Friday, July 31, 2009

Morning Links: The Asia Edition

This morning's links have an Asian theme. The first two articles are about China and the third is a piece by the Economist from 1990 that is very relevant now. I think the current situation in China, with the massive stimulus in place, is fascinating. What if the US just gave out billions of dollars to people to put into the stock market? Obviously, some of the Fed's money printing has indirectly led to investment in the stock market, but in China it is apparently much more explicit. If you are interested in learning more about the effects of the stimulus on China, I suggest reading the works of Andy Xie of He seems to have a very good perspective on where the money is going and does an admirable job in articulating his fears in an unbiased manner. If you are making any investments based on the idea that China can drive the world's economy and help pull the US out of this current mess, I suggest looking into Xie's material and reading the next 3 pieces.

1. Latest missive from The Prudent Bear: Some countries follow the economic principles of Adam Smith. Others, like the US, are enamored with Keynes. We know the USSR was devoted to Karl Marx. But what about China? According, to The Prudent Bear, China is (probably unknowingly) following the writings of 17th century mercantilist Thomas Mun. Mun believed that countries should limit imports, focus on increasing exports, and then use the proceeds from the exports to establish colonies in which Britain could exploit the existing natural resources. Sounds kind of like what China is doing with their $2B in reserves, right (well aside from the colonies part)? The problem, of course, is that if China is right and we are entering a period in which natural resources will be the increasingly less available, the world could turn into a pretty ugly place. The way to avoid this fate according to the author? Intergalactic travel or going back to only 1B people on the planet. Neither of which seems too likely.

2. Tim Swanson's Take on Chinese Stimulus: In this piece Swanson succincltly explains why the course that China has chosen in terms of flooding the system with money could end up in a bubble. Here are a few facts that he uses to support his thesis:

-According to the People's Bank of China, for the first six months of this year, new lending amounted to more than 7.3 trillion yuan (about $1.1 trillion) — which, according to the Royal Bank of Scotland, is equivalent to two years worth of credit
-Wei Jianing estimates that roughly 20% of the stimulus funds have ended up in the domestic stock bourses, creating a speculative bubble much akin to the previous dotcom and housing-heavy cousins. Another 30% of the funds are believed to have been shuffled into the ailing property markets
-Residential property rates in places like Beijing are once again climbing at a spectacular rate — 6.5% in one week alone
-Since 2006, roughly 152 million square meters of commercial office space has been built in Beijing — more than all of the office space in Manhattan — yet 30 million square meters is still vacant

Sound like all the makings of a nasty property and stock market bubble? I sure think so.

3. Predicting the Crash: Embedded below is an article that appeared in the Economist in 1990 that presents the case that the incredibly overvalued Japanese real estate market was due for a nasty fall despite many arguments to the contrary. It was sent to me by one of my readers named Roland Nelson. The timing of the article preceded the gigantic fall in property and land values that occurred, a drop Japan’s real estate market has never recovered from. The article attempted to debunk all of the reasons why the real estate market would not crash and evaluate the potential impact on the region’s banks. The reason why this is so interesting and pertinent now is that many of these same issues are being explored in New Zealand and Australia (and don't forget China) due to the recent run up in prices of residential real estate. As I have said before, people can always make the case for and against the popping of a bubble, but as the US has learned twice over the past 10 years the only really relevant question is when. For those who are long residential real estate in AU and NZ, I hope this time it is different.

1990 Economist Article on Japanese Real Estate

Thursday, July 30, 2009

Morning Links

Some goodies this morning:

1. No green shoots here: This article from Bloomberg discusses the quarterly results from Nintendo and Sony. At the beginning of the retrenchment in consumer spending, certain market pundits suggested that video game sales would be resilient. Guess not. A 57% drop in sales of the formerly wildly popular Nintendo Wii is not a positive sign. Neither is the 31% drop in Playstation shipments. It may be true that the market for the hardware is saturated and most people who would like to buy have already bought. But remember, these companies make their money on software sales. How did overall sales hold up? Down 40% for Nintendo who blamed the 40% drop in sales in lack of “blockbuster software.” Hard for any single title to become a blockbuster if no one spending. The moral of the story? Beware financial prophets who claim that consumer spending is going to be back anywhere near boom time levels. New normal is the new reality.

