Heads Up: The Insiders Are Trying To Tell Us Something

Lord knows there are enough reasons to feel morally outraged and politically incensed these days — the “sordid legacy” of the Japanese Internment policy rising up in the Muslim ban decision; the continuation of the moral depravity demonstrated by the Mis-administration’s Immigration policy; the utter stupidity of trade spats and tariff wars with our friends, to name some major causes for immediate concern.  However, there’s one more, esoteric as it is, which hints at some problems yet to come — Jacob Marley’s third visitor waiting in the wings.   It’s called a yield curve.  The New York Times explains:

Terms like “yield curve” can be mind-numbing if you’re not a bond trader, but the mechanics, practical impact and psychology of it are fairly straightforward. Here’s what the fuss is all about.

The yield curve is basically the difference between interest rates on short-term United States government bonds, say, two-year Treasury notes, and long-term government bonds, like 10-year Treasury notes.

Typically, when an economy seems in good health, the rate on the longer-term bonds will be higher than short-term ones. The extra interest is to compensate, in part, for the risk that strong economic growth could set off a broad rise in prices, known as inflation. Lately, though, long-term bond yields have been stubbornly slow to rise — which suggests traders are concerned about long-term growth — even as the economy shows plenty of vitality.

Okay, pretty straight forward so far.  Something has the traders on Wall Street spooked about long term economic growth.  So what?  Well, all those pretty predictions about what the Great Trumpian Tax Giveaway To The Rich and Richer would mean for the overall economy were based on what were already unrealistic expectations for economic growth, and now the traders are edgy about even that?  A stagnant, or worse faltering, economy could easily turn a really bad idea (and we’ve figured that out already) into something close to catastrophic.  But fear not, the Trumpers will castigate the previous administrations for causing a problem the Trumpers created for themselves; whilst the Trumpers announce They Alone Can Fix It…with something worse than the initial problem because there is never a Plan B because they never had a Plan A to begin with.

Thus the New York Times continues:

At the same time, the Federal Reserve has been raising short-term rates, so the yield curve has been “flattening.” In other words, the gap between short-term interest rates and long-term rates is shrinking.

The Times has my attention at this point, and then the old Gray Lady gets me bolt upright.

The gap between two-year and 10-year United States Treasury notes is roughly 0.34 percentage points. It was last at these levels in 2007 when the United States economy was heading into what was arguably the worst recession in almost 80 years.

Ouch.  Before we hit the Panic Button, there’s no way to predict exactly when recessionary pressures take form, and we can’t be certain that the central banks may not take actions which mitigate the recessionary trends associated with previous economic downturns.   However, we can’t ignore a situation in which people put more funds into long term investments which in turn causes more people to put ever more funds into long term investments because they fear a recession, and wishing makes it true.  And, this spiral makes banking a losing proposition — borrow at short; lend at long; hit the golf course by 3 — inversion can, as the Times says “slam the brakes on” the banking sector. Love them or hate them — banks are the circulation system of good old fashioned free market capitalism.

So, we need to keep the economic data in our peripheral vision as we stare into the abyss of corrupt immorality and utter ineptitude so evident in our current mis-administration. We can’t say the traders didn’t try to warn us.

Three Legs and Not One To Stand On

The political philosophy underpinning the remarks of such Representatives in Congress as Heck (R-NV3), Amodei (R-NV2), and Senator Dean Heller (R), is that implementing the Three Legs of the Grand Plan will create Prosperity.  Leg One is to be a reduction in government spending. Leg Two is to be the deregulation of the financial sector.  Leg Three is to be the tort reform.   The stool is shaky as it is, but the implementation of this policy makes a bad situation even worse.

Theoretical Fantasies

The first leg of the stool is based on a fantasy vision of economic practice as it has never existed.  As has been argued repeatedly in this space, you don’t get economic growth as measured in improvements in the Gross Domestic Product if you reduce one of the components of the GDP formula: Government spending.  One of the reasons GOP economic arguments make no sense is simply that you can’t have it both ways — the reduction of government spending reduces in turn the total GDP, therefore contending that government spending is a drag on the overall economy is nonsense.

