Nachhaltigkeit in der Finanzindustrie

February 26th, 2013 — 4:48am

­­­­­Die Schweiz stimmt am Sonntag, 3. März über die sogenannte Abzockerinitiative ab, die Rahmenbedingungen schaffen soll welche der Selbstbedienung von Managern Einhalt gebietet. Trotz einer populistisch anmutenden Bezeichnung findet man die einzelnen aufgeführten Punkte in jeder Aufstellung von nachhaltigen Rahmenbedingungen wieder. Die Wahl zwischen Initiative und Gegenvorschlag fällt allerdings nicht leicht. Nach einigen Diskussionen hab ich mich für die Initiative entschieden. Entscheidend ist, dass diese stärker als der Gegenvorschlag den Rechten und auch Pflichten von Aktionären Vorschub leistet. Die Wiederbelebung des Aktionärsgedankens ist meines Erachtens eine der wichtigsten Massnahmen in der Herstellung von gesunden Strukturen in unserer Finanzindustrie und der nachhaltigen Überwindung der globalen Finanzkrise.

Nachfolgend ein Blogpost vom August 2012 (aus dem Englischen übersetzt) welcher die Problematik darzustellen versucht.

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Nachhaltiges Investieren verlangt nach nachhaltigen Strukturen in der Finanzindustrie

Stephan Olajide Hüsler, 29. August 2012

. . .

Nachhaltiges Investieren ist populär, allerdings nicht so sehr in Finanzkreisen. Wieso ist dem so?

Ein erster Blick deutet auf erhebliche Schwierigkeiten einen gemeinsamen Nenner zu finden, was denn Nachhaltigkeit eigentlich bedeutet. Nachhaltigkeit wird nämlich unterschiedlich gesehen und gelebt.

Einige fokussieren auf die Umwelt, andere auf Soziales, wieder andere auf Führung und Überwachung (Governance) oder alle drei oder einzelne Unternieschen. Trotz grosser Popularität (und auch Wichtigkeit) der umwelt- oder sozialbezogenen Produkte sind deren direkte Märkte im Kontext des globalen Kapitalmarktes verschwindend klein, schätzungsweise kleiner als 1/10 eines Prozentes des investierten Kapitals. Der grosse „Elefant im Raum” ist die Governance, welche sich aber als Spielball von Machtinteressen vernünftigen Lösungsvorschlägen starrköpfig widersetzt.

Nachhaltiges Investieren,  Versuch einer Definition

Nachhaltig ist eine Investitionsstrategie dann wenn sie langfristig wirksame Faktoren wie die Sorge zur Umwelt, soziale Kriterien sowie Aspekte der Unternehmensführung und Überwachung in die Entscheidungsfindung einbezieht.

Während der vergangenen Jahre hat eine kleine aber stark wachsende Gruppe von Leuten aus öffentlichen Körperschaften, Investorenkreisen und Unternehmern mit grossem Eifer und guten Vorsätzen vereinigt, Wissen und Daten gesammelt und so eine kleine Industrie geschaffen. Die UNO hat 2006 die Prinzipien für Nachhaltiges Investieren geschaffen (UNPRI, UN Principles for Responsible Investment) welche heute von einer satten Mehrheit der kotierten Unternehmen unterzeichnet worden ist und von den bestgeführten meist auch ernst genommen wird.

Trotzdem hat sich der Nachhaltigkeitsgedanke noch nicht von seinem Mauerblümchendasein lösen können.

Ein sehr gewichtiger Grund ist die Tatsache, dass unsere Pensionskassen nicht auf den Zug aufgesprungen sind. Diese führen (zu Recht) an, dass nachhaltige Aktienfonds schlecht rentieren. Es sei für sie unverantworlich in diese sogenannt verantwortlichen Fonds zu investieren.

