Thursday, March 26, 2009

A Tectonic Shift In The Global Banking Industry!

It is said that a picture is worth a thousand words.

Well below are some stirring graphs that highlights on the unexpected changes arising from the recent global financial crisis.

As the old saw goes, in every crisis there are opportunities. In the present case, we seem to witnessing an evolving transition to a new order in the global financial industry.

All graphs from Financial Times...


At the topmost window, the market cap of banks as % of the GDP of key developed nations depicts of a "leveling"-where the pecking order of market cap erosion have been heaviest in UK, followed by Europe, the US and Japan. This has led to nearly a congruous distribution of market cap as a ratio to GDP as the crisis evolved.

The next chart ("What difference a decade makes") is THE revelation: China has snatched the banking industry's leadership (lowest chart) from what used to be a stranglehold of the West (upper pane)!

And for a better visual, FT.com provides a great comparative breakdown of the top financial companies of the world in 1999 and in 2009...

The above had been the ranking of top global financial institutions based on market capitalization in 1999...

And the radical transformation seen in the present ranking.

As Peter Thal Larsen and Simon Briscoe wrote at the Financial Times, (bold highlight mine) ``New names have meanwhile arrived as if from nowhere. This is partly a reflection of shifting economic power: China’s three big banks dominate the rankings after joining the stock market in 2006 and 2007. Australian and Brazilian banks have also risen to prominence. But the shifting composition also offers evidence of how well different countries have managed their financial systems. Canada, for example, has been praised for its risk-averse approach to regulation. A decade ago, no Canadian bank made the list. Now there are five in the top 50."

So aside from China we have major commodity producers sharing the honors or a wider distribution of financial leadership.

But where will the next best growth area be?

Based on Boston Consulting Group's investment banking model, we will likely see a shift in the leveraged based business model to one of stabilizing profitability through a return to a simpler smaller model, smaller profit pools, greater client demand for simpler financial solutions and specialized capabilities of individual investment banks in an environment of increased regulatory and governmental influence.

And the region, as illustrated above, which has the least increase in government intervention could likely benefit most.

Combined with many other fundamental factors as high savings, growing middle class, demographic trends, urbanization and etc..., Asia looks likely a winner!

Ideology, Economics and Policy Making

New York University's Mario Rizzo in his "In Defense of Reasonable Ideology" delivers a sterling dissertation of why economic ideology matters in conducting economic policy analysis.

Some noteworthy excerpts from Professor Rizzo,

``In the realm of scientific hypotheses, even the “falsificationist” Karl Popper accepted a principle of tenacity which had it that hypotheses are not to be dropped in face of any conflicting evidence. No hypothesis will have a 100% of the evidence in its favor. Is this rational? It depends on the nature of the prior probabilities or the prior hypothesis. Suppose someone says: “By and large the free market is best, among all of the feasible alternatives, at promoting human welfare.” Is this ideology? I think most people would say it is. What is it based on? Well, for some people it may be a religion or faith or sorts. But then its negation can be as well. However, it need not be a faith.


``Ideologies stress the interconnections among policies and problems. They may point us in the direction of the general principle implied by a policy and hence the implicit rationalization of further policies. They may make us alert to unintended changes in incentives in related problem areas especially when this worsening of other problems has happened time and again. They show us that when the State intervenes there is more than just some pinpointed technology involved.


``Most people are not scientists, economists or intellectuals. They are not testing hypotheses. They have other things to do. They are often rationally ignorant. How can they make up their minds about public policy? Many, though not all, are ideological. They choose a set or complex of beliefs that comports best with their observations and experience. For them too it is not rational to give up the world view because some (few) observations seem to conflict. Forgive some of them who are not willing to throw away long-held beliefs on the say-so of a president who is someone most never heard of eighteen months ago.


``Public policy questions are not simply technical questions. They involve ethical issues...The science is the technical aspect: causes and effects. The ethics involves the standards that are applied to determine whether a state of affairs is good or just. And the art involves the sometimes intuitive judgments of how to apply the science to get (or allow) the outcomes policymakers want."

Read the rest here


A Stunning Public Resignation Letter From An AIG officer

An AIG employee's lens of the latest BONUS uproar through a resignation letter published at the New York Times...

All bold highlights mine...

The following is a letter sent on Tuesday by Jake DeSantis, an executive vice president of the American International Group’s financial products unit, to Edward M. Liddy, the chief executive of A.I.G.

DEAR Mr. Liddy,

It is with deep regret that I submit my notice of resignation from A.I.G. Financial Products. I hope you take the time to read this entire letter. Before describing the details of my decision, I want to offer some context:

I am proud of everything I have done for the commodity and equity divisions of A.I.G.-F.P. I was in no way involved in — or responsible for — the credit default swap transactions that have hamstrung A.I.G. Nor were more than a handful of the 400 current employees of A.I.G.-F.P. Most of those responsible have left the company and have conspicuously escaped the public outrage.

