Thursday, December 31, 2009

The Greedy Market Hypothesis

The past two years have proved an unbelievable market roller-coaster ride for investors, traders and sovereign governments. The financial markets, which were rocked to their very core by scandal and crime, have become a favorite topic of conversation among the least likely people. Economists are treated like rock stars, filing auditoriums and juggling visits to CNBC, Bloomberg and MSNBC. Their opinions are sought after then dissected, and often dismissed if they don't give the right (positive) answer. The Efficient Market Hypothesis has been questioned and criticized. After all, how can markets be efficient if they tumble by 50% seemingly overnight? Was it efficiency that wiped out pensioners' savings and turned hundreds of thousands of homes into a liability to be walked away from? Market bubbles are not efficient are they? Yes and no. A theory has been proposed by Dr. Andrew Lo of MIT's Sloan School of Management, called Adaptive Market Hypothesis. He uses neuroscience and psychology to help explain why markets do what they do. Essentially his theory is that the origin of all financial bubbles and busts are fear and greed. I agree wholeheartedly. And I propose a simpler theory that one can use to explain to non-finance types how markets work. There are clever people (let's call them hedge funds and investment banks), and there are stupid people (let's call them us). Both sets of people are greedy. The clever people want to make more money for their employers so that they get a bigger bonus and buy more stuff. The stupid people just want to have more stuff and prefer not to have to work too hard for it. So the stupid people invest their money in markets that the clever people manage. The clever ones rake a fee off the top, then invest our money in things that we will never in a million years understand. Then the other clever clogs trade the same things, because if X bank is making money on it then Y bank will too! They make money (hopefully) by all trading the same things. Sometimes they trade them fast using their computers(high frequency trading). Sometimes they trade them slowly over the counter. They buy them and they sell them and then do it all over again the next day. Everyone is happy. Dr. Lo says that prosperity is like a anesthetic to the brain: “a drug-induced stupor that causes us to take risks that we know we should avoid.” Then - bang! The risks come home to roost, so to speak. The stupid people suddenly realize that they have too many loans for SUVs and ATVs and plastic crap for Xmas that they can't pay off. The clever people can't spin their way out of the trading tangle they invented. Panic sets in, markets crash. Governments get blamed. So governments dig deep and find gazillions (most overused word of 2009?) which they give to the clever people interest free. The clever people say: "Wow! Look at all this dosh. I can spin this and make gazillions more! Whooppee!" And they do. But wait. The stupid people are still living in debt, maybe have lost their homes, and don't have any jobs. How is that Adaptive or Efficient?
Again, to simplify - if the clever people get on with making money it will eventually filter down to the stupid people again. Businesses will get loans, companies will be bought out or merged. Banks will hire again. More bankers will buy more stuff and manufacturers will have to make more stuff. Then manufacturers will have to hire more people. Who will be able to buy more stuff. Do you get the picture? I call it the Greedy Market Hypothesis. Maybe 2010 won't be so bad after all.

Monday, December 21, 2009

Taxing Transactions a Terrible Idea

The Wall Street Journal must be desperate for stories this week. Today it ran an article that raises the specter of a tax on financial transactions proposed by the forthright Congressman Peter Defazio. This is a terrible idea, as I said when I first wrote about this in March for Financial News. I'm not sure why it is rearing its ugly head this week, unless the WSJ has the inside track on some progress on the proposal. Led by Congressman Peter DeFazio, eight US senators submitted proposed legislation to the House Ways and Means Committee proposing a 0.25 percent transaction tax on buying or selling stocks, futures and options. The proposed bill, known as H.R. 1068 or "Let Wall Street pay for Wall Street's bailout Act of 2009", was put forth on February 13th and is seeing fierce opposition from exchanges, trade associations and electronic communications networks alike. As I said in March, the bill could increase volatility, decrease liquidity, and decrease efficiency. The proposed quarter percentage tax, or 25 basis points, would be applied to the value of every transaction. If the average stock price is $20 per share, it would add 5 cents per share to both sides of the transaction. High frequency traders would be hardest hit as they operate on very thin margins, and comprise nearly 70% of daily volume.
This could be a stealth move, designed to make Main Street happy because it will think that only Wall Street will pay, one that could lead to the demise of HFT. The truth of the matter is that Wall Street will be able to figure out how to get the 10 cents back, Main Street traders (that's you and me) will not. Once again the government is trying to interfere in something of which it has no knowledge. It is a dangerous game.

