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