France Takes Center Stage

Long time readers (ok, there are none... I admit this is the least popular blog on the internet) will know that I've been looking at France as the real tipping point for the crisis see here, here and here.  In fact, it's a shame that nobody seems to read this blog, because That Retired Guy (TRG) has been pretty good at predicting the crisis (just a little early on most of his calls).


Recent events as well as this brilliant cover on the Economist bring TRG welcome vindication.

As if on cue, immediately after the above was published, Moody's came out with a downgrade on Frances debt.  S&P already made that judgement, but that mattered less for two reasons. 

First, S&P had already lost any credibility that might remain when they botched the US downgrade.  Of course saying S&P is the least credible of the rating agencies is a bit like saying they are the worst wreck in the junk yard, but it made it possible to completely blow them off rather then giving some short consideration.

Second, for any institutions that use credit ratings in their investment criteria, the rules are generally structured such that when the agencies disagree then the outlier is discarded (up until now, the outlier for France was S&P).  Of course investment criteria everywhere are a bit of a joke, and can always be changed (or completely ignored) if the investor decides.  For a great example, look at the ECB and their collateral criteria which used to rely on rating agencies until the agencies inconveniently started marking down European sovereign debt.  At that point, the ECB promptly changed the requirements so the debt of Europe's sovereigns would continue to function as collateral.  A bit like a parent who can't get their kid to come home on time, and fixes the problem by setting a LATER curfew.

So what now?  That depends, it is still possible to blow off the ratings agencies, and ignore the Economist (and those other haters in the press).  France's bonds are still priced at RIDICULOUSLY low levels.  They have started to creep up this week, but they have a long way to go.  The 10 year bond in France is currently at 2.15%, and it will not gain much attention unless it raises above 3.5% quickly.

The crisis may not kick off for France until the January or February, but something important has still happened this week.  This is the week that the ball gained momentum, not much, but more momentum then Hollande's government is likely to control.  It's not out of control yet, but it's on a track with few likely detours and a big catastrophe at the end.  Sure the track is long, probably longer then we can guess, but does that really matter when we know what's at the end?

Fault Lines - What's Now

There's not really much to say in the Fault Lines department.  Things seem to grind along without much better or worse.  This should certainly be NOT be taken as an indication that the crisis is over, or even ending, however the probability that we are able to grind along back to normality has increased.  In some ways this is a shame.  Grinding along to normality may take 10 to 15 years, and there must be a quicker way to heal the wounds and move on.  TRG is going to take a break from the Fault Line predictions, but the following issues will still interrupt his sleep:

Public Revolt

Spain, Italy and Portugal staged major strikes yesterday, and the public mood across Europe has turned decidedly against austerity.  Regardless, every batch of politicians plays from the exact same script.  There exists an extremist fringe in Europe, but up until now they have not been able to front a leader who can effectively rally the masses.  Will the extremists produce a movement before the standard politicians bumble their way out of the debt mess?

Crisis Spread

The real frontier of the crisis is not Spain or Italy, it is the UK, France and even Germany.  Take the UK first, the shrinking in the financial sector is putting a major drag on London, and since London is the last bright spot holding a very shaky housing market together, things do seem likely to get a bit worse.  France is full of problems, Hollande is losing credit with his people fast even though he has been pretty good at threading his way through a hopeless situation.  What's wrong with Germany?  First off the population thinks they are economically superior to the rest of Europe, and that sort of overconfidence can make for painful realizations.  Germany's state banks are not particularly stable, and even the great Deutsche Bank is pretty threadbare when it comes to capital.

Crisis on Entirely New Front

The world is shaky right now.  The US is facing another political crisis, Japan is realizing that a lost decade is actually starting to look like a lost future.  China is going through a change of guard.  There's potential for problems everywhere.

Revisiting Apple

It's been a while since That Retired Guy (TRG) has commented on Apple.  In the time since the last post, Apple had a mildly disappointing quarter, and released a new version of the the iPhone.  The iPhone re-design is a particularly big deal because it is the first major re-vamp post Steve Jobs.  First impressions are that it's not earth shattering, but it is probably good enough for Apple to continue selling as many of them as it can make for the next few quarters.

The change from Google Maps on the iPhone has been a major hiccup, but is probably not a fatal flaw.   If Apple really throws their development weight behind the new mapping app, then they can probably fix most of the issues by the next release, and longer term, owning the mapping tool will be positive for Apple.  As great as Google maps are, the fact is that they have left the door wide open on this feature, and there is plenty of room to do it better.  Having a unique mapping application on Apple products gives one more opportunity to pull user's into the 'Apple Ecosystem', and any Apple user will tell you that once someone starts using Apple products they quickly (and happily) become 'locked in'.

TRG came across a very interesting article yesterday.  Apparently, Toni Sacconaghi at Bernstein Research (one of the better Wall Street Research firms) believes that 70% of iPhone 5 purchases are coming from NEW USERS and not upgrades.  TRG finds this a little hard to believe, but if it's true, it's really bad news for Google and Samsung because Apple users are very loyal, and not just because the products are good.  Apple creates loyal users because the products work together in a seamless way, and users become comfortable, and dependent on the features.

The iPhone will have a limited impact on this quarter, but it MAY be enough to bring Apple's yearly profit to 44 Billion.  That would place them in the top 5 in the list of largest earnings ever, and there's still an outside chance that they will make number 1 on the list this year.  For those who want to measure the historical greatness of Apple, this is the list to pay attention to.  The press has spilled a lot of ink on the fact that Apple's market capitalisation has made it the 'most valuable company ever'.  Even though on an inflation adjusted basis, Microsoft still holds the title.  The fact is that market capitalization really doesn't mean much.  When Microsoft topped the list, it was no where near as profitable as Apple is today.  In fact, Microsoft's highest earnings do not even place them in the to 20 of highest earnings of all time.  Microsoft rode the tech bubble to an inflated market value, while Apple continues to trade at a very modest 15 times earnings.

Is AAPL stock as good of an investment as it was a year ago?  No, the stock price growth has started to match (even exceed) earnings growth.  But at 15 times earnings, AAPL is still a pretty good deal.  Apple will struggle to keep up with demand for the iPhone in the next quarter, and if the rumors are true of a new iPad mini, then they will likely continue to increase profits.  Most analysts forecast growth greater then 20% for next year, and TRG does not see any major issue with Apple meeting or exceeding that target.

Longer term, it's harder to say.  Apple's products are by far the best designed consumer electronics, but it is always hard to stay on top when everyone is gunning for you.  Can Apple create the next big thing without Steve Jobs?

Book Review - Debt the First 5000 Years

It is not often that TRG finds a statement about finance and markets that looks at the industry from a totally new prospective and completely broadens the debate.

However, the book 'Debt the First 5000 Years' by David Graeber accomplishes that feat in spades, and goes on to completely shake the foundations of Modern Economic Theory.  Graeber is a well respected Anthropologist and also a Wobbly, and an Anarchist.  Recently, he has been active with the Occupy movement, and has even been credited (by Rolling Stone Magazine) with coining the statement 'We Are the 99%'.

TRG loves to have his ideas shaken, and Graeber's background makes him well qualified to accomplish that.  TRG has been in contact with other anarchists, and has generally found their arguments weak, poorly thought through, and or Utopian.  Graeber's book does NOT make an argument for anarchism directly.  What it does is show that the current political debate that pits Government vs Markets is nonsense, and probably counter productive.  We need to start asking bigger questions.

The book starts with an analysis of the founding principles of Economics.  At it's core, Economics has a creation myth, and the book rather effectively attacks this myth.  The creation myth of economics is  that markets grew naturally as an efficiency improvement over barter based systems.  According to Graeber, Anthropologists have long had a major problem with this idea because they have NEVER been able to find evidence of any society that ever existed on anything like the barter system as Adam Smith (and every entry level Economics book) describes it.  Graeber lays the arguments out effectively, and although he generally does so in a calm, academic way, don't be fooled.  For Economists, attacking Smith this way is a bit like telling the Pope that Jesus was a serial killer!