After 12 months of hard work dismantling the company — during which A.I.G. reassured us many times we would be rewarded in March 2009 — we in the financial products unit have been betrayed by A.I.G. and are being unfairly persecuted by elected officials. In response to this, I will now leave the company and donate my entire post-tax retention payment to those suffering from the global economic downturn. My intent is to keep none of the money myself.

I take this action after 11 years of dedicated, honorable service to A.I.G. I can no longer effectively perform my duties in this dysfunctional environment, nor am I being paid to do so. Like you, I was asked to work for an annual salary of $1, and I agreed out of a sense of duty to the company and to the public officials who have come to its aid. Having now been let down by both, I can no longer justify spending 10, 12, 14 hours a day away from my family for the benefit of those who have let me down.

You and I have never met or spoken to each other, so I’d like to tell you about myself. I was raised by schoolteachers working multiple jobs in a world of closing steel mills. My hard work earned me acceptance to M.I.T., and the institute’s generous financial aid enabled me to attend. I had fulfilled my American dream.

I started at this company in 1998 as an equity trader, became the head of equity and commodity trading and, a couple of years before A.I.G.’s meltdown last September, was named the head of business development for commodities. Over this period the equity and commodity units were consistently profitable — in most years generating net profits of well over $100 million. Most recently, during the dismantling of A.I.G.-F.P., I was an integral player in the pending sale of its well-regarded commodity index business to UBS. As you know, business unit sales like this are crucial to A.I.G.’s effort to repay the American taxpayer.

The profitability of the businesses with which I was associated clearly supported my compensation. I never received any pay resulting from the credit default swaps that are now losing so much money. I did, however, like many others here, lose a significant portion of my life savings in the form of deferred compensation invested in the capital of A.I.G.-F.P. because of those losses. In this way I have personally suffered from this controversial activity — directly as well as indirectly with the rest of the taxpayers.

I have the utmost respect for the civic duty that you are now performing at A.I.G. You are as blameless for these credit default swap losses as I am. You answered your country’s call and you are taking a tremendous beating for it.

But you also are aware that most of the employees of your financial products unit had nothing to do with the large losses. And I am disappointed and frustrated over your lack of support for us. I and many others in the unit feel betrayed that you failed to stand up for us in the face of untrue and unfair accusations from certain members of Congress last Wednesday and from the press over our retention payments, and that you didn’t defend us against the baseless and reckless comments made by the attorneys general of New York and Connecticut.

My guess is that in October, when you learned of these retention contracts, you realized that the employees of the financial products unit needed some incentive to stay and that the contracts, being both ethical and useful, should be left to stand. That’s probably why A.I.G. management assured us on three occasions during that month that the company would “live up to its commitment” to honor the contract guarantees.

That may be why you decided to accelerate by three months more than a quarter of the amounts due under the contracts. That action signified to us your support, and was hardly something that one would do if he truly found the contracts “distasteful.”

That may also be why you authorized the balance of the payments on March 13.

At no time during the past six months that you have been leading A.I.G. did you ask us to revise, renegotiate or break these contracts — until several hours before your appearance last week before Congress.

I think your initial decision to honor the contracts was both ethical and financially astute, but it seems to have been politically unwise. It’s now apparent that you either misunderstood the agreements that you had made — tacit or otherwise — with the Federal Reserve, the Treasury, various members of Congress and Attorney General Andrew Cuomo of New York, or were not strong enough to withstand the shifting political winds.

You’ve now asked the current employees of A.I.G.-F.P. to repay these earnings. As you can imagine, there has been a tremendous amount of serious thought and heated discussion about how we should respond to this breach of trust.

As most of us have done nothing wrong, guilt is not a motivation to surrender our earnings. We have worked 12 long months under these contracts and now deserve to be paid as promised. None of us should be cheated of our payments any more than a plumber should be cheated after he has fixed the pipes but a careless electrician causes a fire that burns down the house.

Many of the employees have, in the past six months, turned down job offers from more stable employers, based on A.I.G.’s assurances that the contracts would be honored. They are now angry about having been misled by A.I.G.’s promises and are not inclined to return the money as a favor to you.

The only real motivation that anyone at A.I.G.-F.P. now has is fear. Mr. Cuomo has threatened to “name and shame,” and his counterpart in Connecticut, Richard Blumenthal, has made similar threats — even though attorneys general are supposed to stand for due process, to conduct trials in courts and not the press.

So what am I to do? There’s no easy answer. I know that because of hard work I have benefited more than most during the economic boom and have saved enough that my family is unlikely to suffer devastating losses during the current bust. Some might argue that members of my profession have been overpaid, and I wouldn’t disagree.