2. Barney Frank wants your bonus: In his most recent opinion piece, Bloomberg’s Jonathan Weil discusses proposed legislation in the House that would give regulators the right to determine whether or not any financial institutions (possibly including hedge funds as well) with $1B in assets have compensation arrangements that lead to inappropriate risk. Listen, I am all for curbing excessive compensation and eliminating heads I win, tails you lose, especially when it comes to institutions that have many billions in assets. But, I don’t happen to believe it is worth anybody’s time to worry about the systemic risk posed by local banks in Michigan with $1B in assets. This appears to be the perfect example of Congress trying to over-regulate in reaction to a crisis that it should take some blame for creating.

3. Thaler responds to criticism: The following is Richard Thaler’s response to a WSJ op-ed piece by Judge Richard Posner in which he criticized Thaler and the Obama administration’s proposal to create a Consumer Financial Protection Agency (CFPA). In the piece he uses the disturbing story of a child who died in his crib to highlight the need for consumer protection. In comparing cribs to mortgages, Thaler states clearly that he does not advocate regulating that only pink cribs are sold or that only plain vanilla mortgages available. His baseline is that there should be a standard mortgage document (as there are standard leases for rental agreements) that can be changed in an obvious way to cater to individual needs. Regardless of your opinions on the CFPA, I suggest reading this to understand the potential benefits better. (Hat tip to James Kwak of The Baseline Scenario)

Wednesday, July 29, 2009

Going Back to Cali


I wanted to give you a brief update on the happenings in my life and the direction I expect the blog to take in the coming weeks. My belongings have officially begun their journey to Los Angeles. Today I booked a one way ticket from New York to LA, which will be the new headquarters for the blog. Orientation for school starts in early September and I anticipate being very busy with classes, networking, blogging for UCLA’s websites, and trying to find a value-focused shop that wants to hire me (if you know of any funds or money managers out in LA that I should contact, please email me). As a result, I am not sure how often I will be posting my usual long (winded) content. I hope to produce at least two pieces a week but of course I cannot be sure until I figure out what my weekly schedule looks like. Accordingly, today I am starting a new posting strategy with the goal of compensating for fewer lengthy posts and quenching the insatiable demand for my content.

From now on I will try to post a few links that I think are must reads or videos that that I find to be the most informative. I expect this to be the type of material that fits in the category, “if you have time to read/watch one thing today…”

So, here goes. As always, I would love your comments and suggestions.

1. This is the August letter from Bill Gross. In it he continues to expand on the concept of the “new normal” and suggests that the robust 5% GDP growth that many developed countries have come to rely on to keep unemployment low and service debts may not be on the table for many years. He also presents a number of implications of this fact that I think all investors should keep in mind.

2. This is a great set of videos that I got from Simoleonsense. If you are not familiar with the site, it is run by my friend Miguel Barbosa and I would argue with anyone who thought there was a better link and video aggregation site in the blogosphere today. This particular set of videos was referenced by fund manager Jeremy Grantham in his most recent letter and Miguel diligently went out and found the appropriate links. The YouTube series of videos is entitled “The Most Important Video You Will Ever See: Arithmetic, Population, & Energy” and if you think energy security and sustainability are important you might agree with the title. In this lecture the presenter describes just how dangerous something as innocuous as a 7% growth rate in energy consumption will be in the future. He goes through some very simple arithmetic that suggests that there is nowhere near as much oil or coal as many people claim there is. If you have the time, watch this. I promise you won’t be disappointed.

3. Finally, here is an article I got from James Kwak at the Baseline Scenario. It is an op-ed in the Washington Post from M&T Bank CEO Rogers Wilmers in which he goes after the risks taken on by the investment banks during the subprime securitization boom. This is his attempt to separate the regional banks from the (former) investment banks with the goal of drawing the public’s ire away from banks like M&T that were reasonably conservative during the credit bubble. As James Kwak points out, there has been a degree of solidarity among the banks and this is one of the first cases in which ranks are broken.


