The Global Perspective (Archive Edition)

Breaking The Glass-Steagall

OP-ED

If you work for a federal regulator right now, or you are in any way whatsoever connected with fiscal policy in the United States, here's a piece of advice: turn off your television, pack your bags, leave your laptop at home, and go spend the next week with a pile of unread Grisham novels on a beach in the Mediterranean (the weather is great at this time of year).

The crisis begun on September 15 on Wall Street has finally entered its lunacy phase, and it would be best for everyone - federal regulators especially - to take no notice. Sadly, that's unlikely to happen, and the mess we find ourselves in now is only likely to intensify over the long-term. The reason: an old, seemingly forgotten act called Glass-Steagall.

BRIEF HISTORY AND INTENT OF GLASS-STEAGALL

Glass-Steagall is a law that essentially mandates the separation of commercial and investment banking activities. Presciently, it was introduced in 1933 in order to control the effects of stock market activities on everyday consumers. Specifically, it prevents a "deposit-taking" bank (such as your local Bank of America) from engaging in speculation activities (such as buying mortgage-back securities).

As a law, it makes sense: after all, it's difficult to imagine anyone wanting to harbor their savings in a bank which is making butterfly-spread crack oil trades that only a very select few people understand (or think they understand, as the case might be). As piercing as that logic might be to anyone, in November 1999, Congress killed the act when it approved the acquisition of Salomon Brothers (an investment bank) by Citigroup (then a pure deposit-taker).

Fast-forward another nine years, and investment banks and commercial banks are being handed out free doses of Viagra before they've even thought about getting into bed together. Monday, federal regulators all but arranged a $50 billion (in stock) buy-out of Merrill Lynch by Bank of America. Meanwhile, Barclays is being shown the red carpet to Lehman Brothers.

IMPLICATIONS

The irony surely cannot be lost on anyone: Glass-Steagall was implemented as a response to the 1929 Wall Street crash, where banks lost millions of dollars, and with it, much of their depositors' savings. Seventy-nine years on, and federal regulators have unsurprisingly found that the only companies around with enough cash to buy ailing investment banks are the ones looking after consumer deposits. That, of course, is proof of the success of Glass-Steagall.

Federal policy in recent days is like using your kid's trust fund to pay off last year's gambling debts, while using still more to double-down on the next Yankee's game in the hope that this time they finally beat the Sox.

From an investor's perspective, it's a wonderful thing, short, even medium-term, just as the kid's trust fund money is for any down-on-his-luck Major League Baseball spread-betting aficionado. It's why I suggest that everyone right now should pile into BoA stock. To extend the analogy, by buying Bank of America at its now greatly reduced price -- with a sizeable increase in the risk component of the bank -- you essentially get a wad of free money to play a whole host of MLB games, which, for a certain period of time, will turn out trumps-up (the Yankees have to beat the Sox sometimes).

But what happens the next time the bets turn sour?

FURTHER DEVELOPMENTS

Worryingly, less than a full day after announcing better-than-expected earnings, Morgan Stanley is plummeting 30%; Goldman Sachs is down 20%. As federal regulators reward the investment banks that have least efficiently managed their risk portfolios with injections of retail banking fresh cash, those that have been fairly responsible in doing so are getting punished by investors. If that scenario continues, then the banks that have been responsible face no option other than to be acquired by commercial banks, thus expounding the level of risk within the financial system.

Left to their own devices, time has shown that stocks with healthy balance sheets and operating systems recover efficiently, and so it would be for Morgan Stanley and Goldman Sachs, the last two independent U.S. investment banks standing. When regulators impose unnecessary artificial stimulae on the financial system however, the risk aspects of that system mutate, often with dramatic long-term social consequences.

It seems the millennium bug many feared would lead to Armageddon eight years ago may not be in the technology of our financial systems, but rather in its Ecosphere. Federal regulators need a holiday before they completely dial back Wall Street's clock one hundred years. 

Black Monday II?

