Happy New Year from Rosie

by Roy C. Smith

Yes, it has been an ugly year.

We’ve had Syria, terrorism, the refugees, a collapse in oil prices, a European sovereign debt crisis, trouble with China and Russia, and world economic growth slumping towards a pathetic 3%. And we have had Trump and the Republican wannabes that make Hillary look good, and a lot of other stuff that has taken the winds of confidence out of our sails.

Unemployment is down to the 5% level, but only 63% of the workforce has jobs, the lowest percentage since 1978.

US stocks are likely to end the year in the red for the first time since 2008, but investors are nervous about rising interest rates without seeing much to look forward to in the general economy.

So, I asked my old friend Rosie Scenario out for a holiday drink, to see if she could cheer me up.

“You’re too gloomy,” she said.

It is true that the US economy has had a rough fifteen years, with two financial crises, a Great Recession and a war in the Middle East that has cost $4-$6 trillion and still isn’t over.

But, she added, after a prolonged period of slow economic growth that has averaged barely 2% per year, things are settling down for a long-term recovery.

The Fed has decided that after eight years the economy is strong enough to leave to its own devices, so it has ceased its price-distorting QE interventions, and allowed rates to rise a little, at least symbolically. Both regulators and litigators have hammered the banks, but corporations have been able to get what they needed from a record level of new bond issues, and consumers and small business are getting a boost from “peer-to-peer” lending, “fintech” and from private equity funds.

The traditional economic “factors of production” – wages, resources, capital and enterprise – still at low costs, are ready for another round of expansion. Real estate activity is up about 10%, consumers have cleaned up their balance sheets and are active again. US GDP for 2016 is expected to be about 2.5%; not great but better than it has been, and building up momentum for a push in the right direction.

Rosie also sees the international situation also looks better than it did.

It has been bleak, she said, but the worst is over. The EU and the euro looked like it might be shaken apart by its sovereign debt crisis, but Angela Merkel and the ECB showed they had the clear head and courage to commit the resources needed to settle things down. The hodge-podge economic union of 28 states, with a common currency used by 19 of them, has survived its first serious existential crisis and is stronger for the experience.

A bigger set of problems now exists in the BRIC countries that are also facing existential issues. Brazil has been affected by collapsing commodity prices and high inflation, but its main problem, like Argentina’s, is political, and can be turned around by a new government.

Russia’s GDP will be down 3.6% this year, mainly due to oil prices, but Putin’s machismo behavior that drew sanctions over his Ukrainian actions has added to his difficulties, and sent him a message – his fifteen years of domination of Russian politics has been enabled by a robust growth in per capital GDP, but because of the recession and the collapse of the ruble, GDP per capita (in terms of current prices) will be 40% less in 2015 than in 2013.

Putin knows that strong, authoritarian leaders in Kiev, Cairo and Tripoli have been brought down by public protests, and seems to realize now that further confrontations with the US and the EU will only make his economic problems worse. After all Europe is Russia’s biggest customer for its oil and gas, and increasingly there are alternative sources of supply available to it. All in all, Putin is likely to end up more helpful than we expected in Syria and Iran, and start to make nice again to get back into the good graces of the EU. Maybe the UN’s agreement to secure a cease-fire in Syria, in which Russia played an important part, is an example. 

China, too, faces big issues in the next few years – it has to be able to deliver economic growth sufficient to satisfy the billion or so Chinese who are not yet among the middle class but aspire to be there. Growth has fallen from 12% in 2010 to 7% in 2015, with government expectations of 6.5% in 2016 (and others looking for less). Efforts to confront falling growth rates resulted in a stock market bubble that burst last summer. Serious government efforts to stabilize markets were not very successful, showing the limits to its power.

Indeed, China’s growing influence in the world has been a result of its extraordinary growth over the last thirty years. A slowdown in growth rates to a more normal level brings many challenges to the Chinese government -- domestically to avoid pressures for the level of political freedom that rival Taiwan has achieved; in South East Asia, where Chinese bellicosity has been fueled by its rising economic power; and in the broader world where China has been accepted as a superpower, but without showing it has the capacity to remain one.  It is hard to see how China’s Communist Party can remain in power without a transition to a more open and democratic state in the future. Slowing growth rates may accelerate this process, which would be good for China, its neighbors and trading partners.

Terrorism is still a big issue, Rosie says, but nowhere near as big as we (and our political candidates) make it out to be. Radical Islam has been most dangerous to other Muslims in the Middle East. It has been less dangerous in Europe, but of course its profile there now is very high (and likely to get the attention it needs). In the US since 9-11, terrorism has been less dangerous than school shootings; so far consisting only of radicalized individuals or small groups operating on their own.

In the US and the EU, terrorism is largely a police issue and the more incidents there are, the more cooperative police become with each other in developing their abilities to prevent attacks. In the Middle East, military force will be needed to contend with ISIS, but it will have to be supplied by Middle Easterners.

Finally, Rosie thinks our wild and awkward political process is likely to produce the best of all possible results.

The drama of primary elections is necessary in a country of 330 million people, who have different things to say about issues and want to vent about them. Sure, candidates say and do whatever they can to attract votes, but in the end, it winnows down to two (or possibly three) viable candidates, who stimulate the economy with billions of dollars of spending on advertising and other expenses. After the election, we either have a “divided government,” i.e., one in which the Presidency and the Congress are not controlled by the same party, or we don’t. If we don’t, then the party in control can enact whatever platform it can get by a 60-vote hurdle in the Senate. That condition doesn't occur very often, and is unlikely this time.

If it doesn't happen, the country will muddle along somehow, with minimal changes in major political or economic positions. When no one gets what he or she wants, not much actually happens. We can live with that, especially if it keeps stuff we really don’t like from being enacted.

The President, of course, can start wars or other military engagements that are hard to get out of.  After a year or more of listening to the candidates, we will know which are more warlike than others. Whatever it thinks of any candidate at any particular time, however, the American electorate has very little enthusiasm for wars in the Middle East or anywhere else.

Meanwhile, after a tumultuous year, the new Speaker, Paul Ryan, managed to get the House Republicans (and the others) to pass a $1 trillion government-spending bill, rather than shut down the government.

So, all in all, Rosie says, things are also messy, but the US will continue to be the strongest economy in the free world, positioning itself through market actions for a return to higher growth rates. The rest of the world is sorting itself out for the best, and our politics aren’t as bad as they look.   

Well, Rosie has always been able to cheer me up (at least for a few weeks), and maybe she will cheer you up too.

Happy New Year from us both.

Did the Fed Really Curb its Emergency Lending Powers?

By Roy C. Smith

Last week the Federal Reserve announced that it would adopt restrictions imposed by Dodd Frank to limit its emergency lending powers under Section 13(3) of the Federal Reserve Act, but it now has even more room to act in the next crisis.

Section 13(3) provisions allow the Fed to lend funds to any entity outside the banking system if circumstances are deemed to be “urgent and exigent.”

