New Bank Leaders Face Limited Choices

By Roy C. Smith and Brad Hintz

Though none have announced their results yet, European capital market banks will surely experience a quartus horribilus. Total 1Q investment banking revenues are down 36% from the prior year, the lowest since 2009, led by sharp declines in M&A, high yield and IPO activity.

It also appears that trading revenues will be disappointing. Several US banks have discussed the challenging market conditions that have impacted market making and Jefferies, which serves as a harbinger of FICC performance, announced dismal trading performance in its first quarter.

2015 looked like a year that would signify the end of the post-crisis slump for the banks - mergers, equities, debt and LBOs all were firing away, and the beginning of the long awaited recovery of profits in the banking industry was foreseen. But, it was not to be. The oil glut rattled stock, debt and currency markets and recession fears forced unexpected credit write-downs.

The quarter’s results, however, mask mighty efforts being made by the big European banks to restructure themselves after years of dithering. Only three European banks will be among the top ten firms ranked by investment banking revenues. 

Eight years after the 2008 crisis most of them have become unviable relics drowning in a sea of tightened regulation and costly litigation, with little sense of what to do about it. But, by the end of 2015, all of the four largest Europeans had installed new management with no ties to past legacies and charged them with transitioning to a workable business model that could once again be attractive to investors.

Bailed out by a resentful Swiss government in 2008, UBS was the first to confront the need for major change, though it took four years to do so.  Sergio Ermotti, former Deputy CEO of Unicredit, was appointed CEO in 2011, and decided to reduce the investment banking business (and its related risk-weighted assets) to minimal levels, choosing instead to build a new, lower-growth but less volatile, dividend-paying business centered on wealth management. This was an easy call because its wealth management franchise was so vast, and it has paid off. In 2015 UBS reported ROE of 11.5%, its stock was trading at 1.1 times book value with a dividend yield of 3.6% that will increase further when the bank reaches its near-term goal of a 50% dividend payout. However, there was a high cost to Mr. Ermotti’s strategic move: UBS is no longer ranked among the top ten global investment bankers by revenues.

The three European banks that have clung to their investment banking market shares and revenue steam – Barclays, Deutsche Bank and Credit Suisse (ranking 6^th, 7^th and 8^th, respectively, by global revenues) remain in terrible shape, as they have been for most of the last eight years. ROEs were negative in 2015 for all of them, and today, on average, their stocks trade at a mere 43% of book value.

In July 2015, John Cryan, a former UBS finance chief, was appointed to replace Deutsche Bank’s ineffective co-CEOs. In October he announced a new “Strategy 2020” (that replaces a previous, but unaccomplished, “Plan 2015+”) that would rely on simplification, increased capitalization, less risk and better management. Risk-weighted assets (RWA) will be further reduced by 22% to  310 billion by 2020; capital and leverage ratios will be improved, some extraneous assets will be sold, and expenses and headcount will be cut further.  Eliminating dividends for two years will fund these efforts. Returns on tangible assets will rebound (it is hoped) to 10% by 2018 (about 8% of book value), which, however, is still less than Deutsche’s continuing cost of equity capital.  Deutsche Bank’s stock is down 27% since the new plan was announced – JP Morgan’s is essentially flat since then; UBS’ is down about 10%.

Tidjane Thiam, the former head of Prudential Insurance, became CEO of Credit Suisse in June 2015.  He also announced a plan in October similar to Cryan’s to trim hard and cut back, but stick to the old business model and protect profitable market share positions in investment banking.  Last month, however, Thiam announced a further tightening of the plan after the investment banking division blindsided him by adding assets to trading positions that then lost money.  RWA will be cut a further 20% along with 2,000 more jobs in the global markets unit. Despite bringing his miracle worker reputation to the bank, Thiam now seems to be in over his head. Credit Suisse’s stock price is down 37% since last October.

The most recent of the new CEOs is JP Morgan Chase veteran, Jes Staley, who took over at Barclays Bank in December. He too has announced a simplification, cost cutting and balance sheet trimming plan that would involve selling assets in Africa and shutting some non-essential business. His plan, however, also included halving the dividend for 2016 and 2017, and focuses on preparing Barclays for the ringfenced regime it will face in 2019. This, he demonstrated in a presentation to investors, will involve transitioning Barclays into two separately capitalized (and ultimately separable) businesses – a global investment bank, Barclays Corporate and International, with RWA of £195 billion, and a much smaller Barclays UK, with RWA of £70 billion. Even so, Barclays’ stock is also down 37% since October.

