Banking on Change (Part 3)

I’ll break banking reform down into two parts: what should be, and what will be.

What should happen in finance is a massive simplification that deals with “too important to fail” and provides funds for all kinds of companies that need cash through their product cycle. This should be coordinated internationally, because the cross-border issues are often what makes finance so complex.

As the banks get bigger they should have to set aside more and more capital, making larger institutions more resilient. This would create diseconomies of scale that would make excessive size increasingly costly, lessening systemic risk. Because capital is expensive, the market would discipline companies that carelessly grow too big.

This could be tied to a leverage fee. Lower capital levels could trigger higher fees. And a resolution authority to shut down undercapitalized banks should be in place. Unlike the FDIC, this should not include debtor protection. Instead, a clear scheme for bankruptcy reorganization should be enacted that includes haircuts for creditors, just as Chapter 7 and Chapter 11 do.

Finally, the Federal Reserve needs to be reexamined. I’m grateful that they kept our economy from falling into another Great Depression, but just because they missed the last two bubbles doesn’t mean they should be given more power to miss the next one.

This is what reform should include: market-based mechanisms to protect the bankers from themselves. What we will get will be another thing entirely.

Douglas R. Tengdin, CFA
Chief Investment Officer
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Banking on Change (Part 2)

So are they bankers, or are they traders?

That’s the question for the big banks. And it’s a fair question for Congress too, as they debate how we should reform our financial system.

Big securities dealers used to be called “bulge-bracket” firms. In the past, they mostly helped companies raise money by selling stocks and bonds, and would trade these securities for their own account. Their trading profits were a big part of their business.

By contrast, banks that helped companies get loans usually kept a large portion of that loan for themselves. Trading the loan wasn’t part of the plan. But as loans got bigger the banks sold more and more of their loans off, and the bulge bracket firms held more and more of new securities on the balance sheet. Now, the line between banking and trading has gotten pretty blurry.

Proprietary trading is now the whipping boy of our financial sector, while holding loans is somehow saintly. But holding pieces of their own deals is what destroyed the capital of Bear, Lehman, and Merrill, and almost brought down UBS and Citibank. Prop trading had nothing to do with it.

It’s ironic that trading is now seen as risky when it’s the banking activities that brought our financial system to the brink. It’s surprising that no one in Washington can seem to figure this out.

Douglas R. Tengdin, CFA
Chief Investment Officer
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Banking on Change (Part 1)

Where is banking headed?

As an investment manager, it’s my job to have an opinion about this. After all, banking and finance represent almost one sixth of the market. In order to have an opinion about the market, you have to have an opinion about the banks.

And right now the banks look like they’re in trouble. The biggest banks—JP Morgan, Bank of America, Wells Fargo, and Citi—have to deal with snarking from wannbe regulators like Simon Johnson who cry, “Break them up! Investigate! Subpoena!” like a modern Cassandra, whose accurate prophesies were destined never to be believed. Only Mr. Johnson doesn’t bother to predict, only to decry.

One thing is certain: countries get the banking systems they deserve. In the US we have Byzantine regulations regarding capital, cash, and taxes. Is it any wonder financial institutions work the system to game these rules? Complex laws breed complex institutions.

It seems to me that the system needs more clarity, not more rules. If taxes and fees are attached to size, institutions will downsize to avoid the cost, but that won’t make them less interconnected or systemically important. We’ll just see more accounting gimmicks like “Repo 105” where a borrowing looks like a sale. Please.

Unfortunately no one seems to understand this. In banking, small may not be beautiful, but simple is safe.

Douglas R. Tengdin, CFA
Chief Investment Officer
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The Golden Rules?

Yesterday I made a comment on Goldman’s ethical position. I want to clarify this today.

Specifically, I noted that Goldman’s negative bet on the housing market in 2006 was neither immoral, unethical, or illegal. Those are three separate considerations:

Legal is the easiest. While I can’t speak to the way they bet on housing, it looks like they used approved investment vehicles in an approved manner. By following the laws, they stayed “inside the lines.” Ethics has to do with standards of professional practice and fiduciary duties. As long as they remain objective, exercise due care, and put their clients first, they aren’t restricted from making market calls, either.

It’s in the question of morals that’s the rub. That’s because, as a pluralistic society, we have lots of competing moral frameworks out there. Morality tells you what’s right and what’s wrong. It could be as simple as “Thou Shalt Not Steal” or as nuanced as Kant’s Categorical Imperative: “What if everyone else did that”?

By some measures, Goldman’s bet on housing crossed the line. But there’s not enough agreement as to where that line is. What I would say is, profiting from a decline in housing didn’t cross any universally accepted moral lines. It’s unclear. Some firms, then, wouldn’t have made that bet. Ours wouldn’t. But to my view Goldman didn’t steal or mislead in order to profit from the market’s move. So I think most people wouldn’t begrudge them a successful strategy.

But I’ll admit that I’m a banker, judging another banker. I may be too generous. When the blind lead the blind, they both may stumble. Hopefully that ‘s not the case here.

Douglas R. Tengdin, CFA
Chief Investment Officer
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Debtor’s Equity

With all the fussing about Greek debt, Goldman’s deals, and the equity markets, it’s important to remember a few fundamentals.

First, remember that every asset is someone else’s liability. If you own a bond, someone else issued debt. If you own stock, somebody raised equity.

This may seem trite, but it has significant implications. The world is 100% long itself. In the end, there is no net hedging. If Goldman made money when housing crashed, someone else lost more. That happened because Goldman made a good bet on housing prices. There’s nothing illegal, unethical, or immoral about that.