That is why I have decided to donate 100 percent of the effective after-tax proceeds of my retention payment directly to organizations that are helping people who are suffering from the global downturn. This is not a tax-deduction gimmick; I simply believe that I at least deserve to dictate how my earnings are spent, and do not want to see them disappear back into the obscurity of A.I.G.’s or the federal government’s budget. Our earnings have caused such a distraction for so many from the more pressing issues our country faces, and I would like to see my share of it benefit those truly in need.

On March 16 I received a payment from A.I.G. amounting to $742,006.40, after taxes. In light of the uncertainty over the ultimate taxation and legal status of this payment, the actual amount I donate may be less — in fact, it may end up being far less if the recent House bill raising the tax on the retention payments to 90 percent stands. Once all the money is donated, you will immediately receive a list of all recipients.

This choice is right for me. I wish others at A.I.G.-F.P. luck finding peace with their difficult decision, and only hope their judgment is not clouded by fear.

Mr. Liddy, I wish you success in your commitment to return the money extended by the American government, and luck with the continued unwinding of the company’s diverse businesses — especially those remaining credit default swaps. I’ll continue over the short term to help make sure no balls are dropped, but after what’s happened this past week I can’t remain much longer — there is too much bad blood. I’m not sure how you will greet my resignation, but at least Attorney General Blumenthal should be relieved that I’ll leave under my own power and will not need to be “shoved out the door.”

Sincerely,

Jake DeSantis

My comment: By keeping the embattled AIG afloat, the US government has made a terrific mess out of the "rights" of employee contracts, fostered organizational disharmony and conflict of interests and skewed incentives for the participants involved in the AIG debacle.


Tuesday, March 24, 2009

Shopping For Farmland?

An ocean of money from global central banks is about to flow into commodities which should trigger a boom.

And as legendary investor Jim Rogers predicted, ``Power is shifting now from the money shifters, that got us to trade to paper and money, to people who produce real goods, whether it is agriculture or mining or whatever. This has happened many times in history, what you should do is become a farmer, or you should go and start a farming network. That’s what you do, because in the future the farmers are going to be one of the best professions you can possibly have."

And farming as the next sunshine profession should also mean a boom in farmlands.

And where are the best priced farmlands?
According to the Economist, ``FARMLAND has outperformed the property market in many countries. Investors rushed into agricultural land as food prices soared, helping to push up prices. A hectare of farmland in England increased by 16% (in sterling terms) in the year to January 2009, according to a new report by Knight Frank and Citibank. And even against a resurgent dollar this equates to $17,100 a hectare, the highest among the countries shown. Canada looks a bargain by comparison with neighbouring America: prices are around a tenth of the $11,000 a hectare paid in Ohio. The prospects for eastern Europe are bleaker, thanks to poorer infrastructure and economic prospects. Farmland in Ukraine fell by 75% to $125 a hectare."

The economist chart above doesn't cover much of farmland prices in emerging markets.

Yet not all farms are equal-there will always be the issue of infrastructure (farm to market), accessibility to water, government regulations, soil quality or structure, climate, security and etc...

Monday, March 23, 2009

Video: Friedrich Hayek's The Road To Serfdom

During desperate times, people have the penchant to put their faith in political "saviors" in the hope of relief. Unfortunately as history shows, embracing this path typically leads to tyrannical rule.

So this cartoon video of Friedrich August Von Hayek's inspirational "The Road To Serfdom" should serve as a reminder- for us not to relinquish the fight for liberty or freedom...




or you can view the original layout by pressing on the image
...

Justify Full

Global Internet and Economic Trends in Charts by Mary Meeker

Check out the great stuff from Mary Meeker of Morgan Stanley, whose slide deck of charts deals with global technology and economic trends (hat tip Paul Kedrosky)

Just two examples...
Philippines leads in the technology usage of Microtransactions via SMS or text messaging...

as the industry is backed by a 57% Penetration level in mobile subscription

check out the rest of her interesting charts here...


Meeker Tech '09 - Get more Business Plans

AIG Bailout: A Model of Failed Government Intervention?

Public Administration Case Study: The AIG Bailout

First, AIG went to the US government to ask for a bailout under the justification that its failure might risk a "catastrophic collapse" for banks and money funds. (scare tactic)

Next, AIG receives the money and spends much of these on paying out or "rescuing" AIG counterparties...

courtesy of nicolasrapp.com

Then, they spent the part of the taxpayer's money as bonuses to the company's employees.

Apparently this caught the eyes of media which subsequently incited a mass hysteria against the "morality" of taxpayer shouldered largess...

Micheal Lewis of Bloomberg wrote of how the brouhaha over AIG's bonuses has obscured some simple truths. Excerpt below...