Nun drängt sich aber die Frage auf wieso die allermeisten dieser Fonds tatsächlich ertragsmässig schlecht abschneiden. Schliesslich ist es trotz grosser Mess-schwierigkeiten zunehmend klar, dass nachhaltiges Verhalten von Unternehmen signifikant wertsteigernd ist, auch im Sinne von Aktienpreisperformance.

Distanz zum Investitionsobjekt

Der eigentliche Grund liegt nicht an der Nachhaltigkeit selbst sondern in der Art und Weise wie heute Portfoliomanagement betrieben wird. Verpönt sind heute nämlich nicht nur die nachhaltigen Fonds, sondern Aktienfonds schlechthin. Aktieninvestitionen werden heute zu einem grossen Teil mit ETF (Exchange Traded Funds) getätigt. Diese sind nicht nur weit billiger, sondern auch liquider und risikoärmer, während aktive verwaltete Aktienfonds als teure Nachbildung von Indices betrachtet werden. Wie kam es dazu?

Vor nicht allzu langer Zeit war es so, dass Aktieninvestoren kleine, unternehmerische, partnerschaftlich organisierte Unternehmen waren. Als aber das Kommerzbankengeschäft ausgewachsen war expandierten die grossen Banken und Kreditinstitute ins sogenannte Asset Management vor und veränderten dieses zu deren Zweckerfüllung: industrialisiert und distributionsgetrieben.

Instrumental wurde die sogenannte Moderne Portfoliotheorie, welche unter der Annahme dass Märkte generell effizient seien einen mathematischen und deterministischen Investitionsansatz bereitstellte. Fortan wurden Investitionen nicht mehr ausgewählt, sondern portfolios maschinell optimiert. Die Einschätzung, das Urteil über die zukünftige Entwicklung eines Unternehmens wurde ersetzt mit einer Korrellationsanalyse von dessen Marktpreisvergangenheit. Der Mensch wurde von der Maschine ersetzt. Eine an sich unternehmerische Industrie wird heute grösstenteils im Angestelltenverhältnis geführt.

Die Maschine wird Aktionär

Das Ergebnis sehen wir heute in aller Deutlichkeit. Extreme Diversifikation (portfolios mit hunderten, oft tausenden von Aktien), Aktionäre welche kaum einen ihrer Unternehmensleiter oder Verwaltungsräte persönlich kennen, kurzfristiges Denken und Handeln, sowie ein Risikomanagement welches sich kaum mehr mit realen Risiken auseinandersetzt.

Ein Aktienspezialist ist heute kein Risikoträger mehr, er ist ein Finanzingenieur. Die Verkaufstrommel  wirbt mit „hochentwickelten“, modernen Modellen optimale Ertrag/Risiko Ergebnisse zu erwirtschaften. Die Realität sieht jedoch anders aus. Aktienfonds unterscheiden sich kaum voneinander oder deren Benchmark, abzüglich Gebühren und Kosten. Optimal daran ist nur die Mathematik eines allerdings weltfremden Modells.

Investieren wird unprofitabel

Während der Aktienhausse war das Fehlen von relativer Performance kaum aufgefallen, wurden doch stetig positive absolute Erträge ausgewiesen. Der stetige Druck auf die Fees und die Profitabilität wurde durch stetig wachsende Kundengelder und steigende Märkte mehr als aufgehoben. Das Hoch vom Jahre 2000 steht aber nun in den Hauptmärkten seit 12 Jahren. Mit dem Ende der Kreditinflation ist auch die Profitabilität eingebrochen und vor allem mittlere und kleinere Firmen bekunden sehr grosse Mühe. Auf der Kostenseite drücken die Regulatoren, welche mehr durch Aktivität denn Logik getrieben scheinen.  Auch verfügen sie nicht über die Marketingmachinerie der grossen Finanzkonzerne welche auch vermehrt die bevorzugten Partner unserer Pensionskassen darstellen. Pensionskassenmanger und ihre Berater sehen in diesen vom Staat garantierten „too big to fail“ Firmen oft zurecht weniger Risiko. Mit dem Resultat, dass 5 Jahre nach der Krise die Konzentration in der global Finanzindustrie noch grösser geworden ist.