Graeber goes on to debate that our money system is really an abstraction who's existence only works because of an implicit (and sometimes explicit) threat of violence.

It is really fascinating stuff!  TRG is not totally swayed by all the arguments in the book, and he has not been turned into an anarchist by reading it, but it certainly opens a great debate, and asks the right questions.

If you still need further convincing to read the book, there is this interview with Graeber... enjoy:

Fault Lines - The Economist

TRG would like to thank The Economist for doing a guest post this week...  OK, not exactly, but the leader 'Tick Tock' in this weeks edition basically hits on all the topics that should be listed here.  It was awfully nice of them to come through when TRG had taken such a low profile for August.  Funny, but being retired does not seem to preclude an August break!

One Addition
France is still waiting for word on their credit rating from Fitch and Moody's.  Considering that they have been on negative review since December (Fitch) and October (Moody's) of last year the verdict should be out soon.  Moody's has recently become more negative on Europe so it's hard to imagine that they will have nice things to say for France.  It seems likely that the news will not be good, and as TRG has pointed out before, this could lead to trouble.

Crime and Banking

That Retired Guy (TRG) has already posted about banking culture and how it has created the latest mess.  In that post, he emphasized how banking culture had degraded to a point where fiduciary duty became a quaint joke, he also eluded to the presence of fraud and corruption.  We are now learning about some of the horrendous crimes that came as a result (for example, see here and here, or just look at this post from The Big Picture).  It should come as no surprise really when you think about the culture that was cultivated over the last 30 years in banking.

In TRG's opinion, the future will bring us a banking industry that once again becomes mundane, as it was in the 1950's or 1960's.  It will likely take some major regulatory changes to achieve this, but the public outcry and Dodd Frank Act have shown that it CAN happen (even if, so far, there has not been nearly enough done so far).  In a way, the fact that we are even hearing about serious and systematic lawbreaking by the banks is a result of a change in public mood that no longer allows the regulators to quietly accept a fine and forget about everything they discover.

Of course the criminal behavior has been going on for years, and the regulators have frequently uncovered it, but the standard practice was to quickly settle with the bank.  The settlements allowed for a reasonable sized fine (banks have paid billions) but the banks were allowed to deny guilt, and most importantly, avoid making the details of the transgression public.

Things are slowly changing.   The public mood has now come to see banking for what it is, and that is pushing the regulators to do their jobs.  In banking speak, the regulators are "growing a pair of balls", and latest action by Benjamin M. Lawsky against Standard Chartered Bank is a great example.  Another example is  Judge Jed S. Rakoff (a TRG hero) and his rejection of the settlement with Citibank.

TRG is thrilled to see the tide changing, but disappointed that the change is not faster.  There are lots of people who should be behind bars, but even that is not enough.  The regulation must change, DRASTICALLY (Dodd Frank is not enough).

Fault Lines - Strangely Calm

That Retired Guy (TRG) spent a few weeks away from the blog, but he's back now.  In the time that he was gone, a strange calm settled into the markets.  It is strange because the overall picture has probably become more troubling even if the terms for Spain seemed more acceptable.  The Spanish bank bailout exposed a new dynamic in the European political landscape.  France can no longer be expected to march to Germany's orders.  Now, Francios Hollande has become a sort of kingmaker, and he seems keen to make anyone but Angela Merkel king.  In the last round he sided with Mariano Rajoy, and Mario Monti  but in future rounds, it's harder to predict.

So the last few weeks have created yet more uncertainty for the future.  Certainly, the problems have not become any less urgent, but the solutions are even more remote.  So where are the fault lines for the next few weeks?  The may reside in surprising places:


Watch The Budgets and Forecasts
It is now mid summer, mid year, and the next round of GDP and budget forecasts will be on the way soon for most of Europe.  The expectations are low, and TRG expects that there will be no positive surprises.  The reason this is a fault line, is that serious issues can (and probably will) be exposed even without negative surprises.  In Greece for example, it will probably start to become clear that even more bailout money would be required to end the crisis.  France, Spain and Italy each stand a serious risk of looking weak in the numbers, and any one of them can easily set off another catastrophe.  Although less likely, even Germany could have bad numbers.  Basically, over the next few weeks, there will likely be problems unless every country in Europe surprises to the up side, and that is certainly very unlikely.

LIBOR Fraud
This is not exclusively a European problem , but the fault line here is so broad for the banking industry that Europe can not possibly be excluded from the trouble.  It may take more then a few weeks for this pot to really boil over, however the heat has been on 'high' for a while now, and it just gets more and more dangerous.  As Bloomberg notes, the real problems will come when the banks start to fight each other.  Any bank involved in fudging LIBOR (or any other benchmark rate) will face a horrible one sided liability problem.  The problem is that they will be sued by every injured party, but they will have no way of claiming from parties who benefited from the fraud.   The potential liability is huge, hard to calculate, and likely to start showing up in the next quarters results.  European banks desperately need profits to repair their balance sheets, so a big LIBOR problem could easily snowball.

Fixing Banking

The banking industry is broken.  That Retired Guy (TRG) is hard pressed to find anyone who will defend the industry, but just in case there are some readers who don't think that the banking industry is broken, read this, and this.  The question now should be 'how do we fix it?', but unfortunately, there has not been much discussion in this area.  TRG actually thinks that just 3 simple, easy to enact laws would completely rectify nearly all of the issues.

1.  Separate Commercial Banking From Investment Banking
It is time to re-enact the bits of the Glass-Steagall Act that separated commercial and investment banking.  It is very simple, commercial banking should include only the following activity:

• Taking deposits and servicing depositors
• Investing in conservative loans mostly held to maturity
• Providing other basic consumer financial services such as credit cards

Investment banking activities can broadly be defined as 'all the other stuff' including underwriting, brokering, trading, investment management and so on.  The fact is that the reasons they were separated by the Glass-Steagall Act in the 1930's are still valid today, and as Barry Ritholtz makes very clear in his book Bailout Nation, it is the regulatory changes that are most responsible for the latest crisis.  The activities of Investment Banking are often by there very nature, high risk, and generally high reward.  Doing these activities lends itself to the type of culture that is incompatible with the activities of commercial banks.  Simply put, if you have a culture of risk taking, you will be a bad custodian of depositors' money.

2.  Mandate That All Commercial Banks Must Be Mutual In Structure
Structure matters.  In a mutual structure, the bank is owned by it's depositors.  This aligns the interests of the organisation with the people who most need the organisation's care and protection.  Mutual banking works, and it exists today in a multitude of credit union organisations.  Generally, they are service oriented, and very conservative in their investments.  There have been problems with credit unions (usually frauds, but that happens in commercial banks too), however, credit unions have NEVER come anywhere near the problems that corporate commercial banks have created.

3.  Mandate That Investment Banks (Hedge Funds Included) Must Be Partnerships In Structure
Partnerships require the managers to own the company completely.  When senior managers become partners, they are required to purchase their partnership share, and therefore, they have a lot (usually nearly all) of their net worth tied to the success of the company.  The investment banks were generally all partnerships before the early nineties, and it worked to keep them small (it's harder to raise capital from a small group of partners then broader corporate shareholders) and risk adverse (partners worried more about risk because the structure provides the ultimate claw back).

Fault Lines: Is the Banking Bulet Really Dodged?

Fault Lines is That Retired Guy's periodic run down of the Euro dangers on the horizon (next two weeks).

Meltdown in Spain has once again been averted with an agreement to provide direct banking support from the European bailout funds (EFSF and ESM).  As usual, the market has cheered, but are the fault lines really all closed?

Watch Out For That French Downgrade

That Retired Guy (TRG) has been very vocal about the risk of a French downgrade from Moodys or Fitch.  The direct risks have actually come down a bit because the ECB has been relaxing it's collateral rules so that the rating agencies opinions are less important.  However, they will still matter to the market, and also to the guarantees provided to the EFSF.   And a downgrade can only be more eminent now that Hollande has made it clear that austerity is not his plan.

