Do fines even work?

When someone sets aside $6.8 bn  just to pay fines, are they really scared of fines? Do fines and financial settlements even matter anymore? That kind of stash, that nowadays any self-respecting bank sets aside, is just a regular expense, a price of doing business. Isn’t it a time to think of some new recourse, like jail time and/or mandatory breaking of institutions into smaller parts?

Although, it’s not clear who would go to jail. So that leaves one option: break-up TBTF – not as a prophylactic measure, but as price for wrongful behavior.


Big Banks should Deleverage or Perish (My follow up in Am. Banker)

Big Banks should deleverage or perish.

But there’s a bright side, albeit with a cruel irony, to such institutional failure. If we’re powerless to break up the banks, then we’re also powerless to bail them out should they fail. There will be no more bailouts, because we’ve simply run out of options.

Jamie Dimon Should Embrace TBTF reform (My new article in the American Banker)

Here’s my new take on TBTF problem.

To summarize, to embrace the TBTF reform is a winning issue for Jamie Dimon. It has a limited downside/unlimited upside an has a potential to repair his tarnished reputation and turn him into  the industry leader. He holds a winning hand and doesn’t know it.

Why laissez-faire advocates are wrong to resist regulations.

My critique of unregulated markets does not stem from the fact that I long for a planned economy. Quite the contrary: I criticize the unregulated markets because their occasional failures revive the delusional far left theories that we all thought were put to rest a long time ago.  And when the free market advocates ran out of defensive arguments and when the evidence shows how wrong they were, then they are exposed to and defenseless against the public furor that, especially after what we’ve been through in the past 5 years, has a justifiable tendency to overreact. People like myself, who criticize the laissez faire system, are routinely portrayed as socialists by those who are too lazy to think. But we all witnessed, over the past few years, that there’s a point where competition and innovation give way to inertia, abandon, hubris and self-delusion. If such factors could be measured numerically, a replica of a Laffer curve would be appropriate to describe the predicament, where X axis is a number of innovations and Y axis is social utility of such innovations. At some point the relationship between the two breaks down and becomes negative.

Many supporters of free markets don’t see a problem here. When crises, like financial crisis of 2008 happen, they view it as a system glitch that would be self-corrected if only the government minded its own business. Some of my readers surely think that I’m a closeted Commie (although I’m merely a Keynesian), but there were times when I thought Milton Friedman, like Clapton, was God! I am, however, also a person who is moved by empirical evidence and if I see that there are too many exceptions to a theory then I begin to question the validity of such theory. Right now I see that people are not rational; that markets do not always self-correct; that there’s not always equal access to information between the transaction parties; that people can use agents that are self-interested, etc. All of this is enough, at least to me, to pause before marveling at the virtue of free markets. Milton Friedman was lucky that during his lifetime the economic circumstances seemed to confirm the superiority of his economic theory. I’ll quote:

“Friedman was also the beneficiary of the postwar economic boom and of global economic conditions that readily resonated with his ideas. During the period between the late 1960s and the mid-1970s, ‘his ideas seemed irresistibly prescient, and those of his numerous opponents repeatedly wrong’. Friedman did not face a world where economic planning enjoyed ideological hegemony. In such circumstances, his free-market liberalism was of the moment and his receipt of a Nobel Prize in 1976 merely confirmed this.”

Some conservative thinkers, even back in the 1970s when the free-market capitalism was clearly proving itself to be a superior social and economic order, realized the long-term fragility of this theory. Friedrich Hayek, the author of the conservative bible “The Road to Serfdom”, understood it even during the heyday of laissez-faire ideas. He realized that in the absence of the Soviet Union and its planned economy as an example of what not to do, there has to be a moral foundation for capitalism’s values. But there was none.

Irving Kristol (the father of William Kristol who founded the conservative Weekly Standard magazine) too criticized market advocates for promoting materialism and for fighting an ideological war that has largely been settled and urged conservatives back in the 1970 to begin to build a moral basis for capitalism. He noted that the new battle should be fought around values, that is, social values.

Conservatives tried to do that in subsequent decades, but the alliance between social conservatives and free market advocates always had an artificial feel to it, like a marriage of political expediency, not of natural compatibility. The former believe that the human nature is wicked and must be somehow controlled or restrained (either by religion or by some other methods); the latter believe in human rationality and ability to make the right decisions. It’s like mixing oil and water. It’s breaking right now before our very eyes.