Friday, December 18, 2009

London Bankers to Have a Holly Jolly

As I (and many others) have predicted, there are already moves afoot to make sure that London-based bankers have a holly jolly Christmas. According to the Financial Times, Deutsche Bank decided to 'share the pain' and spread the UK supertax among staff globally. I can just hear cries of despair coming from Frankfurt, Zurich and Singapore. Apparently some US banks are also considering this, cue howls of outrage from Wall Street. In a separate move, as reported by the Guardian, a group of top UK banks are trying to convince the UK Treasury to take a $2bn payment from them instead. Clearly there is a lot of money floating around as the result of clever traders making the most of low-interest capital supplied by our governments and us taxpayers. Well done boys, take those bonuses and spend them on expensive new cars or kitchens (feel free to support my uncle's upscale custom kitchen business, too:!). But make sure you save enough to pay any niggling extras on your health insurance bills. If Obama cannot force through some kind of national insurance company regulation at the very least, then we will all continue to be rogered senseless by the rising costs. A friend just got the best quote possible for health insurance (he is freelance too) - $1,000 per month. I know people who would be thrilled to MAKE $1,000 per month, never mind spend it on lining the pockets of fat cat insurance companies. I have never understood why these companies (which, along with drug companies, make up nearly 40% of GDP in the US) have been regulated on a state-by-state basis. Robber barons, the lot of them. I hope they get a nasty surprise in their Xmas stockings - a big, ugly national regulator.

Tuesday, December 15, 2009

He Who Cannot be Bothered

Not enough has been made of the fact that three mega-bank CEOs could not be bothered to get to a meeting called by President Obama in Washington, D.C. yesterday. Lloyd Blankfein (Goldman Sachs), John Mack (Morgan Stanley) and Richard Parsons (Citi CEO Vikram Pandit was already not bothered so he was sending the chairman) called in delayed because their commercial flight was fogged in. A frequent traveler myself, I know how frustrating this can be. But surely with all of their money and resources they could have found another way to travel? There is a train - the Acela Express. There are limos - it is only 227 miles says Wikipedia. And despite the vitriol it might have inspired in the chattering classes, there are private planes that can be chartered at a moment's notice. But wait. Why didn't they tag along with (J.P. Morgan's) Jamie Dimon on the corporate jet? Poor old Jamie had to face the music alone (OK, with 9 other CEOs).
One of the things I learned in my (mediocre state university) business college was that you have to behave responsibly in order to get and keep a job. That came as useful advice when, for example, I had an early morning meeting or conference in Madrid or Oslo. I would go there - gasp - the night before. The company paid for the hotel room to make sure that I arrived on time and fresh. Imagine that. And last time I checked there were hotels in Washington, D.C. Plus I believe despite the credit crisis Citi, Goldman's and Morgan Stanley executives still have expense accounts. In my opinion there is just no excuse for not making that meeting. It makes the three CEO's look disorganized, or arrogant. Or both.

Monday, December 14, 2009

The Millennium Starts with a Bang

Almost exactly ten years ago I was sitting at my desk at Risk Waters off of Piccadilly Circus and marveling at all of the Millennium bug hype. As editor of two newsletters it was my responsibility to winkle out just what technology and market data companies were afraid might go wrong on January 1st, 2000. And to write sensational (well, for technology anyway) stories about these potential technological time bombs. Reuters was one of my best sources, it had an actual "Millennium bunker" set up inside its data center on the Thames. There its technology gurus sat and analyzed their systems, on the alert for any glitches. Product marketing staff and even corporate communications had to do shifts around D-Day. I thought it was hilarious. There were Millennium parties where bankers and techies and geeks would sit and drink and wait for their shifts at various "bunkers" around the City of London. We all know what happened on January 1st, 2000. Nothing. Zip. Nada. Now it seems that the Millennium bug was more subtle that we had thought. It wormed its way into electronic trading systems and algorithms and bankers' minds, creating the desire to trade more, make more money, invent more complex derivatives. The Dot Com boom and bust whetted the bankers' appetites for more and better technology. High frequency trading was a glint in some geek's eye by then. The speed at which the technology for lightning fast trading evolved was staggering. We went from a place where a couple of all-electronic exchanges which were considered somehow lesser beings (Nasdaq, Eurex) to a place where every exchange in the world desired to emulate them. As soon as was technologically possible the banks had dumped all of their 'vanilla' trading onto algorithms. Then ECNs came into the picture and they needed to route orders more intelligently. Cue the new smart order routing algos. Then they thought, 'hey, if I can spin a gazillion trades of XYZ company when it is being hyped, I can make a trillionth of a penny on each round turn. That adds up!' And voila - high frequency trading was invented. Then all of the new derivatives (credit default swaps), all of the bad ideas (sub-prime mortgages), and all of the greedy bankers (you know who you are) did what the Millennium bug never did. They imploded. They almost took the global economy to meltdown stage. Those bunkers might have come in handy after all.