TRG is sticking to his prediction that a French 10 Year Government Bond yield of 4% or more would predicate another serious turn in the crisis.

Did They Really Agree?  Really?

Today, the markets are very excited about the agreement to allow the bailout funds go directly to Spanish banks.  However, the real work is yet to come, and the likelihood that there will be some bickering over the details seems almost certain.  If the details have some holes, then the net effect will be disillusionment with Europe's ability to end the crisis, and that in itself may cause problems.

Where's Cyprus?

Cyprus has requested a bailout.  Any surprises will make for nasty headlines.  Cyprus is a small country, and the bailout funds available are certainly enough plug any Cypric hole, however there is still a change that Cyprus becomes a catalyst for bigger problems. 

Angela Against The World

Angela Merkel had a rough night.  First, her German boys got ejected from the Euro 2012 Tournament, and she found herself facing a united front of meek governments demanding easier crisis terms.  She buckled, and so this morning, the markets are once again inspired by hope that the latest measures will put an end to the crisis.

Angela must miss her old friend Nic.  Hollande has been boosted with a surprisingly strong mandate in France, and is now leading the revolutionary cry against austerity.  So far, Angela has maintained her support in Germany in spite of a number of political u-turns, but will the German public really tolerate France's insubordination?

That Retired Guy predicted a slightly different form of Merkeland when Hollande was elected.  It's still a little too early to say weather 'Angela Against The World' is the new normal, but even if it is, the big question today (considering the market's move up):

Is 'Angela Against The World' really such a good thing?

Spain's Problems Were Made by the ECB in Greece

Spain's banking bailout last week has been less then successful, but the blame has not managed to get to the responsible party.  There is little question that Spain's problems stem from the property bust, and resulting banking crisis.  Spain has not helped it's cause by acting as if the banking problem could be solved without state support.  However, considering that the problem is a banking crisis, and the 100 Billion Euro bailout should be sufficient to recapitalize the banks, it is curious that the bond market's judgement of Spain is so harsh.  The 10 year government bond for Spain crossed 7% on Thursday.  If Spain is forced to pay that rate for long, then a full bailout will be required.  So why does the Spanish banking bailout appear to be such a failure?  The answer lies with the ECB, and the way they handled the Greek debt restructuring.

Europe's handling of Greece has been a comedy of errors, but possibly the biggest error or all was the ECB's idiotic insistence that they be spared the effects of the debt restructuring.  When Greece restructured their private bonds on April 25th the ECB had held approximately 50 Billion of the bonds which they had bought in the open market in an earlier effort to support bond prices.  The bonds that the ECB owned were the same bonds that were being restructured, and the long standing legal principle of Pari Passu states that ALL bondholders (including the ECB) must be treated equally.  The ECB didn't like this idea, and pulled an audacious, illegal kludge to insure that their bonds would be treated differently.  The did this by exchanging their bonds for new ones, but since this treatment was not offered or granted to any other bondholders, it was an absolute travesty.  The outrage was muted because the other bondholders (mostly European banks) are so beholden to the ECB that they did not want to bite the hand that props them up.  However, just because no one complains does not make it right.

Additionally, just because they thought they got away with it in Greece does not mean that they actually did.  Today, we see the fallout of the ECB's behavior in Spain.  The banking bailout should have been enough to calm the market, but it only made things worse.  Bondholders of Spanish debt understand that they are implicitly subordinated whenever official support is provided.  The subordination can be legal (in the case of the ESM) but the real concern is the illegal kind.  The precedent has been set, and it states that  in a pinch the ECB will change the rules in their favor at the last minute.  How the rules get changed is unknown, all that can be certain is that it will be to the detriment of anyone holding Spanish debt.

The ECB is getting their comeuppance, and it's poetic justice in a way, only it's a shame that Spain and the Euro will suffer for the ECB's poor judgement.

Hempton is a Brave Man

Fellow finance blogger and surfer John Hempton has been investigating and exposing Chinese frauds for some time now, but his latest post raises the bar quite substantially:

The Macroeconomics of Chinese kleptocracy

Were it not for his impressive record of finding fraud, his recent post would be easily dismissed, but That Retired Guy (TRG) thinks he may actually be on to something.

The real surprise is that he is willing to come out with something so inflammatory in the first place.  China is a pretty nationalistic place, and if he is right in his post, it is also the largest, richest mafia organization in history.  He is hitting at the core of what is likely to be seen as THE most sensitive issue for the nation.  At very least, Hempton can probably expect his computers to be hacked, and at worst, you can't eliminate the possibility of becoming personally hacked-up or otherwise coming to a violent end!  So, TRG says 'hat's off'  for speaking truth to power, and if not actual truth, then 'hat's off' for having the guts to say it anyway.

His main premise is that China works because the captive population is forced to save an negative rates, and this gives the thieves in power room to steal and still look like a successful economy.  It's true enough, although TRG suspects that most Chinese bureaucrats and SOE employees (at least the low level ones) probably have a firm conviction that they are doing the right thing for their country.  Not that their conviction matters per-se, in fact, that may be the reason the the whole fraud works.

The problem with macroeconomics is that there is generally little, or no predictive value to it.  Knowing that China will blow up someday does not tell me what to do tomorrow.  Furthermore, when China does blow up, the macroeconomic story will still be a background issue, and the thing that really gets the ball rolling will be some sort of event.

Macroeconomics are a bit like the stage design in a theater production.  The theme of the stage certainly contributes to the feeling of the play, but it does not direct the plot in the way that the dialog, or action does.  Even if China is the biggest fraud ever, it can still get much bigger.  It could even grow to become the first world empire before things collapse.

TRG doubts Hempton would refute this, for example, it's unlikely that he has found a way to make a financial wager on the macroeconomic story.  Of course, that doesn't make the macroeconomic story any less interesting.

Fault Lines - Now it Gets Political

Fault Lines is That Retired Guy's weekly run down of the Euro dangers on the horizon (next two weeks).

What a difference a week makes.  Last week, the main concern was banking, and to a degree, it remains, but the Spanish move to ask for a bailout for it's banks is likely to reduce the chance of a run at least in that country, and there were no major issues coming out of the Greek banks last week, so for the next two weeks politics will play center stage.

Hollande is Likely to Cement His Position, Is That a Good Thing?
The issue with French elections is that they have been surprisingly good at ignoring the elephant in the room.  France does not see itself as an overburdened debt country with too generous of a state, and a aging, growth starved economy.  In fact, evidenced by their bond rate, the rest of the world doesn't see France that way either.  Unless of course you actually ASK someone.  In that case, you will here some version of French troubles that include too much debt, too little growth, an aging population, a overly generous state and (especially if you ask an American) a tendency of the population to not work very much.  This is a curious condition...  TRG is used to seeing cases where perception and reality have become disjointed, but in France, we have a case where perception has in fact become disjointed from perception!  Nowhere is this more apparent then on the French political stage where the issues are widely acknowledged, and yet somehow completely ignored in policy proposals.

Were Europe not in such a mess, France's identity crisis could probably continue for years, however...

So what are the risks for Europe coming from France.   It seems likely that Francois Hollande will take another victory for his party by packing the parliament with his party.  He has played his cards perfectly since the presidential election, and he is surprisingly popular going into the parliamentary election.  The problem for Hollande is that there are wolves stalking.  Moody's and Fitch seem very ready to downgrade France, and probably they are just waiting for the end of the election cycle so as not to give an appearance of taking a political angle.  Things are playing out almost exactly as TRG himself had predicted (and yes, he is very surprised whenever that happens).

The crack that will open to engulf France is not the election, it is the downgrade (see 'Merkelland' for a full description why).  The downgrade may not be in the next two weeks, but TRG sees the election as a significant step in the process.

Greek Politics
The upcoming Greek election is such an obvious fault line, that TRG isn't even going to delve into it deeply hear apart from saying that another Greek deadlock is almost certain.   With Greece running out of money, and the Troika looking for any excuse not to give more, things are bound to come to a head.

