behind the big, bad investment banks. There are humans behind the calculations of Wall Street. There are humans behind the legal and illegal financial manipulations in the news. They’re not always the best humans, and they’re not always the worst humans, but All the Evil of This World tells their stories with abundant curiosity, empathy, and honesty.

On March 2nd, 2000, the technology company 3Com spun off its insanely profitable hand-held computer subsidiary, Palm. It was one of the most high profile, complex, and bungled trades in history, and it’s a story about much more than the millions and millions of dollars that instantly came into play. All the Evil of This World tells it via seven separate voices from seven separate players, including an ambitious low-level clerk fresh out of school, a drug-addicted, party-throwing broker with bad taste and gross amounts of money, and a seemingly infallible hedge fund manager tortured by his own good luck. The 3Com/Palm trade is what weaves their stories together. They all collide into it and out of it, and it sometimes unites them, implodes them, saves them, or destroys them.

It isn’t for the faint of heart—these characters are just as troubled and intense and volatile as their surroundings, and not a single punch is pulled—but it’s an examination into a cast of characters that we rarely examine fairly or patiently, and who we often find it too easy to dehumanize. The people who inhabit this world aren't cartoon heroes or villains—as it turns out, they’re just like us.

There’s no other book that captures how real, how raw the world of trading is.

It’s also an interesting piece of historical fiction, about what the markets were like 16 years ago, when open outcry was at its peak, before technology, before decimalization.

A warning: If you wouldn’t see an NC-17 movie, you might not want to buy this book. It is graphic, jarring, and relentlessly dark. But if you think you can handle it, it might be the most important financial book you will ever read.

It’s available for pre-order on Amazon (and other places) in e-book form right now. The hard copy will be available for sale when it is released on June 21, if you’re the kind of person (like me) who likes holding a physical book.

I’d be honored to have you read it.