Markets Dive Again, Financial Reform Bill Passes

As they say, "stocks go up on an escalator and down on an elevator". The Dow dived 376 points today (-3.60%) entering the first official correction (greater than 10% decline) in the entire rally since the March 2009 bottom. Today's closing price puts the S&P 500 12.1% off highs but still 13.5 handles off the "flash crash" intraday lows.

The euro finally found some friends today bouncing today from a deeply oversold condition. After hitting lows of $1.2143 yesterday the currency recouped the psychological $1.25 level hitting highs of $1.2597 before leveling off later this evening.

The US Senate passed the financial reform bill today. The far-reaching bill is a broad expansion of government regulation and oversight of financial firms and markets. Now begins the reconciliation process between the House and Senate versions of the reform bill. All I have to say is it's about time. It's been a year and half since we witnessed the incredible crash of 2008 and Congress has yet to enact any meaningful reform. While the bill goes quite a bit further than I would have liked, I see the need for basic leverage limits and greater transparency in derivatives trading. I would have liked to see the Volcker Rule as part of the legislation but it looks to have been killed in the debate.

Any soccer fans out there? The 2010 FIFA World Cup starts June 11th, only a few weeks away! Nike released an absolutely brilliant commercial that will get even the most ambivalent fan excited for the upcoming games. The first game for the United States is against our arch-rival, England, on June 12th. Let's kick some British ass!

Correction: The Volcker Rule did make it through. Check out the New York Times for a comprehensive chart of the reform bill.

Senate Moves to Vote on Financial Reform

The Senate overcame the filibuster today voting 60-40 to end debate and clear the way for the final vote on passage of the financial reform bill. Republican Senator Brown of Massachusetts flipped on his vote providing the last needed vote to reach 60. The vote is expected to happen by the end of the week after each Senator has had their hour to speak on the bill. Below are the major provisions in the bill. Still up for debate is an amendment for the so-called Volcker Rule which would prohibit banks from proprietary trading (Click here for the full summary.)

• Consumer Protections with Authority and Independence: Creates a new independent watchdog, housed at the Federal Reserve, with the authority to ensure American consumers get the clear, accurate information they need to shop for mortgages, credit cards, and other financial products, and protect them from hidden fees, abusive terms, and deceptive practices.

• Ends Too Big to Fail Bailouts: Ends the possibility that taxpayers will be asked to write a check to bail out financial firms that threaten the economy by: creating a safe way to liquidate failed financial firms; imposing tough new capital and leverage requirements that make it undesirable to get too big; updating the Fed’s authority to allow system-wide support but no longer prop up individual firms; and establishing rigorous standards and supervision to protect the economy and American consumers, investors and businesses.
  

• Advance Warning System: Creates a council to identify and address systemic risks posed by large, complex companies, products, and activities before they threaten the stability of the economy.

• Transparency & Accountability for Exotic Instruments: Eliminates loopholes that allow risky and abusive practices to go on unnoticed and unregulated - including loopholes for over-the-counter derivatives, asset-backed securities, hedge funds, mortgage brokers and payday lenders.
  

• Federal Bank Supervision: Streamlines bank supervision to create clarity and accountability. Protects the dual banking system that supports community banks.

• Executive Compensation and Corporate Governance: Provides shareholders with a say on pay and corporate affairs with a non-binding vote on executive compensation.
  

• Protects Investors: Provides tough new rules for transparency and accountability for credit rating agencies to protect investors and businesses.

• Enforces Regulations on the Books: Strengthens oversight and empowers regulators to aggressively pursue financial fraud, conflicts of interest and manipulation of the system that benefit special interests at the expense of American families and businesses.

Richard Koo Says Maintain Course with Deficits

Richard Koo on Bloomberg. Koo has an excellent perspective of the current "balance-sheet recession" having lived through and learned from Japan's mistakes that resulted in the nearly two lost decades of economic contraction. His speech at this year's Institute for New Economic Thinking event was brilliant.

My buddy, Elliot, over at AZ had some great thoughts today on the current deflation battle.

European Markets Leap on Aid Package

A huge day in Europe boosted US markets with the Dow gaining 404 points on the day (3.9%). The gain was largely a result of a pre-market gap higher in prices with uneventful sideways consolidation price action throughout the trading day.

The €750 billion ($957 billion) debt aid package arranged by the European Union and International Monetary Fund is having its intended effects on debt and equity markets within the Eurozone. The aid deal consists of €440 billion in loan guarantees, €60 billion in emergency European Commission funding and another €250 billion contributed by the IMF. A special purpose vehicle (SPV) will be setup to distribute the aid and manage the loans. Quite a few questions remain as to how this massive undertaking will be structured, how it will be run and what the incentives/disincentives will be for countries receiving aid. In general, the package has been modeled after the TARP plan enacted by the United States during the 2008 financial crisis.

I did some homework on European markets with the results below:

Market	Day's Gain	YTD Return
United Kingdom (FTSE)	5.2%	(0.5%)
Germany (DAX)	5.3%	1.0%
France (CAC)	9.7%	(5.5%)
PIGS
Portugal (PIS)	10.6%	(11.3%)
Italy (MIB)	11.3%	(9.8%)
Greece (ATHEX)	9.1%	(19.0%)
Spain (IBEX)	14.4%	(13.3%)

Investment Banking: Changed Forever?