If conservatives are so afraid of collectivist ideologies and believe that those will never go away completely, they have to build a solid defense against them rather than mock them. One day accusing your opponent of being a socialist might not suffice. In the 60s, 70s and 80s, the existence of a real life collectivist experiment made it possible for conservatives to demonstrate their moral superiority with ease, but now that the Soviet Union is gone the burden of proof is on the conservatives themselves. I suggest that the first step to build such a defense should be to embrace regulations. Free market advocates are afraid that by embracing regulations they will somehow admit the imperfections of their ideology; thus they are incapable of looking at regulations as a tool that can come in handy when confronted by hardcore Commies. (Note: I, of course, don’t think that Commies are coming – conservatives do). The obstinacy with which conservatives cling to free markets ideology makes them weaker when facing opponents that under normal circumstances can be easily defeated. Their tactics and strategies seem tone-deaf and oblivious to widespread public anger, both on the right and on the left. The equivalent of such tactic on the left would be a complete denouncement of a capitalism system. But those kinds of far-left voices, while existing on the fringes, are forcefully rejected by the mainstream Democrats who merely advocate a regulated capitalism and a modest increase in taxes, not a collectivist utopia. Keynesianism can be a salvation, not an inhibitor. If socialism, the real socialism comes to America, ironically, it will be the Democrats that are best equipped to fight it, not the Republicans.

I cannot stress this enough, so I will repeat myself. After you accuse me of being a socialist know this: I’m trying to help the supporters of free markets. If the foundation of their ideology is weak, we all risk sliding into an alternative social order. If you can’t demonstrate that your system of belief is superior you only have yourself to blame if the assortment of Commies will have a stronger case (and public opinion) on their side. That is a major reason I support a stronger regulatory environment – not because I’m anti-business or anti-capitalist – but because I want to protect market participants from inadequate behavior that can discredit their philosophy and expose them and eventually the public to a harmful outcome.

Happy New Year!

I want to wish everyone who reads this blog a very Happy New Year!

Also, I’d like to speculate about what the new year might bring in areas that I follow closely: politics and economics.

If the fiscal deal is not reached tonight (and it increasingly looks like it won’t be), we will begin the 2013 with Democrats in congress and Obama pushing for the middle-class tax cut. Republicans will grudgingly, and after some mandatory posturing and howling, accept it. The bigger wave on the horizon is the impending debt ceiling which will have to be raised somewhere in February. Unless debt ceiling is somehow dealt with during the tax cuts negotiations that will happen in January, we can have a repeat of August 2011 debacle. And Republicans will have the upper hand again, because as they have demonstrated earlier, nothing indicates their love of the country better than the willingness to hold it hostage to placate the far-right constituents in their home districts. If I were Obama I would deal with it now, while I have a better hand and can force some consessions. But there’s a silver lining here too – those who are looking to buy some stocks will be well advised to wait till Feb or March when the markets will dip during the certain debt ceiling debacle.

Here, I must say that I have been 70-80% long stocks for the last 3 years. It’s been a rollercoaster, but I held on during the 2010 flash crash and 2011 debt ceiling sell-off, notwithstanding several other, smaller dips. My strategy is not fancy, but rather straightforward,  and it worked for me during the past years and it will work for me again in 2013. In a nutshell, the reason why I’m long stocks is because of the deleveraging (a process where everyone pays off their debts and stores cash on their balance sheets) and low yields in pretty much all asset classes out there. In plain English that means financial institutions are sitting on  hundreds of billions of cash and have nowhere to put it. Bonds across the board (corporate, mortgage, Treasuries) have rallied so much that they earn zilch now. So stocks look more and more attractive to invest in. It’s riskier than bonds, but at some point (especially when the market dips again during the inevitable debt ceiling clusterfuck) many fund managers, pressed by their clients to deliver yield, will be forced to buy equities. Another powerful force that is behind my back on this strategy is Ben Bernanke who will stay as Fed Chairman through 2014 and will keep the rates low as he has been doing for years. Low rates are bullish for stocks.

I hope Wall Street will stop fighting the Obama administration and will come to terms with the new normal. The business model and the payoffs of the 2003-2007 era was an aberration and Wall Street handicappers, if they are as smart as they claim, should come to this realization.  

And as always, I wish Obama and the Democrats would learn to play the hand they’ve been dealt forcefully. Here’s a great poker parallel about the way Obama plays his hand now: “The negotiating style Obama has displayed in these instances is what poker players call “tight-weak.” A tight-strong player avoids throwing in his chips, saving them for a big hand, which he plays aggressively in hopes of a huge win. A loose-weak player plays lots of hands, bluffing frequently. Tight-weak is the worst of all worlds — when you have a weak hand, you lose, and when you have a strong hand, you fail to maximize your position.

Happy New Year!

