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Monday, February 29, 2016

Waiting for the Conventions

By Roy C. Smith

Certainly for economists, this is likely to be the most unpredictable, exasperating and mindless US presidential election contest in generations. It will also be the most interesting.

Results from the early “primary” elections for delegates to the presidential nominating conventions in July, have frontrunners Donald Trump and Hillary Clinton modestly ahead as the process heads into “Super Tuesday” (March 1), when 11 states vote, followed by another 20 inside the next two weeks. Delegates are awarded on a proportionate basis before March 15, and winner-take-all afterwards. Most of the large states have their primaries after March 15. California, the last, is on June 7.

Primaries are brutal tests of endurance, organization, media management and fund raising.  Fewer than 20% of registered voters participated in the 2012 presidential primaries, so to win candidates, have to be able to attract the votes of those motivated to show up, usually the most politically extreme.

This year, both parties have been greatly shaken up by populists of the sort that never would have impressed voters in the past. Both Trump and Bernie Sanders, the lifelong socialist seeking the Democratic nomination, are enjoying surprising success because they have tapped into deep-seated anger and frustration of blue collar workers who’s real incomes have been stagnant since the 1970s and who’s economic future seems bleak and beyond their own control.

They have a point. Real GDP growth in the fourth quarter of 2015 was 1.0%, bringing the annual rate to 2.4%, the same as for 2014 -- well below the US historical average of about 3.5%.

More alarming is the fact that real GDP growth has averaged only about 2% for the past 15 years – one of the longest growth slumps in US history.  The stock market turmoil so far this year (partly influenced by the campaigns) has increased the fear of the economy getting worse.

The lack of growth has focused populist arguments on economic “victims” and “income inequality,” the share of the economic pie that different segments of society get.  The appeal of 74-year old Bernie Sanders is his passionate argument that the system is so fundamentally and unfairly flawed that it can only be fixed by changes so radical that they have never been presented to the electorate before.  The electorate, especially the younger part of it, is listening carefully.

Hillary Clinton, however, is still the favorite to win the Democratic nomination, because of her resources, organization and political legacy within the party. But, her campaign has faltered. Sanders has forced her well to the left into an awkward place for her, as she and all her family have been made very wealthy from speaker fees paid by Big Business that Sanders disdains, and other windfalls available only to celebrities like them.

At this point, Clinton has 544 of the 2,382 delegates needed (including 432 party assigned “super-delegate” votes), and Sanders has 85 (16 super-delegates). Excluding super-delegates, the vote count is very close and Sanders seems to be gaining momentum.

Trump’s economic positions have almost no connection to mainstream Republican economic policy lines. Like Bernie Sanders, he is against foreign trade deals, against entitlement reform, for tariffs on Chinese and Mexican goods, for taxing hedge funds and breaking up the banks, and for large government-financed health care and infrastructure programs

Yet, the Trump machine continues to roll on. He got more votes in South Carolina from right-wing evangelicals than right-wing evangelical Ted Cruz. 

But it is not clear that Trump’s appeal will carry over to the more urban, better-educated, less evangelical populations. If more moderates participate in the coming primaries, their votes, cast among a smaller number of continuing candidates, may dilute the power of Trump’s supporters, making it difficult for him to gather the 1,237 delegates needed to secure the nomination (he has only 82 now, Cruz has 17).

If this proves to be the case, delegates voting at the convention will determine the nomination. This is what the Republican Party establishment is hoping for; that the outcome would be “brokered” (something that has not happened to Republicans since 1948) and Donald Trump would be blocked.

But after the conventions, the two nominees will have to battle each other, and a hard fight ought to emerge over economic policy, the key issue to most voters.  

The Democratic candidate will have to defend the Obama administration’s lackluster economic record and explain how alleviating income inequality can enable growth, and how his or her policies might ever be enacted, given that the Republicans control both Houses of Congress and have already rejected Barack Obama’s effort to achieve a ”fair share” tax increase on the wealthy.

The Republican candidate will have to explain how his plan will restart the growth engine without having all the benefits going to the wealthiest Americans, which of course includes Donald Trump.

There are lots of things to talk about – why productivity growth is down despite great technological advances; the need for tax reforms; the cost-vs-benefit of the many new regulations of the past eight years; and how future social welfare claims are to be paid for, especially when the national debt is already large.

The discussion is likely to be pretty thin, however. Clinton has credible economic advisers, but no real policy agenda; neither Trump nor Sanders have advisers and their agendas have been broadly declared unworkable.

If the nominees turn out to be Trump and Sanders, there may yet be another outcome. Former NY Mayor, Michael Bloomberg, has said he may become a third-party candidate, hoping to win enough votes to deny a victory to either of the others. If so, it would throw the election into the Republican controlled House of Representatives that just might select a more centrist and broadly acceptable candidate (such as Bloomberg) instead.  