The Cyprus Bailout
TRG expects a bailout to be announced for Cyprus in the next few weeks, and this could unsettle markets.  Cyprus is small, so a bailout will be hay rather then a haystack, but there is a real risk that we are coming to the straw that breaks the camel's back.

A Banking Surprise is Still Ever Threatening
TRG is probably going to stop talking about this particular Fault Line, but not because it is going away.  Rather, it is so ever present that he is going to get tired of mentioning it.  See the last Fault Lines post for a description.  Needless to say, it could happen in the next two weeks.

The Market's Up, But Don't Let That Fool You

To the casual observer, the market performance over the last few days would suggest that things have changed dramatically.  That Retired Guy (TRG) is not so sure.  The Fault Lines in the Euro certainly have not become any less precarious.  Of course there has been market commentary linking the moves in the market to the prospect of direct capital injection into Spain's banks from the European Union.  TRG is not convinced about this either.

The fact is that on any given day, it's damn hard to explain what the market is doing with the actual facts of world events.  In the latest news, there are two New York Times articles that demonstrate that things are still pretty bad in Spain and Greece:

Greece Going Broke
The title say's it all.  Greece is running out of money, and the EU is not going to be happy about providing more.

Spain Holds Trump Card
This article puts a positive spin on the idea that Spain will enter bailout negotiations with a strong bargaining position.  It's true enough, but TRG fails to see how difficult negotiations are somehow a good thing, as if the situation in Greece, Ireland, and Portugal would have somehow been better if the bail out countries had gotten a better deal for themselves.  The fact is that German voters will NEVER think that the PIIGS are doing enough, and the PIIGS will ALWAYS think the austerity is too extreme.

So the market's up, but the storm clouds are as dark as ever.

Fault Lines - Watchout for the Banks

Europe is in a mess at the moment.  The once sturdy Euro has suffered some substantial blows, and a lattice of cracks have appeared in the foundation.  TRG has (belatedly) come around to the idea that Greece will leave the Euro, which immediately raises the question 'what will happen to the Euro then?'  Exit for Greece is bound to be messy, and the politicians have shown over and over again that they are incapable of getting in front of this crisis.  If Greece leaves, then that is likely to trigger more events that will spread pain through Europe, and the world.  However, Greece leaving the Euro may not even be the first event.  Clearly, we are no longer talking exclusively about Greece when we discuss threats to the Euro, and TRG believes that limiting the discussion to even Portugal, Italy, Ireland, Greece and Spain (PIIGS) is too narrow.  The cracks in the Euro spread far wider, for example, a credit rating downgrade in France could easily spark another moment of deep crisis.

'Fault Lines' will be a regular feature on the That Retired Guy blog, hopefully once every week or so.  The idea is to look at the coming two weeks and suggest what seem to present the Euro threats.  These threats are sure to change overtime, and TRG is hoping to chronicle where we are in each step.

Running (on) the Banks
The most likely catalyst for the next crisis would be if the current slow motion 'Bank jog' turned in to a full scale 'Bank Run' in Spain or Greece.  The smart money (corporate deposits of international companies) has likely already left these countries, and individual deposits are slowly leaking out too. 

All banks have an implicit risk of becoming insolvent if depositors all ask for their money at once.  Typically, this happens when a roomer circulates that the bank is going to fail and anyone who does not get their money out fast will loose it.  If this were to happen to any significantly sized bank in Greece or Spain, it would create an instant Euro crisis, that could easily result in a breakup of the currency.

The sad fact is that some people are being awfully foolish.   TRG has read stories of people pulling money out of the banks to keep it in cash at home.  Aside from the obvious security risk this creates, it is also completely ineffective as insurance in the event of Euro exit.  In an exit scenario, ALL money inside the borders of the country will be re-denominated INCLUDING NOTES AND COINS, the military will secure the border to prevent cash from leaving.  So keeping money as cash at home will not protect it.  Better to open a bank account in Switzerland, or use the money to buy an asset (such as Bunds) that will continue to be denominated in a currency worth having if the Euro splits.  TRG is not a big fan of gold, but it would also work as a short term store of value if the Euro breaks apart.

A Large European Bank (Anywhere) Has A Big Unexpected Loss
JP Morgan recently demonstrated that big banks have not learned any lessons from the past crisis.  TRG believes this is no accented, but rather a result of the broken banking culture that continues to fester, and is decaying the banking system from the inside out.  If a large European bank (Deutsche Bank is TRG's favorite candidate) suddenly announced that a few billion Euro's had gone missing due to some sloppy risk control, and/or 'rouge' trader then it would set of a shit storm in the market.  Deutsche Bank is TRG's favorite candidate for such a misfortune because like JP Morgan in the US they have been a big proponent of the "But our shit doesn't stink!" line of reasoning.  The reasoning is that because they survived the last crisis without any major scars, they should be seen as special.  Deutsche Bank has a ridiculous leverage ratio, and a weak capital position, one reasonably sized loss is all it will take before they are suddenly looking very shaky, and the fact that the German government would inherit the problem could leave the rest of Europe in a poetically ironic state of schadenfreude.  Deutshe Bank is not the only bank that could set off trouble, Societe Generale, Barclays, Unicredit, and Santander have all drunken deeply from the "But our shit doesn't stink!" trough, and any of them would suffer double if an unexpected loss were to come to light now.

The Ever-Present Political Risk
When times are rough, the simplest political mis-step can set off a major problem.  We came close last week when Spain's Rajoy suggested Europe help with the Bankia bailout without getting Angela Merkel's take on the idea first.  It looks like Europe will be coming to the rescue of Spain's banks regardless but the bullet seems to have been only narrowly dodged (and the Bankia story is not over yet).  Political risk could also come on the campaign trail in Greece, although the real political story will be latter in June with the election itself happens.

Some Day, 'Financial Innovation' Will Once Again be an Oxymoron

That Retired Guy (TRG) is a refugee of the world of high finance.  His career spanned 15 years mostly in New York and London.  TRG saw a lot in those 15 years.  Most of that time, finance was a celebrated industry, and in the glory days, it was hard not to swallow some of the cool-aid.  Now, with the benefit of hindsight, TRG can see that the rot had started long before the crisis of 2008 exposed it to the outside world.  Like a zit on the face of the globe, the puss built up below the skin even when the outside world thought everything was beautiful.  When the painful zit-head finally appeared, the full extent of the problem was still hidden.  But when agitated, the puss exploded everywhere.  Of course, this 'zit' analogy only really works if you've seen John Bolushi's zit joke in the movie Animal House.  That's the short story of the downfall of finance in the last 20 years (put in terms that any adolescent can easily understand).  For anyone interested in what really happened, read on.


It Started With a Little Lie About Efficient Markets
This story starts a few years (maybe a decade) before TRG hit the financial scene.  At the time (and even today to a certain degree) the Efficient Market Theory was seen as a hard to refute fact.  Those in the world of Finance certainly were (most still are) big believers.  Bankers then and now often fall back on the idea of Efficient Markets as a raison d'être.  The logic goes something like this: the market is efficient, so if someone is paying for a financial innovation, then it must be valuable to them, and by extension society overall.  Loyd Blankfien famously pushed that button when he said he Goldman Sachs was doing "gods work".  The idea Loyd was hitting on was that financial innovation was making the world of capital allocation more efficient, and this increased efficiency was a benefit to all humanity.  This is of course, NONSENSE, but it's that dangerous sort of nonsense that sounds nice, and is easy to follow.

After what we have experienced in the last 3.5 years (and are still experiencing today) the idea that financial innovation is making the world better should be a hard sell, but it seems some people still take it for granted.  The academic debate will rage for years.  Academia is particularly fond of the idea of Efficient Markets, but the theory actually suggest that corruption and fraud are market inefficiencies which will be resolved 'naturally' as long as markets are free and transparent.  Anyone who has ever worked in an investment bank knows that 'transparent' financial markets are a useful illusion used to distract the client's attention while you get extra revenue from some part of the process that is left surprisingly opaque.