Investitionssozialismus

Tatsächlich scheint es so, dass die grossen Finanzinstitute sehr gut verstanden haben ihre Positionen zu stärken, ihr Risiko zu minimieren und ihren Profit zu maximieren. Ganz abgesehen von der Staatsgarantie bietet die Industrialisierung des Asset Managements sehr viele Vorteile. Das intellektuelle Eigentum wird vom einzelnen Manager auf die Unternehmung übertragen, Manager sind dadurch leicht ersetzbar. Der Investitionsprozess ist einheitlich, schabloniert und skalierbar. Der “Erfolg” eines Produktes ist berechenbar und stetig.

Dem Kunden wird erzählt dass relative Performance nicht möglich und nicht notwendig ist. Viel wichtiger ist eine optimale Risiko/Ertragsstruktur, wobei den wenigsten klar ist was sie eigentlich damit meinen und wessen Risiko und Ertrag wirklich optimiert wird: derjenige des Kunden oder des Finanzunternehmens.

Geld wird heute nicht mehr investiert, nicht alloziert, es wird verteilt. Es lebe der Investitionssozialismus!

Im 2007 hatte der Chef einer der grössten Pensionskassen Europas die Vision und den Mut vorzuschlagen die über 4000 Positionen umfassende Aktienallokation seiner Kasse auf 400 zu reduzieren. Nach dreijährigen „Diskussionen“ wurde er entlassen. Das Team welches mit beachtlichem Erfolg ein Aktienportfolio verwaltete welches auf einem langfristigem und selektivem Investitionsprozess nachhaltiges Investieren pflegte und sehr gute Ergebnisse erzielte musste wenig später auch über die Klinge springen.

Die Finanzlobby will uns glauben machen, dass sie mit höchstentwickelten Risikomodellen alles im Griff habe. Tatsache ist, dass unsere Banken und Pensionskassen sehr grossen Fundamentalrisiken ausgesetzt sind.

Den meisten Leuten in der Finanzindustrie ist die Problematik wohlbekannt. Das System hat aber übernommen, übt globale Macht aus und ist schlicht zu gross für den Einzelnen, einzelne Unternehmungen oder sogar die Bemühungen eines einzelnen Landes.

Mutige erste Schritte alte Tugenden zu beleben

Unter diesem Aspekt verlangt die Strategieänderung der UBS, so bescheiden sie sein mag,  einigen Respekt. Die Abzockerinitiative über welche in der Schweiz am 3. März abgestimmt wird ist international wegweisend. Ihr Hauptziel, den Aktionären mehr Recht und mehr Verantwortung zu Übertragen trifft ins Schwarze. Die Angst vor Isolierung ist fehl am Platz. Der Schweizer fühlt sich nicht sehr wohl als Vorreiter obwohl er es ist. Während in vielen führenden Nationen Machtinteressen vernünftige Lösungen blockieren bestimmt in der Schweiz noch vornehmlich das Volk.

John Kay, Professor an der London School of Economics schrieb in seinem Papier über den Englishen Aktienmarkt “Aktienmärkte sind von einer Aufsplittung von Prinzipal und Agent betroffen in welchem langfristige Investoren, Eigentümer fehlen“. Er umschreibt das Wort Eigentümer, welches er nicht gebrauchen möchte, da, wie er sagt, das Konzept vom Eigentümer dem Markt heute nicht mehr verständlich sei.

Eigentümer, Aktionäre mit einem langfristigen Horizont ist aber was wir brauchen. Kurzfristiges herumschichten von Positionen ist nicht Investieren und schon gar nicht nachhaltig, auch nicht unter Einbezug von mathematischen Modellen.

Investieren ist für Eigentümer welche Verantwortung übernehmen für die Investitionen welche sie tätigen, für die Entscheidung welche sie treffen.

Was ist der Weg dahin? Die schweizerische Abzockerinitiative ist sicher ein guter erster Schritt.