An Outsider’s Perspective on High Frequency Trading

I think it would be an understatement to say that there is a lot of confusion in the mainstream press and in the blogosphere regarding high frequency trading (HFT). For many of us, it is only in the last few weeks that we have started to add the words “co-location,” “flash trading,” and “predatory algorithms” into our lexicon. Fortunately for HFT novices like myself, blogosphere luminaries such as Karl Denninger of The Market Ticker and Tyler Durden of Zero Hedge have been vigilant in trying to educate us regarding the potential for market manipulation that apparently surrounds HFT. Furthermore, I think that people such as Joe Saluzzi from Themis Trading have done a great job in explaining what HFT is in a way that people who have never worked on a trading desk or never created an advanced trading algorithm can understand. As a result, I am not going to try to explore the nuances and potential pitfalls of HFT. I will let those who have far more experience than I tackle that. My concern only surrounds the illegal uses of certain HFT strategies.

Having said that though, I happen to think this entire developing story is fascinating. Starting with the details of the stolen Goldman algorithm and the US prosecutor’s admission that anyone (including GS) could use it to manipulate the markets, you have a very compelling beginning to a new Russell Crowe movie about corporate espionage and government conspiracies. And now that we find out that some of these HFT programs could be used to front run trades and provide phantom liquidity, I wouldn’t be surprised if Jerry Bruckheimer is currently taking diligent notes. Where is a Law and Order “ripped from the headlines” episode when you need one?

All joking aside, I think the people who espouse the virtues of HFT could use some advice on how to sound more credible. If types of HFT are not actually as nefarious as some people seem to believe they are, then the proponents are doing a terrible a job of defending them. So far, I have seen a couple of arguments that don’t help their cause in the slightest. Both were articulated by Irene Aldridge of Able Alpha Trading who is about to publish a book entitled “High-Frequency Trading: A Practical Guide to Algorithmic Strategies and Trading Systems.” If you haven’t watched her showdown with Joe Saluzzi from last week I highly recommend it. Not that all of it is comprehensible due to the fact that the CNBC moderators always allow people to talk at the same time. But, her reactions to the criticisms are very curious and seem somewhat indicative of a person who doesn’t spend much time out of the office or read the newspaper. Here are a couple quotes from Ms. Aldridge:

Ms. Aldridge: “First of all there is nothing new about high frequency trading…”
Ms. Aldridge: “Everyone knows that front running is illegal, especially in equities, and it is strictly monitored…”

CNBC’s Steve Liesman: “Are some people able to see the data of other people’s orders ahead of time and able to trade in front of it using supercomputers?”
Ms. Aldridge: “It’s illegal.”

Huh? Is there some connection between something being illegal and actually being a deterrent? Let me list a few other things that are illegal: $50B Ponzi schemes, smoking marijuana, jaywalking in New York City and insider trading. All of these things happen (or happened) often despite the fact that they are illegal. Obviously, Madoff’s crime is a little more serious than jaywalking, but that just illustrates the point that the magnitude of illegality does not preclude people from partaking in certain activities. In other words, just because it would be a huge scandal that would likely land people in jail if HFT firms were actually front running does not necessarily mean that it isn’t happening. Our recent corporate history is littered with examples of somewhat brazen attempts to flaunt the law.

Furthermore, the suggestion that we can trust that HFT programs are not front running because trading is “strictly monitored” by the regulators seems very naïve. Here are some examples of recent regulatory failures to protect consumers and investors:

Fed: Mortgage fraud and predatory lending throughout the housing bubble
SEC: Madoff’s Ponzi scheme
SEC: Insider trading- just look back at the spike in the option activity on Schering-Plough (SGP) a few days before the Merck (MRK) deal was announced and tell me people weren’t trading based on knowledge of the deal
FDIC: Continuing to allow regional banks to carry loans on their books at levels that do not reflect the actual magnitude of impairment
SEC & Others: Allowing the rating agencies to deem anything and everything AAA without any scrutiny of their models or assumptions

These are just a few examples off the top of my head. I’m sure there are dozens more. Oh yeah, the regulators have a fantastic track record of spotting and putting a stop to illegal or intentionally misleading practices. Accordingly, for anyone who wants to defend HFT, my suggestion is to not use the fact that the regulators are on the beat and that front running is illegal to bolster your case. Instead, say that your firm does not engage in front running and that any group that does should be prosecuted to the full extent of the law. Or explain how HFT is like a weapon of mass destruction in that it can be abused or misused by less honest individuals. But, in the hands of people who believe they have a responsibility to make markets more efficient and fair, HFT can be a very useful tool.