The investment banking and securities dealing industry underwent massive disruptions over the past two years. The year 2008 saw a complete makeover of the industry as Bear Stearns fell into the hands of JP Morgan, Lehman Brothers filed for bankruptcy protection, Merrill Lynch staved off collapse with a Bank of America takeover and the two remaining giants, Goldman Sachs Group and Morgan Stanley, converted into bank holding companies to qualify for government assistance. We have seen an incredible destruction of the industry that was years in the making. Many of the causes came from perverse regulatory incentives as the industry transitioned from a natural oligopoly into freer competition.


Structure

The investment banking industry directly correlates to economic growth given that its ability to profit derives from the securitization of businesses. Generally, mergers, acquisitions and other underwriting services depend on the overall level of corporate activity. Corporate activity directly follows from earnings increases of individual companies and the general economic outlook and confidence in business prospects. So the fate of investment banking revenues relies heavily on the fate of the overall economy. Given some of the key structural characteristics of the investment banking industry, investment banks must seek to form long-term relationships with individual firms while respecting others banks’ relationships in a naturally oligopolistic industry.

First, investment banks must perform significantly deep and pointed research into the companies that they offer securitization services to. The initial enticement into private placements is largely dependent on the solid reputation of the lead investment banks promoting the security. In order to find buyers for a particular stock issue that the investment bank wishes to sell to the public, the bank puts its own reputation on the line claiming its high-standards and due diligence of financial statement review give the investor security. An investor needs to be able to trust the investment bank’s opinion on the future prospects of the company and the investment. No investment bank will survive long should it promote the securities of soon-failing institutions. Any individual bank promoting worthless companies will soon go bankrupt as investors realize the ill-advised investments they are taking. This is clearly why so-called “chop shops” and penny-stock promoters typically never gain respected status and fail in short order or are shutdown by the SEC for fraud. The major players in the industry have had collective breakdowns in underwriting standards in times of the past but generally banks must be trustworthy and provide accurate assessments of future business prospects. (2001 Anand & Galetovic)

Initially, then, a bank must study the company and its prospects and assign an appropriate valuation. This initial due diligence is costly and results in sunk costs in order to begin a relationship with outside firms. The costs are necessary but are undertaken because the bank clearly believes it can garner greater profits in the future by having a relationship. (2001 Anand & Galetovic) These unrecoverable costs are worthwhile if the bank can create a lasting relationship where it reuses the same information for future deals and is able to recoup the costs associated to that particular company as well as the sunk costs lost on firms where potential deals were rejected due to lower credit quality.

These sunk costs relate to another trait in the investment banking industry, the misaligned connection between costs and fee revenue. (2001 Anand & Galetovic) Investment banks only generate revenue when they create and execute a particular security deal. While banks may spend months and months studying a company, gauging market buying interest, promoting a deal, offering advice, they are only paid fee income once the deal is finally consecrated. Ultimately a bank may provide a great deal of services and never collect fee revenues.

A third characteristic of the industry is a bank’s inability to claim any rights over the information it generates about a particular firm it is investigating for a potential deal. (2001 Anand & Galetovic) The firm may spend hundreds of man hours dedicated to deal but it has difficulty maintaining that information as proprietary. The risk of a lead person on the deal team to be hired away by another bank is high. Banks can attempt to reduce this risk through non-compete agreements but given the global nature of today’s financial system, non-competes can fail rather easily given their geographical limitations. Then, this employee who is hired away would bring with them all the information they had gathered in hours of research at the bank. Also, once the bank has researched the potential company for underwriting, it must use its reports to generate outside interest among investors. In seeking these outsider investors, the research is pushed into the public forum and its privacy is lost.

These three traits of the industry point to why investment banking is naturally oligopolistic. In perfect competition, investment banks would allow other firms to incur the initial sunk costs for a deal and then free ride off the information obtained. A bank could easily achieve this by stepping in late in the deal just before the security is actually created and sold and undercut the initial firm. A simple way to create the relationship would be to hire away the lead employee on the deal who has the most intricate knowledge of the company and the deal at hand. “For example, Deutsche Bank built a global investment bank in a year (Deutsche Morgan Grenfell) by hiring away staff en masse from other major banks” (2001 Anand & Galetovic). The information and advice exchanged prior to a deal’s completion give strong incentive for another investment bank to free ride and offer the deal at a much lower price having not incurred the setup costs. Therefore, the investment banking industry cannot be perfectly competitive and must result in a voluntary cooperation among banks not to undercut each other in ruinous competition that will ultimately destroy the incentives to create long-lasting relationships with firms. Evidence of this dynamic has been studied in various literatures. In Struggle and Survival on Wall Street written in 1994, Matthews found that firms have charged 7/8 percent for underwriting top quality bonds for decades. Matthews concluded that there must be some type of unspoken collusion among banks for this to occur so systematically for so long. Chen and Ritter reported that “gross spreads received by underwriters on initial public offerings in the United States are much higher than in other countries. Furthermore, in recent years more than 90 percent of deals raising $20-80 million have spreads of exactly seven percent, three times the proportion of a decade earlier.” The spreads were not near or around seven percent, they broke down to exactly seven percent. In a more competitive industry, one would expect to find spreads in a range where banks would compete with each other at least to some degree. Chen and Ritter go on to claim that investment bankers will openly admit that “they don’t want to turn it into a commodity business” so banks do not compete on the prices charged for initial public offerings. The ability to perform high-yielding securities deals is the lifeblood of the investment banking industry and executives have made sure not to cause a breakdown in the fee schedule. These implicit agreements show the oligopolistic structure of the investment banking industry.