More likely, it could end up as most third party candidacies do and draw votes away from the favorite to elect the likely loser instead, as happened to Bill Clinton when Ross Perot took votes 19% of the votes away from George H. W. Bush in 1992.

 from eFinancial News, Feb 29, 2016


Tuesday, February 9, 2016

Barriers to Entry on Wall Street

By Roy C. Smith

It is now suggested that barriers to entry in global investment banking are so high as to create a powerful oligopoly – don’t be so sure.

A recent editorial in the WSJ suggested that Hillary Clinton, who was paid an inflated $675,000 for a speaking engagement by Goldman Sachs, invoked a silent quid-pro-quo in which she would say she would be tough on the banks, but in reality would protect the industry.  Wall Street must believe it because Ms. Clinton’s campaign has received more contributions from the financial services industry than any other candidate’s has.

The editorial went on to float the idea that Wall Street has benefitted by Dodd Frank, Basel III and all the other increased regulation of systemically important financial institutions, because they have raised the barriers to entry to the global investment banking business, leaving those that were well entrenched (like Goldman Sachs) safely within an oligopoly.

Indeed, Goldman Sachs’s CEO, Lloyd Blankfein, was quoted as saying last year that the “intense regulatory and technology requirements” have made  “this is an expensive business to be in if you don’t have the market share in scale.”

This may be true, but the value of being a member of the oligopoly was certainly not so clear as of the end of 2015.

All of the oligarchs reported earnings significantly diminished by heavy litigation costs, layoffs and cost-cutting measures and by sizeable write-offs of goodwill from earlier acquisitions to build market share in scale.

Despite a record year in mergers, 2015 was by no means a good year for the oligopoly. Global securities market new issues totaled $6.9 trillion, down from $7.5 trillion in 2014, but a third less than the record $10.2 trillion raised in 2006.  Securities issues were 58% of total capital raised (including from syndicated bank loans) in 2015, as compared to 69% in 2006.

Further, the market shares attributed to the top ten lead-managers of combined global debt, equity, syndicated loans and M&A transactions dropped to 66% in 2015 from 94% in 2006.  The top five represented 41% of the market in 2015, but 57% in 2006.

Market shares have also been pared by competition from non-oligopic banks and by specialized nonbanks, such as the dozen of so boutique investment banks (about half of which are less than ten years old). Lazard Frères, the largest such boutique, ranked 11th in the combined 2015 lead-manager league tables, despite being active only in M&A. Three other similarly focused boutiques ranked among the top twenty originators for the first time in 2015.

The oligarchs’ market shares in trading, derivatives, hedge funds, private equity and venture capital, all of which contributed significantly to their profits in the past, also have been reduced by regulatory changes that limit the ability of major banks to compete in these areas.

More important than market shares, the intense pressure on profits from greatly increased capital and liquidity requirements, much reduced leverage, and an endless wave of litigation seeking settlements for sins for the crisis period, complete the picture of life today among the oligarchs. 

In the political arena, oddly, most of the leading candidates from both sides want to break up the banks. The popular perception continues to be that big banks that wrongly were bailed out during the crisis are still too powerful and dangerous. The reality, however, is that they all have been forced to drink from a poisoned chalice and only the strongest, and most adaptable can be expected to survive.

All of the European investment banks have undergone major management changes to affect these adaptations. UBS has done the most to shrink its investment bank (and its market share has shrunk accordingly); the others have promised something similar, but have not yet done enough to convince their long suffering investors that they are truly turning things around.

The American oligarchs appear to be relying on a strategy of “optimizing” their balance sheets.  This is a complex re-engineering task that forces all the different business units to justify the capital allocated to them. So far, this is proving more difficult to do than they thought – many of the variables involved in such an effort, are themselves variable, and vary differently over changing market conditions that are hard to predict.  And the regulatory constrains to be optimized are very tight.

Despite several years of such effort, it is starting to become clear that optimizing will not work, at least not for Bank of America, Citigroup or Morgan Stanley. Even if they could balance things out optimally, the resulting return on equity is still too low to cover their ongoing cost of equity capital.  The market already knows this, even if the boards of these banks do not.  Like the Europeans, they will have to adopt more radical changes to get to where they need to be.

The changes, by the way, cannot come from scaling up market shares through mergers – as was done over the past twenty years. Investors know they don’t work well, and because, under Dodd Frank, regulators would probably deny most large bank mergers.

The changes will have to come from the banks breaking themselves up – so Bernie Sanders or Ted Cruz or their EU equivalents won’t have to.

For the supreme oligarchs, JP Morgan and Goldman Sachs, which are already very focused on capital markets, it may be possible to achieve optimization through management improvements and major upgrades in technology, but the market remains skeptical, even of them. They, however, can hope that the other oligarchs will quietly fold their tents and slip away, leaving the battlefield to them when market volumes return to what they once were.

It is true that the regulatory climate has left the capital markets industry surrounded by near impossible barriers to entry – that is, barriers to entering the business as it was. The barriers protect the survivors, but have also changed the survivors’ former business into one that no one can live with.

Aversion of this article appeared in eFinancial News on March 9, 2016.