1) To the political process all big numbers look alike; above a certain number the money becomes purely symbolic. The general public has no ability to feel the relative weight of 173 billion and 165 million. You can generate as much political action and public anger over millions as you can over billions....

2) As the financial crisis has evolved its moral has been simplified, grotesquely. In the beginning this crisis was messy. Wall Street financiers behaved horribly but so did ordinary Americans. Millions of people borrowed money they shouldn’t have borrowed and, not, typically, because they were duped or defrauded but because they were covetous and greedy: they wanted to own stuff they hadn’t earned the right to buy.

3) The complexity of the issues at the heart of the crisis paralyzes the political processes’ ability to deal with them intelligently.

Be sure to read of the rest of the discerning article here

Lastly because of the furor, legislators rushed in to exact vengance...unfortunately by punishing the economy.

How? By licensing the abrogation of contracts, by passing retroactive taxation and by making taxation punitive.

This astute commentary from David Kotok of Cumberland Advisors (bold highlight mine),

``The result of this House action is
already damaging. The federal regulator of Fannie Mae and Freddie Mac has shown the courage to ask that this law not be advanced in the Senate. We expect to hear more from those federal personalities who have the strength to speak up and oppose this House-approved proposal.

``But depending on the Senate to soften the law or depending on the US Supreme Court to overturn it is a dangerous strategy. Some Congressmen admitted privately that they voted in favor because of constituent pressure, even though they were really opposed to the concept. They voted “yes” because they were relying on the Senate or the courts to say “no.”

``Some damage is already done. Firms that were gearing up to participate in the federal program to be announced this coming week are considering withdrawal. They fear that any action which puts them into the federal assistance plan will subject them to the chance of retroactive punishment and taxation. The House has undermined the so-called public-private partnership designed to help restore financing of consumer items like automobiles and credit cards."

So those hoping for a quick economic recovery from the barrage of government intervention should see the reality-the visible hand has pernicious unintended effects.

Authorities appear to be immensely confounded by the clash of interests among various economic agents in the AIG dilemma: those being bailed out (e.g. AIG,'s CDS counterparties, bondholders, etc.), the unwitting participants (e.g. employees), the public (taxpayer money, mass hysteria/sentiment) and the economy (the passage of reactive populist laws that are business unfriendly).

Perhaps AIG's experience should be a paradigm of 'how NOT to bail out a company'...

Obama's Job Approval: Different Polling Agencies, Different Results


From Gallup



The firm's ideology or political affiliations could be driving these divergent poll results.

Sunday, March 22, 2009

Taking The Hyperinflation Risk With A Grain Of Salt?

``But the boom cannot continue indefinitely. There are two alternatives. Either the banks continue the credit expansion without restriction and thus cause constantly mounting price increases and an ever-growing orgy of speculation, which, as in all other cases of unlimited inflation, ends in a ‘crack-up boom’ and in a collapse of the money and credit system. Or the banks stop before this point is reached, voluntarily renounce further credit expansion and thus bring about the crisis." Ludwig von Mises in Interventionism: An Economic Analysis (p. 40)

Recently a link from last year’s TV interview of an eminent Cassandra, Mr. Gerald Celente, was posted at a social community network. Mr. Celente prophesized, not only of the “greatest” depression for the US, but of an environment marked by “revolution, food riots and tax rebellions”. Such development would bring about America’s “ceasing to be a developed nation” or essentially would translate to the country’s defacement as the world’s premier economic and financial power by 2012.

The accompanying the link had a note from the link author who questioned about how such an interview was “allowed” to be aired and what was this “doomsday” scenario all about.

We have long known about such extreme views (which should include James Kunstler-another Cassandra who believes of the real risks of a world at war arising from the unsustainable energy infrastructure from which the world currently operates and survives on), but has refrained from discussing it because of our “optimistic” predilections. Nonetheless, on the account of the “ripeness” of the occasion, this article will attempt to elaborate on the risks of such concerns.

Cognitive Biases and Censorship

As Julius Caesar remarked, ``People readily believe what they want to believe."

Obviously the late great Caesar alluded to people’s proclivity to act in social norms. And as social norms, popular views are often dressed up as lies which are repeated so often and digested as the reality or the truth, especially when buttressed or promulgated by figures considered as “authorities” in their fields or from the bureaucracy. Yet, most people only look at the superficial and intuitive side of any issues without belaboring on the tacit intents proposed by the advocates or of its unseen consequences.

Bluntly put, people are basically faddish and tend to look for grounds to confirm or substantiate their beliefs or are predisposed to absorb only the quality of information which they believe suits their palate. In behavioral finance, this is known as the CONFIRMATION bias or “the tendency to search for or interpret information in a way that confirms one's preconceptions” (wikipedia.org).

Applied to social trends, the acceptance of mainstream views (or seeking “comfort of the crowds”) or conformity represents as the more psychologically rewarding route than in defiance of them (regardless of the validity of the observations or theories).