Hoffentlich sind aber die weiter notwendigen Schritte nicht auf einen suboptimalen politischen Prozess angewiesen. Können wir darauf hoffen, dass die Finanzindustrie selbst erkennt welch grosse Chance sich ihr präsentiert? Nicht nur ihr stark angeschlagenes Image aufzupolieren sondern auch ihre angeschlagene Profitabilität wieder zu gesunden.

Langfristige, selektive Investitionsprozesse sind nichts Neues und werden heutzutage immer noch gelebt und erfolgreich betrieben. Diese wieder zu einem wesentlich Bestandteil unserer Finanzindustrie zu beleben wird zwar Zeit aber kaum viel Kapital kosten. Das grösste Risiko ist es nicht zu tun.

 

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Eurozone Policy, All Talk

October 22nd, 2012 — 9:15pm

The leaders of Europe continue to dodge tough decisions apparently clinging on to the rapidly thinning hope that flooding financial markets with ever more liquidity will eventually have some real effect.

Jim Walker is watching closely.

 

By Dr. Jim Walker

Signs of stabilization in Europe? … the flash manufacturing ISM is still in contractionary territory (and barely two points above its July nadir)… other measures of producer confidence are still very weak, loan growth to households and businesses remains below zero on a YoY basis and measures of final demand like retail sales and new orders for capital goods remain flat at best (see attached chart). Adding to the apparent mystery is the fact that the trade balance, which had improved all the way to the highs of a decade ago, has begun to stall out. …. nearly all of the trade improvement developed as imports slowed down faster than exports, following the decline in eurozone domestic demand growth. Obviously, a trade surplus that emerges from an import collapse is not likely to be associated with stronger real GDP growth – rather, that would take a trade surplus fuelled by an export resurgence.

We have been watching for signs of sufficient cost cutting and product innovation (or in lieu of either of these real improvements, an artificial boost from a major euro depreciation, which has also yet to transpire) in the eurozone, but in all honesty, while progress is being made, this is a multi-year project at best and one bound to run into political resistance time and again along the way.

What precisely has the eurozone done to solve the problems in Spain (forgetting the disaster which is brewing in France as a result of the nutty policies of its current Prime Minister – banning homework because it favours the middle class and rich is his latest nonsensical gimmick) since Mario Draghi beat his chest and said’ I can do it’? The answer is a big fat zero.

The latest summit meeting of eurozone politicians last week rumbled around delaying any action on Spanish banks, committed no funds to anything and studiously ignored the fact that the fiscal deficit in Spain is running 14% higher in 2012 than it did in 2011. So much for ‘austerity’ being the cause of Spain’s growth problems and so much for serious action on forcing countries to adhere to Maastricht 2. In short, markets have been duped.

Every time European politicians, including the central bank chairman, open their mouths, investors rally the markets. Every time markets rally, European politicians back away from concrete action. It has to be said, it is investors that are the dumb ones in this game. Politicians, by their very nature, will not do anything concrete or politically painful until they are forced into action. Give them an inch and they will take a mile. European stock markets are at elevated levels given the growth prospects that lie ahead for the next few years for the region. They are all sells. The euro’s resilience, far from being a mark of strength in the eurozone, is a nail in its coffin. The eurozone desperately needs parity with the dollar if not below to enable a beggar-thy-neighbour external policy to take effect and ease the pain of adjustment. Otherwise countries like Greece, Spain, Portugal, Italy and Ireland will be a decade in depression. Meanwhile, the deflationary path chosen by Europe’s elite in order to effect a competitiveness adjustment continues to destroy the poor in the peripheral countries. Socially, and ultimately politically, European politicians are walking a very dangerous tightrope. They may think themselves clever so far – and to have ‘got one over’ on the markets – but we fear they are about to learn some nasty lessons. Short the euro, buy puts on European equities and peripheral bonds

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Pushing on a String

October 7th, 2012 — 4:09am

Global economic attention has been on the European crisis for some time now.  The summer of 2012 has been intense and has culminated with European Central Bank chief Draghi announcing that the ECB will do “whatever it takes” to keep the monetary system alive.

