Big Finance: It Shrinks?

As the Great Financial Crisis recedes in memory and mainstream organizations such as the Conference Board (Leading Economic Indicators) and the Economic Cycle Research Institute (Weekly Leading Index) continue to predict growth for months ahead, where are the indicators for those with longer horizons than one year or so? The zigs and zags of these indicators ultimately cannot drive a successful longer-term strategy for owners of long-term assets such as bonds, stocks, and durable physical assets.

Such a strategy is individual-specific and should take into account longer-term trends and projected changing perceptions. Short-term economic cycles are as irrelevant to investors as the retrospective knowledge that Japan, in its 20 years since the peak of its economic supercycle, has been out of recession perhaps 75-80% of the time. In another example, what would an investor in December 1944 have thought was the prognosis for stocks with the foreknowledge that the next 16 years would contain 5 distinct recessions, only 2 of which were to be mild? The stock market soared in price while providing substantial dividends as an important kicker. And the 16 years beginning in December 1963 contained only 2 recessions, only one of which was severe, but the stock market was a poor investment adjusted for inflation.

After all, a bond is just a promise to pay and a share of publicly traded common stock is simply a tiny share of a company controlled in general by strangers who care about themselves more than they care about the outside shareholders. How the proper prices of these assets can be determined by knowing the level of economic activity merely one year in advance is unclear.

It is felt at EBR that what matters more than the gross amount of debt is the quality of the loans. In this regard, the best one can say is that recent experience with high-volume lenders inspires little confidence in prospective lenders of new money.

I personally do not know anyone who wants to take on (more) debt. Certainly there are people buying a home who are jumping at the chance to take on a non-recourse loan called a mortgage, but that's largely because of the subsidies underlying the rate on the mortgage and the fall in nominal house prices. Yet the truth is that given the transaction costs involved in buying and selling homes, probably many younger home buyers would be better off renting. Outside of that special, government-favored case, the public has finally figured out that revolving credit is a loser and should be reserved for truly special cases, such as overseas travel and certain business situations.

(For a downbeat, fact-rich "take" on the ongoing debt situation from an international perspective, please consider reading Money figures show there's trouble ahead.)

While it appears that the surviving Large Complex Financial Institutions have emerged stronger than ever from the crisis, in the broader historical context, the suspicion at EBR is that finance is currently an over-large part of the developed world's economy, that too much financial activity is wasteful of society's resources, and that therefore the odds favor its shrinkage relative to the economy as a whole.

As we have seen with the "roll-ups" that such giant tech companies as Oracle and Cisco have become, such a business model bespeaks a lack of vitality within the industry.

Gold, as the monetary asset with no offsetting liability, had a bit more good news recently, per Mark Hulbert's Deja vu all over again?:

Gold's drop in recent days, after rising to the $1,020-an-ounce level just one week ago, certainly appears to be déjà vu all over again.

On four previous occasions over the last two years, gold has approached, or slightly exceeded, the $1,000 level. On each of those earlier occasions, gold promptly retreated.

But there is one big difference: Gold timers are a lot more discouraged now than on any of those four previous occasions.

Contrarian analysts, who believe that the consensus is rarely right, therefore give gold better odds this time around of mounting a rally that rises to markedly higher levels. If so, then this week's correction in the gold market would be a mere pause -- and not the beginning of a major bear market.

A measured and supporting view is found in a piece by the inimitable Bill Fleckenstein in A golden opportunity for investors?

The best-run countries that stayed away from toxic U. S.-generated debt, and in general stayed away from the whole derivatives scam, have the strongest economies. They are in fact decoupling. These countries include Brazil and India. In the next rung are countries with a greater connection to the U. S., including China, Australia and Canada. The U. S. and the U. K., as the originators of the mortgage- and derivatives-based allied scams, are the two countries the central banks of which continue to literally print (electronic) money by purchasing the bonds issued by the Treasuries of the governments of those countries, bonds which are going to bail out shareholders and bondholders of the Large Complex Financial Institutions that were complicit in creating this mess.

Capital that can be created merely by an electronic command has no durable value. On the other hand, precious metals must be torn from the earth and refined, and thus cannot be created out of government fiat.
Such metals, especially ones such as gold that do not even tarnish, can outlast the life span of governments and thus can never fail, and their owners can always wait for better times if they want to trade that ownership for that of a house, a share of a company, or a debt instrument.