Lehman anniversary

This is an entry from my trading journal from Sep 15th 2008:

Well, Lehman filed over the weekend. No one wanted it without the gov’t guarantee and Fed didn’t want to backstop this time. This is a once in a lifetime event. I can’t even begin to describe the feel in the market right now. The levels that I’m seeing and the volatility are unprecedented. IG/HY/CMBX are wider by unseen before levels. I guess I picked the wrong day to quit sniffing glue.

Bill Gross is wrong again.

I know, I should be focusing on politics these days, but I just can’t but marvel at the sheer lack of common sense of some of the world’s best asset managers. Bill Gross, a legendary bond trader at PIMCO, has not had his top game lately and he keeps sticking to the losing trade. As some of you may know Bill Gross has been an inflation fiend for years now, predicting soon-to-come inflation back in 2008. And then in 2010. And then in 2011. And then again now. You can check current inflation data here, as you can see it’s under 2% as of July 2012. But he’s been wrong so many times before why should we listen to him now? I guess one day he will be right, but as a matter of coincidence, not as a matter of insight and expertise. I’d give him a few more years though.

This is one of the best commentary that I saw arguing that inflation isn’t coming anytime soon. I just don’t understand why everyone is puzzled by it.

“What the economy really needs for a full recovery is time and stability. Once U.S. banks have cleaned house and rebuilt their balance sheets, once consumers have their debt under control and their home values have stopped falling, and once companies have to start putting their cash to work, spending will pick up.”

Perhaps this what sums up my thinking for the last 4 years – I just thought about the delevering of both banks and individual homeowners and as I looked at the landscape it became perfectly clear to me – and mind you I’m not an economist or a venerated bond trader, I’m just an average observer – that it will take a long time for a turnaround and consumer spending to pick up and thus the ultimate inflation. I’m just amazed that people like Bill Gross (who is not running for political office and has no reason to scare the public with upcoming inflation) can’t grasp such simple truth. Perhaps, he’s still talking his book, but I thought he already took his Treasury position down. Maybe he’s trying, like a broken clock, to be finally right in the upcoming years. The fact that inflation will come eventually doesn’t make him a prophet or an insightful and thoughtful economist. Every fool in the industry in 2006 knew that the market was gonna crash, the trick was to know when exactly and on what scale.

Here’s one quote from his article:

If the dancing has slowed down, then the reason is not just an overweight partner. It’s that the price of money (be it in the form of a real interest rate, a quality risk spread, or both) is too low. Our entire finance-based monetary system – led by banks but typified by insurance companies, investment management firms and hedge funds as well – is based on an acceptable level of carry and the expectation of earning it. When credit is priced such that carry is no longer as profitable at a customary amount of leverage/risk, then the system will stall, list, or perhaps even tip over.

So that’s his argument for the upcoming inflation? System is stalled that’s why the inflation is coming?

He then goes on to say that “by historical models 0% interest rates should inevitably lead to dynamic economic recovery”. But did those historical models account for the massive debt plaguing potential borrowers? He seem to focus on the one side of the equation – banks flush with cash with nowhere to put it – and the notion that too much cash in the system will lead to inflation. It sure will – if it’s spent. But who is there to spend it and on what? He himself said there’s no yield out there and the potential borrowers (who would spend it) are overleveraged. To me that’s the answer that the inflation is not coming anytime soon.

“But what about the Chinese?” – some would say. “Don’t they hold a trillion dollars of US Treasuries? What if they stop buying it?” That’s a good question. If the Chinese stop buying Treasuries, or start demanding a higher yield – that can certainly spur inflation. But why would they do it now? Why didn’t they demand a higher yield when the world was coming to an end in 2008, 2009 and every year since then? They had plenty of opportunity to demand a higher yield before and they didn’t. What’s to change that dynamic now?

 The solution to a heavily indebted borrower and consumer is a slow, step by step process of deleveraging. This will take years, perhaps even a decade. Underwater homeowners will not get a refi or a principal reduction because of the absence of mechanisms to do it on a massive scale, uncooperating servicers and banks unwilling to refinance. So the consumers will not go out and buy a 5th plasma TV and stock up on other goods until their house values will meet their outstanding mortgage balance. So, if it’s not the American consumer and not the Chinese then who? Who will bring about the inflation that conservatives like Paul Ryan and bond masters like Bill Gross have been warning us for years? What will generate it?

Time will. Mortgage servicers are a bottleneck for foreclosure relief, and banks are the bottleneck to healthy lending. Money, received from the Fed for free, is sitting on banks’ balance sheets and the inventory of underwater mortgages has no way of resolution other than time. A long time.

That’s my trade and I’m sticking to it.