"How did this mess get so big?" – Steve Levy

“The tectonic plates beneath the world financial system are shifting, and there is going to be a new financial world order that will be born of this.” – Peter Kenny, Knight Capital

SUMMARY

How fitting that we are barely a month away from the anniversary of October 19, 1987; it’s quite probably fair to label today Black Monday the Second. With the Dow Jones plummeting 4.4%, to 10,917.51, wiping out over  $300 billion of market value in the United States, Monday September 15, 2008, is up there with the worst of them.

Only Bank of America came riding in on a white horse this morning with a $50 billion offer for Merrill Lynch. Even then, the market showed little signs of gratitude: Bank of America had lost 21% of its valuation by the final bell. At the grand old age of one hundred and fifty-eight years old, Lehman Brothers was laid to rest.

SAYONARA SPECULATION

Now the talk is turning back to speculation that the world’s largest economy is facing an early 1990’s Japanese-style debacle. This was a story I broke back in March this year at TheStreet.com, under the title “Fed Playbook Looks Familiar to Japan.” From the article:

The theory, which has gained popularity over the past week, originated in a trading note that has been passed around dealing floors in Hong Kong and Japan. The note, titled "Is Bernanke making the same mistake as Japan?," was issued last Wednesday by Gavin Parry, a director of Hong Kong-based Helmsman Global Trading, a Japanese and Asian trading specialist for U.S.-based hedge funds. So far, it has inspired broad appeal.

"There are two basic options in front of the Fed," goes the argument. The first is "a quick cleansing of the system," such as dramatic interest rate cuts and subsidies to bail out the financial markets. The downside, Parry argues, would have dramatic social consequences however, such as high unemployment and consumer price inflation.

"Alternatively the Fed can copy the Japanese strategy and put everything on life support and spread the pain over a longer period," writes Parry. This, some argue, is exactly the strategy that Bernanke is pursuing now, which raises the question of whether America will one day begin to look like Japan.

This weekend, Tony Tan, deputy chairman of GIC, Singapore’s $100 billion sovereign wealth fund, made similar remarks in Geneva. More here, here, and here.

SEPARATING SPECULATION FROM SPENDING

What is most surprising about the Lehman’s debacle is that there were no sovereign wealth funds around looking to pick up a slice of the American Pie on the cheap. With dwindling oil fortunes, this would have been a great long-term diversification opportunity for many a foreign investor. It’s difficult not to speculate that perhaps some of those sovereign wealth funds being touted as harbingers of the world’s capital are a little poorer than previously thought. There is, however, another possibility no one is stepping in to buy Lehman’s: investors are confusing market value with fundamental economic value right now (it’s a surprisingly common mistake, even -- or maybe especially -- among those with Harvard PhD’s).

The distinction between market value and economic value in an economy is key to successful investing. In fact, it’s precisely why investors such as Warren Buffet have made so much money. Singapore's Tan is too, quite possibly confusing the two concepts.

In a nutshell, the key difference between the two value concepts is that market value is the price speculators are willing to pay for something (such as a stock), whereas economic value is the price consumers are willing to pay for something (such as a Coke). When there is damage in the latter camp, the effects are long-lasting, and felt in every household. On the other hand, damage to market value is much more instantaneous and headline-grabbing, but tends to pass much faster too. What we are witnessing today is damage to market value, not economic value in the U.S. 

Many readers express surprised at how bullish I remain on the economy overall. But critics miss the point -- even IF the U.S. is headed toward a Japanese style financial tsunami, for most investors days like today (and you can be sure, tomorrow and the next day, too) offer wonderful buying opportunities. All of a sudden, Bank of America wields enormous power in the world of the U.S. consumer, shadowing rival JP Morgan Chase. For sure, there’s a ton of work to be done in synergizing such a gigantic corporate monolith (not to mention lots of IF’s over whether such synergies will work at the operating level), but, assuming the deal passes, BoA all of a sudden has a disproportionate slice of U.S. economic growth, and hence, global growth.