Despite the less than ideal institutional conditions of European state only part way into its creation without fiscal authority this promise matches the US American strategy of unlimited provision of liquidity as the main, essentially only strategy to deleverage the economy.

Although, as expected, markets “uttered” a big sigh of relief, many of us are lost for words at the insanity of our political leadership who is shamelessly spineless in making the tough decisions to reverse years of foolish and politically motivated bad decision making. Where this ends is all too clear. We could just consult the history books that tell us a wholly one-sided and conclusive story.  Or, we could simply observe what 5 years of QE has done for the US.

Chris Woods, a well respected strategist with CLSA writes “the view here remains that Bernanke’s manipulations will not work in any fundamental sense”.  To many of us the failure of his policies have been a foregone conclusion as documented extensively in my book “Eye of the Storm” back in 2008. Now, 5 years into the crisis the situation on the ground is worse than ever, not just in Europe but in the US and the choices of policymakers are narrowing.

A recent article in the WSJ by George P. Shultz, Michael J. Boskin, John F. Cogan, Allan H. Meltzer and John B. Taylor starts with “The next Treasury secretary will confront problems so daunting that even Alexander Hamilton would have trouble preserving the full faith and credit of the United States.  “

In his recent letter “What if the FED has it all wrong” Denis Quellet, an asset manager out of Toronto makes a good case that the various QE’s may not even be responsible for pushing up the stock market and shows the detrimental effects that work against Bernanke’s goal to jump start the economy and to raise employment.

Mr. Quellet rightly states that stocks went up as company earnings increased. However, not because revenues went up, a per Bernanke strategy, but because “margins expanded on the back of cost cutting (mostly labour) and increased productivity.  Today corporate profits are at their highest level relative to GDP since 1950 and labour takes home its lowest share in 50 years. “

Certainly, media and pundits point to an unemployment rate on a down-trend but that is really beside the point when employment is at levels it was 10  years ago and people are exiting the workforce as conditions deteriorate.

 

Even today Dennis writes “Employment growth remains below 1.5% YoY, a rate insufficient to reduce unemployment. Nominal wages are growing 1.2% while inflation is 1.7% and threatens to accelerate, in large part due to the impact that the Fed’s actions are having on commodity prices, particularly oil prices.”

“Unlike the relationship with equity prices, it is difficult to find anything other than excess financial liquidity to explain the spectacular rise in commodity prices. Considering how world economies have been doing lately, why is it that commodity prices have not declined significantly? “

How does Mr. Bernanke hope to create jobs with the waning income of most americans? Supposedly by pushing up asset prices and creating a so-called wealth effect to induce american people to start spending again.  It sounds like one of those hairbrained story lines from a third rate movie. And Dennis Quellet shows us just how hairbrained.

“The problem with Bernanke’s wealth effect thesis lies with the new reality in America. Income and assets have lately been so significantly redistributed that only a tiny few actually feel a wealth effect from rising equity prices. Here are some sad facts:

  • Last year, the top 20% of households took in 51.1% of all income in 2011, up from 50.2% in 2010 and the highest share since at least 1967, according to the Census Bureau.
  • After the top, each quintile of income earners saw their share of income decrease, with the biggest drop among middle-income earners.
  • The middle fifth of households took in 14.3% of all income last year. (WSJ)
  • In 2007, the top 20% of income earners had 53% of their financial holdings in stocks (directly and indirectly), down from 59% in 2001.
  • Middle-income earners had 38% of their financial assets in stocks in 2007, down spectacularly from 47% in 2001.  Stock holdings have obviously declined since 2007.
  • US house values remain 30% below their 2006 peak level and now match their 2003 level.
  • Total residential mortgage debt has only declined 7.5% since 2008.
  • Some 1.5 million homes are in foreclosure, but 10.8 million homes remain in negative equity.