The only way to prevent this notion from being obviously risible is to couch it in terms which will appeal to those who don’t rattle Christmas packages to see if there’s anything inside.  Thus we get an infinite variation on the same old theme: “The government takes your money, that’s money you can’t spend for what you want.  So, the government is taking money out of the economy.”  Stop and think for a second.

This argument works IF and Only IF the government takes the money, salts it away in a giant mattress and never spends it, draining money away from the consumer economy.  But wait — the government does spend it.   The Defense Contract Audit Agency deals with some $19 billion worth of private contracts, and reviewed over 2,600 forward pricing proposals totaling $103 billion in FY 2011. The Defense Contract Management Agency offers advice on about 334,000 prime contracts performed by 19,600 contractors.  [Comptroller DoD pdf]

Since there was almost never a Defense Department contract inked in any congressional district that wasn’t beloved by the local congressional Representative — there’s a corollary to the government spending argument:  Government money is spent on Stuff We Don’t Like.

At this point the argument moves out of the realm of economics and into the pit of fear-mongering and all too often good old garden variety racism.  “They” are getting all your hard earned money.”  Who’s “They?”   It’s nonsensical to argue that all government spending is a drain on a consumer based economy, so the GOP targets those who are benefited by government services in categories other than Defense.

The old canards are still popular on the hustings: The Welfare Queen — a mythological character long since debunked;   greedy foreign powers to whom we give “foreign aid,” which in reality only takes up only about 1% of the total federal budget; and, in its latest incarnation, The Mooching 47% who supposedly don’t pay taxes and simply mooch off the rest of us.   The obvious point is ignored — these people do pay taxes (especially state and local ones) and they aren’t earning enough money from their low and minimum wage jobs to be liable for federal income taxes.  If we truly wanted to reduce the federal deficit by increasing tax revenues then increasing the minimum wage would be a way to do it.

In sum, when a supposedly economic argument depends on a self-contradicting predicate and self-serving mythologies to support it there is really nothing there.  It’s mostly wind bags blowing into the sails of corporate executives and the rentier class who don’t want to pay taxes.

The De-Regulation Myth

The Welfare Queen isn’t the only bit of ideological  mythology out there which tends to promote the interests of the few over the general benefit of all the others.  What bankers want is reduced risk.  Why not? None of us like to be in seriously risky situations.  The purpose of various kinds of funds and investment products is generally to reduce risk…and then the investment houses can play with their derivative products.  It’s the play time which has become part of the problem.

Boiled right done to the skeletal remains of Casino Capitalism, de-regulation has helped create the manufacturing of financial products which have no function other than to create secondary (and tertiary) markets for palming off risk onto others and thence to bet on the results of various sales.

There’s no small amount of circumlocution involved in justifying these products and practices.  “We’re not doing anything wrong,” whine the investment houses,”We’re operating within the laws, and the revenue from these sales (“markets” ) is now a crucial part of our total revenue.”  Yes, and who helped write the laws creating the de-regulated environment, and implementing the rules for functioning in a de-regulated financial regime?

To illustrate the point:  Imagine a game in which I get to write the rules.  Further imagine a game in which not only do I get to draft the original rules but if at any point it looks like you might win something I get to revise the rules to my advantage?  Now, imagine my dismay when you discover what I’m doing and try to make me play by the original rules?

Returning to the original rules — there is nothing intrinsically wrong with derivative trading, and nothing essentially nefarious about swaps and other financial products — it’s when the system becomes freighted with sales which would be more appropriately assigned to realms like Las Vegas and Atlantic City than to the investment in corporate bonds and similar products that the problems begin.

If there’s slippage in commodities and foreign exchange trading, there’s always something to bet on with interest rates? So it would seem.