In 2010, a Congress angered by federal “bailouts” of banks and other financial institutions passed the Dodd Frank Act, including in it an amendment to the Federal Reserve Act of 1913 to limit 13(3) programs that enabled loans to Bear Stearns and AIG during the financial crisis. The amendment requires such programs be limited to those with a “broad base” of eligibility (now interpreted to mean involving at least five different participants) that are also approved by the US Treasury Secretary.  The idea is to limit 13(3) to only being able to provide liquidity to multiple, solvent financial institutions in times of crisis.

It took the Fed five years to come up with these new rules to implement the amendment, despite its being spurred by Senator Elizabeth Warren, Representative David Vitter and others in Congress from both parties who seek to limit the Fed’s powers.

The Fed’s action, according to Congressman Vitter, “is the first real acknowledgment from the Fed that it needed to do more to curtail its own bailout authority.” 

The new rules will prevent the Fed from lending money to prop up a single failing firm, said Fed Chairman Janet Yellen. Both the Bear Stearns and AIG rescue operations were considered crucial to the 2008 effort to stabilize the financial system by both Ben Bernanke, then Fed Chairman, and Hank Paulson, Treasury Secretary at the time.

But a lot has changed since 2008 that makes the one-off emergency lending powers of Section 13(3) less important to maintaining stability.

First, there are no longer any potential too-big-to-fail financial institutions that are outside the orbit of regulatory control established by Dodd Frank for “systemically important” financial firms.

Of the five large, independent US investment banks existing in September 2008, only two have survived and both are now bank holding companies regulated by the Fed. And, four of the largest other US nonbank financial firms have been designated as systemically important by the Dodd Frank authorized Financial Stability Oversight Council, thus requiring them to be regulated by the Fed and subject to enhanced capital controls, intervention and other constraints that should reduce systemic risk, and thus the need for a future 13(3) loan.

Other large nonbanks (e.g., Fidelity, BlackRock, and some hedge fund groups) have successfully argued that as managers of other people’s money through hundreds of different investment vehicles, they should not be considered as a single entity whose failure would have systemic effects.  So far the Fed has bought (or has been forced by political pressures to buy) into these arguments, so presumably it would have no reason to assist them in a crisis.

So, the lost power to intervene in individual cases of systemic risk is now a power no longer needed. However, since September 2008, other powers available to the Fed to avert and manage crises have been greatly increased.

Dodd Frank conferred additional authority and influence on managing systemic risk to the Fed. It now conducts annual qualitative stress tests on large banks and can deny those who fail the ability to pay dividends or do other things. The Fed also sets capital adequacy levels, leverage limits, and the requirement for “total loss absorbing capital” (in which bond holders participate in losses). It monitors banks closely and has the power, and apparently the will, to force them to remain in safe waters.

The banks have complied with the Fed’s post-crisis requirements, so are safer. But this has meant that much of the financial risk the banks used to carry on their balance sheets has migrated into capital markets and the nonbank sector.

This sector is a multitude of nonsystematic firms that operate in financial markets, but it is not directly subject to Fed regulatory control.

But, don’t worry, the Fed has found important ways to assert de-facto control over the nonbanking sector too.

This is done through market intervention programs, in which the Fed, through asset purchases, can inject large amounts of capital to preserve market functionality and alleviate liquidity panics. After September 2008, the Fed began an unprecedented effort to stabilize financial markets across the board, ultimately expanding its balance sheet to $4 trillion from less than $1 trillion.

Indeed, as early as March 2008, after Bear Stearns was rescued by JP Morgan (with Fed assistance), the two-dozen or so authorized market makers in Treasury securities were struggling to maintain their funding arrangements. As a result, the Fed established a temporary Primary Dealers Credit Facility and Term Securities Lending Facility to assist them. This was the first time in the history of the Fed that it had provided funding for nonbank broker-dealers in its efforts to maintain market stability.

These programs usually are ended after stability returns, but the Fed seems comfortable in starting them up whenever they seem to be needed.

Today, as a result of capital and other constraints, many banks have reduced their exposure to the repo markets, and nonbank money market funds and other participants have increased theirs. Consequently, in 2013 the Fed offered a $300 billion Reverse Repo Facility to assist dealers in this important market.

If a problem in the nonbank sector should require it, the Fed can intervene more precisely by declaring a 13(3) lending condition after designating five or more intended recipients in order to stabilize their broad based ability to roll over maturing liabilities of their own or of funds they manage. This would be within the scope of the new rules, even if only one firm (targeted for assistance) actually used the facility.

Though there are many in Congress who would like to clip the wings of the Fed further, the Fed is more powerful than ever. "We're perfectly happy now that there are alternative ways to deal with a failing firm,” said Ben Bernanke recently, “the Fed doesn't have to intervene in [individual cases] the way we did in 2008."

And, he might have added, what we have learned from our various intervention efforts has increased our confidence that when another crisis comes we will have the tools needed to meet it.

Building the European Champion

By Brad Hintz and Roy C. Smith

Barclays, Deutsche Bank and Credit Suisse have all announced plans to cut back capital market activity under new CEOs brought in to revise the business models.  What to do with the investment banking remnants is the difficult part, but an imaginative solution is available.

The three European universal banks have used investment banking as a way to supplement slow growing domestic banking and subscale asset management businesses. Over many years, going back to Big Bang, they have poured their dreams and capital into acquisitions of businesses and talent that they hoped would enable them to occupy the high ground of global capital markets, only to encounter wave after wave of pain and suffering. Finally they appear to be bowing to the inevitable – cutting back investment banking to the bare minimum needed to sustain and protect their basic banking businesses, and, one way or another, jettisoning the rest.  

What makes this difficult to do is that investment banking represents 20-40% of these banks net revenue, and over half of their balance sheet. What makes it good to do is that at least 70% of their troubles come from this culturally alien business that they have all had to engage mostly American hired guns to manage. 

The lost income and the prestige will be missed, but the impaired balance sheets and the debilitating exposure to regulatory constraints and litigation will not. Getting rid of the troublesome investment banks leaves the parents with much diminished scale and more limited aspirations, but the rebooted banks would be able to concentrate on their commercial and retail businesses and have a chance to improve their stock prices considerably, as UBS has done, while greatly easing the minds of their regulators.

But transitioning out of investment banking is not easy. A simple solution might be to transfer some portion of the unwanted assets to the non-core pile and liquidate them over time. Doing this might release required capital of 10% or so held against risk-weighted-assets (RWA), but the liquidation itself is likely to require haircuts that would consume most of it.

We looked into Barclays Chairman John McFarlane’s suggestion that a “European champion” capable of competing with the Americans might be put together from among the parts of the European players.  We studied a combination of Barclays Capital and Deutsche Bank’s investment bank, two of the strongest, to test the feasibility of the idea. 