In such a structure, there is a relatively fixed size of each individual dominant firm in the industry. If firms are all too small, they will free ride off each other’s information and ruin each other. While if a particular firm is too large relative to the others, the smaller firms will have increased incentive to free ride to the detriment of the large firm. Therefore, no firm can become too large without other, smaller firms attacking it and driving up its costs and reducing its fee revenues through undercutting. The large firms operate on mutual high reputations and an implicit agreement not to fall into ruinous competition. This creates the “boys club” that Wall Street is sometimes seen as.

The high barriers to entry in the industry also help support the Wall Street club. The Securities and Exchange Commission has set a high standard of capital and regulatory requirements that must be passed in order to setup as an investment bank (2009 IBIS). The capital standards require large initial investments for conducting business. More recently, increased regulation of the industry is likely thus further increasing the barriers to entry for companies not able to produce significant economies of scale to spread the high costs of compliance with legal regulations. Yet, once a bank is established, their fixed capital costs are relatively low in comparison to variable labor costs. The services provided by investment banks require a large amount of administrative work and are highly labor intensive in general (2009 IBIS). These employees are typically highly educated and very specialized in their field resulting in outsized wage expenses to maintain the workforce. This relatively large portion of variable costs helps banks deal with downturns in economic activity and massive layoffs are an understood part of the business in times of economic contraction. But, as a barrier to entry into the industry, it can be difficult to attract the well-qualified candidates in order to setup an enterprise especially in investment banking because of its reliance on a bonus as a significant portion of an employee’s compensation. This bonus is very large relative to the employee’s salary and is only guaranteed if the firm can guarantee its ability to perform high profile securities deals. In this way, the top firms of the industry are naturally supported by their employees who stay with the reputation and success guaranteeing their income at the end of the year.

Also, one of the greatest components for success for an investment bank is its reputation. Reputations are not made in short order but rather take years of quality servicing and then decades to establish the firm commitment to maintaining integrity in its dealings. Gaining acceptance from firms as a desired promoter and underwriter of securities is a long, hard-won battle that substantially hinders new entrants from the market. Reputation and brand can be measured by goodwill accounting within the financial statements. Goldman Sachs, for example, records an asset value of over $5 billion for its goodwill and intangible assets on its financial statements (2009 GS). UBS valued its goodwill at over $4 billion for the year ended December 31, 2008 (2008 UBS). These goodwill measurements indicate the value of the business segments that exceed the discounted expected future cash flows and point to a valuation of a company’s reputation, brand image and customer loyalty.


The Panic of 2008

According to U.S. Census Bureau statistics, the investment banking industry had 5,583 firms in 2007 generating a total of $207.4 billion in sales and employing over 140,000. The industry experienced rapid growth over the previous five-year period with a 109.7 percent growth in revenues fueled by a relatively minor 19.7 percent growth in the number of firms coupled with a miniscule 6.4 percent increase in the number of employees. Compensation increased 57 percent over the same period from 2002 to 2007, a 9.5 percent compound annual growth rate. (2009 Census)

The state of New York is, by far, the dominant player in the investment banking industry in terms of revenue, but not hardly so in terms of the number of institutions. While accounting for only 20.8 percent of the total firms in 2002, New York firms produced 77.9 percent of the total revenues generated in the industry. California takes up second in the total revenues with a measly 4.1 percent of total sales. This divergence clearly points to the dominance of Wall Street and the large market shares of a limited number of firms. (2009 Census)

The year 2008 saw an extraordinary 93.0 percent drop in industry revenue as the sector imploded in the wake of the subprime mortgage meltdown. As recently as the year 2007, the top six investment banking firms accounted for 86 percent of the total market. By the end of 2008, major consolidation had occurred and the top three firms now had market share of 65 percent. The top six investment banks in 2007, in order of market share, were Goldman Sachs, Morgan Stanley, Merrill Lynch, Lehman Brothers, Bear Stearns and JP Morgan. By the end of the 2008, Goldman Sachs and Morgan Stanley had survived only by converting to bank holding companies to qualify for government capital infusions. Merrill Lynch was forced into an acquisition by Bank of America after Lehman Brothers dramatically collapsed in a short time. Bear Stearns was the first to fall in early 2008 forcing a takeover by JP Morgan. The composure of the investment banking industry has dramatically changed and will continue to change in the future. There are no independent investment banks remaining of any sizable importance. (2009 IBIS)

The current industry now has four key players accounting for 80 percent of the market. JP Morgan, after acquiring Bear Stearns in May of 2008, now holds a 26 percent share operating with assets of $1.6 trillion and 180,000 employees. JP Morgan bartered an exceptional deal with the Federal Reserve Bank bearing only the first $1 billion in potential losses from the acquisition while the Fed bears the next $29 billion offering JP a great chance to snap up huge market share gains without excessive risk of losing capital. JP participated in the same leveraged loans and mortgage investments that other banks did but on a much more conservative scale so that still maintained profitability in 2008 with incomes declining 64%. (2009 IBIS)

Goldman Sachs, one of the two remaining firms from the group of the five independent investment banks, comes in second in market share with 23 percent. Goldman also weathered the subprime meltdown relatively well as it hedged its positions wisely and experienced an 80 percent decline in net income in the year 2008. Morgan Stanley ranks third in share with 16 percent and Bank of America rounds out the top four with 15 percent market share. These four companies dominate the investment banking industry in the United States now. Citigroup is the fifth largest and holds a measly one percent share. (2009 IBIS)


Causes of the Collapse

The 54 percent drop in the equity market from the October 2007 high to the March 2009 low has left many market participants asking why the crisis occurred. Given that the crisis was first felt within the walls of Wall Street firms, it makes one ask how investment banks could have incurred such massive losses. The top five firms as well as other commercial banking institutions threatened the collapse of the entire global financial system with their extraordinarily excessive leverage and concentration in subprime mortgage backed securities. Much of the changes in banking habits can be traced back the Gramm-Leach-Bliley Act (GLBA) of 1999.