“Trading revenue at U.S. banks increased 73 percent last quarter, on a surge in trading of over-the-counter interest rate derivatives, according to a report on Wednesday by the Office of the Comptroller of the Currency.  U.S. commercial banks and savings institutions reported trading revenue of $4.4 billion during the last three months of 2012, up from $2.5 billion in the same period a year earlier.

Interest-rate trading revenue represented 95 percent of total trading revenue, and more than made up for sharp declines in commodities and foreign exchange trading, and a $713 million loss from trading in credit products.” [WSJ]

There are a couple of other points in the Office of the Comptroller of the Currency’s report which deserve more attention:

“Derivatives contracts are concentrated in a small number of institutions.  The largest five banks hold 96 percent of the total notional amount of derivatives, while the largest 25 banks hold nearly 100 percent.

Derivative contracts remain concentrated in interest rate products, which represent 81 percent of total derivative notional values.  Credit default swaps are the dominant product in the credit derivatives market, representing 97 percent of total credit derivatives. “

While some of the Wild West aspects of investment banking seem to be calming down, with better collateral and tighter internal controls, the Big do seem to be getting Bigger — with another 10 major banks dropping out of the derivatives game.

Since the last investment banks collapsed in a heap after the Mortgage Meltdown, and just about everyone now is a “commercial” bank, U.S. taxpayers should be paying far more attention to how banks are accounting for the use of deposits in their derivative games.  Just a friendly little warning.   And, Paul Farrell, of Marketwatch has more on the subject of Wall Street banking, which is well worth the click and read.

Finally, good old fashioned corporate bonds have been attractive to investors because they were seen to be safer than equities, and paid a slightly better yield than Treasuries.  These are the “loans” made to corporation which finance expansion, etc.  Manic Mr. Market might be having a spasm lately?

“New, more granular data compiled by the New York Federal Reserve shows a worrying picture of the corporate-bond holdings of primary dealers—the big securities firms who deal direct with the Fed.

As of May 22, they held net positions of just $13.5 billion of investment-grade bonds maturing in more than one year and $8.3 billion of high-yield bonds—in a market with a value of trillions of dollars. Anecdotal evidence suggests institutional investors have on occasion found dealers unwilling to buy relatively modest amounts of bonds in recent days. That could mean sharper price declines lie ahead. Investment-grade bonds, which offer historically low yields, could be hit hard.”  [WSJ]

Investment grade would be the good stuff, and if investment divisions aren’t buying into corporate financing plans…what will they be buying?

Pain and Peril

From the moaning and groaning emanating from the far right one might think the Federal courts were awash in product liability cases, and the manufacturing sector hamstrung by PL cases.  Not so fast.

First, the numbers shown in the graphic above are only filings — they aren’t the outcomes.  Cases get tossed, get settled, get bogged down… even then the percentage of PL cases in Federal courts hasn’t moved above 23.04% in the last few years.

Secondly, the odds aren’t really all that favorable for tort cases. The Bureau of Justice Statistics reported for the 2002-2003 period in which there were a total of 274,841 civil cases in Federal courts, some 13,000 of which were related to product liability, that “Plaintiffs won in 48% of tort trials terminated  in U.S. district courts in 2002-03. Plaintiffs won  less frequently in medical malpractice (37%) and  product liability (34%)trials.”  Therefore, the odds the plaintiff will win in a product liability case aren’t all that good, plaintiffs who do win will find the judgment appealed, and most appeals are more beneficial to the defendant than to the plaintiff.

Third, consider the kinds of corporations which are most commonly involved in litigation over product liability — pharmaceuticals, medical devices, automobiles and other vehicles, general aviation airplanes and other products…  Generally speaking when something goes wrong with a product to be inserted, injected, or ingested in a human body it goes very very wrong.  Likewise, human beings don’t tend to survive hard crashes and long falls.   Large numbers of cases, such as the number in 2006 may also illustrate a particular problem — in that instance asbestos — or in other instances things like dangerous intrauterine devices.

Far from being an horrendous burden to corporate headquarters, the total filings in federal product liability cases really haven’t  moved all that much in recent years, as the quick graph below illustrates.