The truth is that the world of finance is subject to fashion, trend and hype; in fact, it seems that most every human endeavor is.  Years of calm markets created a complacent public who believed that the smart folks in finance had finally figured out how to create profitable, never ending stability.  Opaque, hard to analyze products, aggressively sold by bankers who present an illusion of providing an 'inside track' came in contact with a willing public allowing the promise of quick profits to dampen their natural skepticism.

Banks create new products because they can SELL them.   This statement seems painfully obvious, but it deserves a deeper look.   Note that the only important aspect is that a sale can be made, not that the sale is beneficial for the client.  Efficient market theory tells us that the sale itself is evidence that the product is beneficial, but TRG has witnessed first hand that the benefit of the client is a secondary concern to the banker, and in fact, it is often absent.

Paul Volcker hit the nail on the head when he said that the only useful financial innovation in the past 25 years was the ATM.  Lord Adair Turner said that most financial innovation was "socially useless" which is probably being generous because it does not account for some innovation actually being socially damaging.  TRG has a humble idea that he believes will easily illustrate that the growth in the finance industry is NOT improving the world.  It's a simple idea,  the premise is this: if the financial industry is good for the world then growth in financial profits should be matched in overall corporate profit growth, and in fact global GDP growth.

The Finance Industry is Actually a Tax on Investment
 Finance is a service, and ideally, it is a contributing service to other useful economic activity.  However, finance is a specific kind of service, at it's core, the job of the financial industry is simple: take excess capital (savings) and deploy it in useful ways (investment).  Finance moves money from savings to investment, and takes a little slice of that money as a fee for the service.  The fee is an important element here because in a perfectly efficient system savings and investment would come together without the need for a financial industry to help them.  When finance takes it's fee, what is really happening is that a small amount of investment money is leaking out of the system and resulting in less investment then if the investment had happened without the financial industry getting involved.  In a way, the financial industry's cut can be seen as a sort of 'tax' on investment.  Everything is fine with that, if the financial fee (tax) is really compensating for a truly enabling activity, then it is worth paying.  Over time, this should become evident because when financial fees increase, overall economic activity that they are promoting should increase more.   The problem is that in fact, the finance industry has been taking a bigger and bigger slice of the pie.  TRG doesn't have the global numbers, but he was able to find the numbers for the US (courtesy of wikipedia who sourced it from here):

 
Unfortunately, the global equivalent of this graph is required to prove the point.  Back in the day when This Retired Guy was That Working Guy, he could have grabbed this data from his Bloomberg terminal (maybe not going back 150 years, but certainly they have some data) to show the same trend.  TRG would really appreciate if one of his readers is plugged into a Bloomberg terminal and can help.

The global numbers are necessary because the above graph could result from the US doing more finance for OTHER countries.  TRG doesn't think that's really what's happening here, but until we see the total global financial industry graphed as a percent of global GDP the jury is still out.

Assuming the global graph looks something like the above graph, then it would be a pretty damning indictment of the finance industry.  The fee (tax) going to finance has gone up from less then 2% of economic activity to nearly 8% in the United States in the last 150 years!  In itself, this graph does not prove that finance is bad, but it does say that at very least, finance is becoming much LESS effective at helping economic activity then it was.  That should be surprising, after all, the banking industry benefited greatly from improvements in computers, and telecommunication over this time.  Why has finance not become more efficient at it's central job of enabling investment?

The Masters of the Universe Have Taken Over
Most of the money that the finance industry earns (from taxing investments) goes to pay staff, compensation ratios (percent of pay to overall revenue) very but generally run 30 to 40%.  This is not surprising in itself, but when you couple this fact with the revelation that the financial industries revenue is actually a tax on investment, then it starts to become clear how we got into this mess.

In TRG's time as a finance employee, he saw the industry increasingly attracting the smartest and most driven individuals with the promise of ever increasing pay.  When a bright young graduate was being hired, there was an implicit bargain being offered.  The bank was basically saying "find a way to increase the tax on investment, and we will share the profit with you".  The banks thought they were getting a good deal, but in fact, they missed an important element.  The easiest way to increase revenue in finance is to increase risk.

Increasingly, the banks have modeled their culture as a meritocracy.  "Make more for the bank, and you will make more for yourself" or in banker jargon "eat what you kill" is an obvious part of that, but pay is only one aspect of the industry's obsession with rewarding on 'merit'.  Promotion to management increasingly worked on the same principal.  Meritocracy seems like a great way to run a business, but in fact, it has some drawbacks.   First, it is critical that the analysis of performance is accurate, and that there is little chance that they system will be 'gamed'.  Second, if different job's require different skills, then the 'The Peter Principle' can become a real thing.  The Peter Principle is the idea that in a meritocracy, each individual will be promoted until they reach a level where they are incompetent, and there they will remain unable to achieve further promotion.  This is particularly troublesome in banking where, for example, the personality traits which seem compatible with successful traders are disastrous when employed in management.

In the golden years, the hyper competitive environment, and difficult working conditions came with a fat paycheck around Christmas time.  The personalities that excelled in this environment created a culture which became less and less human, and more ruthless in it's drive for maximum reward.  TRG remembers well the common refrain whenever a high flying trader was confronted with anyone who didn't agree with them, or do what they wanted...  these individuals had a name in the trader's mind, they were called 'Fucking Idiots'.

When the fire-hose of profits was spraying far and wide, none of this seemed to be an issue, it was even glorified.  Financial industry employment itself became a fashion.  This process was already well underway when TRG started, but then it really took off.  When we say 'banker' today, we envision slick Wall Street types in expensive suits.

The banking crisis of 2008 was a direct result of this culture, and the result was inevitable.  Of course, mortgage securities packed with sloppy underwritten loans paid their part, but if it hadn't been Synthetic CDO's then the slick bankers would have come up with something else.

We Need to Get Back to the Old Style Banker

 This vision of the modern banker would sound very strange to a man on the street in the 1950's, or in fact, most of history.  Historically, banking has been a conservative boring career; a bit like being an accountant but not quite as exciting.  This is in fact what banking should be; boring.  Bankers should be hyper conservative rather then hyper competitive.  They should be custodians of wealth who pride themselves at saying 'no' to everything except the most solid investments.  Innovation should be a dirty word in finance!  The economy will not grow as fast, but it will be more stable.  Today's stereotypical banker is the real reason that things went wrong.  Fortunately, the flashy high flying banker of today is an anomaly, not a permanent evolution.  The industry is already showing signs of change, but this is just the beginning.  The adjustment has started; the old banker is coming back.  It took decades for things to get this messed up, so it is going to take time to make it right, and it wont be easy.


Getting to the Old Style Banker Will Be No Fun For the New Style Banker
For the modern day financial professional, this adjustment is going to be particularly painful.  They were sold a promise that is no longer valid.  There is now pressure to reduce pay and pay is coming down, but the culture change has not even begun, in fact, the culture has become even more poisonous.  As the revenue has come down, most of the big banks have also cut back on staff as well as pay.  The jobs have not become any less intense, but now there are fewer people to do them.  In fact, with the wave of regulation (Dodd-Frank and Basel III to name just a few) the workload has dramatically increased.

There was a fair amount of truth in the old stereotype of banking jobs being unbearably stressful and intense, but justified by the high compensation.  That was the old stereotype, now the stereotype is of a job that is unbearably stressful, intense, surrounded by backstabbing assholes, and providing an ever shrinking paycheck.  Since staffing levels are down at most banks, this increased work is falling on the remaining employees, at a time when the big compensation packet is no longer in the cards.  TRG had his own reasons for leaving the finance industry,  but he knows many who are heading for the exit now for this reason.

As the pay pools have dried up, the hyper competitive staff have become increasingly preoccupied with grabbing recognition for anything that has generated positive revenue, and avoiding any work that distracts from increased revenue generation.  Naturally, if anything goes wrong, then shifting blame has also become a critical professional skill.  What was once a team oriented focus on getting the job done has increasing become an environment of constant witch hunts, and passing the buck.   In the last years of TRG's career, he noticed that it was increasingly not good enough to get someone to agree, it had to be written in an e-mail correspondence somewhere because the agreement or promise was likely to be reneged later.  The environment was always high pressured, but when you get to a point that people can't be trusted to keep there word, it's really no fun!

