The Big Picture - Macro Perspective on the Capital Markets, Economy, Technology, and Digital Media

In this morning’s NYT column — Lehman’s Last Hours — Andrew Ross Sorkin wrote:

“But what is clear is that the politics of the moment played a factor — or at least was discussed among senior and junior staff — in the decision not to lend to Lehman Brothers, perhaps the greatest mistake of the crisis.

While there is no question that our leaders at the time worked around the clock to find a private market solution for Lehman — and I have praised them in this column for staving off another depression in the wake of the panic that followed Lehman’s collapse — its failure should go down in history as a gigantic misstep. (In truth, though, no one has yet to offer up another option for the government.)”

Andrew’s book does a good job in describing what happened; but I am more interested in Why this happened.

Hence, I disagree with his conclusion. I suspect that the bailing out of Bear Stearns was the worst mistake of the crisis.

Why? It allowed banks to forestall raising capital; Almost as bad, it affirmed to bankers that they would be rescued by Uncle Sam from the results of their own follies (assuming they could create a big enough systemic risk). The Bear rescue created a huge moral hazard. It is likely why Fuld turned down Buffett’s capital offer.

But this is merely my view. Was Lehman the biggest error? Fannie/Freddie Nationalization?  Something else in entirely?

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Crowd Query: What do you think was the biggest error of the crisis?

For those of you who have XM Satellite radio, I will be discussing the new proposed spending programs from 5:00 to 6:00 pm today on POTUS with Pete Dominick:

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Dhaval Joshi is clearly in the deflation camp. Bloomberg’s Chart of the Day references his recent RAB Capital sovereign debt commentary as suggesting bond yields are set to “massively collapse.”

Here’s an excerpt:

“Yields on U.S. and U.K. government bonds have room to “decline massively” if history is a guide, according to Dhaval Joshi, chief strategist at RAB Capital Plc.

The CHART OF THE DAY displays the differential between yields on 20-year debt and benchmark interest rates in the two countries, according to data compiled by the Federal Reserve and Bloomberg. Joshi made similar comparisons in a Sept. 3 report.

“Interest rates cannot go up meaningfully for a very long time” in either country, the report said. U.S. Treasury yields have yet to fall far enough relative to the Fed’s target rate for loans between banks to reflect this prospect, he wrote. The same holds true for yields on U.K. gilts by comparison with the Bank of England’s base rate, in his view.”

I  haven’t gone that far — but I suspect the fear trade into bonds will end badly.

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Government-Bond Yield Gap vs Benchmark Interest Rates

click for larger chart

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Previously:
Do US Bonds Resemble Dot Com Stocks? (August 18th, 2010)

Source:
U.S., U.K. Bond Yields Set to ‘Decline Massively’: Chart of Day
David Wilson
Bloomberg, September 7, 2010
http://noir.bloomberg.com/apps/news?pid=newsarchive&sid=aZalCz1.dkfw

Today’s chart porn is a quick look at major world indices since January 2000, via the always excellent D-Short.

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click for ginormous chart

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Hat tip Grant Williams

Amongst the items coming out of the FCIC hearings last week were new docs that revealed exactly how over-reliant LEH was on daily, short term funding to cover their longer terms costs. It was a recipe for disaster, a trailer park in search of a tornado.

Here is the WSJ:

“In looking last week at Lehman’s demise, the Financial Crisis Inquiry Commission produced testimony and documents that suggest the firm’s short-term funding was a serious problem well before its Sept. 15, 2008 crash. The new Lehman material is a brutal reminder of the flightiness of short-term debt. And it begs the question: Why didn’t Dodd-Frank do more to limit banks’ use of things like repo markets, in which banks take out short-term collateralized loans?

It was in the repo market that Lehman experienced stress from early 2008. J.P. Morgan Chase, which plays a central role in the “triparty” repo market, decided to introduce a reform in early 2008 aimed at making the market safer. The firm decided that borrowers would have to start providing collateral that slightly exceeded the intraday amounts it had advanced them. This extra collateral is called margin. When discussing the change, a Lehman executive called it “a problem,” in a February 2008 email contained in FCIC documents.”

There are many other factors that the FinReform did not address — I have a post coming up on that for the anniversary of LEH’s demise.