What the proponents of so-called tort reform are counting on is the impact of jury awards in a few spectacular cases to grab the public imagination, and from thence try to make the point that “we” are paying for other people’s pain and suffering with higher prices at the register.  It isn’t too far-fetched to conclude that those who are marketing some of the more dangerous products are the ones most interested in “tort reform” for guns (almost impossible to sue these days), pharmaceutical products (also almost impossible if the FDA has approved the drug), and automotive and aviation equipment — you have about a 34% chance of winning your case.

Long Leaps of Faith

Employees and business owners alike should be cautious about accepting the claims from the GOP that their “economic” vision will do much of anything for the average worker or the average business owner.    The Federal Spending Myth demands a person believe in the impossible — more growth while diminishing one component of the GDP formula.  The De-Regulation Myth demands a person conflate the wants of Wall Street with the needs of Main Street.  And, the Great Tort Argument is merely an inflated barrage balloon deflecting further away the odds of a person injured by a defective product having his or her good day in court.

Three legs of the stool and not one holds up to scrutiny.

* Information on the Judicial system and statistics can be found in the Bureau of Justice Statistics reports,  and in reports from the Supreme Court, other tables offer more statistics and compilations.  The format and contents for reports from the Supreme Court changed in 2004, and some statistical data may need to be gleaned from other sources.

If You’re So Rich Why Aren’t You Smart?

The FDIC recently reported that bank profits were at the highest level since 2007 in its latest quarterly profile.  [BizJ] [FDIC link]

“FDIC-insured commercial banks and savings institutions reported $35.3 billion in net income for first quarter 2012. This represents a $6.6 billion (22.9 percent) improvement over first quarter 2011 results, and is the highest quarterly net income reported by the industry since second quarter 2007. The average return on assets (ROA) rose above the 1 percent threshold for only the second time since second quarter 2007 (third quarter 2011 ROA was 1.03 percent). Quarterly net income has now improved year over year for 11 consecutive quarters. More than two-thirds of all institutions (67.5 percent) reported year-over-year improvement in their quarterly earnings, and only 10.3 percent were unprofitable, the lowest level since second quarter 2007.” [FDIC]

The investment banking sector doesn’t seem to be doing too badly either, as the following two charts from the Wall Street Journal would indicate.

There’s even happy news in the mergers and acquisitions for middle-markets:

“The market for Mergers & Acquisitions (M&A) is clearly improving in valuations, financing availability, and deal volume and will continue to do so throughout 2012 according to a survey conducted by MBA students and Professor Kevin J. Mulvaney at Babson College in collaboration with members of The Association for Corporate Growth and Exit Planning Exchange.

Looming clouds on the horizon may include variations in the capital gains rate, estate changes, and uncertainty about economic growth and the effect of world events on the global economy. This is the 4th year of the Babson survey which has delivered “extremely accurate” projections in its previous years said Mulvaney.

Findings That Impact Business Owners
The environment for exit continues to improve. Valuations are rising and are projected to continue to rise. The market to sell a business or restructure capital is very good. Key is getting the company’s revenue growth and EBITDA (earnings before interest, taxes, depreciation, and amortization) to acceptable standards vs. the industry average and the expectations of the buyer.”  [PRNewswire]

Note that one of the things that troubles the people engaging in the M&A trade is how much they might have to pay in capital gains taxes — let’s be clear — you don’t worry about capital gains taxation levels unless you stand to earn beaucoup bucks in investment banking.

So, if the commercial banks are experiencing the best profits since things on Wall Street started to unravel in 2007, and the mergers and acquisitions are doing nicely thank you very much — then why have the Financialists been so far behind the curve?