The GLBA most notably repealed Section 20 of the Glass-Steagall Act of 1933 (2009 Geyfman & Yeager). After the stock market crash in 1929 the Federal government passed many new wide-ranging sweeping measures to curtail excessive risk-taking in the financial markets by large banking institutions. The SEC was formed to regulate entities and Federal Deposit Insurance Corporation was founded to insure the deposits of individual customers. Along with these two entities which have proved to be major successes in creating stability in financial markets, the Glass-Steagall Act had the specific provision of Section 20. Section 20 prohibited commercial banking institutions from engaging in securities activities. Banks that held customer deposits were now prohibited from engaging in or having affiliations with firms that “engaged principally in the issue, flotation, underwriting, public sale, or distribution at wholesale or retail or through syndicate participation of stock, bonds, debentures, notes or other securities” (Title 12, U.S Code, Section 20).

Section 20 intended to separate the riskiness of activities that dealt with securities and the necessity of safety for consumer depositors. Glass-Steagall looked to curtail the negative effects losses in securities dealing would have on the security of banking deposits in a firm participating in both aspects of the financial system. As with many other industries, the move to deregulation seen in the United States throughout the 1980s had its effects on the financial services industry as well. The slow erosion of Section 20 finally culminated in the passing of GLBA, otherwise known as the Financial Services Modernization Act in 1999. This Act allowed bank holding companies to convert into financial holding companies and perform dealings in securities through subsidiaries without regulatory limits. (2009 Geyfman & Yeager)

The repeal of Section 20 was strenuously lobbied for in Congress by banking institutions on the premise that major synergies could be achieved without it creating significant economies of scale. Investment banks must undergo costly creditworthiness evaluations in order to underwrite securities. These activities are linked to a firm’s day-to-day financial activities. A bank holding company holding the deposits and providing credit lines to an institution will have already conducted evaluations of the firm that can then be transferred into underwriting activities without repeat of the initial sunk costs independent investment banks must endure. Recent studies have shown a “modest risk diversification benefits in the post-GLBA era” (2009 Geyfman & Yeager) and “significant revenue synergies between IB and commercial banking” (2005 Yasuda). On the other hand, now banks are participating in a significantly riskier world of securities dealing with the downside of the risks to be felt by those seeking safety in simple depository transactions with the bank. Geyfman and Yeager found that “universal banks had similar systemic risk but sharply higher total and unsystematic risk than more traditional banks” (2009). This finding points to the inherent risks in securities dealing and the possible spillover disruptions these activities could have on traditional commercial banking activities.
The GLBA led to significant changes in the investment banking industry. The five largest independent investment banks that had operated under implicit cooperation were forced to produce earnings elsewhere as many new competitors entered the market. Previously an unhindered oligopoly, the top five independent investment banks found themselves competing for securities deals with the new so-called universal banks, major players like JP Morgan, Citigroup and Bank of America. Every banking institution was now allowed in on the deal-making turf and held significant sway over firms making securitization decisions because of the existing relationship with banks holding depository funds. A study in 2005 showed that companies having existing banking relationships will more often choose that particular bank as their underwriter in securities deals (2005 Yasuda). This poses a great challenge to investment banks that do not hold deposits because customers that were previously forced to seek out an independent investment bank were now choosing the bank holding companies they already had established relationships with for securities deals.

After five years of competing with all other firms in the banking world for securities deals, investment banks needed a new way to make money. The new solution included employing a great deal of leverage. One of the most crucial elements of the financial industry collapse was the major change the SEC passed in legislation in 2004. Since 1975, the SEC had limited broker dealers a debt-to-net capital ratio of 12-to-1. Most banks exhibit leverage ratios between 9 and 12 percent depending on the management’s appetite for risk. Investment banks though, have always found ways to exceed those ratios but the 2004 SEC rules gave them free reign. The SEC now allowed the top five investment banks to leverage up 30, even 40 to 1. (2008 ParaPundit)
One of the most striking elements of the leverage equation is that it does not include many off-balance sheets obligations and does not account for the implicit leverage in derivatives contracts. Unhedged positions in credit default swaps and options can produce catastrophic losses in an extremely short amount of time. American International Group is a prime example of the riskiness of CDS contracts with the asset values of their books plummeting as fear of counterparty bankruptcy skyrocketed after Lehman Brothers’ collapse. Yet, even without the inclusions of these pieces of the equation, the leverage seen on investment banking balance sheets struck market participants as showing astounding arrogance and extreme recklessness.
At first, leverage was a great boon to the industry as evidenced by the 109.7 percent growth in revenues from 2002 to 2007. Investment banks increased their principal trading throughout this period rising from 16% of revenue generation in 2002 to 23% by 2007 (2009 IBIS). Average leverage ratios skyrocketed in a short time after the 2004 enactment at the major five investment banks. On average from 1999 to 2003 the top banks had leverage ratios of: Bear Stearns, 27.6 percent; Goldman Sachs, 19.2 percent; Lehman Brothers, 25.8 percent; Merrill Lynch, 18.5 percent; and Morgan Stanley, 21.7 percent. By 2007 every bank had large increases in their debt to capital ratios: Bear Stearns, 21.5 percent increase to 33.5 percent; Goldman Sachs, 16.6 percent increase to 22.4 percent; Lehman Brothers, 19.2 percent increase to 30.7 percent; Merrill Lynch, 73.2 percent increase to 32.0 percent; and Morgan Stanley, 53.8 percent increase to 33.4 percent (2008 Epicurean). These banks took advantage of the SEC rule change to the fullest extent pushing their balance sheets to the limit, and then over the limit. While the top four investment banks had market share totaling 39.1 percent in 2002, the leverage fueled large gains and by 2007, the top four firms had combined market share of 69.0 percent (2009 IBIS).