Even companies unrelated to Wall Street’s risk-management massacre are suffering. For example, Google, China Mobile, and Coca-Cola are all sitting at or near 52-week lows. Granted, there are stock-specific reasons, such as China’s telecom shake-up, and Coke’s battle vs. the rising dollar. Still, none of these companies manufacture or provide products that consumers stop purchasing or using in times of recessive activity, if such activity exists at all.

Sensible investors will differentiate today’s one-off market wipe-out with actual economic performance. With such a dramatic fall in equity prices, and heady inflation figures, it’s sheer foolishness to be sitting in cash right now.

*UPDATE*: Here's some characteristically straight-talking commentary on the Lehman Bros fiasco from Eddy Elfenbein over at Crossing Wall Street:

I’m going to go on the idea that the reason there wasn’t a deal for Lehman is that no one wanted one. If someone wanted, it would have happened. Novel thinking I know. But it tells us that the Street is hardly concerned about counterparty risk. JPM was concerned about with Bear because it was mostly their risk.

I heard Hank Paulson talk about bringing stability to the markets. Yeah, right. That’s basically like the flea giving orders to the dog. The Fed and the Treasury do not have this thing contained. If the housing market recovers, then the problem goes away. It’s as simple as that.

Uncertainty: Where Economic Fallacy Meets Political Analogy

Global markets are shaping up to look a little like the U.S. election in recent weeks, bearing out a one-hundred and eighty degree turn. While oil is staging an Olympic dive from its $147-a-barrel mid-summer high, the U.S. dollar is in the midst of an almighty rally vs. the Euro and other major currencies; gold is being punished on renewed optimism over slowing inflation. (Since the Republican National Convention at the beginning of the month, GOP Presidential nominee Senator John McCain has been enjoying a surprise about-turn in the electoral polls, largely thanks to his campaign’s savvy in picking a female running-mate, Sarah Palin).

Investors can be forgiven for their confusion over why equities are not responding more aggressively. For sure, there are problems: after Lehman Brothers announced a further $3.9 billion write-down in the third quarter, prompting a 76% tumble in the stock price, buyers willing to pick up the check for the bank’s colossal risk management failures look scare. The federal takeover of Fannie Mae and her little bro Freddie Mac hardly inspires confidence, either. 

But equities are trading at low valuations, while at the same time macroeconomic conditions are finally starting to look like they might lend a hand to market bulls. This scenario stands in direct contrast to earlier this year, when the argument went that valuations were still too high, while energy and food costs stood in the way of sustainable growth. So what’s standing in the way of equities now? Well, pretty much the same thing that is holding up Senator Obama’s previously certain ascension to holder of the world’s top job -- uncertainty.

It’s often the case in both economic and political reality that just when the water looks calm, you find it’s a leap year and the full moon came early, bringing with it choppy tides again. In the case of the global economy, that reemerging nocturnal crater comes in the guise of the bankruptcy of a 158-year old American financial institution; for Obama, it’s a pretty-in-lipstick “hockey Mom” (pitbull or pig – you decide).

Both Obama’s woes, and those of equity holders the world over, have been brought about by the unexpected. While one of those factors was cunningly strategic (the McCain Palin ticket) and the other was anything but (Freddie, Fannie, and the Lehman risk wonks), both have the same effect in their own universes: the creation of uncertainty.   

The question is, will the uncertainty last long enough to drag the world’s largest economy into recession, and to cause lasting damage to Obama’s bid for the Presidency? As usual, while the pundits say yay, the numbers say nay.

With close to $2.5 trillion swirling around the world economy, two full consecutive quarters away until a recession can officially be called, plunging energy prices and a strengthening dollar (along with a weakening Japanese yen and a steadyish Chinese yuan), there’s a lot of room for maneuver monetarily speaking. (In fact, in the case of the U.S. and Japan, one can marvel at the way a substantial economic downturn has been averted this year by those countries’ currencies: just when the U.S. needed its exports most, the dollar remained near an all-time low, while Japan’s yen may have weakened just in time to avert its own woes). 