For instance, the mainstream has repeatedly mocked, jeered or scorned at those who warned of the illusions of the wealth derived from unsustainable debt driven boom. Contrarians were deemed or labeled as “killjoys” or “partypoopers”. Eventually as the boom turned into a bust, losses turned into reality, and the “IN” thing or “THE” social trend is now to be a pessimist.

The contrarians, who were previously the “outcasts”, have been exonerated and have now commanded sufficient clout of an audience enough to be embraced by mainstream media. In short, since media’s role is to sell what is mostly in popular demand, the Celente interview represents as pessimism becoming an entrenched social trend.

And that’s why gloomy videos have found their way into social networks. And that’s why too, we should expect more of these until perhaps we have reached the stage of “revulsion” or “capitulation” for one to reckon the US as in a “bottoming” phase.

Remember, throngs of “finance and banking” professionals or organizations (such as banking institutions, insurance and hedge funds) have not been eluded from such basic human frailties of “crowd” following or falling prey to “confirmation bias”. As the present bust or crisis clearly shows, technical expertise or even quant algorithmic models can’t substitute for the process ability driven emotional intelligence which is more a required attribute in the analysis of the market’s risk-reward tradeoff. As we have discussed in many occasions, most of them have even fallen prey to Ponzi schemes as the Bernard Madoff or the Robert Allan Stanford case.

I won’t suggest anyone to disregard extreme views especially if the Cassandra sports a good track record in projecting major trends and this includes Mr. Gerald Celente.

Yet, a remarkable past may not necessarily extrapolate to another successful forecast. Since any mortal can only wield so much of limited information in a highly complex world, like anyone else, his views aren’t infallible. The point is to understand the merits of his argument than simply to dismiss it out of the Pollyannaism or blind optimism or from the outrageous belief of a messianic salvation from the present leadership or fanatical subscription to the economic school of orthodoxy.

Worst of all, is the implication for the socialistic bent of “censorship” by those intolerant of diametric or contradictory perspectives. One should ask: would it be better for us to adhere to fantasies masquerading as truth and eventually suffer? Or would reading an expository “falsifiable” mind be a better alternative as to recognize potential risks and prepare for them?

The Fundamental Problem: UNSUSTAINABLE DEBT

So what seems to ail the US economy so much as to risk turning its political economy into an emerging market?

This from Bloomberg, ``Bill Gross, co-chief investment officer of Pacific Investment Management Co., said the Federal Reserve’s purchases of Treasuries and mortgage securities won’t be enough to awaken the economy.

``We need more than that,” Gross said today in a Bloomberg Television interview from Pimco’s headquarters in Newport Beach, California. The Fed’s balance sheet “will probably have to grow to about $5 trillion or $6 trillion,” he said.”

The Fed’s balance sheet is roughly around $2 trillion with an additional $1 trillion more for the QE as it gets implemented. This brings the Fed’s balance sheet around $3 trillion. Mr. Gross has asked to double the size.

Now this from Jeremy Grantham an erstwhile ferocious stock market bear whom has turned into a raging bull recently said, ``To be successful we need to halve the level of debt. Somewhere between $10 trillion and $15 trillion will have to disappear."

So how do we do that? ``Grantham sees three ways, according to the Wall Street Journal, “to restore the balance between private debt levels and asset values.” That is by “1) Drastically write down debt, 2) let the passage of time wear down debt levels, 3) “inflate the heck out of our debt” and reduce its real value.” (bold highlight mine)

In short, the fundamental problem comes with the government policy induced overdose of debt intake as shown in Figure 1.

Figure 1: American Institute for Economic Research: Total Debt by the US

AS you can see, the debt ratios for the US economy mostly held by the private sector have exploded beyond the nation’s paying capacity, according to the AIER, ``The debt-to-dollar ratio currently tops $3.50, more than double the ratio of 50 years ago.”

Given the unsustainable debt structure from which the US and the world economy has been built, the recent collapse in the financial markets (estimated at $50 trillion-ADB) and the subsequent meltdown in global trade, and investments (or deglobalization) has managed to reduce parts of such massive scale of imbalances.

But the adjustment process has a long way to go.

The US Federal Reserve’s Agency Problem

However instead of allowing for an orderly rebalancing of the US economy by permitting institutions that took upon the unnecessary burden of the speculative excess to fail or undergo bankruptcy proceedings, the US government has been pushing to revive the past Ponzi financing model by substituting the losses from these institutions with taxpayer money…to no avail so far.

And the Federal government’s heavy handed interventions in many significant parts of the economy and the prevention of price discovery has contributed to the prolonged nature of recovery and has added uncertainties in the marketplace, by distorting market price signals and altering the incentives for market participants which has been skewed towards prospective actions of the government.