In terms of market share, the idea is compelling. With over $28 billion in revenues this new European champion would command a number two market share in fixed income trading, number three in institutional equity trading, and in investment banking it would hold the leading market share in both debt and equity underwriting and would be number two behind Goldman Sachs in mergers and acquisition advisory. Even if one were to assume a 10% client defection this new combination would remain a top three investment bank with powerful positions in Europe, the USA and Asia.

The regulatory capital position of the new entity looks reasonable with an equity capital to RWA ratio of 12.9% compared to a 13% ratio for the Goldman units. On a pro forma basis the new entity would generate an 8.2% ROE in 2014 versus Goldman Sachs estimated ROE of 9.4% in its investment banking and trading businesses. This performance remains below the cost of capital for a standalone investment bank but the potential for some merger synergies, balance sheet rationalization and a shift in the mix of the product portfolio makes a 10% ROE a reasonable near-term goal.

But there were some problems.  The combined balance sheet of the new firm is 50% larger than Goldman’s balance sheet due to the new firm’s heavy reliance on fixed income sales and trading and therefore the pro forma leverage ratio is too high. It's RWA to asset ratio also is suspiciously low which may imply challenging regulatory discussions in the future.  All this will require further surgery and adjusting to shrink the trading units to a more reasonable size with a balance sheet able to secure a BBB debt rating.

For such a combination to work it will require new some new entrepreneurial energy, capital and resourcefulness beyond what’s available at the parent banks. This could be obtained by pairing up with one or more private equity investors to build a new, viable business outside the EU banking regulatory regime, though the firm most likely would be considered a SIFI and subject to Basel and some other rules. The new investors would assemble a high-grade, well-incentivized management team from the best in the business that would pull together such other assets and talents it needed.

The new firm could be funded in part by offering cash, some debt, Buffett-like preferred stock, or equity to banks selling the RWA, and by selling LP interests to institutional and other investors. Ultimately the new firm would present itself as an independent privately owned investment bank, with managers and employees owning significant stakes. It would hope to have an advantage over the banks in attracting both top talent and capital.

Such a solution is complicated, but doable. The large discounts from book value at which Barclays and Deutsche Bank stocks currently trade leave room for negotiations that incentivize new investors and still recover shareholder value for the banks.

Barclays has selected Jes Staley, an American investment banker, to become its next CEO. Although this suggested to some that Barclays was committed to retaining its commitment to investment banking, a different message seems more likely. As McFarlane surely knows, and Staley will soon find out, the future of Barclays Capital after ringfencing in 2019 is bleak. The two thus will be forced to look for alternatives to simply continuing as before. What exactly they or the other banks will do we will have to wait to see, but Barclay’s choice for its next CEO, with long experience in asset management, and more recently with hedge funds, understands the private equity terrain very well and would know how to explore a solution from that direction.

 eFinancial News, 9 Nov. 2015

Preventing the Next Existential Moment

By Roy C. Smith

VW is facing an existential moment, one like BP’s after the Deepwater Horizon oil spill that cost its shareholders $70 billion in market value. Surely, someone on VW’s Supervisory Board must have asked “what could we have done to prevent this from happening?”

The same question must have been asked by the Boards of Directors of the dozen of so major banks who between them have paid out approximately $200 billion to settle lawsuits brought by the US Department of Justice, the Federal Housing Authority, the SEC, the CFTC, State Banking Regulators, and British and European regulators since 2008. 

These various and numerous regulatory offenses leave the impression that today’s Big Business firms ignore or deliberately flaunt laws and regulations intended to contain their power and influence.  Observers must wonder whether anyone has ever asked the question of any large corporate board members.

There is, alas, little evidence that anyone has.

Boards are the bodies charged under the law with looking after the interests of the shareholders of private corporations.  They are required to appoint CEOs, but otherwise their duties are unclear, having to do with “monitoring” things, making sure takeover offers are handled fairly, looking after social responsibilities, and, of course, avoiding the existential moments.

How to prevent those moments from occurring is of utmost importance to their shareholders, so boards need to consider some different approaches to doing so. Here are four ideas:

Challenge Strategies

Boards not only appoint CEOs, the CEOs establish business strategies that boards must approve and fund. This may include VW’s strategic initiative to use its diesel engine performance to rise to the top of the auto industry.  If people independent of management had challenged this idea rigorously then the plan’s Achilles heel (they can’t do it without violating emissions standards) might have been revealed.  But it wasn’t.

After the merger of Citicorp into Travellers to form Citigroup, there were dozens of other mergers of big banks.  None were seriously challenged by their boards, all of whom seemed to go along with the idea that being bigger was always better, even when it plunged them into a realm of new businesses and risky activities they knew little about.  Almost all of the litigation settled by the major banks is the result of missteps in trading, underwriting, mortgages, or other activities the banks were not in a decade before.  More pushback from the independent board members (supported by their own experts and advisors as needed) might have made a difference. At least they could have focused attention on the difficult implementation of the strategy that proved to be their Achilles heels.

Rethink Middle Management

Goldman Sachs became a public company in 1999 after 130 years as a partnership.  It wanted to preserve some of the uniform cultural and managerial aspects of the partnership, so it devised a different kind of management structure from other banks, one that put a lot of emphasis on middle management to enforce professional standards for the whole firm.  Today, Goldman Sachs has about 34,000 employees, of whom 2,100 or so are Managing Directors, the firm’s principle culture carriers.  Of these, approximately 20% are Partner-Managing Directors, a senior position that is entitled to partner-like compensation based on a share of the whole firm’s annual income. Managing Directors are selected based on their performance as middle and upper mangers responsible for revenues, risks, costs and legal exposures.  The units they supervise are under constant surveillance to maintain high standards, and to detect and prevent any form of misconduct or wrongdoing. Things fall through the cracks sometimes, but with 2,100 of these guys continuously roaming the halls, there are fewer accidents than might occur otherwise.

Learn from Mistakes

Every legal or regulatory settlement that occurs can be a teaching moment. There is something to learn from a thorough discussion of the events that ended in lawsuits, especially by the standards-enforcing middle and upper managers of a firm. The need to know what motivated the troublesome events, why they went undetected and what the outcome of the litigation was, but can only do so if someone prepares the information (from the extensive legal proceedings) on the cases and enables a full discussion of them by the entire middle management cohort group, however large, though the discussions must be held in small groups overseen by someone in touch with top management.

Few firms do this – they don’t want to highlight their own settlements, or take the time necessary to send everyone to school periodically on such matters.  They should. It would improve everyone’s understanding of what happened, what was wrong with it, and to clarify for everyone’s benefit how such things should be handled at their own firm should they crop up.

Pay and Promote Differently

Increasingly, it seems necessary to replace “you-eat-what-you-kill,” pay-for-performance compensation programs with ones that are more holistic and take into account defensive and preventive measures taken by managers. If the word gets out at the mid-manager level that performance is to be judged by several factors, not just profits contributed, including how well one’s unit performs over time and what managers have done to prevent harm, things will change quickly. Boards should be willing to pay well for good managers that do these things well. They are scarcer than good engineers or traders.