In TRG's humble opinion, this is how the world ends for the modern day banker.  The job will end because the culture has slowly poisoned itself on it's own glutenous behavior.  Bankers are already leaving the industry like rats from a sinking ship (exactly like rats actually).   It will take time, but eventually, banks will become boring places full of people who seem to pride themselves on their  conservative, bureaucratic routine.  'Banking Innovation' will once again be an oxymoron.

Jamie Dimon better start looking for a new job

When news broke a few weeks ago about the Chief Investment Office (CIO) at JP Morgan, and trader Bruno Michel Iksil last month, That Retired Guy (TRG) looked on with bemused curiosity.  "Hedging" according to Jamie Dimon...  sure.

And now, we find that JP Morgan's 'hedge' has resulted in a market loss of approximately $2 Billion.  Dimon, is playing the tragic hero and continues the story that it was intended as a hedge, but some mistakes were made.  He has a genetic flaw that excludes him from recognizing the possibility that he himself was wrong!   He has decided that he's going to blame those mistakes on someone else!  Clearly he is forgetting the roll he personally played in the restructuring of the CIO office which made this 'error' possible.

Dimon's head needs to roll.

It is long past time to get the risk takers out of banking.  As a society, we MUST return to a time when bankers are boring, cost conscious, and overly conservative.  NO MORE JAMIE DIMONS!

What to do about Greece?

A couple of years ago, when the debt crisis in Greece really got going, That Retired Guy had a look, and came to the early conclusion that default was inevitable, but that exit from the Euro was not necessarily required.  In a way, events so far have proved him right, but alas, this story isn't over yet, and TRG can now see that he was wrong; Euro exit is probably inevitable.

TRG now believes that we will see a return of the Drachma before long (probably this year).  The reason for this belief is simple; among the solutions that might work, leaving the Euro is the most likely to actually work, and it is, in fact, the best solution for the Greek people.  Let's look at the possible solutions in turn:


Austerity
Austerity has been tried, and it is not working.  It's the same story everywhere, cutting government spending and raising taxes at a time when the economy is soft is counter productive.  There used to be a debate about the effectiveness of austerity.  The debate is over.  Austerity has been tried everywhere, and everywhere it is failing.  Greece has made a heroic effort, but the mountain is just too high.


Fiscal Transfer
Fiscal transfer is the idea that someone (IMF, ECB, Germany, whoever) will give Greece the money they need with no (or limited) strings attached.  Silly as it sounds, it is basically what West Germany did for East Germany in the nineties.  The main difference of course is that Greece does not really want to be absorbed into another country!  With enough will, the European Union could actually become a real United Government of Europe and provide this sort of help for it's struggling members, but let's be real; a truly United Europe is about as likely as a Britney Spears comeback. 

Without a more united Europe, only a small scale fiscal transfer is possible. Unfortunately, small scale isn't going to do the job.  Realistically, Greece probably needs something north of 400 Billion as a direct payment (not a loan) to end their turmoil.  Nobody has the ability to make a gift that large.

Default
Partial default already happened, and the remaining debt holders are now the ECB, EFSF and IMF.  Given that fact, default is basically Fiscal Transfer by another name, and for that reason, it's just as unlikely.


Leave the Euro
Leaving the Euro will not be easy.  It's hard to overstate just how hard it will be.  It will involve using the military to enforce marshal law in order to avoid people running across the boarder with as much cash as they can get their hands on.  It will mean banks closing, and being nationalized.  It will involve years of difficult court battles to determine what currency should be used for existing Euro contracts.  In the short term, it will decimate the Greek economy.  But there is one thing that a Euro exit will provide that none of the other ideas can...  HOPE. 

Exiting the Euro provides a real, credible path to a future with economic growth.  Once the tactical difficulties of switching the currency are complete the population of Greece will become unable to afford imports, and the local Greek economy will come to life to fill the gaps.  Exports will also be possible because Greece will provide a competitive labor market.  This is not some sort of hazy economic theory, there are multiple examples (most recently Argentina) the illustrate how effectively, and rapidly currency devaluation can spur an economy.

There's another benefit to exiting the Euro.  It will be painful, but the pain will be equally spread.  Austerity is having a unbearable effect on the young and poor in Greece.  Exiting the Euro will hurt too, but once the new currency is established, the benefit will come first to those looking for work.  Prices on anything locally produced (food especially) will be affordable.  People will see the benefits quickly, and the path to future prosperity will be believable.

The political situation in Greece may be the ultimate catalyst.  By some estimates, Greece will be out of money in June if they don't get the next batch of support from the Troika.  It appears that new elections will be required, hopefully, it can be done quickly, and provide a government strong enough to make the difficult decisions required.  Probably the Euro goes no matter what, so hopefully, it can be done without too much ciaos.

The big question really is what happens to the rest of Europe (especially the other periphery countries) if Greece leaves the Euro.  That will have to be discussed in another post.

Merkeland

The French people have chosen, and as expected, Francois Hollande is the winner.  The immediate fallout of this choice will probably be limited.  Hollande is likely to soften some of his campaign promises, and he is sure to try to cooperate with Angela Merkel.  Certainly, Hollande would love to see the dawn of a new era of Merkellande to replace the heady Merkosy days, but TRG see's another possibility.

The election in France did not open a new fault line, but the likelihood of a quake has nonetheless increased.  S&P has already downgraded France; Fitch and Moody's both have France on negative watch.  Since all the ratings agencies have pointed to a lack of political will to control the budget as a key risk for France, they cannot be feeling too comfortable with the election that just took place.  The battle for French votes often seemed like a contest for who could be the most fiscally irresponsible.  As noted previously, TRG does not think that austerity is the answer, but at the moment, nothing workable appears to be on any European table.

Normally TRG pays little attention to the ratings agencies.  At best, they are just incompetent, and at worst, they are a willing participant in a corrupt financial system.  Nonetheless, a France downgrade by Moody's or Fitch is worth paying attention to because it will position a very dark cloud over the core of Europe.  The S&P downgrade had a minimal effect, but another downgrade will mean big trouble, and here's why:

The EFSF, and ESM both rely heavily on financing that is guaranteed by European governments.  The amount of financing this guarantee provides is directly related to the credit ratings on the guaranteeing governments.  Currently France is calculated as a triple A credit for the EFSF and ESM because when the three main credit rating agencies disagree, then two out of three count.  So if France looses it's rating from one more agency, the safety net for all of Europe is going to suffer.  Already the EFSF and ESM would struggle to provide a meaningful bailout for Italy or Spain, but without France's triple A rating things will start looking very grim indeed.

The EFSF and ESM would suffer an indirect consequence of a credit downgrade on France, and that would be on top of any direct consequences (higher interest rates on French debt).  It's hard to estimate what the direct consequences of a downgrade would be on French debt, but if the yield were to get much above 4% on the French 10 year note, then suddenly, we might have to find room for an 'F' in the 'PIGS' acronym.

Even a remote possibility of France becoming a USER of the EFSF and ESM rather then a guarantor/contributor would be catastrophic.  Additional financing would have to be arranged, but unlike the last shotgun negotiations between Sarkosy and Merkel, this time, Angela Merkel will have no partner.  Rather then Merkellande, we will have Merkeland, and the problem with that should be obvious.

France and Greece Vote Tomorrow

Whatever happens tomorrow, it is sure mark a significant moment on the timeline of the European Crisis.  That Retired Guy (TRG) will go out on a limb here and predict that Hollande will win in France, and in Greece, the main parties will receive a painful message from the electorate, but continue to run the country.

The result of the election will get a lot of attention from commentators everywhere, although the immediate impact will probably be limited.  Financial markets may wobble next week, but things will return to the usual uneasy calm soon enough.  That is not to say that this will not be seen as an important election, as this crisis has already demonstrated, single events are not shaping the world, rather, we are suffering the crisis more as a cancer that slowly consumes us.   Nonetheless, even in the slow death of cancer, there are significant turning points.