We’re learning more about the debacle at JPMorganChase, enough to know that their $2 billion and climbing blunder stemmed from a failure to learn some of the lessons of 2007.  One lesson unlearned appears to be that price doesn’t always equate to value, and all the accounting treatments in the world won’t help you if one unit isn’t sharing accurate information with the others.  To wit:

The JPMorgan Chase & Co. (JPM) unit responsible for at least $2 billion in losses on credit derivatives was valuing some of its trades at prices that differed from those of its investment bank, according to people familiar with the matter. [Bloomberg]

Recall, if you will, it was not so long ago the CEO of JPMorganChase, Jamie Dimon, was moaning loudly about the capital requirements under new regulatory regimes.   In September 2011, Dimon “exploded” during an IMF conference about “growth killing capital requirements.”  [BusInsider] This wasn’t Dimon’s first confrontation.  He questioned Federal Reserve Chairman Bernanke about capital requirements in June 2011:

“The substantive issue that seems to be bothering Dimon is capital requirements, and particularly the news that the Fed is leaning toward making large banks, such as JPMorgan, hold a 3 percent capital “surcharge” (a complete misnomer; the requirement for more equity financing relative to debt would be a buffer against losses, and not a tax.)”  [Bloomberg]

Lo and behold — what would have prevented the Balaenoptera musculus* sized losses at JPMorganChase?   Reliance on larger capital reserves against risks.

“Those bets, which led to $2 billion of losses, wouldn’t have been necessary if JPMorgan did what banks once did: rely on bigger capital buffers rather than credit-default swaps to hedge against souring loans. One hundred years ago the equity of U.S. lenders was about 20 percent of total assets, compared with 9 percent now, according to data compiled by the Federal Reserve. For JPMorgan, it was 7 percent last quarter.”  [Bloomberg]

One finance professor summed up the problem: “Only equity capital is the true protection against losses, whether from loans or other risks,” said Admati, who has written about bank capital. “Dimon and other bank CEOs lobby against rules that would force them to reduce leverage. Then they try to hide risks through derivatives that offer more ways to borrow and speculate.” [Bloomberg] (emphasis added)

Quick translation: Dimon and other bankers are lobbying against rules that would require their banks to maintain more capital reserves, and rely less on borrowing.  Instead, they played in the Wall Street Casino hoping to cover potential losses in ways that would generate more revenue.  It didn’t work.   All it took was one London Whale to create a multiple billion dollar mess.

All the king’s Quants and all the king’s computer models couldn’t accurately value the risk JPMorgan was taking and without an accurate account of the risk, and without adequate capital reserves which would have obviated the need for the swaps dealing, the London Whale sank the bank to the tune of at least a tidy $2 billion.  There’s nothing like a little obscurity to enhance the chances of exotic deals blowing up.

“The source of JPMorgan’s problems is an obscure group of indexes that track the performance of corporate bonds. One of the indexes, the Markit CDX NA IG Series 9 maturing in 2017, is essentially a portfolio of credit default swaps – basically contracts that protect against default by a borrower.  This particular index is tied to the credit quality of 121 North American investment-grade bond issuers, including such names as Kraft Foods and Wal-Mart Stores .  JPMorgan used that index, and others, to bet that credit markets would strengthen. Because that position is widely known on Wall Street, many traders are betting the opposite way in the hope of profiting as the bank’s losses increase. The index has been moving against JPMorgan in recent days.”  [Guardian]

Surprise?  If memory serves it was trading in exotic swaps that got several large financial institutions on Wall St. in a bit of trouble in 2008?  And, why were they trading in exotic swaps until their wasn’t a single stand-alone investment bank left on Wall Street?  Because they chose to hedge possible losses with swaps rather than maintaining higher capital reserves.

The merger & acquisition crowd may moan to the moon that such things as increased capital requirements are “growth killing,” BUT what really kills growth are investment banking practices which reward engaging in swaps dealing rather than more conservative practices like keep the piggy bank sufficiently filled to hedge against potential sour deals.   Additionally, if we want another look at what’s really “growth killing” all we need is another Wall Street investment banking fiasco generated by banks that aren’t accurately calculating their risks and aren’t doing such a hot job of hedging them either.

In short, if they’re so rich — why aren’t they smart?

*Blue Whale