Thus the recommendation at EBR is that those interested in precious metals as a hedge, speculation or long-term store of value not bother with stocks of companies involved in producing the metals. Owning the commodity is very different from owning a small part of a company that produces the commodity. As one example, I like physical gold better than IBM from a risk-reward standpoint, but I like IBM stock (and the stocks of several other low P/E free cash flow-generating companies) better than the stock of any gold miner I know.

Big Finance "should" shrink, from the moral and practical standpoints. Durable commodities may come into
increased demand relative to the "average" financial asset as the memory of the scams of the past decade that are gently called bubbles created by Big Finance with the assent of governments and their central banks lasts through the emerging post-crash economic cycle.

Copyright (C) Long Lake LLC 2009

What Does Reform of the Banking System Have to do with the Internet?

We have previously argued that the approach to dealing with our problems by adding a layer of regulation is a mistake. The political, financial and academic communities are enamored of this approach. If only we could watch these guys more closely!

Most recently, NYU's Stern School of Business has put out a series of 2-page discussions and recommendations called "Restoring Financial Stability: How to Repair a Failed System".

This is a good read. I would like to take exception to Chapter 5, "Enhanced Regulation of Large Complex Financial Institutions (LCFIs)".

A key part of that Chapter reads:

"We believe that regulation by function is not enough in the case of LCFIs. For these institutions, we advocate a third option - a special, dedicated regulator for LCFIs. (authors' emphasis)

Au contraire. We have had enough foxes guarding enough henhouses. The regulator comes from the same milieu as the regulated and can't wait to join the institutions he regulated, especially a "LCFI" that has lots of money to pay rather than the parsimonious regulatory agency.

The simpler solution is to prohibit any LCFI from coming into existence that has governmental subsidy or poses a systemic risk to society/government.

The Internet provides a conceptual solution. The 'Net was developed to deal with a nuclear attack on the U.S. It allowed data and communications to take a meandering path through whatever nodes for data switching happened to survive the proposed attack. When you read this blog over the Internet, the packets of information get to you not through a dedicated pathway such as a traditional phone call, but rather through whatever communications path is open at the time. The system is redundant and can survive the loss of lots of interchanges. It takes a lot to destroy all Internet potential paths.

The same should be true of a modern financial system. LCFIs have proven that the purported benefits to society they offered were really licenses to gamble with what turned out to be our money when things went really, really bad. The posturing by politicians that now they really mean to stop the big bonuses etc. are for show. The truth lies in the apparent resuscitation of the TARP 1 plan by the Obama Administration for taxpayers to buy up the bad assets on these institutions' balance sheets. Why bother doing it unless it's a massive subsidy?

If, however, the financial system had a modern series of single-state, interstate or national banks, each one small, the failure of none would be systemically important. The benefits to businesses, travelers, North-South snowbirds, etc. would be present as it is now with BofA.

In order for the financial institutions to be small, they would have to have simple functions. They should little other than take deposits and make loans. And all their assets would have to be liquid. "Tier 3 assets" is an abomination as a concept.

Regarding complex financial instruments, leveraged pools of money would in my proposal be banned from borrowing from these banks. Let various people and entities lend to one another with private, risk capital. Thus, subject to whatever regulation and/or reporting is truly necessary, let them do what they want, but essentially stay out of regulating them. It's their money, after all.

One of the underlying points comes from my background as a physician. Anything a trusted physician is associated with gets some or all of the trust the patient has in the doctor, even if it is independent of the doctor's control. Similarly, once a "bank" gets into other lines of business, the average person and even a sophisticated investor associates the presumed safety and government guarantee of a bank deposit with the other functions that the holding company that owns the bank provides. One can put forth all the disclaimers one wants, but people will both misunderstand or forget those disclaimers, or at least will be subconsciously swayed to underestimate the risks. Let's not kid ourselves. How many average people understand to this day the difference between Citigroup, the holding company, and Citibank, the depository institution?

(In fact, if you Google "Citibank", your first click will be to a web page promoting Citi, presumably meaning Citigroup, rather than Citibank, which also gets mentioned now and then on the page but less prominently.)

"Prudential regulation" of large complex financial institutions is little more than putting more and more doctors on the case of a complex diabetic patient with high blood pressure who is prone to nicotine or alcohol addiction. Keeping this patient in balance is a constant struggle. And if the doctor is a friend of the patient and is also prone to sweet foods and nicotine or alcohol himself, fuggedaboutit. And if such a patient is a systemically important person, such as the Pope or President of the U.S., then what a burden on the doctor!

Keep your vices few and simple.

Let's also keep our banks simple as well; interconnected and properly regulated; but never too big to fail.