The is hard to exaggerate how bad the situation in Europe right now is.  Every government has become painfully aware that the financial situation presents an existential threat to the European Union, and by extension the regional political order of the past 60 years.  It's not hard to imagine scenarios that involve dark forces sweeping to power and returning Europe to a state of violent conflict that was so common before WW II.

The cause of the crisis is simple, there is more debt then people or governments can easily pay, all across Europe, in fact, all across the world (especially in the United States, and Japan, but basically everywhere).  This, of course, raises an interesting question.  Why is only Europe in crisis, and why NOW?  These will remain highly debated academic questions for a millennium, but they are not actually relevant to the current situation.  It doesn't matter WHY the crisis has hit now, it was probably inevitable for some time what matters is how we resolve the issue, and move on.

There appear to be no easy or good solutions.  The solution that is getting the most attention now is austerity.  Governments everywhere are increasing taxes, and cutting spending.  This remedy is not proving successful, probably because financial responsibility is really only effective at PREVENTING a crisis.  Once the crisis has started (as we have seen) it doesn't resolve the issue.  It's a bit like using fire prevention techniques (fire alarms, smoke detectors, extinguishers) to fight a raging fire.  These things are useful to keep a fire from starting, or getting to extreme, but once you have an inferno, the only thing that's going to make a difference is lots of firetrucks.

TRG has been watching the events unfold closely.  He is also absorbing the literature of past financial turmoil to gain some prospective.  Some useful books:


This Time Is Different: Eight Centuries of Financial Folly
The Great Depression, A Diary
Debt the First 5000 Years

History has much to teach about financial crisis, although it's pretty worrying stuff. 

We are not headed for a easy or fun time.  'This Time is Different' makes the case that whenever a nation finds itself in deep financial trouble the result is generally default often followed by war and/or revolution.  In fact, they point out that most wars and revolutions have some financial aspect where the conflict can often be framed as an argument over a real or perceived financial debt.

TRG will devote the next post to the possible resolutions being discussed and their likelihood of resolving the current situation, but today (actually, tomorrow) let's just sit back and watch as democracy makes another great show of public choice without any real choice being presented or made.

Hurray for May Day!

Happy May Day to all (except for Americans who don't play May Day because they think it's a communist thing).

No irony there, some retired guy telling the working world to enjoy their day off!

In celebration, That Retired Guy (TRG) has decided to join the Occupy Movement in their general strike of everything.  There will be no consumerism today!  No trips to get grocery store (he stocked up yesterday) and no coffee in the cafe. 

Naturally, this will not make a bit of difference to anything, but in his romantic way, TRG would like to imagine it would.  Lets imagine a world where every May Day, we really ALL STOPPED.  Not just stop working, stop consuming, stop forcing anyone to work (apart from the most essential services).  Would it not be the ultimate statement that PEOPLE are in control, not governments or corporations?

Why not one day were we not just have a holiday, but we actually try to reflect on the impact that all these consumer things around us have.  Reflect on the society we have created and ask ourselves 'is it really working?'  A natural setting is better for these types of reflections.  Go to a park instead of a mall.  Go camping, or hiking.  TRG tried to go surf, but alas, it's raining, cold and miserable out, so he came home to write a blog entry instead.

Of course devout Jews do it once a week, they are really good at this.  TRG recognizes there effort.   But alas, justifications matter.   And religious justifications can never be less nonsense then religion itself.  In the case of the Jews... wasn't a bit silly to dream up a god who only had enough energy to work six days straight?  And why is creating the earth seen as work anyway?  Was someone paying this god?  Surely it was more of a 'hobby'?  These obvious questions aside,  the real problem with religion is the distraction.  At best, imaginary gods distract us from the important issues around us, and at worst, give an excuse for not making necessary changes.  So, unfortunately, the Jews, who are doing the right thing for the wrong reasons end up failing in the same way as the math student flunks a test because they couldn't show the correct thought process even if they may have came up with the right final answer.

TRG has some ideas that he thinks could improve our society, and this blog will hopefully become a forum to discuss them.  But that's for a latter day, today let's just try to make May Day a true day of rest and reflection.

Missing the Point on AAPL

OK, so this is post number 3 on the same issue.  TRG has already made this case here and here, but now he feels the need spell it out, plain and simple.  AAPL stock is too cheap, and nobody seems to be noticing.  All the talk is about future iPhone competition, and margins that can not stay this high.  They are missing the point.  The stock will surely rise today, probably more then 10% based on pre-market activity.

IT WILL STILL BE TOO CHEAP!

Simple math will show it.  The current PE based on the April 25 close price of 560.28 and the announced earnings (past 12 months earnings are 41 dollars per share) is 13.66!  The current average PE for the S&P 500 is 22.5.  Based on this simple fact, 1 dollar earned at Apple is only worth 13.66/22.5 = .60 cents earned at any other company...  THAT'S STUPID CRAZY.

Apple is an exceptional company, and TRG would really like to believe that they deserve a commensurate valuation.  But lets be conservative and value them as an AVERAGE company:

41.02 X 22.5 = $922.95

There it is.  AAPL stock, with an average S&P valuation, should be trading at $923 per share.

So, that life thing... what's it worth to ya?

Here's a question.  How much (in dollars) is a human life worth?  Priceless?  Hardly.  Given the impact on the earth's limited resources, it could be argued that there's a net benefit to one less person (resulting in a negative value for a life).  However, in social, and economic terms, a life certainly has a (positive) value.  This isn't just a philosophical question, there are a lot of situations where we really need to know.  It's time to come to have a responsible discussion and come up with a reasonable, consistent number.

Society puts a value on life all the time.  Courts, insurance companies, even municipalities deciding whether to make road safety improvements are putting a dollar value on your life every day.  The problem with modern society is that we are inconsistent, unjust, and unequal in our assessment.   For example, if you are killed by an American State, you are probably worth around $100 to 300K (regardless of weather it was an accented or not).  If you die because a doctor misdiagnosed you then it's a jackpot!  This woman hadn't even died yet.  Of course, that's medical malpractice in the United States, in other parts of the world, it's not so much a jackpot as a joke (in Europe, it can be a real challenge to raise a malpractice claim at all).  If a US military soldier barges into your house and kills your whole family (for no apparent reason) you are likely to receive a paltry sum.  If you are homeless and you die because no one will give you a warm place to sleep, then the value is probably $0, and if the state can find heirs, they may charge them for the disposal.

Wouldn't it be a little more equitable if we as a society came up with a single number, and applied it consistently?  This is not a new or original idea, in the 5th century the 'Barbarian Code' (an ironic appellation considering that, on this topic, the code was more sophisticated then our current system) contains the concept of 'WereGild'.  According to Philip Grierson the Barbarian Code itself was quite a complex list of values and equivalences, such that if the responsible party did not have actual cash money (which was not in common circulation) then an equivalent number of say chickens could be supplied.  So there you go, modern law does not even give you a value in dollars, let alone chickens.  outrageous!

If life had a price, it would set a useful benchmark for all sorts of other compensation issues too.  For example, lose an eye, or a limb on the job, and the compensation should work out to be some proportion of the compensation due for a life.  Naturally, in cases where the injury (or loss of life) was caused by gross negligence, or intentional action, then the compensation award could be a multiple of the normal value.  This would immediately solve one of the major issues in American healthcare by reducing medical malpractice awards, and by extension malpractice insurance that doctors must pay.   There are other legal is issues that impact healthcare costs, but this would go a long way to fixing things.

Setting a value for life would allow us to plan our society in a much more consistent way.  Insurance liabilities could be estimated with much more accuracy.  Safety improvements could be more easily analyzed for their cost/benefit.  Fair, consistent settlements for wrongful death would be easily arranged, and could probably even avoid expensive court trials.  The benefits are obvious, what's the drawback?