Similarly, McCain may have peaked at just the wrong time. With another two months until voters hit the ballot box, the Obama campaign has plenty of time to deal with the “shock” of Palin’s appointment and effectively employ Senator Hillary Clinton to the battlefield, while showing they intend to inject her into their proposed government with a meaningful policy role to play. (The fact the democrat party failed to see that America wants a woman in power, is a lesson they should have learned hard by now).

Furthermore, if you’d listened to analysts or pollsters this year when placing your bets, you’d have lost a pile of money. From predictions of a first-quarter U.S. recession, to $150 oil prices -- both concepts I vehemently argued against at the time -- the boys at Goldman Sachs and others look as clumsy as their risk managers. Political analysts -- I confess, myself included -- foresaw a sweeping Clinton victory at the democrat primaries.

Right now, uncertainty is rocking the fiscal and political fronts, stalling the obvious. Don’t get swept in; instead prepare for a big, bullish rush in equities at year-end, an eventual $45 oil price, and the first black President of the United States in history. Then make your mind up about how you’re going to play the next five years. 

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Emerging Market Hedge

This morning I'm reporting on Thai economic growth over at TheStreet.com, and how amazingly, in the global liquidity crunch, it's managed to trend upwards -- and fairly fast, too:

In August, year-over-year exports in Thailand rose 17.9% vs. a rise of 5.9% in July, while the country's trade surplus rose to $770 million from $211 million. And at the end of September, the Ministry of Finance revised economic growth for the year up 50 basis points to 4.5%, and at 31.64 vs. the dollar, the baht is climbing its way back up to its July levels.

The scenario is a far cry from 1997, when the baht dropped 30% overnight vs. the dollar and Thailand was thrown into a cash crisis.

Now, contrast this scenario with the U.S. economic outlook:

As of Friday, Thomson Financial pegged overall third-quarter earnings growth for the S&P 500 at an anemic 1.4% rate. Should that come to pass, it would be the worst performance since the second quarter of 2002, when earnings rose by the same amount.

Analysts note that a weaker U.S. dollar, which continually set record lows against the euro during the third quarter, undoubtedly aided some export-heavy sectors. Unfortunately, the belief is that housing woes and a slowdown to the U.S. economy will sabotage profit growth for many.

"Downward estimate revisions have already come in from the banking sector, consumer finance, and mortgage companies," notes John Butters, research analyst with Thomson Financial.

And -- most fascinating -- on a rate cut conspiracy theory in Thailand:

The argument goes that consumer price inflation was down on the year to 1.1% in August from 1.7% in July, creating the right conditions for a rate cut alongside relative weakness in Thai securities, which have yet to feel the effects of positive economic growth in the country.

The rate cut would most positively impact home builders and financial stocks, giving what many say is a long-overdue boost to the Thai stock exchange (SET) in general. In the last year, the SET has advanced 37% to 847.93, much less than other regional stock exchanges: in the same period, the Hang Seng has gained 65% to 27,066, the Korean Kopsi is up 54% to 2003.60 and the Shanghai Composite Index has soared 217% to 5552.3

It's going to be an interesting week. I have a feeling that you'll see the SET take off amid all the positive spin on the Thai economy after the BoT meets on Wednesday -- even if it doesn't cut rates (great time to get some exotic SET index futures right now). Wednesday also happens to be the day the official transcripts of the Fed Reserve meting last week is out, which is not going to be as pretty, unfortunately. After last week's uptrend in the Dow, expect some mild nausea from the prop desks in NY. This could be a good time to purchase some put options on the Dow, alongside those SET index futures, and create almost a mirror-image opposite hedge of the one many were playing with back in July 1997.

It's a good emerging market hedge for the following reasons: it concerns two rate-slashing, tame  inflation markets (unlike, say, China or Brazil), one is an export-led economy and the other is an import-led economy, and it takes advantage of all the emerging market growth around. Let's see if you would have been in the green on Friday.

