Traderbill’s Financial Markets Weblog

 

The above quote should make Americans hang their heads in collective shame…that it would take a German to proclaim it. Only the neo-cons of America feel that ‘unbridled’ capitalism is the right way and the only way for economic well-being…at what cost to our own people and to other citizens of the world?

 

A little regulation goes a long way towards guiding capitalism in the interests of the people, but a neglect of this responsibility is precisely what has put us and the entire world in the place we are today, and that is on the brink of financial ruin. Some of you will scoff at this and sadly, if so, you are wrong. It has often been said that the US is never more one generation from destruction…or one President when the checks and balances created by the Constitution and the Bill of Rights are trodden on. Perhaps that was the Constitution saying: “Don’t tread on me!”…a warning and a plea for the future of the noble experiment.  

 

TB has been moved by several pieces he has read along with voiced concerns of people like him with decades of investment experience…not voices of fear but voices of reason…fear will come later if we don’t do something first. What appalls TB is that the financial markets have turned into a crapshoot where only the biggest are winners. This is being perpetuated by CNBC with 90% of the stock mavens being trotted out daily always bullish and always using historical averages to support their hypothesis. This economic downturn is anything but average…it is unlike anything seen since 1929 since the economy did not put us in the crisis we are in…the financial markets did while the real economy was doing quite well thank you…by that TB means large business as individuals and small businesses were already beginning to feel it. By focusing on big business and thus the stock market we were and are unable to see the weakness in consumption…see yesterday’s commentary on the inventory/sales ratios of retailing, ex-groceries and thus on retail sales ex food and energy. How we can believe that the housing market implosion will not affect the economy via consumption defies explanation…Allan Sloan in the Fortune article referenced yesterday called it ‘Tinker Bell’ an obvious slam at ‘Goldilocks’…and it is broke. Not only did the housing boom fuel the economy, mortgage equity withdrawals (MEW’s) added more than 2% to economic growth every year over the past three years deluding us into believing things were better than they were concealing any problems (objects in the rear view mirror are larger than they appear). 

 

As TB has written on several occasions, without the growth of credit cards and financial derivatives which allowed for the financial placement of hitherto illiquid instruments …i.e. mortgages…we could not have achieved the growth we experienced, yet thru a total neglect of responsibility, dereliction of duty, even that growth would have been challenged yet we would still likely be on an upward track, albeit from a lower level…but that is good…isn’t it slow steady growth that produces the best results with the least danger? Not if you are on commission or receiving enormous bonuses relative to your added value. Was Exxon Mobil’s Lee Raymond responsible for the growth of earnings and revenues?…certainly not! A toad at the helm could have succeeded similarly given the unprecedented rise in the price of crude. IF Chuck Prince at Citi and Stan O’Neal at Merrill…not to mention guru’s Jimmy Cayne and Alan Schwartz at Bear Stearns…all of whom said they had no idea the risk was so high…when the engine of growth is as singular as it was aren’t you supposed to ask questions?…not just sit back and collect your bonus!

 

In a sister article to the Sloan piece, Shawn Tully, editor at large for Fortune, said ‘bankers’ (in the broad sense) “fell victim to their love of risk, leverage, and high pay.” If a little is good more must be better, and besides the commissions and bonuses are sooooooo nice! Here is the link: http://money.cnn.com/2008/03/31/news/companies/tully_wall_street.fortune/index.htm?section=money_topstories

 

He notes that from 2002 to 2006 the big five (Goldman, Merrill, Morgan Stanley, Lehman and Bear) tripled their earnings to more than $30 billion while achieving at the peak a 22% return on equity…and do remember: they don’t produce anything…not of value or if it was like CDO/CDS it is no longer. Their fees were traditionally fee-based such as M&A advisory, underwriting, and asset management. But from 2000-2006 trading jumped to 54% from 41% of revenues, rising to $70 billion a year for the big five.

 

Tully points out that they depend far too heavily on risk…such as their proprietary trading…which often stems from watching trading patterns of their top clients…there are no secrets on trading desks…what’s the percentage in that? When TB worked for L.F. Rothschild proprietary trading would make or break our year in an almost predictable pattern…yet salaries, let alone bonuses for traders are ridiculous given the level of risk they take. TB recently read where an average CDS trader earned $500,000 a year while a top trader could earn $5 million. But here is the problem: when they have losses, they don’t feel them other than see a decline in income to their base salary…they have already booked the prior profits.

 

As for leverage…nobody…nobody…including LTCM Founder John Merriwether learned from that debacle…unless you think Merriwether’s reincarnation into another hedge fund with 25 times leverage was an improvement on 100 times! In LTCM’s case it was repo on treasury bonds which morphed into all forms of global debt until the Asian and Russian crisis brought them to their knees. Wall Street was taken to the shed over that by William McDonough of the NY Fed who arranged a bailout at no cost to the taxpayers…instead forcing the big five to take the hit (which they ultimately made money on…when you are highly leveraged time is definitely not on your side due to those nagging margin calls). But prime brokerage being as profitable an engine as it was clouded the eyes and brains of Wall Street.

 

This leads us to the third reason cited by Tully: an incredible share of the profits go out the door in the form of commissions, bonuses…from salesmen to traders to the CEO. This has been another recurring theme with TB: the problems over the past two decades derived from investment firms going public. This began before that when Merrill Lynch went public and other firms gradually followed suit. Goldman Sachs was really the last powerhouse partnership, forced to go public by a limited partner, the Bishop Trust who wanted their money back but couldn’t take out any more than the income…as went for the partners…the same as it was for Salomon Brothers before and every other partnership.

 

That is the most important point: in a partnership, the salesforce and traders are paid bonuses not commissions…and since their capital is at risk, partners have a reason to care about hiring the best, not some hotshot who can produce quick returns that eventually cost the firm…and themselves…money!

 

But in a publicly held company you are playing with OPM - other peoples money and unlike a partnership even your own longevity is not guaranteed so make the most of it while you can. Again, at L.F. Rothschild, TB witnessed the transition to a publicly held company…by the way the stock symbol was ‘R’, which has covered several companies before and since…and the accompanying change in risk-taking which eventually bankrupted it or would have had it not been bought up by a savings and loan!

 

It is not just the individuals in a corporation that succumb to fear of losing their jobs and greed, it is the shareholders who no longer care about sustainable earnings but those for the last and next quarter, so don’t hold management totally accountable…they have been aided and abetted by investors.

 

So the first step back to financial health is to only allow a percentage of the bonus to be paid out each year, say 25% with the remainder into a pool which would earn at the firms return on equity…fair? Then, each year it be increased…except that losses would also be netted against gains…withdrawals could then be made on a rolling five year basis. Something also has to be done about other companies to eliminate management from getting obscene bonuses thru things other than the job they are doing…this cuts both ways as they would still receive something if, due to factors other than their own doing…such as the broad economy, not people they have appointed…they too would only receive a fraction of the payment in cash and the remainder in restricted stock.

 

The second step is a much more painful one…because it involves you! Instead of thinking of our own instant gratification we have to think of future generations…that means saving again…and not counting those illusive paper profits on homes and investments. It also involves teaching our children to save, something we haven’t done since the 70’s. Babyboomers are now at risk of being the first generation in history to not leave the next generation better off than they were…as the saying goes…it isn’t as if they are egocentric…they just believe the world revolves around them…a funny but sad commentary.