Pay, of course, also needs to be increasingly in company shares as managers rise in the firm, and always subject to “clawback” provisions, including in cases in which a subordinate is charged with wrongdoing. The firm should also make it clear that individuals charged by regulators may not be reimbursed for legal expenses, and the firms will cooperate with prosecutors in their prosecution of the individual.

Existential events are not often fatal, but few companies escape the years of lackluster performance that follow the thumping that the events engender. Boards of Big Business companies need to wake up and recognize that they can lower the probability of such events in the future by reshaping the cultures and middle management cadres that have enabled them.

Whatever Happened at VW?

 

by Ingo Walter

With the resignation of CEO Martin Winterkorn and his replacement by Porsche’s CEO, the firing of three key R&D bosses, the herds of prosecutors and tort lawyers hoping for years of litigation, and the ominous clouds overhead from the media, among regulators and customers – and not least investors who have lost up to 42% of the value of their shares - the VW scandal raises lots or questions that go way beyond the world’s largest car manufacturer itself. They concern corporate governance, management decision processes and individual accountability, the regulatory environment, as well as industry competitive structure and performance. A true learning moment.

As the proud owner of a VW Toureg turbodiesel, it also hits close to home. Happily for now, VW V6 diesels like mine have not been named in the fraud allegations. But that may just be because of the expensive urea-based technology to cut nitrogen oxide (NOx) emissions found in large diesels was what VW was trying to avoid using in small ones by relying a “magic” approach that nobody could replicate and that turned out to be fraudulent. Now pundits have proclaimed the “death of diesel,” probably prematurely and unfairly.

What next for VW? Examples from the banking industry suggest that "rogue" behavior in one firm often turns out to be "industry practice." Examples include manipulation of foreign exchange and Libor benchmarks, hedge fund “late trading” in mutual fund shares, mis-selling of “payment protection insurance to ordinary retail customers,” insurance broker kickbacks from underwriters, falsification of international payment transactions, aiding and abetting tax evasion, and the list goes on.

One firm gets tagged and the others run for the hills and take a very low profile until the posse rounds them up. That could be the case here also, with MB, BMW, Renault, Peugeot, etc. Some are saved (for the moment) because they focus on big or expensive cars able to support urea-based approach. Others focus on mass-market, cheaper diesels and may have encountered engineering problems similar to VW’s. They say they have not, that VW is unique. If not they will step up very soon. Last guy in is a reputationally rotten egg. So we’ll soon see whether the VW problem is in fact firm-specific or industry-wide.

Certainly the nitrogen oxide emissions remain an issue with the US and especially California most aggressive in putting on the regulatory pressure. The European approach seems to have been more retarded and haphazard by comparison, with heavy lobbing from the important car manufacturers and their governments. Travelers can tell you that the air pollution problem is pretty bad in parts of Europe. On a dozen or so days a year the speed limit in the Paris region is cut to 90 km/hr because of the health effects of NOx and particulates – in an air-shed where well over half the cars and almost all trucks are diesels. This is not a matter of engineering fraud but rather one of deficient emissions standards, but now that the VW cat’s out of the bag it points to things to come for the automakers.

To the outside observer it seems that what happened here is that the VW engineers got seriously squeezed between the marketing pitch for modern European common-rail diesels (fuel economy, durability, torque and environmental friendliness – much of it true) and the tightening noose of US environmental standards. This eventually made the two simply incompatible.

The engineers no doubt signaled the problem internally (how high up we don't precisely know) and senior management told them to fix it or else. So they were trapped. Pressed to the wall, the engineers came up with a workaround. Whether in the whole process anyone raised the full range of potential consequences including the possibility of individual criminal charges we also don't know. Anyway, decisions got made somewhere. Under German law such matters tend to move quickly into the criminal domain where unlike in the US firms cannot be charged in civil proceedings (and allow a range of punitive options, possibly including criminal pleas by firms themselves) but rather are targeted on the individual.

So the otherwise walk-on-water CEO has walked the plank instead and may be personally charged (famously, this has rarely happened in banking).

Some Europeans have blamed the US regulatory approach and litigiousness for triggering the brouhaha. In Europe it would have been taken care of in a sensible way by corporate specialists talking to regulatory specialists, eventually arriving at a mutually acceptable solution. Maybe so. But they said the same thing in the FIFA mess.

Two Questions Raised by the VW Case

by Roy C. Smith

The VW case will raise two questions for sure: is someone going to jail?, and what should be expected of boards of directors in preventing corporate misconduct?

Last month Volkswagen’s Supervisory Board asked for the resignation of CEO Martin Winterkorn and said it was investigating the company’s engineering staff to pin down responsibility for the installation of the “defeat devices” used for seven years to disable emission controls on 11 million diesel engine cars sold in the US and Europe. The devices were installed to boost performance standards for the cars that VW emphasized in its advertising. Prosecutors in Germany, the US and Sweden and other countries are investigating the situation for possible criminal violations.

Meanwhile, market analysis have estimated VW’s potential all-in costs of fines and legal settlements to be in the $18 to $20 billion range, roughly equal to the loss of about $25 billion, or a third of the company’s market capitalization since the admission was made to the US Environment Protection Agency on September 18th. VW has taken an initial $7.5 billion charge to its legal reserves to cover the exposure.

This is likely to be the biggest self-inflicted corporate disaster since BP’s 2010 Deepwater Horizon oil spill in the Gulf of Mexico that has cost it $28 billion so far. BP’s market capitalization is about $70 billion less (35%) than what it was in 2010.

Going to Jail

Senior corporate executives do go to jail for their actions. The former CEOs (and other executives) of Enron, WorldCom, and several other companies from the 2001-2003 era are either still in prison or have only recently been released. Financial figures like Bernie Madoff and Allen Stanford are too, though the top executives of global banking firms are not, despite a certain amount of public support for locking them up.

The simple truth is that under legal systems in most developed countries, to be convicted of a criminal offense requires proving that an individual intended on breaking the law, and then did so or compelled others to.

Corporations make a lot of mistakes, and sometimes engage in activities that offend the ethical sensitivities of others, or fail to comply fully with the voluminous regulations to which they are subject. Most corporations exist to make profits in competitive businesses that require them to develop what edges they can. Sometimes they overdo it. When they do, they have to face the consequences in civil courts where a payment of money is thought to be the best way to settle claims against them. If their conduct is considered to be especially objectionable, public opinion becomes a factor that can amplify the consequences.

VW’s admission that it knowingly installed 11 million devices to thwart emission regulations appears to be a case of criminal wrongdoing for which there will be a paper trail of responsibility. We shall see where it leads, but somebody had to approve the plan to install the devices, and probably a range of senior officials knew about it.  German prosecutors have shown themselves to be completely indifferent to the status of individuals they regard to be responsible, and the publicity surrounding the VW incident (reminiscent of Enron) only makes its executives more vulnerable to being charged with a criminal violation.