Additionally, there was another argument that Ms. Aldridge used that I have seen multiple times but does not necessarily help the case of HFT supporters. This is the contention that HFT is not a new thing so we should assume no one is misusing their advantages. In a Bloomberg article on the same subject, Frank Troise of Barclays plc candidly stated:

“This has been going on for quite awhile, and it’s now at a fever pitch…There’s always been an advantage to executing with speed.”

Are we supposed to conclude from this statement that firms aren’t using their enduring speed advantage to swindle institutional and retail investors? As we learned with Madoff, just because something has been going on for a long time does not mean anything about its legitimacy. It is entirely possible that traders using supercomputers have been able to front run for many years now. Does the length of time that HFT has been a force in the market really have anything to do with whether or not specific programs are acting properly? Also, the idea that if front running were going on then it would have already been detected seems a bit foolish, considering the regulatory failures listed above. Therefore, HFT advocates should continue to highlight the benefits in terms of providing actual liquidity to the markets instead of asking us to put our heads in the sand and assume that the regulatory infrastructure is sufficient to protect us from bad actors.

Finally, I would like to conclude with a word of caution. I have no insight into whether or not firms are using predatory algorithms to front run. I hope it is not happening but at this point nothing would surprise me. And that is the problem. We have all become so jaded by the actions of too many of our fellow Americans during this crisis that we don’t even blink anymore when we learn that someone was fleecing or robbing one of his neighbors. We also are now so used to the words billions and trillions that any infraction that falls short of those amounts doesn’t seem so severe. But, in the case of proven front running through HFT, let’s not allow our collective outrage to be shaped by the previous prevalence of scandals or the magnitude of the crime. I don’t care if the entire scheme only netted $1M illegally. The fact that someone was willing to ignore the laws and manipulate our markets so brazenly should be enough to spur on widespread anger, despite the inherent complexity of the crime. If illegality and the presence of regulators are not strong enough deterrents, maybe in the future public shame will be a more effective method of preventing abuses.

(Picture of Joe Saluzzi courtesy of

Friday, July 24, 2009

Why Confirmation Bias is so Tough to Counteract

According to the website Science Daily, confirmation bias is defined as:

“[A] tendency to search for or interpret information in a way that confirms one's preconceptions, leading to statistical errors”

Now that may be a lit bit too technical of a definition for some tastes. In more plain English, conformation bias refers to the tendency to look for information that supports what you already believe. An additional manifestation of this bias rears its ugly head when people automatically dismiss information that is contrary to their previously formed views on a subject. Let’s start with a very simple example. Assume that you believe that the Fed’s recent monetary policy actions will inevitably lead to inflation. Not being aware of confirmation bias it is very likely that you would be prone to searching out data and arguments that agreed with you on the inflation issue. You would read Simon Johnson’s blog and put together your own narrative on how inflation will come about. You would look at David Einhorn’s and John Paulson’s large purchases of gold bullion as evidence that the smart money was on inflation. You might follow John Hussman’s lead and start purchasing TIPS for your own account. In other words, it would not be hard at all to find a number of people who agree with you and who make a very logical case that inflation will eventually be on the horizon.

The problem with succumbing to this bias, whether you are aware of it or not, is that there are very few things in life that are completely certain. Other than death, taxes and Goldman Sachs’ (GS) exorbitant profits, most things are more nuanced and ambiguous. By only focusing on information that confirms your convictions, you are by definition ignoring the other side of the argument. And no matter how sure you are that your thesis will eventually play out, there is always a piece of contradictory evidence or someone out there who can make a credible case for why you are wrong. Continuing the inflation example from above, there appear to be just as many intelligent arguments that deflation is a much more proximate risk. Thus, if you limited your analysis you would be ignoring the views of people like Paul Krugman and San Francisco Fed president Janet Yellen who have detailed the ever-present risks of deflation in an environment of falling wages and asset prices.