The recent fracas of over the bonuses is a case in point.

Take this article from the New York Times,

``As public outrage swells over the rapidly growing cost of bailing out financial institutions, the Obama administration and lawmakers are attaching more and more strings to rescue funds.

``The conditions are necessary to prevent Wall Street executives from paying lavish bonuses and buying corporate jets, some experts say, but others say the conditions go beyond protecting taxpayers and border on social engineering.

``Some bankers say the conditions have become so onerous that they want to return the bailout money.

In other words, some banks have resisted availing of government bailouts because of the burdensome conditions imposed on them, which is not helping the situation at all. As we said earlier the incentives in trying to normalize bank operations are being contorted by minute by minute changes in government intervention. Investors look for stability in policy.

And how much of these government intervention has been affecting the banking industry? The same New York Time article admits…

``At the height of the savings and loan crisis in the 1980s and 1990s, Congress and regulators adopted new rules known as “prompt corrective action” that required the government to quickly close weak financial institutions if they could not raise money to absorb mounting losses.

``The rules were a response to a consensus that keeping weak institutions open longer, under an earlier practice known as forbearance, damaged healthy banks competing with the government-subsidized ones and ultimately destabilized the banking system. By shutting weakened institutions before their losses grew, prompt corrective action was also seen as less costly to taxpayers and the deposit insurance fund.

``Administration officials say that some of the banks at issue today are simply too large to be seized by the government, making comparisons to the savings and loan crisis less meaningful.”

But this is exactly what has been happening today, damaged banks have been competing with government subsidized ones at the expense of the industry and the economy. And much worst, those subsidized are banks have been TOO LARGE to be seized by government, which is why the accrued losses have led to a creeping nationalization. See figure 2…


Figure 2: BCA Research: Top 20 Banks

According to the BCA Research, ``The Chairman of the FDIC, Sheila Bair, contends that U.S. banks are well capitalized. However, she must be referring to the multitude of small banks, rather than large banks (i.e. there are many small banks that are well capitalized). The top 20 financial institutions have a thin capital cushion of only 3.4% (defined as tangible capital/total assets). In other words, it would require a writedown of total assets of only 3%-4% to wipe out all tangible capital for the largest banks. The FDIC data on the broader banking universe confirms that the capital cushion of large banks is much less than their smaller counterparts. Moreover, toxic assets are concentrated in large financial institutions.”

As you can see the risk profile of the top 20 banks have largely been because of the Level 3 assets which simply means ``Assets whose fair value cannot be determined by using observable measures, such as market prices or models.” (investopedia.com)

And what are the possible Level 3 assets? Perhaps figure 3 may provide the explanation…


Figure 3: OCC: 3rd quarter Report: The Average Credit Exposure to Risk Based Capital

The average credit exposure to risk based capital in percentage is 317.4% for the 5 largest banks as of the third quarter of 2008! The pecking order of the riskiest banks: HSBC (664.2%), JP Morgan (400.2%), Citibank (259.5%), Bank of America (177.6%) and Wachovia (85.2%).

Moreover, consider that 96.9% of the total derivatives of the US commercial banking system is held by the just these 5 institutions according to the Comptroller of the Currency Administrator of National Banks!

In other words, of the 8,451 banks and savings institutions insured by the FDIC, or of the 7,203 commercial banks operating in US (Plunkett Research), 5 banks have essentially held hostage the entire industry, if not the economy!!!

Free market anyone?

Why is this?

Could it be because the US Federal Reserve is a privately held corporation, bestowed with a monopolistic power to create and manage the country’s legal tender, whose complex web of owners could be some of the same institutions that are presently being rescued?

According to James Quinn, ``Most Americans believe that the Federal Reserve is part of the government. They are wrong. It is a privately held corporation owned by stockholders. The Federal Reserve System is owned by the largest banks in the United States. There are Class A,B, and C shareholders. The owner banks and their shares in the Federal Reserve are a secret.”

As Henry Ford once wrote, ``It is well enough that people of the nation do not understand our banking and monetary system, for if they did, I believe there would be a revolution before tomorrow morning.”

So could Mr. Celente’s dire projections have been partly premised from such agency problem or conflict of interest issues that would perhaps gain national consciousness over the coming years?

Regulatory Arbitrage + Regulatory Capture=Market Distortion

In addition, considering the US banking industry have been a heavily regulated industry, why have the core institutions, which originally attempted to disperse risk by introducing financial innovations, ended up with the “risk concentrations”?

This from Gillian Tett of the Financial Times, ``After all, during the past decade, the theory behind modern financial innovation was that it was spreading credit risk round the system instead of just leaving it concentrated on the balance sheets of banks.