Duty of Boards

The question of whether boards can be expected to prevent corporate misconduct is one with a long history of unsatisfactory answers. There seems always to be a regular flow of corporate scandals in which boards are shown to have failed to monitor executives adequately. Despite a fair amount of post-VW introspective huffing and puffing, this is not likely to change in the future.

The most important thing that boards do is to appoint the company’s chief executive.  That means choosing someone to be responsible for the company’s financial performance and for safeguarding its reputation. Most boards emphasize the former and take the later for granted. Some think it is a zero-sum game, in which aggressive growth policies come at the cost of increasing reputation risk.

In reality, however, most large company boards are unable to monitor CEOs carefully enough to prevent unforeseen events. This is because of the complexity of corporate operations, the sociology of boards and the limited time any one board member has to delve into details, especially if these are being concealed. Nor is there evidence that splitting the Chairman and CEO roles, or emphasizing long-term results in compensation arrangements makes much difference.

Some economists think that markets are more skeptical of corporate results and explanations, and accordingly are better monitors of CEO performance than a group of loyal and supportive board members, but there is not much evidence of this either.

It just may be that boards are not much good at preventing trouble. What they have to be good at, however, is cleaning up after the trouble – replacing CEOs as soon as evidence of trouble arises, conducting thorough, honest investigations to get to the bottom of things quickly, and then doing what they can to rebuild the company after the trouble.

There is some evidence that this is improving. CEO turnover, according to a 2011 Bloomberg study, was at an all-time high for the world’s largest companies. Certainly this is so for the global banking industry that has turned over the CEOs at nine of the top twelve firms since 2008, some more than once. Even so, the larger the enterprise, the longer it seems to take for boards to step in with a cleanup.

VW, however, has been quick off the mark. 

Time for a Change at Justice

by Roy C. Smith

This week the Deputy Attorney General of the US, Sally Q. Yates, “stung by years of criticism that it has coddled Wall Street criminals” (quote from New York Times), announced new policies to place higher priority on the prosecution of individual executives of corporations suspected of wrongdoing. “Corporations can only commit crimes through flesh-and-blood people, Ms. Yates, said, “and those responsible should be held accountable.”

Surely the shareholders of the world’s largest banks that have been forced to pay many billions to settle charges against them rather face criminal trials before uncertain juries would agree. Executives of banks, who are selected and monitored by their board of directors, are not supposed to commit crimes (fraud, larceny, whatever) nor do the banks’ owners (shareholders) want them to be tempted to do so by management urging, compensation or other incentives.

The Justice Department, however, appears unwilling to cede the banks the benefit of the doubt that the intention of their boards is to behave properly. Ever since 2008, the Justice Department has been the Obama Administration’s agent for blaming the banks for the financial crisis and the Great Recession that followed.

The public has accepted this effort to shift responsibility for the whole mess onto the banks, and to infer that their actions could only have been the result of criminal activity that should be punished by jailing responsible executives.

The only trouble is that, despite serious and thorough efforts, the government has not been able to build a case against any of numerous responsible executives of several major banks investigated since the crisis.

Some say that the lack of indictments after 2008 is because financial fraud is hard to prove and top executives insulate themselves purposefully from those who actually do things. This may be true, but after the collapse of several high tech companies in the early 2000’s, the CEOs of Enron, WorldCom and some other companies did go to jail and for considerable periods.

The fact that the Justice Department did not find evidence of crimes would ordinarily satisfy the public that there were no crimes, but not in this case.

You may think that the banks acted unethically during the mortgage-backed bubble, or that they made stupid mistakes, but neither of those allegations are criminal. Disputes between parties in business transactions over ethical missteps or mistakes usually are settled by negotiation or civil litigation with compensation paid for damages. The Justice Department should have nothing to do with such matters.

But, this time around the Justice Department elected to act of behalf of the public by taking a highly political moral stand against the “greedy and reckless banks.” It did so by threatening to sue the banks for unnamed fraudulent actions knowing that the banks would settle, even for enormous amounts. It forced the banks into a position in which they had to choose between a large, perhaps unfair settlement and facing a possible criminal trial, which if lost could be their end as happened to Arthur Anderson, Enron’s accountants, in 2002.

The Justice Department’s practice of bringing such lawsuits changed when Eric Holder, in 1999 when Deputy Attorney General in the Clinton Administration, published the first in a series of memos by Deputy Attorneys General offering guidelines on prosecuting corporations. For a corporation to be indicted it had previously been necessary to demonstrate that it engaged in, or tolerated, or failed to prevent criminal activities.  Holder added the idea that the extent to which a corporation “cooperated” with the Justice Department in its investigations was also a factor. These criteria included turning over information on executives, waving their rights to lawyer-client privilege, and denying payment of executives’ legal expenses. Later some of these were deemed too intrusive of defendants’ rights and were withdrawn.

Ms. Yates’ memo is the latest in the series, but it doesn’t reinstate any of the withdrawn criteria, only notes that to get “credit” for cooperating, companies have to report or identify suspected employees and turn over evidence against them “regardless of their position, status or seniority.”  

Most banks had already assumed they would have to do this if circumstances required, so in that sense Yates’ memo emphasizing individual wrongdoing is nothing new.

What might be new, and certainly would be welcome by the banks, would be Justices’ subtlety deciding it was shifting ground and was finished with its campaign of suing the banks. If so, it’s very subtle, and indeed may only be reassurance to the left that the Obama Administration has not given up on going after the bad guys.

Almost all of the senior-most executives serving in the major banks in 2007-2008 have been replaced and suffered considerable financial losses in the bank shares they held. Some have also been disgraced and left unemployable. They attract little sympathy, however, because, looking back, the banks clearly did turbo-charge their activities in a giant mortgage market bubble that ultimately burst.

But they didn't cause the bubble (low interest rates and enormous institutional demand for mortgage-backed securities did), or the liquidity collapse that forced the mortgage-backed securities to absurdly low levels that caused mark-to-market write offs, that in turn imperiled some of them sufficiently that they had to be bailed out. The government’s actions to rescue Bear Stearns and AIG but not Lehman Brothers further confused the markets and drove prices even lower.

It is now clear that the blame-the-banks posture taken by the government has hurt the banks and the financial system. Not only have the banks faced the huge legal settlements, their regulatory constraints have been tightened to the point that they are struggling to earn enough to cover their cost of capital, not a viable position for the country’s most important banks to be in.

We need strong and healthy banks to help us recover from the too-low economic growth rates we have experienced in the seven years since the crisis. It is time for the government to contribute to the effort to improve the banks rather than to continue to prosecute them.

Let’s hope that that is what Ms.Yates was really trying to say.

Its Just a Correction, Unless China Makes it Worse

by Roy C. Smith

China’s market crash began in June, but has accelerated rapidly since, despite massive intervention by government entities to stop it.