Sadly, despite the fact that I am well aware of this innate tendency and am even on a first name basis with it, I find it very hard to shake the habit of searching out only the information that is confirmatory. Even worse, I tend to give arguments that support my view much more credibility than those that do not. I sometimes find myself looking for reasons why the author or the source of opposing information is either biased or just flat out wrong. It is when I get a little rush when I read that someone I respect agrees with my analysis that I fully understand the magnitude and power of this bias. Even more troubling, I have to admit I often feel a little down when my thesis appears to not be playing out or when I read that an investor I look up to has taken the opposite position.

The bright side of all of this is that I am aware of my proclivity to dismiss views that don’t mesh with mine. In fact, I am so cognizant of my biases that I force myself to seek out information that reflects a conflicting opinion (irrespective of how much it pains me) in an attempt to be well-informed regarding that factors that will ultimately influence who is right and who is wrong. By doing this I hope to be able to avoid falling in love with my beliefs. An investor who automatically rejects an argument that he or she does not agree with risks becoming stubbornly and foolishly stuck in an unprofitable position. Investing is so dynamic that skilled participants must being able to change their asset allocation on a dime. Accordingly, understanding an issue from multiple perspectives allows a person to buy or sell a position as a result of news or fundamental changes in the markets that indicate that the initial investment thesis was incorrect or mistimed.

Of course I am not advocating forsaking investing discipline at any hint of the potential for loss. Especially on the short side, it often takes a long time for the fundamentals to catch up to the asset price. Patience will always be a virtue when it comes to investing. However, it is important to avoid becoming too married to your positions and views. I think another example of my own battle to overcome my biases highlights why flexibility and open-mindedness are such crucial attributes of successful investors. As many of you know, the sector I follow the closest is the regional banking sector. I believe my familiarity with the companies and the factors that influence share prices gives me an advantage over less knowledgeable investors. As a result of my extensive research I have been incredibly bearish on the regional banks since the end of 2007 when it became obvious that a deteriorating economy and poor underwriting standards were going to saddle these companies with millions of dollars of toxic loans. In hindsight, that was a very good time to be advocating the short selling of these banks as just about every one I recommended experienced a dramatic fall in share price.

Specifically, I used to joke that identifying troubled banks was like shooting fish in a barrel. California residential construction exposure? Borrow as many shares as possible! Florida condo loan portfolio? This thing could go to zero! Despite the fact that a lot of the calls I made ended up being right (and yes, some did go to zero), it completely biased me against the sector. Knowing the fundamentals of these companies, I could not even come up with an argument for why anyone would want to own the stocks. In the process I forgot Buffett’s rule that any company can be attractive at the right price. I was so jaded by my analysis that when the bank stocks reached valuation levels that implied that the whole industry was insolvent I was paralyzed. Instead of using my knowledge to help me look past the Armageddon scenario, I just sat there and watched the stocks fall, unable to react to the unprecedented valuations.

Well, since then some of these stocks have doubled or tripled off of their March 2009 lows. I tell myself that there was the risk that some of them could have gone to zero without the government’s help, but that does not justify my inaction when it came to companies that would have inevitably survived the crisis and may have come out stronger as a result of the destruction of the competition. What this painful lesson has taught me is that investors can’t be seduced by what the market is doing or by the most commonly held beliefs. Just because a stock continues to rise or fall, that should not necessarily tell you anything about the company. Taking your cues from Mr. Market is a great way to lose money or miss out on once in a generation opportunities. Similarly, focusing your attention and analysis on data that confirms your already developed beliefs puts you at risk of missing or flat out ignoring information that indicates your thesis is wrong. Only by being aware of the potential impact of the confirmation bias and proactively working to offset the associated tendencies can investors avoid painful and costly errors.

(Picture of Janet Yellen courtesy of the Federal Reserve Bank of San Francisco)

Tuesday, July 21, 2009

Marks and Klarman Join Together to Rescue CIT

With the incessant barrage of CIT-based headlines over the past week or so, you would be forgiven if you hadn’t bothered to delve into the final details of the $3 billion financing the company has apparently secured. What you unfortunately would have missed as a result of CIT fatigue is the identity of those who are providing this capital.