What has always mattered most to financial firms are base capital amounts and leverage. Plunging headlong into both residential and CRE funding in a mad dash for profits led to firm’s having too little of the former and too much of the latter. That, in the simplest of terms, is why Lehman died. Everything else written about the deceased is merely noise . . .

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Previously:
Grading Financial Regulatory Reform (June 25th, 2010)

Source:
Lessons of Lehman’s Flighty Funding
PETER EAVIS
WSJ, September 7, 2010
http://online.wsj.com/article/SB10001424052748703713504575475532391301148.html

Earlier this month, Jeff Miller posted an interesting discussion about The Fly on the Wall litigation (lower court decision here; coverage of appellate arguments here).

For those of you unfamiliar with The Fly, it is an online service that reproduced a headline feed of Wall Street Research coverage: Upgrades, downgrades, price targets. Several firms (Barclays/Lehman, Merrill, Morgan) sued The Fly, who lost the case after a bench trial (no jury).

This was not a First Amendment case (as it might appear), but instead was about protected work product and copyright infringement. Unauthorized parties — including the iBanks’ own employees — were forwarding research to the Fly, who was excerpting the stock calls.¹

The Fly was ultimately found guilty under the theory of “hot-news misappropriation” and the plaintiffs were granted injunctive relief.

Here’s where things get rather interesting:  When determining the proper scope of injunctive relief, a court may be guided by matters of public policy. Specifically, the court noted that the granting of equitable relief, such as a permanent injunction, “may go much further both to give or to withhold relief in furtherance of the public interest than where only private interests are involved.”

Now, I would argue that this was in fact a dispute between two private parties — The Fly on one hand, and the iBanks on the other. The public interest was not in any way represented here. However, the court inexplicably found a “Public Policy Consideration:”

“It was undisputed at this trial, and explicitly conceded by Fly, that the production of equity research in general, and its production by the plaintiff Firms specifically, is a valuable social good.”

This was a terrible error by the Judge. Wall Street Research does not meet the qualifications of “Valuable Social Good.”

In my opinion, this was an error on the part of legal counsel for the Fly to concede as much. There is no evidence whatsoever that equity research by the firms involved offer any such public good. Indeed, anyone familiar with Wall Street history can demonstrate that over time, the inherent conflicts have cost the public 100s of billions of dollars. It can also be demonstrated that Wall Street research exists to serve the needs of the firm’s syndicate and IPO business, not the public.

Wall Street research is guilty of groupthink, is congenitally too optimistic (by 100% according to McKinsey) — except at bottoms, when it is too pessimistic. Often times, it is a contrary indicator. If we include the fraud of the 1990s and 2000s, Wall Street research has worked as a mechanism for extracting wealth from the public. The nicest thing I can say about Wall Street research is it constitutes a nuisance (perhaps an Attractive Nuisance) at best, and at its worst is a menace to the public.

Let’s look more closely at what the judge found in her decision about Wall Street research:

“Such research plays a vital role in modern capital markets by helping to disclose information material to the market, to price stocks more fairly and, as a result, to produce a more efficient allocation of capital.”

Equity prices are driven over time by a variety of factors: Earnings, Discounted cash flow, dividends, etc. These are facts that comes directly from the comp0anies to the public via SEC filings. They do not come from Wall Street research.

The judge is not simply wrong — she is thoughtlessly repeating a Wall Street myth about equity pricing without any evidence. Companies themselves disclose information to the public about their revenues, sales costs, profitability and earnings. What The Street’s  research generates are opinions — sometimes right, often wrong, rarely in doubt.

This myth, not coincidentally, is promulgated by iBanks as a way to help sell their products and generate commissions. Study after study shows that the more an investor trades, the worse their performance is. Pray tell, how is generating more trading activity a “public good” if it hurts investor returns?

Some hedge funds and other active traders may find these calls valuable, as they swing in and out of equities. But is that a public good? I doubt it — and the judge, despite a lack of any evidence whatsoever, appeared to merely assume so.

Indeed, according to Graham and Dodd, the factors that matter the most to the valuation of any equity are not the opinions issued from Wall Street, but are the specific factors that describe the companies actual performance over time. And as laws (such as Sarbanes-Oxeley) require, that data comes from the companies themselves — and are not subject tot hew opinions of Wall Street.