It has now triggered a sympathetic response from the world’s capital markets (the market value of which is about $230 trillion, according to a recent McKinsey report) and stock prices in Europe, Japan and the US also slumped in another example of global market linkage.
These global market corrections have developed a tendency to be sudden and steep when they kick in.
However, they are always in response to three fundamental factors.
First – digesting the new news. China’s economic slowdown is not new news at all. Nor is its effect on global commodity prices, including oil. Clearly, a slowdown to probably less than 7% annual growth from 12% five years ago was going to affect other markets and investors have had plenty of time to make adjustments.
China’s intervention to attempt to stimulate growth in 2014 is not new either – China was expected to use its vast power in the economic realm to improve things, despite a commitment of some sort to allowing market forces to have more influence.
One consequence of the stimulative effort, however, was the enormous bubble in Chinese stocks that began about a year ago. The bubble has now burst; with all the usual effects, but, even so, the Shanghai Composite is only back to about where it was when the bubble began.
What is new is the fact that even after $200 billion of government-mandated purchases of equities, the Chinese market continued to drop sharply. This has forced China’s massive intervention to switch back to lowering interest rates and easing money, a move that may not work either but certainly will increase risk in the already bloated credit sector. China has serious political and economic issues ahead, but not all of these have global consequences.
Second – psychological forces are released. These are several. A major one may be that investors may no longer consider China to be an invincible economic superpower; instead conventional wisdom may have changed to regarding China as (only) a large but troubled emerging market economy with lots of growing problems.
But a global markets move of this magnitude – this is the fourth time that the VIX (US volatility index) has exceeded 40% since 2008; most of the time it has remained below 20% – unleashes investor responses typical of behavioural economics (and originally described by Keynes in the 1920s). It’s not what the investors think about all this that matters, its what they think other investors will do. If there is likely to be a sell off, these investors will want to act first to get in ahead of it. This means that corrections, when they come, are accelerated, at least until the expectation of what others will do changes.
Third – the underpinnings of the technology driven marketplace are not what you think. There are now a multitude of so-called exchanges on which stocks can be traded electronically. The NYSE and Nasdaq today only account for 25% of trading in US equities – so when a sell off occurs there is a frantic search for liquidity. Banks and broker dealers are also less active as market-makers than they were due to regulatory changes.
But it is more than liquidity. Around 30% of all equity trades today are in passive indices or ETFs, which have to be rebased when markets move rapidly. This is more difficult to do when circuit breakers designed to lower volatility are triggered. In turn this complicates pricing in the equity derivatives markets, leaving all of it in a twisted mess of mispricing until things get back to normal. So the prices you see in the midst of a crisis may be illusory.
But illusions can result in bad judgements. In 2008 a long but slow adjustment was already taking place in the overleveraged mortgage finance sector. These adjustments endangered a number of firms with heavy exposures, but there was no real avalanche until September when the US government wrong-footed markets by allowing Lehman to fail, AIG to live and embarked on several months of unpredictable interventions in markets to save the banks and automakers. This resulted in a rapid acceleration of psychological factors that panicked markets and led to a sharp fall off in GDP growth, which then became new news to which markets further had to adjust.
Most investors survive global market sell-offs with cool heads. They reflect on what is really new, and how much of the adjustment is driven by psychological factors and stresses in market pricing. Governments, however, may be more inclined to jump in and do something, even though increasingly evidence is developing that market intervention can make things worse, sometimes much worse.
China has intervened in this episode in massive ways, spending vast amounts in efforts to stabilise both the stock market and the yuan, without lasting success. It has also intervened in lending markets to extend a credit bubble within China that had already pushed total debt to 250% of GDP.
China has acted as if it has unlimited confidence in its ability to override market forces, despite evidence that this is not the case. It needs a cooler head to intervene less and let market forces restore equilibrium. So far, there is little sign that this will happen, but China may be learning more from experience than we know.

From eFinancial News, Aug 28, 2015

Street Smarts Reconsidered

By Roy C. Smith and Ingo Walter

Now that Tom Hayes, a 35-year old former Citigroup and UBS trader, has been sentenced by a British court to 14 years in jail for attempting to rig LIBOR, young people keen on building careers and fortunes in high finance should stop and think. His defense was a common one for traders in trouble: He did not know that what he was doing was illegal, his bosses were fully aware of what was going on, and anyway it was common practice among all of the global banks.

The jury didn’t buy it, and convicted him on all eight counts of conspiracy to defraud. Hayes will be almost 50 when he gets out, the best part of his life gone, permanently barred from returning to his profession, and who knows about his wife and child?

Back in 1997, after an earlier run of financial misconduct prosecutions, we wrote a book called Street Smarts – Linking Shareholder Value with Professional Conduct in the Securities Industry.  There were two basic themes. First, for financial firms and their shareholders, “reputation loss” was likely to far exceed any gains from misconduct, and so firms had to learn to manage the risk - with persistence backed by sufficient resources.  Second, for finance professionals, the risk-adjusted “expected value” of carefully staying inside the rules over a full career far exceeds the value of breaking them.

Few paid much attention - in an industry where “the long term is after lunch” and memories are short as people, products and strategies turn over rapidly, everyone is preoccupied by the constant search for an “edge” in markets that became hypercompetitive. And so, in the years since our book was published there have been several waves of scandals, each separated only by a few years.  And, as we predicted, the cost of reputation loss among major banks and other financial firms has been enormous, almost enough to destroy the industry.

Should shareholders care? Since 2008, the world’s top global banking firms have traded at book value or less – compared to roughly twice that historically. Legal settlements with government prosecutors have amounted to about $200 billion. Prosecutors have extracted guilty pleas to civil fraud or criminal charges from a number of the world’s most prominent financial firms, though none have availed themselves to their right to trial. Bank regulation has been totally revamped, and made much stricter. Even so, central banks and other regulators still treat the word “culture” with suspicion and have arranged a number of “qualitative” stress-test requirements focused on good behavior that bankers must meet.

The public has shared in the regulators concerns, and in some quarters has agitated for the bankers that wrecked the system in 2008 to go to jail. Top executives at all of the banks have been closely investigated without finding sufficient evidence to bring criminal charges. But, since 2007, two-thirds of the CEOs of the twelve largest global banks have been replaced, along with a large number of unit heads. Most of the highly paid mid- and senior-level executives from the time of the Crisis have lost a great deal of their personal wealth held in the shares and options to buy stock in their firms. Many also lost their personal reputations, and have become unemployable in their professions.  Some have become a laughing-stock or poster-boy. Others keep their heads carefully below the parapet.

So the allegation that banks and bankers got off scot-free is not true.  But maybe it’s worth repeating some of the lessons that we learned almost twenty-five years ago.