The three new CEOs have now all had early lessons on how hard it is to turn around a large underperforming European bank under present regulatory constraints and unsettled market conditions. It may be that balance sheet “optimization” won’t work any better for them than it did for their predecessors, who tried versions of it too.

Ultimately, there may be only two ways out. One is to convince regulators that important players in the global capital market system (there are some Americans too) will be sidelined indefinitely unless there is some relaxation of the capital adequacy, leverage, liquidity and other rules to allow market pricing to adjust to regulatory shifts. This may happen in time, but not soon. The only other way out is to split off the investment banking units into separate companies, which market conditions may make difficult, but not impossible, to do.

The new guys need to be brutally objective about their situations. If the renewed cut, squeeze and trim approach doesn’t work within a year or so, then the more drastic spin off approach may be all that is left.

 From: EFinancial News, March 31, 2016

What Has Changed in Cuba?

by Roy C. Smith  

Mr. Obama’s visit to Havana has refreshed the enthusiasm for a New Cuba that was created when he and Raul Castro announced their intentions to “normalize” relations fifteen months ago.  But while enthusiasm is high, progress in improving economic relations has been slow. The outlook is for it to remain slow.

Since the announcement in December 2014, embassies have reopened, travel restrictions administered by the US Treasury Dept. have been relaxed, and some limited concessions to allow financial transactions have been made. Cuban-Americans have travelled back and forth more freely with many bringing money for investments in new licensed private enterprises that are burgeoning.

However, Congress has done nothing to address the several US laws passed over past decades that prevent US companies from doing business or financial transactions in Cuba (called the “Embargo” by us, and the “Blocade” by the Cubans), without which the major US economic opportunities of a New Cuba will be remain sterile.  Though there are loopholes in these laws, without their repeal the President’s hands are tied and there is little more he can do to speed things up while he remains in office.

However, the Cubans have done very little to open their economy for foreign investment, trade and development of their industrial sectors and public infrastructure since the announcement.  Non US enterprises seeking to engage with Cuba, but unaffected by the Embargo, have been frustrated by Cuba’s slow progress in opening up.

It is true that since Raul Castro became head of state in 2008, a number of economic policy changes have occurred – mainly as a result of laying off about 20% of the work force from government jobs to encourage them to become “self-employed” entrepreneurs.  This was a necessary step to take as Cuba’s failed economy, propped up for years by the USSR and then by Venezuela, slid further towards bankruptcy. Even so, the government still employs about two-thirds of all workers.

Raul has said that economic reforms are necessary to preserve “Cuban Socialism,” the legacy that more than 50 years of Castro rule has left behind.  Without the recognized economic threats facing the country, it seems unlikely that Castro would have agreed to the announcement.

Cuban Socialism (Communism is rarely mentioned) has had some achievements – the population is literate, has access to decent free health care, and enjoys a very high degree of income equality, though only to the extent that everyone is equally poor.  But the economy is very sick. It had about a 2% growth rate for the five years trough 2014, little to no foreign direct investment, and has accumulated government debts equal to 125% of GDP. Cuba must import 80% of its food (20% of which comes from the US under a human needs exception to the Embargo) even though Cuba has vast amounts of uncultivated agricultural land in a tropical climate. It has little to export but sugar, cigars and rented-out Cuban doctors.

Despite all this, Cuba has experienced very little social unrest. Civil authorities are powerful and strict, but so were they in the Ukraine, Egypt, and in the former Eastern European states before these regimes fell to public protest.

Indeed, Raul may feel that the announcement already has been a big success. It has been popular with the people, and attracted lots of attention to the prospects of a New Cuba. Without having to give much of anything, Cuba’s foreign exchange inflows from tourism has greatly increased, and GDP growth jumped to 4% in 2015.

Even so, though the announcement increased applications for foreign direct investment, these have largely been rejected or stalled indefinitely. Of 200 such applications since 2014, only about 35 have been approved, and those were have faced draconian obstacles from the Cuban bureaucracy to being implemented.

Raul’s ideas about economic reform seem only to go as far as the retail sector – more small shops and street markets, but not large corporate engagement in the agricultural, manufacturing or financial sectors through which Cuban economic sovereignty, pride and “values” might be at risk.  Going that far but no farther, however, will make little difference to Cuba’s considerable economic problems.