Friday, December 11, 2009

Toothless, Toothless, Tooo-ooothless

Hum along to the Neil Young song "Helpless". I'm referring to the latest version of regulation from the dingbats that call themselves our leaders in Washington, D.C. As feared (by me), so-called 'commercial' end users of derivatives will not have to toe the OTC clearing/transparency line. In theory I can agree with this, as they of course have to hedge commodities and currency exposures. In practice it is clear that none of the regulators, and in particular the CFTC, has got a clue what the difference is between 'commercial' and 'speculative trader'. If the CFTC and the government think that Cargill (one of the examples that I keep seeing) is a commercial hedger only, then they are smoking something not quite legal. Cargill is one of the biggest speculative traders out there. It is also a privately held company so much of its business is just that - private. The bill is so watered down and full of loopholes and double-talk that I find it hard to believe that even one of the politicians on Capitol Hill truly understands what he or she is reading. The bottom line is that the powers-that-be on Wall Street gave the government a good, old-fashioned rogering - probably threatening direct financial consequences if regulation was too strict. Given that anywhere from 12-14% of US GDP reputedly comes from financial services, it would take a brave politician indeed to truly stand against them.
Although some of the things that slid through, such as not requiring foreign exchange trades to be cleared, make sense. FX markets work perfectly well without getting exchanges involved. I also support limiting bank ownership of clearing platforms. I never understood how the 'fox guarding the henhouse' situation was allowed to begin with.

Wednesday, December 9, 2009

UK Stings Bankers with 50% Bonus Tax

As if UK Prime Minister Gordon Brown wasn't unpopular enough, his government has added insult to injury by stinging UK bankers with an extra 10% tax on their bonuses. For one year only (thus far) City high rollers will have to pay 50% tax on their bonuses. The government is also adding taxation to employer pension contributions. The UK Finance Minister (unbelievably) thinks that this will deter banks from paying out-sized bonuses (and contributing to 'wealthy' people's pensions) for a year where profits were fueled by government bailout money. I can see his point, but he obviously does not know the beast. Traders will threaten to walk if their employers don't make up the difference in bonus. This has happened before. There are already teams of accountants and lawyers working with City types to try and find ways to prevent City boys from 'suffering' unduly.
If the employers cave in to traders demands, it means that the bonus pots increase and the actual amount that employees get will also increase. This erodes shareholder value, and is the exact opposite of what the much-deluded Labour government is trying to achieve. Otherwise it means that employers will simply defer bonuses until next year - paying only a small percentage this year and staggering the rest over the next couple of years.
I can see that the Labour party's ludicrous solution will appeal to the unemployed or blue collar workers in the UK. Those on the dole that sit around all day shouting at the telly will cheer. But the UK middle and upper classes will not. It took a long time for paychecks in London to equate even remotely with competitor cities such as New York or Geneva. Watch out for mass emigration.

Tuesday, December 8, 2009

Obama Scores with EPA Coup

The timely usage of the EPA to help control carbon emissions was an absolute coup for President Obama and his team. After all, why wait for Congress and the Senate to agree on something that almost none of them understands? Plus the pressure on politicians from industry must be enormous, making it difficult for even the most environmentally correct to vote for change. Industry in the US is notoriously paranoid about having to clean up its emissions. So much so that George W. Bush actually took steps to weaken the Clean Air Act in 2005, so that coal-burning power plants (in particular) did not have to comply with lowering emissions. (He went against his own father, who had strengthened the EPA's mandate in 1990 to fight acid rain.) According to SourceWatch, in 2004 US coal-fired power plants produced 35.8% of total US CO2 emissions, and 8.0% of total world CO2 emissions. To put this in perspective, U.S. coal-fired power plants produced more CO2 in 2004 than was emitted by all sources in all of Africa, South America, and Central America combined, said SourceWatch.
The EPA option has been waiting on the sidelines since 2007 when the Supreme Court ruled that the EPA violated the Clean Air Act by not including greenhouse gas emissions. Obama's coup was to wait and take the EPA route just before the Copenhagen summit on climate change, where the US was destined to look like a giant polluting chump. I have my doubts that the EPA can effect immediate change, after all it took 23 years for it to phase out lead in gasoline due to pressure from Big Oil and Big Car. But it got there in the end. Obama's challenge now is to ensure the EPA remains a viable, well-funded and - above all - powerful organization.

Tuesday, December 1, 2009

What Defines Socially Useful?

A bit of a bunfight has broken out in London about whether the City (read investment bankers) is socially useless or not. Lord Adair Turner, head of the FSA, said that some types of financial innovation are socially useless, according to Financial News. Michael Spencer, chairman of uber-broker ICAP begged to differ. He said he was "genuinely offended" that Lord Turner would say such a thing, then blamed the Labour party for allowing the financial crisis to happen. The City of London has not changed much under Labour, nor has the regulatory system in the UK, so that was a bit self-serving (Spencer is treasurer of the Conservative party). Spencer also spoke out against Lord Turner’s recommendation of a Tobin Tax on financial transactions. Here, I agree with him. A tax on transactions will only force more players out of London. Switzerland is already gaining the lion's share of hedge funds that are moving out.
The City has its uses, the biggest of which is that it generates huge amounts of corporate and income taxes to spread all around the country. As for financial innovation, I am going to wade in here and say that I think most financial 'innovation' comes from US banks - certainly most of the credit derivatives that helped cause the crisis were invented here. The innovation of such products cannot be called 'socially useful' unless you define it as 'money spinning'. The obfuscation and complexity that they add to the system are not in any other way useful.