Leverage is a great bonus in boom times as seen in the housing market throughout the early 2000s as real estate prices soared. But, leverage is much more of a zero-sum game than most would like to admit and the fall in housing demand towards the end of 2007 caused losses in banking portfolios and ultimately resulted in billions of dollars in writedowns.
In the end, none of the top five investment banks existed in its independent investment banking form by the end of 2008. Bear Stearns collapsed and was sold off to JP Morgan at a pittance of its former stock price. Lehman Brothers found the government unwilling providers of bailout monies and claimed bankruptcy in September 2008. Merrill Lynch, seen as the next domino in a falling cascade, was forced into an acquisition by Bank of America to salvage the company. Goldman Sachs and Morgan Stanley soon converted into bank holding companies to receive access to the Federal Reserve discount window. This conversion dictates a major reduction in leverage for the two banks to comply with regulation.


Conclusion

The underlying regulatory structure created economic incentives that fueled the boom and bust in the investment banking industry. A naturally oligopolistic industry that would fall victim to ruinous competition under a perfectly competitive market found itself in a state of implicit cooperation. Investment banks chose not to compete on price for securities deals as evidenced by clustering of spreads on corporate bonds offerings and initial public offerings in equities sold by banks. The repeal of Section 20 from the Glass-Steagall Act of 1933 allowed a new field of entrants into the investment banking arena. The rise of the universal bank allowed institutions that held depository accounts to now be the one-stop shop for all a firm’s financial needs. As studies have shown, firms are more likely to use the bank they already have a relationship with in going forward on securities deals. So, the independent investment bank found itself in a tough spot. Its oligopoly was invaded by a swath of new competitors and it had to find a new competitive advantage. The solution was disastrous in the long-run even while providing five years of record-setting growth rates.

Investment banks leveraged up their mortgage dealings and engaged in a variety of high-risk derivative bets. It is interesting to note that the two banks with persistently highest leverage ratio prior to the 2004 SEC rule change were the first to collapse in the 2008 panic. Goldman Sachs, the best-surviving member of the top five, exhibited the lowest leverage ratio directly resulting in lessening the blow from the mortgage fallout.
It is unclear whether the investment banking industry will ever be the same again. What is clear is that an underlying regulatory framework that encourages perverse economic incentives can easily cause collapse.



Works Cited

“Banks’ Interactions with Highly Leveraged Institutions”, Basle Committee on Banking Supervision, January 1999.

Chen, H. and J. Ritter, “The Seven Percent Solution,” Journal of Finance, 2000.

Economist, The, “The Living Dead: Restructuring Banks”, November 7, 2009.

Goldman Sachs Group Inc., Stock Report, Matthew Albrecht, Standard & Poor’s, The McGraw-Hill Companies, October 20, 2009.

GS Quarterly Earnings Release, Goldman Sachs Group Inc., September 2009.

Investment Banking & Securities Dealing in the US: 52311. IBISWorld Industry Report, July 29, 2009.

Investment Banking and Security Market Development: Does Finance Follow Industry?, Bharat N. Anand, Harvard University; Alexander Galetovic, Universidad de Chile; February 2001, http://www.people.hbs.edu/banand/investmentbanking.pdf.

Matthews, J. Struggle and Survival on Wall Street. New York: Oxford University Press, 1994.

“On the Riskiness of Universal Banking: Evidence from Banks in the Investment Banking Business Pre- and Post-GLBA”, Victoria Geyfman and Timothy J. Yeager, Journal of Money, Credit and Banking, Volume 41, Number 8, December 2009.

ParaPundit, “SEC Leverage Rule Change Contributed to Investment Bank Failure”, http://www.parapundit.com/archives/005558.html, September 21, 2008.

Epicurean Dealmaker, “Supermassive Black Hole”, http://epicureandealmaker.blogspot.com/2009/09/supermassive-black-hole.html, September 22, 2008.

UBS Quarterly Financial Statement. UBS Financial Services. http://www.ubs.com/1/e/investors/accounting_standardsandpolicies/criticalaccountingpolicies/goodwill.html, December 31, 2008.

U.S. Census Bureau, http://factfinder.census.gov, November 2009.