But, Raul says he will retire in 2018, at 86, and turn the government over to someone else.  Within a few years, however, he and Fidel will join their revolutionary colleagues in Cuban Socialist heaven, and a new team will have to decide how far to go.  

In the meantime, other things are changing, due to Raul’s earlier reforms and the announcement. One is the end of fifty-years of anti-Americanism, and rising expectations for improvement in standards of living and economic opportunity because of the possibilities of interacting with the US.

Another, however, is a rapidly growing differential between those who are making money from all the tourist trade (restaurants, real estate, arts and entertainment) or otherwise from wheeling and dealing or corruption. Already the sort of envy and public concerns about the power of the newly rich has surfaced.

And, Cubans are getting more information about how others live as compared to themselves. As the Internet becomes more available this will spread further and faster.

Cuban-Americans are changing their attitudes. Recent surveys show that most of the Miami Cuban population favors normalization, and many see opportunities in bringing their capital and well developed business skills back home. 

So maybe the most likely near term future for Cuba is continuing rigidity and hostility towards large corporations that will be eroded by expectation sof normalization, drip by drip, until the Castros are gone.  By then, the Embargo (which has little continued support in the US) most likely will be gone too, and a greater flow of capitalist economic activity will result and this, as it did in Eastern Europe, will start to carry away the last of the rigidities.

The Castros greatest fear, I presume, is that after them, Cuba will revert to what it was in Batista’s time. A gold-rush of unrestrained capitalism might just bring that about, but it doesn’t have to.  The best thing for the Cubans to do over the next few years – which some of them are –is to spend time planning for a modern political and economic framework that can survive the transition from socialism to a markets-driven form of mixed economy. There are a number of good examples from the recent past – Poland, Hungary, the Baltic countries, Spain after Franco, and more locally, Chile and Costa Rica.

Crowdfunding -- The Next Disruptive Technology

By Roy C Smith

On August 28, 2015 Elio Motors, a startup manufacturer of a slick looking, $6,800 two-passenger, three-wheeled minicar that gets 84 miles per gallon, filed the first equity Crowdfunding IPO under the SEC’s new rules that were published in June 2015.  It could change startup financing forever.

Elio’s founders invested $5 million in the company at an average price per share of $0.26. Accredited investors purchased an addition $9 million of shares at an average price of $1.48 per share through private placements.  In 2015, the company issued $3 million of subordinated secured notes convertible into common stock at $5.98 per share. It has also raised about $38 million of debt since 2008.

Paul Elio did each out to VCs, but was rejected. Every time he pitched his idea to one of them, he encountered skepticism that there would ever be a mass-market for the tiny, three-wheeled commuter car. No single small-sized vehicle has ever had a material success in the US; even the globally successful small cars such as Daimler Benz’s Smart and Fiat’s 500C.

To demonstrate market demand and raise some startup funds, in January 2013 Elio introduced an on-line vehicle reservation system similar to one used by Tesla. . A potential buyer can reserve future delivery of a vehicle by depositing an amount from $100 to $1,000. Depositors have priority for vehicle delivery and receive a discount. By January 1, 2016, the company had more than 50,000 advance reservations for vehicles worth $340 million, and $21.1 million in deposits.

Elio hoped to raise sufficient funds from its equity Crowdfunding issue to fund prototype building and testing of 25 vehicles to be used to demonstrate various performance and safety features required to obtain a major loan from the US Department of Energy to fund production costs.

Enabled by Startengine, a for-profit Crowdfunding portal approved by the SEC, Elio sought non-binding “indications of interests” for up to $25 million of equity from investors over a three-month period to determine an appropriate price level and number of shares to be sold.

In August 2015, Elio closed its market test with over $42 million of interest in purchasing shares indicated by 11,000 investors with an average order of $3,820.

On August 29, Elio Motors filed a registration statement on the newly approved and abbreviated Form 1-A with the SEC. The proposed offering was to be of a minimum of 1 million and a maximum of 2 million shares. The expected offering price, set by the Company, was $12 per share.

The registration statement disclosed that Elio had not yet sold any vehicles, and in 2014 it lost $25 million and ended the year with a cumulative shareholder deficit of $45 million. Elio Motors obtained approval for the offering from the SEC in late November 2015.

The offering was conducted online via the Startengine website for 74 days from late November 2015 to late February 2016, during a period in which the S&P 500 stock index dropped 6.8% and VCs and other investors in many high visibility technology “unicorns” took substantial write-downs.