First, beginning in the 1980s, banks stopped being viewed largely as public utilities or (in the case of independent investment banks as small focused professional firms) as deregulation, globalization and technology combined to transition them to trading-oriented, high-margin growth firms. Such an extensive transformation changed the industry’s risk exposures considerably. With the change in strategy came much greater risk, not only from trading but also from competitive dynamics that pushed firms towards a morally ambiguous, “you eat what you kill” business culture. Transparency became an enemy. Valued clients became mere trading counterparties.

Second, the new competitive culture quickly transformed compensation practices into a turbocharged pay-for-performance model, which altered who was getting rewarded, how much and what for - without full recognition of associated risks, including hard to assess regulatory and reputation risks. Traders pushed out to the riskier end of the market and behavior patterns changed to justify almost any potentially profitable activity that was not obviously illegal. These notions jumped from firm to firm via chat-rooms and a high-mobility mindset that expected little loyalty from employers and gave little in return. Moral and business conduct issues became ambiguous and often were set aside. The ancient ideas that “if others are doing it, it must be all right” and “if we don’t do the business someone else will” reappeared essentially unchanged from the preceding scandal.  Nothing much was learned.

Third, managing the moral and ethical components of risk was new, difficult to evaluate, and attracted little support from the top beyond fervent lip service. No one wanted to pay for it either, whether out of pocket or by foregoing profitable business opportunities.  The longer this attitude persisted, the more inculcated it became in firm cultures.  So, reputation loss was an unmeasured crisis waiting to happen – and when it came, it did so with a vengeance.

Fourth, professionals working in such firms had to follow a difficult script. Attracted by and comfortable in precisely this just this kind of culture, unless they were very watchful and careful while at the same time treading softly and going with the flow it was easy to imperil their careers.  Once their firms felt the sting of reputation-related losses and penalties, so did all employees compensated via bonuses linked to the share price. When the stock price tanked so did the personal wealth of employees from Drexel Burnham, Bear Stearns, Lehman Brothers, AIG, Citigroup, Bank of America, and many others.  And during times of trouble many competent employees (including people who had nothing to do with any misconduct) were fired or otherwise let go in periodic waves of lay-offs and cost-cutting.

Fifth, few employees that engaged in misconduct seem to have understood the basic math. To adjust what may seem like a large difference in compensation from creating more profit for the firm, one has to estimate the probability of getting caught and the consequences that will follow (financial and otherwise).  The probability of being caught may be low - although the technology that is your friend can be turned against you very quickly to locate a smoking gun, and there are plenty of people up and down the line who can squeal on you.  And adverse consequences applied over a full span of a 30-year career are almost infinite: Loss of accumulated fortunes (through stock losses and clawback provisions), loss of future income, fines, personal and familial shame, and possibly even incarceration.

Despite efforts by some firms to reward internal monitoring and increase surveillance, the industry as a whole seems to have failed in learning how to manage these risks and still satisfy shareholders that they are performing well against the competition. Market discipline has, in effect, failed as a behavioral and cultural safeguard.

So the big fist of public policy has been applied, and financial firms have been forced to improve by Dodd Frank and other extensive regulatory efforts that have made it nearly impossible to compete as they once did.  Some are reverting to the public utilities they used to be, others are focusing on less risky areas like asset management where they see a competitive advantage. A few are doubling-down on trading in securities markets and striving to reengineer themselves to remain leaders – knowing that the future risks of misconduct are ever-present. Each has its own behavioral and cultural traps, but at least they are easier to identify and perhaps to manage effectively.

However business models evolve in global finance, all of the incumbent firms and new entrants will have to learn to manage internal misconduct risk far better than ever before. It’s now a matter of survival.

August 21, 2015_

The US Should Privatize its Infrastructure

By Roy C. Smith

We are told that public infrastructure investment creates jobs and efficiencies, and should easily be financeable, but politics prevent this from happening.  Privatization can help.

The American Society of Civil Engineers recently awarded the US a minimally passing grade of D+ for its crumbing infrastructure, and identified $3.6 trillion of unfunded requirements.

This is because US public infrastructure (highways, bridges, airports, etc.) is paid for by user taxes and tolls that politicians are loath to raise, or by direct government grants that are equally unpopular.  Thus, it is continually under-depreciated, under-maintained, and under-financed.

The New Jersey Turnpike (constructed in 1951) is in poor shape and needs to be improved and renovated. In 2007, Governor Jon Corzine proposed a $30 billion sale/leaseback arrangement, but the New Jersey Legislature would not approve it because doing so was feared to involve job losses and wage cuts, as well as raising the tolls. The current toll to travel the turnpike’s entire 122-mile length is less than the cost of crossing once over the 1-mile George Washington Bridge. Raising the toll, about half of which is paid by motorists passing through the state, is still politically toxic in New Jersey.

The Tappan Zee Bridge over the Hudson River was constructed in 1955 with an expected life of 50 years. The bridge is now being replaced at a cost of $5 billion that has not been funded by the NY State legislature. Raising the toll from $5 appears to be completely off the table (the George Washington Bridge’s toll is $14).

The US Highway Trust Fund, established in 1956 to fund and maintain the federal highway system by assessing a national gasoline tax (last updated in 1993 at 18 cents per gallon), would have run completely of out money last month except for a last-minute, three-month, $8 billion fix. This does little to address the $92 billion deficit that the Congressional Budget Office expects the Highway Trust Fund to run over the next five years.

The simple truth is that public infrastructure is fully financeable as long as tolls are set at rates sufficient to generate revenues to cover capital and operating costs. If so, bonds issued by the entities readily can be sold to investors in global capital markets.  New entities such as Infrastructure Banks are not necessary. What is necessary is getting agreement on how to set up infrastructure projects at market rates so they can be financed and we can get on with them.

In other words, a kind of privatization needs to be applied.

In Europe, privatization began in the 1980s and resulted in several hundred billions of dollars of sales of shares in state-owned-enterprises, including portions of the national highway system in France, Spain and Italy.

These programs involved acute political struggles at first as opponents feared job cuts, wage reductions and rate increases, and resented the idea that rich people would end up owning all the public goods.

But it wasn’t just Mrs. Thatcher and her Tories who became believers; most of the rest of Europe, Latin America and Asia joined in as the positive results of privatization became clear.  The enterprises, required to follow economic laws of the marketplace, became profitable, paid taxes, made new investments and increased employment once they returned to a growth mode. If they didn’t they would be taken over by other companies or private equity funds that would try again.

In America, however, there are very few state-owned-enterprises. Instead, the idea of regulated “public utilities” was preferred. This meant that potentially monopolistic, but very capital-intensive energy, water, transportation and other companies could remain in the private sector if state or federal utility commissions regulated their rates and other activities. These private sector companies have been successful and are not the ones getting failing grades from the American Civil Engineers. They fund what they need as they go along.  In 2014 these types of companies raised $750 billion in global capital markets.