From Bloomberg today:

Bondholders providing the financing include Boston-based hedge fund Baupost Group LLC, Capital Research & Management Co., Centerbridge Partners LP, Oaktree Capital Management LLC, Pacific Investment Management Co. and Silver Point Capital LP, a person familiar with the deal said.

That’s right. Value investing luminaries Howard Marks of Oaktree Capital Management and Seth Klarman of the Baupost Group both were involved in this deal according to Bloomberg’s source. Why, you ask, would Marks and Klarman get involved with a company that Credit Sites analyst David Hendler as recently as last week said this about?

“This thing doesn’t have a future,” CreditSights analyst David Hendler said yesterday in a telephone interview. “Anything is possible but the problem is not solvable anymore. They’re just in denial it’s finally over,” the New York-based analyst said referring to the rescue financing.

The first (and simple) answer to that question is margin of safety. According RBC analyst Hank Calenti the deal had to be significantly over-collateralized in order to attract investors. In fact, a New York Times report cited by Bloomberg claimed that the loan is backed by a mix of assets with a face value of $30 billion. For only $3 billion worth of financing these investors have claims to a substantial amount of collateral. While this shows how desperate CIT was to avoid bankruptcy, it also highlights why this deal structure was so attractive to Klarman and Marks. Not only do they have a direct claim on corporate debt, aircraft credits and loans to small and medium businesses with a face value of $30 billion, but they also will receive an interest rate of 10 points above Libor. Not the current puny Libor rate of .51%, but Libor with a 3% floor. By my calculations that means that the minimum interest rate is 13% on a $3 billion loan backed by $30 billion in collateral.

Now you can see why Klarman and Marks likely didn’t have to do weeks of due diligence on this specific deal to be willing to participate. And if Credit Sites analyst Adam Steer is right and this rescue has only delayed a bankruptcy filing that is inevitable based on CIT’s broken business model? In that scenario even if equity holders and those who own other CIT bonds (for example PIMCO) are wiped out or suffer low recovery rates, Oaktree and Baupost would be protected by the substantial over-collateralization. While no investors have had a perfect track record in navigating the crisis over the past few years, if you had to follow the so-called smart money you would be hard pressed to find any better candidates than Marks and Klarman.

(Picture courtesy of

Monday, July 20, 2009

Has Patriotism Officially Been Replaced by Profit Motive?

While doing some leisurely reading over the weekend, I came across an article in the New York Times by Jackie Calmes and Louise Story on JPMorgan Chase (JPM) CEO Jamie Dimon. The article describes Dimon’s ascendance over the past couple of years that has allowed him to become the unquestioned king of the US chapter of the Banksters (yes, I think the term should now be capitalized). He has gained so much political clout over this period that he apparently now has Obama’s chief of staff Rahm Emanuel on speed dial and somehow has enough influence to convince Emanuel to graciously accept an opportunity to speak in front of JPM’s board.

According to the article: Mr. Emanuel’s appearance would underscore the pull of Mr. Dimon, who amid the disgrace of his industry has emerged as President Obama’s favorite banker, and in turn, the envy of his Wall Street rivals. It also reflects a good return on what Mr. Dimon has labeled his company’s “seventh line of business” — government relations."

The matter of fact way in which the authors describe Dimon’s candidness regarding the need for lobbying to be as important a part of his company’s business as accepting deposits underscores the extent to which the government has become (for better or worse) the ultimate decider of the future of the banking industry. As a consequence of the number of former Wall Street Banksters now or formerly employed by the government, investors no longer even bat an eye when they read about the increasingly cozy and brazenly out in the open relationships between Banksters and government regulators and officials. We now take it for granted that these individuals will have an outsized influence over the political debate and laws created in response to this everlasting crisis and we are expected to believe that what is best for Wall Street is also in some way good for the rest of us.