``But the AIG list shows what the fatal flaw in that rhetoric was. On paper, banks ranging from Deutsche Bank to Société Générale to Merrill Lynch have been shedding credit risks on mortgage loans, and much else.

``Unfortunately, most of those banks have been shedding risks in almost the same way – namely by dumping large chunks on to AIG. Or, to put it another way, what AIG has essentially been doing in the past decade is writing the same type of insurance contract, over and over again, for almost every other player on the street.

``Far from promoting “dispersion” or “diversification”, innovation has ended up producing concentrations of risk, plagued with deadly correlations, too. Hence AIG’s inability to honour its insurance deals to the rest of the financial system, until it was bailed out by US taxpayers.”

Institutions as the AIG Financial Product (AIGFP) circumvented or went around regulatory loop holes to ante up on leverage and increase risk exposure in order to generate additional returns. Arnold Kling of Econolib.org quotes Houman Shadab, ``AIGFP was treated as a bank for its counterparties' risk-weighting purposes, but AIGFP was not regulated as a bank (or an insurance company) for its own CDS credit exposures (had it been, it would've had to set aside capital/reserves).”

In short, this hasn’t been a free market problem as some anti-market pundits paint them to be, but one of regulators conspiring with Wall Street participants to “game the system”.

For Wall Street it had been one of regulatory arbitrage (profiting from legal loopholes) but for the regulators it has been one of regulatory capture (situations where government acts in favor of the interest groups of which it is regulating).

As we have previously quoted Robert Arvanitis Risk Finance Advisers, in Seeking Beta: Interview with Robert Arvanitis, ``Being mortal, the bureaucrats desire to avoid pain is as dear to them as the desire by their counterparts in private industry to seek gain. And it is far more profitable to game the rules, for example, than to enforce them. And any system can be gamed.

To quote Mr. Celente, ``It was Fed finagling, Washington deregulation and Wall Street’s compulsive gambling that created the crisis.”

Yet people have been distracted by the most recent BONUS issue, which simply implies that Americans have been looking for an issue to vent their wrath on (a misguided one though).

To consider, the enormous backlash over the $168 Million is a pittance over the money spent by US taxpayers ($178 BILLION) to sustain AIG counterparties as Goldman Sachs ($12.9 billion), Merrill Lynch ($6.8 billion), Bank of America ($5.2 billion), Citigroup ($2.3 billion) and Wachovia ($1.5 billion). Big foreign banks also received large sums from the rescue, including Société Générale of France and Deutsche Bank of Germany, which each received nearly $12 billion; Barclays of Britain ($8.5 billion); and UBS of Switzerland ($5 billion) and some 20 largest states (New York Times).

Yet as the Federal government expands its presence into industries these governance conflicts, e.g. as in the proposed bonuses of Freddie Mac and Fannie Mae, will certainly serve or operate as a major disincentive that would impact diverse institutions from meeting desired goals, which eventually results to an increased overall inefficiency in the system.

Again, with big government comes the inevitable ramifications: resource allocation inefficiencies or wasteful spending, incompetence, corruption, dispensation of favors to political constituents, conflicts of interests, governance conflicts which may lead to organizational demoralization and reduced productivity, bureaucratic rigidities (tendency to be too technical or legal), crowding out of private sector investments, massive distortion of incentives, a vague pricing system which increased uncertainties and other impediments –all of which obstructs on the US’s economy wellbeing.

Obviously, governance policies based on populism will do harm than good.

Signs of Resurgent Inflation?

Now that the US policymakers appear to be losing out of ammunition, they have begun to openly resort to the crudest of all central banking policy approach-money printing.

As mentioned above our money experts have recommended “inflating away debts levels” which means reducing the currency’s purchasing power (or raise price levels) in order to diminish real debt levels, from which our policymakers have obliged.

According to the Economist, ``Mr Bernanke showed his own will on Wednesday March 18th, when the Fed’s policy panel said it would purchase $300 billion in Treasury debt, mostly maturing in two to ten years, starting next week. It will also boost its purchases of mortgage-backed securities to a total of $1.25 trillion from a previously announced $500 billion, and its purchases of debt issued by Fannie Mae and Freddie Mac, the mortgage agencies, to a total of $200 billion from $100 billion.”

But since the US is privileged to have her debts denominated on her own currency, when she can’t payback her obligations, instead of defaulting, she may resort to flooding the economy with money enough so as to reduce the value of liabilities at the expense of her existing creditors-i.e. local savers and foreign creditors.

Of course, these will temporarily benefit those who own financial assets, because “money out of thin air” will likely be absorbed by the institutions who will sell their portfolio of treasuries or mortgages to the US government. Eventually, the proceeds can be expected to be recycled into the financial markets. Although the policymakers are hoping that a revival in the capital markets will fire up the credit process by reigniting the speculative “animal” spirits.