Yasuda, Ayako. “Do Banking Relationships Affect the Firm’s Undewriter Choice in the Corporate-Bond Underwriting Market?” Journal of Finance, 2005.

Chart: Financial Reform Components

Courtesy of Wall Street Cheat Sheet

Richard Koo: Balance Sheet Recession

Richard C. Koo, Chief Economist at Nomura Research Institute gave a speech at the Institute for New Economic Thinking's inaugural conference entitled "The Age of Balance Sheet Recessions: What Post-2008 U.S., Europe and China Can Learn from Japan 1990-2005". The video and PowerPoint below offer fascinating insights into the current economic situation in the United States. I admit I have been ignorant of many of these concepts and I have started to see our situation in a new light.

My Two Cents on Health Care

What's being called the most sweeping health care reform bill in decades passed the House of Representatives last night 219-212. Since everyone has an opinion on this topic, I figured I might as well join the fray. But, for the most part, both sides of the aisle need to be realistic about this bill. No, it will not destroy America. And, no, it will not revolutionize the entire health care industry and provide all Americans with the best coverage at no cost.

First, I have to hand it to President Obama for his ability to get this passed. In December, most of us thought the bill was dead. Some key losses in Democratic seats seemed to act as a referendum on the health care debate. But, Obama refused to give up. He rallied the Democrats and brought Republicans into the debate with a round-table discussion. Love him or hate him, I am impressed with the political ability Obama showed on this issue.

My largest problem with the bill is the cost. As I understood it, the entire reason for addressing health care at this time, a time of record deficits and a crippling recession, was to curtail the burgeoning costs of health care. Obama argued for the economic imperative of lowering the costs on our system. (On that issue, I really dislike the projections made on health care costs as if we can just regress the last 10 years and claim as fact that costs will continue their trajectory.) But even so, assuming those costs and the goal of cost reduction this bill extends coverage to roughly 32 million people and regulates insurance companies' ability to deny coverage. The CBO projects that the bill will increase deficits just under $1 trillion in the first year and then somehow cut the deficit by just over $100 billion over the next 10 years. Frankly, I don't believe it. It'll only take a year to prove me wrong but I don't see how this program will run surpluses for the next 20 years. Increasing coverage and reducing deniability does absolutely nothing to reduce the cost trajectory, absolutely nothing. The only way the CBO estimates work out is through tax increases.

Clearly, the only way for this to be possible is to raise taxes a great deal. There's a variety of taxes that will be raised in order to fund the bill but this is the worst time for that. I fully understand that the federal government will need to increase revenues in the next couple decades to pay down our record deficits and support our current spending habits. The worst thing we can do though is add entirely new entitlement programs that need funding. We cannot pay for what we already have and now we're creating new monsters to deal with. I just don't see how this helps our economic and fiscal situation.

Also, we're stealing from Medicare to pay for this program. One of the biggest problems with running pension and entitlement programs is that the managers of the plans don't save surpluses. This is a classic case of not putting Medicare in Al Gore's "lockbox". This will create shortfalls in leaner times.

Also, why is everyone demonizing the health insurance companies? There is a legitimate argument to be made as to whether we want the health insurance industry to be for-profit. I think support for non-profit firms could help. Though I don't think the profits being made are what's causing the problems. Of our five largest health insurers, 2 of them have margins just over 7% and the other 3 have sub-5% net profit margins. It's not like these firms are just printing money. Regulation on pre-existing conditions and such is important but I don't see the evil insurance company line of thinking.

Anyway, there's my health care debate ramble. This bill has some good stuff in it, some bad stuff. My primary problem is that I don't believe we can afford it. Health care for everyone is a great ideal but I don't see how it happens without sacrificing quality. There's an equilibrium between quality and coverage. America has always tilted the scale towards higher quality, lower coverage and higher cost. Increasing coverage comes with a give in other sides of this equation. I believe costs will be higher and quality will be lower over the long run.

Obama Finally Supports Nuclear

Obama Offers Loan Guarantees for Nuclear Power Plant

President Barack Obama is making roughly $8 billion in federal loan guarantees available to help build the first U.S. nuclear power plant in three decades.

Discussing a plant envisioned for Burke County, Ga., Obama told a union audience Tuesday that the initiative will create thousands of construction jobs and 800 permanent jobs. He called it "only the beginning" of efforts to develop "safe, clean" energy-efficient technologies.

Finally! I have long been a supporter of increasing our nuclear energy capabilities and have been baffled by the excessive fear and nonsense about the radioactive waste. First, no one has ever died from a nuclear plant meltdown. And, given the increasing safety standards, the chances of disaster happening are absurdly small. Second, when comparing nuclear and coal pollution, nuclear makes a lot more sense because it "operates on the principle of containing wastes, not dispersing them". What's better: a small, controlled nuclear rod that is stored for breakdown or the spewing of tons upon tons of waste into the air without controls? I hope this is a beginning and our country makes a real push into the nuclear space, we've got a long way to go to catch countries like France that use nuclear generation for 80% of their electricity use.

I have been arguing for a while that the only way this country emerges from this Great Recession and reclaims its status as economic world leader is an energy technology revolution. The wave of the future is clean energy and the US must be a leader in developing these technologies. We are already being left behind by China and need significant investment in these fields. Let's not forget, even with oil's extreme volatility, crude prices began the decade around $30 per barrel. Today we are at $77, a greater than 10% annual compound rate of increase. This increase significantly curtails economic growth for the US while we get to watch Dubai build the world's tallest buildings.