In other words, the Judge based part of her remedy on a faulty understanding of equity pricing models:

“Although the gains from immediate trading and rapid stock movement based on knowledge of Recommendations may be realized initially only by sophisticated investors, all market participants benefit from a market operating to align prices with underlying value as quickly as possible. Indeed, three decades of jurisprudence in federal securities law have built upon the understanding that investors may rely in bringing a securities fraud lawsuit on the integrity of the market price of a stock to create a presumption of transaction causation.” (emphasis added)

The judge cites “three decades of jurisprudence” that is loosely based on the Efficient Market Hypothesis — a mostly discredited view of how markets operate, whose value was eviscerated by the financial crisis.

Conclusion:  I have no opinion on whether The Fly should have won its case or not. But the remedy fashioned was based on a market urban legend that has no basis in fact. Wall Street myths have worked their way onto American legal jurisprudence. It would be helpful if attorneys could understand these myths, and at the very least challenged them in open court.

Until then, Judges are issuing orders that have no basis in reality. This does not serve investors or a “social good” in any appreciable way.

And on the possibility that future cases are against not obscure investing websites, but Google News, Yahoo Finance, or even Bloomberg, this decision could have lasting importance.

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Sources:
Lawyer: Finance firms’ suit not free-speech attack
LARRY NEUMEISTER
AP Aug 6, 2010  
http://bit.ly/cPYnq0

Website’s instant posts of Wall Street research banned
Jonathan Stempel and Grant McCool
Reuters, March 18, 2010
http://www.reuters.com/article/idUSTRE62H4NJ20100319

Barclays v. TheFlyOnTheWall.com: Hot News Doctrine Alive and Kicking; Will News Aggregators Be Next?
Sam Bayard
Citizen Media Law Project, March 23rd, 2010
http://www.citmedialaw.org/blog/2010/barclays-v-theflyonthewallcom-hot-news-doctrine-alive-and-kicking-will-news-aggregators-be

Barclays Capital Inc. v. Theflyonthewall.com, Inc. (06 Civ. 4908).

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1. The Fly did not help its case by suing a competitor for essentially the same claims the iBanks made against it.

Further, the Wall Street firms’ research had inscriptions such as “This material may not be reproduced, forwarded, excerpted, etc, without prior wrritten permission.”

The Fly’s own website had a similar disclaimer: “The material presented on this Web Site is the property of Theflyonthewall.com, Inc. and is protected by copyright. None of it may be reproduced, broadcast or resold without our permission.”

Thus, the judge appears to have found the Fly’s copyright position both novel and hypocritical.

This is from April 2009, but in light of recent data points, I thought it was worth revisiting:

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Source: Jess Bachman via Mint

Marshall Auerback is a Denver, Colorado-based global portfolio strategist for RAB Capital.

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If the US government had a dollar every time someone proclaimed to learn the lessons of the Great Depression, we probably wouldn’t have a budget deficit. Usually, these debates turn on the question of fiscal policy and whether in fact, FDR’s New Deal had a discernable role in generating recovery. “Fiscal austerians” have done much to dismiss the economic achievements of the New Deal, some even suggesting that FDR’s fiscal policies worsened the crisis.

For a brief period during 2008, the views of neo-liberals like Alan Greenspan and Robert Rubin were shunted aside. But the FDR revisionists, who disapprove of fiscal policy measures of any kind, have come back. Now they’re brandishing the old arguments that “excessive” government spending risks “crowding out” private spending, making it impossible for the US government to deal with the recession (because it has run out of money) and hindering the capacity of the private sector to recover because of too much government interference in the “free market”. These complaints are usually accompanied by a wave of rhetoric condemning the “business un-friendly” policies of the current Administration, along with dire warnings of a “national solvency” crisis. After all, fiscal austerians are nothing, if not fully predictable.

Was the 1937 Relapse Caused by Increased Taxes and Unions?

In that context, we have to give some credit to Professors Thomas Cooley and Lee Ohanian, who have taken a more novel approach in their critique of the New Deal. In some respects, they actually validate the case for fiscal policy expansion (although the two authors might not see it that way). Cooley and Ohanian argue that:

The economy did not tank in 1937 because government spending declined. Increases in tax rates, particularly capital income tax rates, and the expansion of unions, were most likely responsible. Unfortunately, these same factors pose a similar threat today.