The “wealthy few” may feel wealthier if stocks advance, but they could nevertheless have much less after-tax income to spend when politicians finally address the looming fiscal cliff nestled within the rapidly growing mountain of debt.

Keep in mind that it is these wealthy people who run American corporations, keeping them lean and mean and flush with cash. They remember how profits literally disappeared in 18 months in 2007-08. They remember how financial markets totally froze in 2008. They see the humongous budget deficits and the debt piling on, and the not-so-distant day of reckoning. They realize that all the QE’s in the world can’t offset inept and irresponsible politicians on either side of the Atlantic. Yet, they are the ones targeted by the so-called wealth effect!”

Call that pushing on a golden string.

Meanwhile, the less affluent, the other 80% – some 250 million people – are little concerned by an eventual wealth effect but highly, directly, and immediately  impacted by the side effects of all these QEs, namely rising commodity prices and near-zero interest rates. Consider that:

  • 15% of the US population lives in poverty. 
  •  44% of those 46.2 million poor Americans are in “deep poverty,” which is half the level of the poverty line, defined as $22,811 for a family of four. 
  • More than 45 million Americans are in the food-stamps program, which is 15% of the population, compared with the 7.9% participation from 1970-2000.
  • Food-stamps enrollment has been rising at a rate of 400,000 per month over the past four years.
  • Just last month (August), nearly twice as many people went on the food-stamps program (173,000) than managed to find a new job (96,000). 
  • More than 11 million Americans are collecting federal disability checks. 
  • 11.2% of the labor force is out of work, if we include the 7 million people no longer seeking employment.
  • This number (over 17 million workers) is unchanged since 2009.
  • Full-time employment remains 1.4 million below its 2009 level. Needless to say, part-timers earn and spend considerably less.
  • Most of the 43.5 million American retirees must cope with nominal interest rates, near zero through 2015, when inflation is around 2.0%.

Call that pushing on a chafed string.

If the Fed has it all wrong, simply pushing on golden or chafed strings, and the only effect of QE3 is to boost inflation, only God(ot) knows what will happen”.

Although, the voices of criticism have started to grow in numbers, in the halls of our decision makers they continue to be thinly spread. Richard Fisher, President of the Dallas Fed remains as lonely a voice in the FOMC as Jens Weidman, the chief of the German Bundesbank is in the ECB.

So what is the bottom line here? Bottomline, our politicians are trying to solve their problem – how to reduce the mountain of debt? – by devaluing the currencies this debt is issued in hoping to kick-start economic growth before causing hyper-inflation and the destruction of their financial system. Some say they are experimenting with unproven and untested theories. I believe that is not accurate, the theories they operate have been proven wrong time and again and they are specifically going against the interests and the well-being of the majority of people of Europe and the US.

Whether we call it political grid-lock or lack of political will or the forces of self-preservation of existing structures the bottom line is that what our politicians are doing is as stark a manifestation of how broken some of our political systems are as any.  Most of us are still happy to live in a democracy. However, in a functioning democracy the system is supposed to work for the majority of people.

Markets continue to react positively to policy action, for now. But consider that more and stronger actions have resulted in rapidly diminishing results. Also consider how short-term focused markets have become. In the real world we are not mainly concerned with the next quarter, we cant just sell out when things turn ugly.

 

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Responsible Investment

August 29th, 2012 — 12:14pm

August 29, 2012

Responsible Investment has been enjoying a continuous surge in popularity in recent years. Finally, awareness and concern for the shortcomings in our system has reached the financial sector in earnest, not least due to a persisting global financial crisis that is ongoing despite the feel-good factor of the current cyclical stock-market high.

Still, despite a broad based call for more sustainable thinking and more responsibility, those meant to implement it, primarily asset managers are not sold on it as they struggle to provide the market with credible investment products. Why is that?

RI (responsible investment) has been around for a while now yet the concept struggles with a multitude of issues, not the least of which is its name. One might ask whether everything outside Responsible Investment should be considered irresponsible!