Top Marginal Rate Low Historically

Source: Chart Porn via My Back Pages

It does seem inevitable that we will be seeing higher tax rates in America over the next few decades. As our workforce shrinks with retiring baby boomers, the rest of us will be forced to close the gap as well as pay down our current $14 trillion debt. Taxes are headed higher. Yet, even a 50% raise in the top marginal rate will still put it well below long-run average rates.

Obama Budget Based on Hope

Obama has now made me understand what the hope is all about. I'm not sure his budget proposal is anything but a unbelievable hope for the future. Obama unveiled a $3.8 trillion budget proposal that needs $1.3 trillion of borrowed money in 2011. The plan will raise taxes on high income individuals and businesses to raise $970 billion and $400 billion, respectively. Now for the shocking part:

The White House budget proposal released Monday assumes the U.S. economy is heading for a six-year run of above-average economic growth with no sign of a worrisome spike in inflation or interest rates...

...It expects six consecutive years of strong growth ranging from 3.2 percent to 4.3 percent — well above what most economists consider the longer-term trend of around 2.6 percent.

The last time the economy saw a similar streak of strong growth was in the late 1990s, during the dot-com boom. Obama has said both that expansion and the housing-powered growth in the mid-2000s were bubble-driven, and he wants the next expansion phase to rest on sturdier pillars...

...The budget forecast reflects a 3.8 percent five-year average. (CNBC)

So raising taxes and overwhelming the loanable funds markets translate into above-average growth. Hope indeed, hope indeed.

What a State of the Union Address!

Presumed Inflation...Really?

The following paper has been making the rounds in the blogosphere and I thought I'd throw in my two cents (all emphasis is mine).

Excerpted from The Elliott Wave Theorist, December 18, 2009

"The Fed’s Presumed Inflation Since 2008 Is Mostly a Mirage"

Many commentators talk about inflationary forces running rampant. We all know that the Fed created $1.4 trillion new dollars in 2008. It has told the world that it will inflate to save the monetary system. So that is the news that most people hear.

But the Fed’s dramatic money creation in 2008 only seems to force inflation because people focus on only one side of the Fed’s action. Even though the Fed created a lot of new money, it did not affect the total amount of money-plus-credit one bit, because the other side of the action is equally deflationary.

When the Fed buys a Treasury bond, net inflation occurs, because it simply monetizes the government’s brand-new IOU. But in 2008, in order for the Fed to add $1.4 trillion new dollars to the monetary system, it removed exactly the same value of IOU-dollars from the market. It has since retired some of this money, leaving a net of about $1.3 trillion. So investors, who previously held $1.3t. worth of IOUs for dollars, now hold $1.3t. worth of dollars. They are no longer debt investors but money holders. The net change in the money-plus-credit supply is zero. The Fed simply retired (temporarily, it hopes) a certain amount of debt and replaced it with money. In fact, if the Fed is to be believed, it desperately wants to sell the rest of these (in)securities and retire the new money. I doubt it will happen, but it doesn’t much matter to inflation either way.

In currency-based monetary systems, the creation of new banknotes causes—indeed forces—inflation. Likewise, the monetization of new government debt creates permanent inflation practically speaking. (Theoretically, the government could retire its debt, but it never does.) But when the Fed simply swaps money for previously existing debt, there is no net change in the amount of dollar-based “purchasing power” on the planet.

The theory among monetarists is that these new dollars are hot money that creditors can now re-lend. Thus, it will multiply throughout the banking system. At first it might seem that new money in banks’ hands should be more powerful for creating inflation than the previously-held FNM mortgages. But this is not the case, because the main thing for which the Fed wants banks to lend out the new dollars is new mortgages. Today, bankers and other creditors are afraid of mortgages, and they don’t want new mortgages any more than they want the old ones. In the mortgage-intoxicated, pre-2008 world, there would have been little significant difference in the paper, because banks were creating new dollars any time they wanted by taking on new mortgages. In the mortgage-repelled, post-2008 world, guess what: there is still little significant difference in the paper, because virtually the only thing banks can use it for is to fund mortgages! The only other outlet for the Fed’s new money is to fund market speculation, which is one reason why the stock and commodity markets rose.

What is very different—as predicted in Conquer the Crash—is the desire of lenders to lend and of borrowers to borrow, which has shriveled dramatically. This abrupt change resulted from the change in the trend of social mood at Supercycle degree that took place between 2005 and 2008, when real estate, stocks and commodities peaked along with the ability of the banking system to write one more mortgage without choking to death.
…
The bottom line is that the Fed hasn’t created much inflation over the past two years. The only reason that markets have been rallying recently is that the Elliott wave form required a rally. In other words, in March 2009 pessimism had reached a Primary-degree extreme, and it was time for a Primary-degree respite. The change in attitude from that time forward has, for a time, allowed credit to expand again. But the Fed and the government didn’t force the change. They merely accommodated it, as they always have. They offered unlimited credit through the first quarter of 2009, and no one wanted it. In March, the social mood changed enough so that some people once again became willing to take these lenders up on their offer.

Frankly, I'm not an economist by training (even though I've studied the subject a bit) but I don't understand this one bit. Maybe I’m slow but this makes absolutely no sense to me. I don’t see how the Fed purchasing the Treasury’s debt is not simple monetization and, therefore, inflationary. Debt holders become money holders (money that was not previously in the system). So, with actionable money they can buy more debt. Doesn’t that support prices and isn’t that inflationary? Whether the Fed buys existing debt or new debt doesn’t seem to matter if the Treasury is issuing debt all the while.