Reflecting this theme, the NY Times piece is generally very complimentary and positive in its description of Mr. Dimon’s rise to the top of the Wall Street pyramid. In fact, the success that JPM has had in navigating its way through the financial meltdown has bought JPM and Dimon a significant amount of positive press that has undoubtedly helped the company gain customers. At a time when everyone was looking for stability when it came to financial institutions, it sure didn’t hurt that the media portrayed JPM as an oasis within the decaying financial landscape. To be fair, it also did not hurt that Dimon had the foresight and humility to pen a very thoughtful letter to shareholders that assessed the causes of and potential solutions to the ongoing trouble in the banking sector and economy. In this very sober investigation of what got us to where we are today, Dimon offered what I see as some prudent and surprisingly ambitious remedies for what currently ails the financial system, including:

  1. The need for a systemic regulator with much broader authority
  2. The need to simplify our regulatory system
  3. The need to regulate the mortgage business —including commercial mortgages — in its entirety
  4. The need to fix securitization
  5. The need to get accounting under control
  6. The need to fix Basel II — leading to higher capital ratios but a more stable system
  7. The need for appropriate counter-cyclical policies

Coming from a man whose company benefited tremendously from lax supervision and insufficient monitoring, suggesting such reforms and regulations appears to be indicative of his belief that a stable system is more important than an unsustainably profitable one. Between the media’s coverage of Dimon and the above referenced shareholder letter, even outspoken opponents of the Banksters like myself have become somewhat seduced by Dimon’s mystique. However, one thing has always bothered me a bit. Despite his candidness and claimed willingness to accept reform, the words in the shareholder letter also lack any real sense of remorse or culpability for helping throw the US and the global economies into this mess. While there is certainly an exhaustive list of people and entities to blame, in a very subtle way Dimon consistently seems to be somewhat detached from the reality that is facing many of his competitors.

Take, for example, the following passage in which Dimon discusses some of the many excesses that led to the crisis:

Over many years, consumers were adding to their leverage (mostly as a function of the housing bubble), some commercial banks increased theirs, most of the U.S. investment banks dramatically increased theirs and many foreign banks had the most leverage of all.

In addition, increasing leverage appeared in:

• Hedge funds, many using high leverage, grew dramatically over time. Some of that leverage was the result of global banks and investment banks lending them too much money.

Yes, we have been told a thousand times that so far JPM has escaped relatively unscathed from the crisis that has brought many banks to their knees. We are also well aware that JPM did not get as involved in dangerous structured products as many others. But as of the end of Q2 2009 JPM had a $448.97 billion consumer loan book. So, who was helping the consumer lever up so much? Even without Bear Stearns and WAMU, JPM’s consumer loan portfolio was over $300B. Furthermore, isn’t JPM one of the largest prime brokers in the business? So, if hedge funds were too levered, who was it that was allowing them to become so? These are just two examples but it's hard to believe that when it came to the excesses in the system listed above, JPM was not right in the middle of the fray.

In was with my general concerns about Dimon’s implict denial of his own company’s role in precipitating the near breakdown of the entire financial system that I came across this passage from the NY Times article:

A centerpiece of that effort involves regulating the market for derivatives, which Mr. Dimon’s firm dominates. While JPMorgan favors new reporting requirements for the complex financial instruments, it opposes the administration proposal to force trades onto public exchanges; doing so would likely cut into the firm’s lucrative business of selling clients custom-made instruments. Like other banks, it also opposes a new consumer agency for financial products.

I think we can all agree that consumers being pushed into loans they could not handle and the opacity of derivatives are two of the major contributing factors to the crisis that began in the subprime space and subsequently poisoned just about every asset class. Therefore, wouldn’t those areas by definition be in need of reform? It then dawned on me that maybe Dimon’s letter only offered reforms that suited JPM and ignored those that would diminish profits. Along the same lines, MIT professor and founder of the Baseline Scenario Simon Johnson offers up the following question in his reaction to the NY Times piece:

Why doesn’t Dimon instead seize on greater consumer protection as a way to rebuild legitimacy for finance – and to shape the new rules so as to create barriers to entry and growth for future rivals?

What would John Pierpont Morgan have done?