Unfortunately the “moneyness” of Wall Street instruments (e.g. structured products, MBS, ABS etc…) has been lost and is unlikely to be revived anytime soon.

But on the other hand, any flow of credit to parts of the world where credit conditions have remained unimpaired is likely to fuel a surge in asset prices first, then consumer prices, next. Apparently such dynamics appear to have emerged, see Figure 4.

Figure 4: A Return of Inflation?

Oil has sprinted beyond the $50 mark and this has been accompanied by Dr. Copper (upper window) and even some industrial metals. Oil’s rapid rise may suggest of a rising wedge or a forthcoming decline. Anyway, the surge in key commodity prices comes alongside with a rally in Dow Jones Asia (ex-Japan) seen at the pane below the main window and Emerging Markets index (lowest pane), as the US dollar index suffered its 3rd largest one day decline.

The unfortunate part for the US is that a resurgent inflation will likely induce more sufferings to the middle and lower class and possibly worsen the political scenario by provoking a “class” conflict.

When price levels of consumer goods are raised at a time when unemployment is high or possibly even growing, where real income levels are also diminishing, and where corporations faced with a struggling environment will be faced with higher costs of operations, these combined could redound as the ingredients for a large scale hunger triggered political malcontent.

Moreover, inflation, as seen through higher cost of money and shrinking purchasing power, is likely to wreak havoc on the cash flows of those attempting repair their overleveraged balance sheet by increasing savings and paying off debts.

And the orthodoxy is putting so much hope that the authorities will know the right time when to close the barn doors before the horses run astray, a hope that seems unfounded to begin with as the authorities have failed to recognize the crisis in advance or limit the scale of its impact.

Again from Mr. Celente, ``What "steps?" The Bernanke Two-Step? Adjust interest rates or print more money? Neither stopped the credit crisis from worsening, the real estate market from tanking or the stock markets from crashing.”


Figure 5: yardeni.com: Net Foreign Selling Are These Signs On The Wall?

The United States’ Treasury International Capital flow have registered a significant net foreign selling (excluding US T-bills) last January see figure 5, although as an important reminder-one month does not a trend make.

While others have argued that such fall in capital flows may have been a function of reduced growth of foreign exchange surpluses, the growing restiveness by global policymakers over the US dollar, could be another incipient dynamic at work.

Over the past weeks we heard resonating voices suggesting a move away from the US dollar as the world’s reserve currency- from Joseph Stiglitz, a UN Panel and Russia at the G20, which was reportedly backed by China, India, South Africa and South Korea.

While there has been no unanimity on the possible replacement, most have recommended the IMF’s Special Drawing Rights or the old European Currency Unit Ecu, albeit both of which have been “combinations of currencies, weighted to a constituent's economic clout, which can be valued against other currencies and against those inside the basket” (Reuters).

Importantly, a new currency can’t takeoff without OECD participation which includes the US. Thus, such cacophony appears to be more symbolic- an implied protestation over the risks of imprudent government spending.

Take The Risks of Hyperinflation With A Grain of Salt At Your Peril

Finally, we can’t discount the risks from the ravages from hyperinflation.

As we brought up in 2009: The Year of Surprises?, a tip over from deflation expectations towards a ramping up of inflation will be a tough act to manage. If government starts to tighten as inflation rises, the ensuing effect will be a sharp fall in prices from which government will need to restoke the inflation engine again.

Again to quote Murray Rothbard in Mystery of Banking,

``But if government follows its own inherent inclination to counterfeit and appeases the clamor by printing more money so as to allow the public’s cash balances to “catch up” to prices, then the country is off to the races. Money and prices will follow each other upward in an ever-accelerating spiral, until finally prices “run away,” doing something like tripling every hour. Chaos ensues, for now the psychology of the public is not merely inflationary, but hyperinflationary, and Phase III’s runaway psychology is as follows: “The value of money is disappearing even as I sit here and contemplate it. I must get rid of money right away, and buy anything, it matters not what, so long as it isn’t money.”

In essence Mr. Celente’s Tax Revolt, Food Riots, Revolution and the return to a banana republic or the state of an emerging market is nothing more than a function of hyperinflation. (Of course, we’re not suggesting that this will surely happen, but what we are saying is that the present actions of the US policymakers have been increasing the odds for such risks to occur. America’s hope depends on the world to absorb those surplus dollars enough to pull the US out of its debt trap.)

So for those hoping against hope that the present administration will deliver the economy’s much needed elixir in defiance of the fundamental function of the natural laws of economics, good luck to you. No economy has survived by merely the government running on the printing press, ask Dr. Gideon Gono.

One must be reminded of US 33rd President Harry S. Truman’s noteworthy comment, ``It's a recession when your neighbor loses his job; it's a depression when you lose your own.”

Take this risk with a grain of salt until such scenario becomes a personal depression.