The OMB numbers suggest that spending actually DID decline in 1937 and 1938 (see here) and, contrary to the assertions of Cooley and Ohanian, that decline had a very deleterious impact on economic activity and employment. I will address the tax issue presently, but let’s first deal with the “excessive unionization” canard. An objective observer looking at the US in the 21st century would hardly conclude that unions have any real power in the American economy today, any more that we have a “socialist” government dedicated to the promotion of a vast left wing agenda which enhanced union power. Obama has not addressed Labor Law reform and wages haven’t risen in a generation; in fact, last year they fell.

True, the President occasionally does display a social democratic rhetoric, but so far, redistributive policies have primarily benefited financial institutions. Social security benefits are under threat via a new “bipartisan commission” on long term deficits, public health care insurance proposals were eviscerated in the “health care reform” bill, and trade unions outside the public sector have withered over the past 30 years. Cost of living adjustment clauses have largely disappeared since the early ’80s (although some government benefits like social security retain them), average hourly earnings are virtually flat, and I would not be surprised to see wage deflation before the unemployment rate peaks this time around. US households are paying down debt on a net basis — even credit card debt — and creditors remain reluctant to make new loans. So the odds of a wage/price spiral taking root as a consequence of excessive union power look decidedly low – in fact, close to zero.

On the other question of taxes, I actually have some degree of sympathy with the arguments of Cooley and Ohanian, but largely because functionally, a tax increase works as a countercyclical policy which mitigates the impact of fiscal policy expansion.

Let’s go back to basics. Under a fiat currency regime, such as we have in the US, when the Federal government spends, it electronically credits banks accounts. Taxation works exactly in reverse. Private bank accounts are debited (and private reserves fall) and the government accounts are credited and their reserves rise. All this is accomplished by accounting entries only, but the main point is that spending creates new net financial assets and taxation drains them.

Read the rest of this entry »

I have been arguing for the government to step away from propping up the housing market for several years now.

It seems that economists are finally catching up with the idea. Today’s NYT has an article, titled Housing Woes Bring New Cry: Let Market Fall. Only I would argue its not new at all, and some os have been saying this for (literally) years.

Excerpt:

“Over the last 18 months, the administration has rolled out just about every program it could think of to prop up the ailing housing market, using tax credits, mortgage modification programs, low interest rates, government-backed loans and other assistance intended to keep values up and delinquent borrowers out of foreclosure. The goal was to stabilize the market until a resurgent economy created new households that demanded places to live.

As the economy again sputters and potential buyers flee — July housing sales sank 26 percent from July 2009 — there is a growing sense of exhaustion with government intervention. Some economists and analysts are now urging a dose of shock therapy that would greatly shift the benefits to future homeowners: Let the housing market crash.

When prices are lower, these experts argue, buyers will pour in, creating the elusive stability the government has spent billions upon billions trying to achieve.”

Its not a crash that is needed — it is merely allowing prices to revert to their historic levels.

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Source:
Housing Woes Bring New Cry: Let Market Fall
DAVID STREITFELD
NYT, September 5, 2010
http://www.nytimes.com/2010/09/06/business/economy/06housing.html

Previously:
Housing Bottoming ? (No) (December 29th, 2006)

Real Estate and the Post-Crash Economy (December 29, 2006) requires free reg.

Propping Up Home Prices, Stopping Foreclosures (November 3rd, 2008)

More Foreclosures, Please . . . (March 25th, 2010)

Why Barron’s Housing Cover Is So Terribly Wrong (July 12th, 2008)

Homes: Still Too Pricey to Stabilize (February 18th, 2009)

No Housing Recovery Before Further Price Declines (February 21st, 2009)

Intelligent Loan Mods & Foreclosure Abatement (February 18th, 2009)

$15,000 Home Buyers Credit Costs $292,000/home (October 22nd, 2009)

Stopping Counter-Productive Mortgage Mods and Foreclosure Abatements (January 5th, 2010)

A Closer Look at the Second Leg Down in Housing (June 24th, 2010)

The $4 Trillion Dollar Question (July 15th, 2010)

Via Ron Griess of The Chart Store, here is a handy assembly of the past month’s changes, including 3 month, YTD and 1 thru 10 year performances.

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click for bigger graphic
(“Command/Control” and “+” will enlarge further)