In February 2016, the Company announced that it had accepted orders for $17 million of shares (approximately 5% of the company) that capitalized the company in the market at $340 million.

Trading in the shares began on February 19, 2016 on OTCQX, an over-the-counter exchange. One week after the offering, shares were traded at $16.50 and soon thereafter increased to $37 per share. Trading volume was very light, however – only in the hundreds of shares. The tradable “float” in the Company’s shares, even after a tripling of the share price, was still only $52 million, an amount too small to attract interest from large institutional investors.

What’s Different About the Elio Offering?

Elio had been denied venture capital financing; the offering essentially allowed the Company to turn to ordinary investors as an alternative source of startup capital, and to do so at a much lower cost than VC investors would have required had they been willing to invest.

The Company itself, not VCs or underwriters, priced the shares

The IPO involved no Wall Street underwriters or underwriting fees; though legal and other fees associated with the offering, including fees to Startengine and Fund America Securities, a broker-dealer acting as a sales agent, amounted to approximately 10% of the amount raised, approximately the same as the sum of underwriting and other expenses associated with traditional IPOs. The Elio offering, however, was the first of its kind and no doubt involved fees and expenses that could be reduced in the future.

The shares were marketed entirely thorough the Internet using user-friendly StartEngine and Elio’s websites, which enabled thousands of potential investors to reserve shares in the offering on a non-binding basis (as well as reserving the Company’s product when it became available).

The shares are not being listed on NASDAQ or the NYSE. Volume of trading in the shares is limited and in small amounts suited to “ordinary” retail investors, but, even so, in the after-market following the IPO, Elio shares initially rose to a 38% premium over the offering price despite a significant downturn in the stock market indices.

Following Elio’s offering, over 40 companies made Form 1-A filings. Companies in many different industries, including healthcare, banking and even cannabis distributers, now see Crowdfunding as a potentially preferable alternative to traditional early stage funding sources.

Bypassing venture capital and the traditional Wall Street dominated IPO process to access ordinary investors through the Internet could certainly be disruptive if Elio’s success is repeated by other companies. 

However, the traditional methods involve venture capitalists or underwriters vetting companies thoroughly and agreeing to pricing at which they are willing to risk their own money.  It has long been thought that this screening process generates value for investors and that investors are prepared to reject alternative processes that do not include it. 

Crowdfunding now presents this unscreened alternative, and the Elio Motors offering suggests the perceived value of the vetting may have been exaggerated.

Indeed, for many years, “angel” investors (individuals investing directly in startup situations) have grown to become significant players in the venture finance area, with 316,000 investors funding 73,000 companies in deals worth $28 billion in 2015. Angel financing assists more startups than traditional VCs do, and angels do not rely on VCs for screening. Crowdfunding can greatly increase angels’ knowledge of and access to deals well beyond what they might encounter on their own.

Further, ordinary investors have been able to purchase shares in traditional IPOs for years, but rarely get a chance to do so because underwriters allocate shares in the IPOs to hedge funds and favored high-net-worth clients. Crowdfunding certainly removes barriers to entry that prevent ordinary investors from participating in the IPO market. 

Crowdfunding brings the power of the Internet to the startup funding market.  Between the SEC’s new rules and Startengine’s new procedures, a different and simpler way to access investors in startup companies has been created that, after some early learning experience, should provide a viable pathway for many companies to raise capital.

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

     

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.

  

Oil Prices and The Ghost in the Machine

by Roy C. Smith

Many years ago I asked the late Nobel laureate Paul Samuelson what was the most important thing he had not been able to learn about economics, and was surprised when he said “the formula for an avalanche.”

By this he meant how financial panics are triggered.  

At that time, financial panics were fairly rare, though mini-bubbles occurred periodically.  Today, especially after the 2007-2008 financial panic that began in mortgage-backed securities and spread to all forms of corporate securities, we are more aware of what might be called “volatility spikes.”  There have been three periods since 2008 when the volatility of the US stock market exceeded 35% (it normally is about 20%), not including the month of January 2016 when the VIX only reached a high of 27%).

Volatility, the variation of returns relative to an index or benchmark, can be measured for anything that trades, including stocks, bonds, currencies and commodities such as oil, which experienced one of its sharpest volatility spikes ever over the past 18 months when prices dropped 75%.  

Crude oil prices dropped by 72% in the year following the 2008 financial crisis, then the largest annual price change for oil since the Iran Revolution in 1979.