When the world goes gaga over a new investment idea, it’s likely that we’ll get overcapacity and subsequent collapse. That’s because all that money can’t go to work profitably in the same place at the same time. It doesn’t really matter if it’s debt or equity: the dot-com bubble was an equity bubble; the sub-prime bubble was a debt bubble. The new idea may seem inevitable, but too many cooks spoil the broth.

If you want to spot the next bubble, follow the money. Who is raising funds today? Need you ask? Banking crises are often followed by government crises. With Greece, we’re seeing one now.

Douglas R. Tengdin, CFA
Chief Investment Officer
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Short!

The last refuge of financial scoundrels is to blame the short-sellers.

That’s what I thought when I read about Greece, once again, blaming traders in Credit Default Swaps (CDS) for blowing up their debt. That’s what I thought when I read all the vitriol leveled at John Paulson for having the temerity to make money for his clients by betting against the sub-prime mortgage market. That’s what I think every time some corporate suit rails on a financial analyst for asking an aggressive question during an earnings conference call.

Short sellers and CDS buyers serve a valuable purpose. They help discover the clearing price. This balances the interests of buyers and sellers. Our institutions are designed, though, to encourage overpricing. It’s much easier to go long a stock or a bond than to go short. That tends to push prices higher than they should be and encourage bubbles.

Short-selling allows investors to speak truth to power in the financial markets. If CDS hadn’t been around to prick the housing bubble, home prices might still be inflating. Even more excess houses would have been built, meaning the crash would be even worse. Thank goodness the market fell as soon as it did.

Shorts allow us to burst bubbles early in the process. Folks like Paulson are critical, not criminal.

Douglas R. Tengdin, CFA
Chief Investment Officer
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Into the Ash Can

The ash cloud that resulted from Iceland’s volcano grounded flights across Europe and cost the airlines billions. Now that flights have resumed again, what have we learned?

First, systems are adaptive. Some 9 million people were affected. Some re-routed. Some drove. Many just camped out at the airport. There’s some comfort in numbers. Because so many were stranded, thousands of beds were brought in to the terminals.

Second, bad news for the airlines isn’t bad for everyone. Travelers may have been stuck, but they still spent their travel dollars. But look out for the airlines looking for another bail out.

Finally, Europe has another thing to learn from the Yanks. Alaska Air has been flying around volcanic ash ever since the Mount St. Helens blast in 1980. They have detailed training and procedures that could have kept much of Europe’s fleet in the air. But no one asked.

Flying’s a great way to travel. But the old saw still applies: “Time to spare, go by air.”

Douglas R. Tengdin, CFA
Chief Investment Officer
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Rent vs. Buy

There’s a new emphasis on renting these days, and it’s a good thing.

Renting requires you to suffer the scorn of real-estate agents and home-flipping friends, but for many it’s a better decision. Never mind that it would have saved millions from foreclosure and financial stress in California and Florida. For some in their stage of life renting almost always makes sense.

The reason is that buying and selling a home is expensive. Total costs, including brokerage, closing, and moving are usually more than 5% and often exceed 10%. Could the internet can reduce this? Not really. Housing is illiquid. There’s no way to avoid the legal expense and the effort it takes to show and shop for a house. If you don’t think you’ll stay put more than five to ten years, those fees can wipe out a lot of savings.

Owning is ideal when you plan to live in a location for ten years or more and when the price of a house is reasonable. One way of testing this is to ask if the listing price is less than 20 times the annual cost of renting something comparable. It’s not foolproof, but it often works.

Who should rent? Students and young people likely to move as they build their careers, and older folks who may want to relocate to be near family. This isn’t just common sense; it also makes good financial sense. One thing is certain: renting ought to get more respect.

Douglas R. Tengdin, CFA
Chief Investment Officer
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Both Sides Now

“The first one to state his case seems right, until another questions him.”

Until now we’ve only heard from the SEC on the Goldman case. The SEC’s contention is that Goldman designed and sold a bond based on sub-prime mortgages that was engineered to fail within weeks, and they lied about who was involved.

But many feel that the Government’s case is weak. The security is exotic, the investors are sophisticated institutions, and the disclosures were extensive. No one is surprised when some people lose money in Las Vegas. People shouldn’t be surprised when some complex bonds blow up. That’s partially why Goldman’s stock went up yesterday.

But there’s never just one cockroach. Never. There were thousands of deals like this one. Millions of investors will now be contacting their lawyers to see if they can recoup by litigation some of what they’ve lost in the market. We will see hundreds of cases, especially if Goldman settles. And the story’s timing is perfect for the financial-reform news cycle.

This flood of litigation will weigh on issuers and the market. And packaging loans for sale will get a little bit harder.

Douglas R. Tengdin, CFA
Chief Investment Officer
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Breakdown

Last week it looked like consumer prices are starting to break down: the core CPI turned negative (over three months) for the first time in decades. And small businesses seem gloomy about the economy, even as the recovery strengthens. What’s going on?

The two items are linked. When the real estate bubble burst a lot of banks lost so much that it threatened their solvency. To stay in business they had to raise cash and reduce risk, and they did that by cutting back on small business loans. So while we’ve cycled from recession to recovery, this has mainly helped larger companies.

That’s led to a situation where small businesses are hurting even while the economy is getting better, and employment is only slowly improving. Since small companies are the biggest employers, the lack of jobs is pushing down on prices.

While this is troubling, it’s nothing to panic over. As the economy slowly recovers, this does filter through, and prices will gradually move up. But inflation and higher interest rates aren’t likely to take off any time soon.

The economy seems like it’s “Waiting for Godot” here. Eventually, unlike the play, a full recovery will arrive.

Douglas R. Tengdin, CFA
Chief Investment Officer
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