AAPL Sillyness

Following That Retired Guy's (TRG) last post on AAPL, the stock has not exactly moved in line with his predictions.  Probably it should be expected that when you stick your neck out with a public statement, fate is sure to prove you wrong.  TRG is not deterred, so he's going to tempt fate.  He's going to double down.  He's going to talk about how AAPL stock has become ridiculously cheap.

First, a graph of the recent activity:

AAPL data by YCharts

As you can see, from the close on April 9th (636.68) to yesterdays close (572.98) AAPL has plunged almost exactly 10%.  Even worse when you consider that the S&P 500 is nearly flat over the same period, and worse still when you acknowledge the fact that AAPL itself has a massive impact on the S&P's performance due to it's outsized market cap as this chart from the Wall Street Journal shows:

But as TRG pointed out, AAPL's stock price growth was already struggling to keep up with it's earnings.  Now the situation has become a little ridiculous.  Basted on AAPL's current close and trailing earnings, the stock has a PE Ratio of 16.32.  If anyone can argue that that PE makes sense for AAPL, please comment, TRG would love to know what he's missing.  Keep in mind that 16.32 is based on trailing earnings, and that AAPL's balance sheet cash translates to approximately $100 per share which technically should be removed before calculating PE (if you remove it, current PE is even lower).  Depending on who's estimate of future earnings you use, you are likely to come in with a number somewhere around 12!  Daniel Tello is respected as one of the most accurate independent Apple analysts (independent's are more accurate then pro's on Apple) and his forward looking PE is around 10.

TRG would sell Apple if it's earnings PE got much above 25 (that is, 25 trailing earnings, the TRG limit is 20 on forward earnings), but at 16, it seems a bargain.  PE for AAPL has been lower, but that tends to be only just after earnings are announced.  Since AAPL tends to beat all earnings estimates, the high earnings cause the PE to become deflated, but this situation is usually rectified within a few days of trading (by a rocketing stock price).  For example, see last April.

Price to Earnings (PE) is a crude measure, but it captures the general idea that a dollar earned different companies and sectors does not have the same impact on the company's/sector's value.  There are some good reasons for this.  For example, if the company high risk, or highly leveraged, or facing low growth prospects then the stock price should reflect this, and the resulting PE should also be lower.

In the case of AAPL, given that the first quarter earnings were so high (one quarter being as much as the whole first half of 2011) the fact that their PE has come down since last year (it was over 20 a year ago) is very hard to square.  Is this actually suggesting that the next 3 quarters will be LOWER then last year?  Certainly the analysts making estimates don't think so.

AAPL has no loans, and therefore, no leverage at all.  From this standpoint, it's a pretty low risk company.  Although earnings have been volatile, they tend to be volatile only to the positive side.
AAPL has not had negative earnings in recent history (you have to go back about 10 years), and even the worst Apple doomsters would never dare to suggest that Apple will have a quarterly loss this year (or next).

AAPL's PE at 16.32 has now come in below some companies in the technology sector.  For example TXN (Texas Instruments) has a PE of 17.32, a fact that should immediately seem a bit strange to any investor.  TRG could go on and on about why this situation is just crazy, but rather, he will just show a graph that says it all (make sure you pay close attention to the scale on this graph):

AAPL Earnings Per Share data by YCharts

No, the crisis is not over

The Economist has a good article this week about the euro crisis.  This retired guy (TRG) has a real soft spot for the cartoon too:

No more sugary euro's in the Sarkozy dispenser, better try the Merkel one.

The New York Times is also on it, and so is Reuters.  Although it's a mistake to think that this is just an exclusively European problem.  There is too much debt EVERYWHERE.  The US has it particularly bad, Japan too, and things are really unlikely to get better until we admit a few things about debt, and take appropriate action.

There are a few principles of debt that have existed since time eternal.  These principles of debt existed long before we even called it 'debt'.  Ever since it has been possible to owe something (anything) to someone (anyone) these principles have been true, so it's surprising that we are forgetting them now.


The FIRST Principle of Debt

The number one, critical, most important principle of debt, that every lender and borrower should understand intimately is this:

If you CAN'T pay a debt...  YOU DON'T.

It's that simple, really.  There are consequences to not paying, and they must be faced, but the simple fact is, if you can't pay, you don't.  You face the consequences.  You get on with it.  In fact, over time, as a society, we discovered that 'getting on with it' is the most important part.  The consequences themselves need to be focused on 'getting on with it', not on punishment, or retribution.  Think about it for a moment, take yourself back a few thousand years, it's not hard to imagine early societies where the consequence of default was DEATH.   In the more recent past, it was imprisonment (debtors prison).  However as a society, we moved away from these stern consequences, and not just because they were inhumane; we moved away from these consequences because they were unproductive.  If you kill or imprison some one for not paying debt then you have effectively GUARANTEED that you will recover exactly zero percent of the debt owed.  In our modern world, we have developed bankruptcy as an alternative.  Bankruptcy is a legal process whereby you pay what you can, and anything you can't pay, you don't.  You pay what you can, and then you get on with it.  How many successful entrepreneurs today were bankrupt at least once in the past?  Would be a shame if we had killed them for it!


The SECOND Principle of Debt

The second principal of debt (nearly as important as the first):

There are ALWAYS exactly TWO responsible parties for every default; the borrower AND the lender.

Whenever a loan goes bad, BOTH the lender and the borrower have failed.  It is easy to forget this, people who struggle to pay all their debts feel a natural resentment to those who don't pay, and the lenders (banks) feed this fire.  Banks want us to forget about the part they played, the lax loan standards, the unreasonable high interest rates, the complex structures, or the heavy handed marketing that entrapped people into more debt then they could reasonably pay.  Don't be fooled, when a loan fails, it's because the LENDER fucked up as much (sometimes more) then the borrower.  "But, what if the borrower never intended to pay?" you ask; that's not a loan, it's a fraud, and we DO have prison for that (China still has DEATH for fraud).

The second principle of debt explains why debts are erased in bankruptcy, it is not just because they CAN'T be paid, it's because the lender is partly responsible for them not being paid.  This is also why bankruptcy is final; even if the bankrupt party latter becomes rich, they don't have to pay debts that were erased in the bankruptcy process, those old debts go away, FOREVER.

Lawyers will go on at length about other principles of debt (pari passu for example) but these are legal principles that may or may not exist except in law.   The First and Second principle of debt ALWAYS exist, whenever there is a debt they exist, they have always have existed, and they always will.  The First principle cannot be ignored, the Second principle CAN be ignored (killing people for default is a good example), but it shouldn't.

The situation we find ourselves in today is not new or unique.  The world has too much debt, everywhere.  This has happened before, (see this book) in fact, you could argue that it happens every time we as a society forget the First and Second principle.  Unfortunately, history is littered with some very nasty consequences to times like these, for example, the great depression played a significant part in setting the stage for World War II.

Two years ago, it became clear to TRG that sooner or latter, Greece would default.  TRG was correct in guessing that that does not necessarily mean that Greece would leave the Euro, but it was clear that they would definitely default.  Greece has now defaulted on the private part of their debts, and they are not done, the public part (loans from the EFSF) will come latter.

Most governments have two ways of defaulting, they can stop paying (direct default) or they can create inflation (effective default).  Inflation (effective default) will likely be the path of the US, although some of the debts (Social Security for example) will likely get the direct kind of default.  There is no such thing as a bankruptcy process for governments, they have a really clean way of defaulting, they just change the law.  For example, when the US want's to default on it's Social Security payouts (probably sometime in the next 5 to 10 years) it will just change the law to reduce them.  Greece did a little fiddling with the law in their recent default too.

Inflation (effective default) has some real benefits over the direct kind.  The main one is the ALL debtors benefit  (and ALL lenders suffer).  When there's too much debt everywhere this is a GOOD thing.  It may be the best answer to our current dilemma.  One of the difficulties for Greece is that ONLY the government defaulted.  Greeks who had loaned the government money lost, but there own debts remain.  If Greece had been able to use inflation, the impact of losses on loans would have been slightly offset with gains on debts for everyone.

Countries in the Euro don't have inflation as an option (not individually at least).  But inflation is an attractive option, and that is why the Euro may be doomed.