What interested Prof. Samuelson about avalanches, he said, was the sudden change from ”normal” conditions to highly abnormal ones in which everything that one knew about prices was suspended in favor of an irrational rush-for-the-exits mind set.

The Economics of Oil Prices

What we know about oil prices now is not much different from what we knew a year ago: Goldman Sachs forecasted an excess of global production over demand in 2015 of about 1.5 million barrels per day, or 1.5%. Though global economic growth was slowing, demand for oil was still increasing modestly, even after taking China’s slowdown into account. So the imbalance has been almost entirely because of supply factors. Saudi Arabia, which needs the cash but also wants to preserve its market share from encroachment by Iran, was the main reason, but US shale producers kept pumping too, apparently to avoid the cost of closing, then reopening their fields.

We also know that many new investments in exploration and oil field improvements have put on hold, which is logical when prices decline and cash is short, but as a result future production levels will decline until these investments are resumed. Thus there is a natural adjustment process built into the system that should stabilize prices over supply-demand cycles.

And, of course, the many economic benefits of lower oil prices should encourage global economic growth and future oil consumption, and therefore increase future demand.

So, how do we explain this year’s major collapse in oil prices, especially given the fact that the drop is not the result of a sudden political or economic shock that drove all the other instances of volatility spikes in oil?

Apparently the laws of economics, which would require some price adjustment but not one of 75%, seem to have been suspended in favor of a Samuleson avalanche.

Speculation

You might think it is because of heightened “speculation” by hedge funds and commodities dealers. Maybe so. A 2014 IMF Working Paper by S. Beidas-Strom and Andrea Pescatori investigated the importance of speculation on oil prices and concluded that that speculation (investments by non-users of the commodity) explained between 3% and 22% of trades, a wide range but perhaps not enough to throw the whole pricing mechanism into disarray over an eighteen-month period.  Speculators operate on both sides of the market, so they actually can contribute to price stability during market upheavals.

No doubt we will soon be reading about the next “Big Short,” in which some obscure oil traders made billions shorting crude oil, or stocks and derivatives tied to it. But, just as in the mortgage-backed securities market rout of eight years ago, for every seller there is a buyer who thinks the fall has gone far enough and wants to profit from a recovery. So far, these buyers (including several well known hedge funds) have lost billions. Many financed their positions on margin, which leveraged their losses or subjected them to forced sell-outs at prices set by lenders as the market deteriorated further.

Even so, since 2010 most large Wall Street banks have ended or reduced their commodities trading activities for regulatory reasons, removing their considerable buying power from the market.  This has reduced the role of speculators in the oil market considerably.

Irrational Behavior

In 1967 Arthur Koestler wrote an insightful book called The Ghost in the Machine that dealt with the idea that human beings still possessed DNA inherited from primitive ancestors, which could force behavior that in modern times might seem irrational or self-destructive.  Koestler worried about this in the context of the nuclear age; we, however, might have to consider whether such a ghost (or maybe instead something very new) could be present in today’s trading machinery.

Of course, irrational behavior is nothing new in financial markets - indeed it’s not so irrational to sell a position because you are convinced others are selling theirs.  But to the extent that such behavior can produce huge unexplained volatility spikes in basic commodities that are sustained for a year or more may be something new.

Leon Cooperman, a hedge fund guru who manages the Omega Funds, has been dealing with irrational markets for more than forty years. On January 15, he said that the turmoil in the stock market was not fully justified by underlying factors. A bit later, though, after the turmoil had further increased, he said there was something going on in the markets that he was uncomfortable with that he could not entirely explain and had made him more cautious. 

What was that something?

In its January 23rd issue, The Economist had a leader entitled “Who’s Afraid of Cheap Oil?”  The article pointed out that rising oil prices were bad, and falling prices were good for economic growth, but this time prices falling so far and so fast might not have been good after all.  That’s because the global economy and political system may be too fragile to adjust to the price changes without immediate negative consequences that outweigh the usual positive ones.

Lower prices, the article says, have already caused a drop in new investment in the global energy industry (including coal and alternative energy sources) of about $500 billion, which will detract from global economic growth, the estimate of which recently was lowered by the World Bank to only 2.9% for 2016.

Lower oil prices are also already having a disinflationary effect on consumer prices, to the frustration of central banks seeking to revive inflation to the 2% area as an incentive for growth.

And, The Economist points out, declining prices severely impact the ability of some energy and related companies to service the considerable debt that has been added over the past few years when prices were much higher. Fears of defaults on risky debt have already pushed Emerging Market and junk bond spreads over Treasury rates to their highest levels since 2012.    