Chasing Beta: Bernanke & Greenspan

Here is a very well-written article about the current US market scenario. Despite my recent bullishness, I have to concede that the Fed's 50 b.p. cut in interest rates was sheer lunacy. The only defense I can think of to support such a cut is that it is just so completely mad that it might actually work. As several commentators have pointed out already, the Fed now has nowhere to go if the going gets tough again. While it's still too early to tell whether this will be the case, it is impossible not to agree with the logic behind Peter Bookvar's (Miller Tabak) statement :

'You don't have a multi-year credit bubble that is over in a couple of months; why the market thinks that is beyond me.'

It's also interesting to see everyone hammering Greenspan right now for having kept rates so low for so long in the 1990's -- as if he is personally responsible for the current volatility. If Greenspan was foolish, then Ben Bernanke looks like a circus jester: giving markets not only a multi-billion cash-fuel throughout the summer, but then topping it all off with a giant, unprecedented rate cut. This is not to criticize Bernanke per se; in many cases he has helped stimulate markets out of a recession which could have been especially difficult to shake off. However, the fact remains, there is always a cost where there is a benefit, and when you stimulate an economy so quickly out of a recession, you get lot of hasty money.

On a further note, it will be interesting to see the consequences if the market does hold up. As I pointed out recently, one potential effect is that speculators increasingly look overseas to the heady emerging markets for record gains:

This recent action in South Asia's derivatives markets looks interesting alongside the ruminations of the supposed global credit crunch. For if there really is a shortage of global liquidity, then why are funds buying ultra high-risk emerging market equity derivatives?

... What appears to be the case is that given the European and U.S. authorities' enormous cash fuels to domestic banks, these banks and funds have started to look for the same kind of gains they were getting from speculating on sub-prime. After all, there is still demand from the hundreds of event-driven funds out there. An obvious contender is emerging market derivatives, which are volatile, but extremely high return. And with emerging market growth soaring this year, the equities possibly look like a good bet.

This would give us almost a mirror-image picture of the 1990's again -- where funds couldn't resist over buying emerging market securities and in turn over-stimulating their currencies, until the whole global system temporarily collapsed. In that instance, it will be much easier to draw parallels between Bernanke and Greenspan than critics of the former chairman of the Federal Reserve may like to admit.

Macro/Micro

Contrary to my comments the other day, it seems that if you have been reading this blog since the beginning of the year, you'd actually have made some decent money (LINK):

And for what it's worth, here's what happens next. The current US economic and market strength will continue at a bullish pace right up until about September/October, when a spew of economic data will show how in Q2 we got just a little ahead ourselves. This, combined with some instability created by a looming election, will prompt some of the big pension funds to throw money back into gold, and it will have a natural, short-term correcting effect for markets (which in all probability probably won't be needed so it's a time to buy then). However, because of this overreaction, we'll probably see that growth re-bound in the final quarter of the year as Q3 fundamentals show everyone that things are actually still in pretty good shape.

And while the Japanese may raise rates, as might China, don't expect too much discipline from the governments of these economies. When Asia has a run, she's usually more afraid of stopping that run too quickly than she is of letting it overheat, so though she might put in a quarter-percent rate hike here or there for show, it's not in keeping with the general ethos of the region, which tends to get a little overexcited about its own economic prospects (usually as a result of knock-on growth from the European region and the U.S.A.) In other words, right now, you want to be buying Japan.

The Nikkei shot up to over 18,000 after that comment was made. Japanese equities look good again right now, with the Nikkei up more than 10% on the month to 16,845.96, and the yen seems to have regained regional stability. And - surprise, surprise - the Dow is back to an all-time high (I said that HERE recently too).

One of the side-effects of globalization is that everyone seems to use Macro- data to judge what are, in effect, Micro- situations, like market movements. It's an information overload problem, and it's not always an accurate way of trying to gauge where stocks are headed.

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