The ones with the failing grades are the government owned “public goods” enterprises that operate highways, passenger rail, airports and other systems that are used by the public at large and are important to the economic infrastructure of the country. The public expects these goods to be provided by the government at a cost that is affordable and fair, but it is also capable of resenting the subsidies that are necessary to keep fees low.

The system for funding public good infrastructure, however, has collapsed into a morass of politically overlapping jurisdictions of federal, regional, state and government-sponsored corporate entities that politicians are reluctant to fund.

For example, a 104-year old railway drawbridge in New Jersey carries 450 trains a day into and out of New York City. It is owned by an under-funded government-sponsored-enterprise called Amtrack, but also carries commuter trains operated by under-funded NJ Transit. The drawbridge, when opened, frequently fails to close properly and causes massive travel delays. Amtrack needs $1 billion to replace it, but it is unable to either raise it or get the federal or New Jersey government to pay for it.  The bridge, which is typical of many such bottlenecks in the US transportation system, remains un-improved.

The system clearly needs to be changed. One idea to do so is to separate transportation public goods and public utilities based on re-consideration of the subsidies.

The Highway Trust Fund, NJ Turnpike, Tappan Zee bridge and the ancient railway bridge are all part of a federal interstate transportation system that is large and robust enough so as not to require subsidies. If left alone to do so, it could fund itself (as gas and electric utilities do) but at present each part has to fund itself.

Congress could authorize an “integrated federal interstate transportation system” to operate as the governing public utility regulator for government controlled assets in the transportation industry.  It could take over decaying infrastructure from states that are unwilling to pay to upgrade it, and privatize it, either by resetting user fees to market rates or by selling it to private operators.

This would get state legislatures out of the rate-setting business, and could enable them to recover some of the proceeds from privatization sales. Considering the dismal financial condition of many large states, this should be a very welcome proposition.

Congress then might even be able to abolish the federal gasoline tax, releasing transportation infrastructure finance from the crippling constraint of ongoing partisan politics.

Privatization solved a lot of problems in Europe after facing a lot of the same political issues.  It is time for the US to apply some of the lessons.

From: eFinancialNews, Aug 10, 2015

Greece is a Mess - but China is the Real Worry

By Roy C. Smith

Three trillion dollars. That’s the amount wiped off the value of shares in China over the last three weeks. That’s about ten times the GDP of Greece.  The government is forcing a rescue of the plunging market, but will it hold? An avalanche in China would be far more consequential than Greece leaving the euro.

There are big differences between the strategies employed in Athens and Beijing as they wrestle with their problems.

Greece is trying a “tyranny of the weak” strategy: if you won’t give us better terms, we will die on your doorstep. It is unlikely to work in the long run. Despite its referendum, Greece is broke, and will have to restructure.  How it does so, and over what time period, is really a European political issue that will go on long past the present deadline.

China, on the other hand is pursuing a “tyranny of the strong” approach: we are powerful enough to be able to make things the way we want them. However it has no more likelihood of success than the Greek strategy.  Applying government resources to manage markets (sorry, that should be to “uphold market stability”) is hugely expensive, creates a lot of other problems, and cannot be sustained for long periods.

Over the past year or so, China has used its authoritarian powers to stimulate financial markets to reverse declining growth through a combination of liquidity measures and policy changes aimed at increasing credit availability and stock market investment.

Lots of money has been poured into shoring up weak local and municipal governments and state owned enterprises, and to increase margin credit for stock purchases.  Clearly, there has been an orchestrated effort by the Xi Jinping government to manage markets for political purposes, which have included creating a bull market to encourage confidence in further economic growth.  

But the bull market became a bubble, and the bubble began to burst into free-fall, requiring further intervention to shore it up.

Over the past three weeks these efforts have become extreme. Among them are are halting trading in half of all listed shares, suspension of IPOs, halting short-selling, directing its sovereign wealth fund and public pension funds to increase stock purchases, and creating a Market Stabilization Fund by 21 “willing” brokers who have agreed to invest additional $20 billion in stocks, and not to sell any stocks while the Shanghai market index is below 4,500 (after a recovery in the last two days, it’s currently at 3,877). $20 billion may be only 0.16% of the $12 trillion market capitalization of the various Chinese markets, but it surely is a lot to the 21 brokers who have agreed to provide it.

Will the government’s effort be able to stop the rout?

Certainly, they might. China has vast resources that could be applied. So far, however, the government seems to be relying on its power to tell people what to do rather than on its deep pockets.  

Japan, which suffered a similar market crash in early 1990, also intervened extensively (to the extent of about 0.8% of market capitalization) to halt the decline, which, like China’s, reached 38% after the first few months. It worked for a while, but not for long. Two years later, the Japanese market index had dropped 65% from its pre-crash peak.

Once the Chinese government decides it has stabilized the stock market sufficiently, and withdraws the extraordinary measures, it is likely that the market will find very little support. 

Eighty percent of Chinese stocks are owned by the country’s 400 million urban middle-class. These investors, who have trusted the government’s economic policies, have already lost a lot of money and many have suffered calls on margin loans that, in response to stimulus efforts, now amount to about $1 trillion.  

Some of the suppliers of margin credit, such as smaller banks, financial intermediaries and government agencies (e.g., China Securities Finance, which was told to increase margin lending to stop the decline) will be endangered, and may been to be bailed out in order to prevent further panic in the markets.

Loans made to shore up weak credits will increase China’s abundant supply of non-performing loans, causing either bankruptcies or further intervention by the government to paper them over

What confidence China has earned from the world and its own prospering middle class in gradually adopting market economics will be lost, and what transparency there has been will be sacrificed as cover-ups spread throughout the system. Most important, a loss of confidence in the Chinese economic miracle would greatly imperil the government’s paramount objective of reversing a declining GDP growth trend.

Because China isn’t a democracy, President Xi has more power than the other leaders. He can make bigger bets that he can override market forces. But, even in China there are factions and rivals that raise the stakes for President Xi to avoid an economic meltdown.

The urgency of addressing the stock market decline has pushed proper, long overdue economic reform into the background. A portion of a World Bank report earlier in July urged China to accelerate reform of its state-dominated financial sector. "Wasteful investment, overindebtedness, and a weakly regulated shadow-banking system," had to be addressed for China's broader reform agenda to succeed, it said. The report also warned that failure to address these issues could end "three decades of stellar performance" for the world's second-largest economy.

China’s response was to request that the offending portion of the report be withdrawn, which it was.  Indeed, since then, rather than thinking about ways of reducing state intervention it has ramped it up. Reforms, if the words can ever be applied to a system so dependent on government intervention, will have to wait until fears of the China bubble bursting are over.

In many areas of policy Beijing’s ‘tyranny of the strong’ mindset works. And in this area too, it may appear to work for a while.  Markets can be propped up, with effort, for months or even a year. But then there is a moment when the markets want no more of it, and start to collapse. Despite efforts to counter it, the collapse gathers steam and can end up as an avalanche.

from eFinancial News, July 9, 2015