So, granted the money doesn’t go into new debt because no one wants to borrow (the consumer is smartening up and deleveraging). So, “The only other outlet for the Fed’s new money is to fund market speculation, which is one reason why the stock and commodity markets rose.” Isn’t this inflation…the pushing up of asset prices with new money?

The Fed has created huge inflationary pressures in the system. The idea that the data have not shown inflation and, therefore, the actions haven't been inflationary is nonsense. Prices should be deflating much further than have been allowed by the Fed. If anyone can explain to me how the Fed's actions have not been net inflationary I'd love to listen. If Prechter actually is right, then the Fed is pretty worthless at stabilizing prices, one of its two core mandates.

GS Sued Over Bonuses

Let the games begin:

Goldman Sachs was sued on Thursday by an Illinois pension fund seeking to recover billions of dollars of bonuses and other compensation being awarded for 2009, saying the payouts harm shareholders.

In a lawsuit filed in New York state supreme court in Manhattan on behalf of shareholders, the Central Laborers' Pension Fund said Goldman had by Sept. 25 set aside nearly $17 billion for compensation and might pay out more than $22 billion for the year. It said this "highlights the complete breakdown" of corporate oversight.

The lawsuit contends that Goldman's revenue for the year was artificially inflated by government bailouts of the banking industry and the insurer American International Group, as well as a change in Goldman's fiscal year.

Such sums, and Goldman's practice of continuing to pay out nearly 50 percent of net revenue as compensation, show "scant regard" for the interests of shareholders, it said... (CNBC)

Start of a new trend??

Why Has Nothing Changed? Same Leaders!

From "A Fair Deal for Taxpayer Investments" by Emma Coleman Jordan (Hat tip The Big Picture):

The prospects for a robust prudently guided financial sector have been substantially clouded by the fact that the both the corporate governance structure and the executive leadership of the financial sector remain largely unchanged—92% of the management and directors of the top 17 recipients of TARP funds are still in office. (Jordan, 2009)

Anyone reminded of Taleb's "Ten Principles for a Black-Swan-Proof World"?

3. People who were driving a school bus blindfolded (and crashed it) should never be given a new bus. The economics establishment (universities, regulators, central bankers, government officials, various organisations staffed with economists) lost its legitimacy with the failure of the system. It is irresponsible and foolish to put our trust in the ability of such experts to get us out of this mess. Instead, find the smart people whose hands are clean.

Did Taibbi Strike a Nerve?

WASHINGTON -- President Barack Obama lashed out at Wall Street, calling bankers "fat cats" who don't get it, in an escalation of tensions with the industry.

Mr. Obama, speaking on the eve of Monday's meeting with the heads of major banks at the White House, said he would try to persuade bankers to free up more credit to businesses, with the aim of boosting job growth. But the president also expressed frustration with banks that the government has assisted.

"I did not run for office to be helping out a bunch of fat cat bankers on Wall Street," Mr. Obama said in an interview on CBS's "60 Minutes" program on Sunday.

"They're still puzzled why is it that people are mad at the banks. Well, let's see," he said. "You guys are drawing down $10, $20 million bonuses after America went through the worst economic year that it's gone through in -- in decades, and you guys caused the problem. And we've got 10% unemployment."

I have to wonder if Obama read Taibbi's December 9th article in Rolling Stone and feels increasingly annoyed that bankers just don't see his point-of-view...ha, good luck!

Quote of the Day: Jim Rogers

"The idea you can solve a problem of too much debt and too much consumption with more consumption and more debt defies belief. I cannot believe that grownups would stand there and say that."

~Jim Rogers on Tech Ticker

Schiff: Gold Standard Not Arcane

From the Peter Schiff Blog:

"Well, the gold standard works. What we have now does not. Our founding fathers put us on a gold standard for a good reason, because paper currency existed around that time. It had existed in the past. And they were familiar with how miserably it had failed. So they wanted to set us on a gold standard. And we became the world's wealthiest nation while on the gold standard.

"We were on the gold standard for all of the 19th century, which was our fastest-growing century (more so than the 20th century). We had the Industrial Revolution; we built up our arsenals and our democracy—we won World War II on the gold standard. We were actually on the gold standard up until Richard Nixon ended it in 1971. So to say that the gold standard is somehow arcane, or that you can't have economic growth on the gold standard—that's all nonsense.

"It's the politicians who don't like gold, because gold imposes discipline on politicians. It keeps them honest, and politicians don't want to be honest. They want to get elected."

in Yahoo TechTicker

Galleon's Incredible Web

Source: Wall Street Journal

Taibbi Strikes Again

Matt Taibbi, the author of the controversial article on Goldman Sachs' market manipulation, is at it again with a brilliant piece published a few weeks ago. In "Wall Street's Naked Swindle", Taibbi raises some serious questions about the power of naked shorting and the ability for some to effect the rapid deterioration in the stock prices of target companies. His expose includes detailed accounts of the trading seen in the stocks of Bear Stearns and Lehman Brothers prior to bankruptcy and even raises some conspiratorial evidence of the Fed's involvement in choosing the winners and losers of the crisis.

Taibbi's article is worth the read!