Thursday, May 31, 2012

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'ĂȘtre.  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 ATMLord 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.

Friday, May 11, 2012

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!


Wednesday, May 9, 2012

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.

Monday, May 7, 2012

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.

Saturday, May 5, 2012

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.

Tuesday, May 1, 2012

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.