Weak Suppliers and the End of OPEC

But the real ghost in the machine and oil-market game-changer is the desperate need by major producers to keep pumping despite the serious negative effects low prices impose on them. OPEC no longer is able to manage prices by curtailing production. Saudi Arabia needs cash to service its growing external debt (its current budget deficit is 12.7% of GDP), to fund its challenges to Iran in Yemen and Syria, and to keep peace at home.  The Russian Ruble has collapsed along with oil prices; most of its economy, which fell by 3.8% in 2015, depends on oil and gas sales; sanctions still restrict the economy and inflation is around 15%. Venezuela, Libya, and Iraq are on the brink of economic collapse and must sell every barrel they can. Iran, with sanctions removed, wants to make up lost ground.  These troubled countries together account for about 40% of world production. 

The biggest buyers, who benefit the most from cheap oil,  (China, India, Japan, Korea, and – still- the US) have been able to play sellers off against each other in the spot market. 

And they probably still will be able to do so over the next few years as long as the political and economic instability among major producers continues.

China’s Transitions Should Not Freak Us Out

By Roy C. Smith

In December 2014 I wrote a column for eFinancial News noting the 25^th anniversary of the great Tokyo market crash of 1989, after which all traces of Japan’s decade-long standing as an emerging economic superpower disappeared forever. The column compared Japan’s rapid postwar economic development and vulnerabilities with China, which has followed a similar economic strategy and now faces similar difficulties.  At the time no one paid much attention. China’s growing power was indisputable, and indeed, China was then beginning a broad economic effort to offset declining growth rates by stimulating domestic consumption.

The immediate impact of this effort, largely implemented by local and provincial governments and SOEs, was to inflate stock prices by about 200% over a nine-month period. The bubble collapsed last summer, and the government (similar to Japan in 1990) launched a series of heavy-handed efforts to force markets back to normal. These efforts worked for a while, but as soon as they were withdrawn, selling began again. The government’s interventions had in fact made the stock market riskier and more uncertain.

This year, stock markets have got off to one of their worse starts ever, largely because of an outbreak of further selling in China, complicated by “circuit breakers” that close markets after daily declines of 7% or so. (The New York Stock Exchange’s circuit breaks trip at a 20% change).

Western observers have interpreted the Chinese selling (SHCOMP is down 18.0% so far this year, despite considerable government support) to mean that the debt-laden Chinese economy will crash and drag down all the others.  The MSCI Emerging Market index is down 9.6% on the year, and even the S&P500 is down 8.4%

China’s economy does have some serious problems. Its estimated 2016 GDP growth rate is less than 7% -- the lowest since 1993 except for one-year crisis-driven drop to 6% in 2009 -- and many observers who now distrust Chinese economic data discount even this rate.  Conventional wisdom in and about China seems to hold that growth below 7% could generate widespread social unrest that could threaten the Communist Party control of the country.

This being the case, President Xi and his party have a great interest in using their considerable powers and skills to revive the economy.  When Xi came into office he appeared to understand that a major priority had to be to shift economic output from the export to the domestic sector, and for this to happen, market forces would have to play a more important role.

But market forces are hard to control, as the government has just discovered.  The dilemma for China is how much to rely on market forces to make the necessary transition to domestic consumption if these forces have such uncertain outcomes. Even so, China has sufficient market activity now to make a reversion to traditional “command” economics impracticable.  Mr. Xi and his colleagues have a lot at stake in getting this right.

In 1989 Japan was the world’s second largest economy; its market crash took about two years to reach bottom, where it remained for several more years. The early 1990s were stressful times in Western markets, but these markets recovered and were not much interested in what was happening in Japan.

Compared to the size of its economy, Chinese stock markets are small and should have minimal impact on Western markets. Fears of the contraction and of a credit crisis in China will reduce Chinese demand for imports (including oil), and lower its exchange rate, but not otherwise have lasting significant impact on US and EU economic conditions.

But the “three transitions” that China must make over the next decade – to domestic markets, to freer markets, and to improved political rights and opportunities -- will make things better in China over the long run s they have in other formerly authoritarian states like Taiwan and South Korea.  The Chinese transitions might be painful within China, but until they are completed, China’s role as an enduring economic superpower must be questioned. In any case, the transitions  are necessary and should not frighten us.

From eFinancial News Jan 13, 2016