I think it is a great question. In fact, I think we should establish that as a standard for all Wall Street banks. How nice would it be to see Porsche Cayennes and BMW convertibles with the bumper sticker “WWJPD?” Of course there is no way to know what the original JP Morgan would have done. Since his death the man has gained an almost mythical status, partially as a result of his actions in 1907, detailed here by Newsweek:

"This is the place to stop this trouble!" J. P. Morgan said on the afternoon of Oct. 23, 1907. After the failure of several trust companies (unregulated banks, kind of like today's subprime lenders), the banker had decided that the collapse of the Trust Co. of America would cause too much damage to America's fragile financial system. He pulled together leading bankers and pooled funds to bail out the firm. Over the course of two weeks, as a fevered crisis gripped Wall Street and Washington, Morgan acted time and again: saving brokerage firms, rounding up $25 million in cash in 20 minutes to help the New York Stock Exchange stay open, underwriting municipal bonds for New York City, bringing in gold from Europe to bolster the dollar and replenish Washington's coffers. "He essentially singlehandedly saved New York City from failure," says Sean Carr, coauthor of "The Panic of 1907."

The implication is that beyond the obvious self interest in saving his own finances, the elder Morgan had a sense of a higher duty. If you believe the accounts, Morgan apparently believed that it was worth some personal sacrifice and risk to make sure that the country as a whole did not fall apart. If this was indeed the case, it is this combined sense of patriotism and understandable self preservation that I think is disappointingly lacking today. This is not just a criticism of the Banksters. I think many in Congress are too focused on their upcoming re-elections to put their own interests aside enough to help get the US back on the path to prosperity. In a lot of ways this short termism that borders on being illogical and self defeating caused the crisis and unfortunately is one of the main contributors to its depth and breadth.

I have a completely unsubstantiable theory as to why putting America first in not a common theme anymore. My thesis is that World War I, the Great Depression, World War II, and to some extent the Cold War brought Americans from disparate backgrounds together in a fight against a common enemies. Financial hardship and war are probably two of the most important fosterers of patriotism. In contrast, the Americans who are too young to remember WWII and whose memory of the Cold War has faded have not been brought together by many recent and meaningful moments or conflicts. The Vietnam War inspired a significant amount of anti-American sentiment, even in the US itself. The wars in Iraq have certainly done nothing to unify this country. Even the impact of the events of September 11th, which at the outset had the potential to spur lasting patriotism, seems to have been watered down by the continuing political infighting regarding the rebuilding of the WTC site. People seem to have become myopically focused on their own lives and financial situations. Consequently, instead of seeing this crisis as an opportunity to embrace the America first doctrine, Americans have instead begun screaming “every man for himself!”

I think I should mention that this analysis was not inspired in one bit by JPM’s fantastic Q2 2009 results. If the government insists on handing out money Dimon and his colleagues have a fiduciary duty to shareholders to take advantage of the offerings to bolster the bank’s capital levels and put it in the best possible position relative to the competition. What this is about is my concern that despite their rhetoric, Banksters like Dimon will push back against reforms that could potentially lead to a more sustainable financial system and fewer global crises in the name of trying to get back to the bubble world that existed in recent years. I fully admit that I don’t know what the right policies, regulations and reforms are. Government actions and responses always have unintended consequences. But I can’t understand why anyone in the banking industry would want to go back to the unstable and unsustainable status quo that existed before the housing bubble so unceremoniously popped.

So now I come to the most important question: isn’t it in the banks self interest to create a system without so much risk? Yes, JPM is apparently very strong now but a few years ago Lehman, AIG, and Bear Stearns all thought they were on top of the world. Without some reforms it is likely that these banks will never know when it is their turn to receive a visit from the nefarious grim reaper. Being deemed too big to fail may seem like a nice safety net, but the heads I win, tails the taxpayer loses has a definite detrimental impact on the financial system and the entire US economy. Don’t these Banksters have friends and family who do not make billions of dollars whether the financial world is imploding or not? Have profit motive and self interest really replaced patriotism completely? I sure hope not. Accordingly, this is my call for Jamie Dimon to stand up and take the lead in helping Obama and Congress create a sustainable financial infrastructure that will avoid these terrible busts that affect Main Streets all over the world. From what I know of them, Banksters are great at following the leader (just look at the race to get into subprime securitizations). Therefore, there is no better person to help bring about necessary and positive change than the king himself.

(Picture Courtesy of FPG-Getty Images)