RI also means different things to different folks. Some focus on environmental factors, clean technologies, carbon emissions and the regulative integration of undesirable externalities. Others emphasize social issues such as labor laws and human rights or offer social impact investment, charitable work and activism.

In recent years we have seen determined and fruitful efforts by investors, NGOs and governments to build a common framework. The capturing and standardizing of ESG (Environmental, Social, Governance) criteria by the UNPRI (United Nations Principles for Responsible Investment) in 2006 was a significant step forward.

One of the most important deficiencies of RI funds is their lack of performance, i.e. investment vehicles that create sustainable financial alpha (if you know of any, please let me know). The pervasiveness of this is rather puzzling given the mounting empirical evidence that RI criteria are in fact substantial value creators in long-term stock performances.

Pension managers, those that administer or manage the bulk of our capital, feel it irresponsible to invest in RI funds. Indeed, how can they justify negative alpha to their stakeholders? Those that have been brave enough to implement RI in-house continue to wrestle with credibility issues and the sustainability of their processes. But how is it possible that ESG principles, shown to create value translate into worse than average performance?

The best place to look for answers is in mainstream investment processes. During the past two decades financial institutions decided to grow profits and build empires by scaling up and consolidating with business models driven by marketing strategies rather than investment strategies and processes. The magnitude and speed of this expansion was facilitated by the same concepts, such as market efficiency and a regulatory slack that lead to the mushrooming of the shadow banking and the excesses in derivative markets.

In the case of asset management the assumption that markets are efficient became the base argument for the falsehood that alpha creation, i.e. to outperform a benchmark is not possible by definition in the long run. This btw I think is part of the background on which hedge funds that are mostly benchmark liberated and absolute return focused became popular.

Market efficiency and its offspring, the Modern Portfolio Theory, led to diversification gluttony and the glorification of statistical optimization. Portfolios are today built around the optimization of artificial backward looking concepts of risk that absolve managers from ever understanding the real risks in their portfolios. An understanding of which is also made quasi impossible by the sheer number of holdings in generally vastly over-diversified portfolios.

Today, a main stream asset manager is not a risk taker anymore. His incentive system forces him to operate within narrow proximity of benchmarks. Investment used to be driven by human judgment, today human input is restricted to managing the data that is being fed to the machines.

The structural transition into a marketing led “investment” model had a profound impact on the business dynamics and the business risks of asset managers. Performance became irrelevant to the point that many believe today that it is impossible to sustainably outperform. However, asset manager’s business risk was reduced significantly. The intellectual property of the business remained with the organization as customer relations management, administration and logistics became the value drivers. Individual managers were now replaceable without significant effects on the funds they “managed”. The scaling up into multi-trillion dollar organizations became doable and very profitable.

Asset managers are focused on growing their businesses, to (cross-) selling investment products to clients and to managing and reducing their own business risk instead of managing the risks and returns of their clients. They are no longer in the business of investing. They are in the business of growing the size of a money distribution machine.

I happen to know one brave and visionary (now ex-) CIO of one of Europe’s largest pension funds who decided that the roughly 4000 holdings in its equity portfolio should be reduced to 400. He was promptly fired and the long-term, focused and engagement driven responsible investment portfolio that he started and that generated significant alpha for more than three years was starved into dissolution by the organization.

Some claim that the industry today applies the most sophisticated risk management tools available. However, we are told these are unable to address market risks. When the entire market tanks and devalues client portfolios, as has been the experience of late, those clients are told that at least they didn’t perform worse than the market and that everyone else has the same experience.

Reality is that most portfolios run in fact enormous risks under the guise of modern theories and a disproven assumption that markets are efficient.

Reality is also that most people in finance are perfectly aware of the problem but feel as helpless cogs in a powerful system that is deemed too big to fail, too big to even reform.

This new asset management organism has spawned all manner of side effects, one of which is that asset managers do not know their investments anymore. They don’t have to. For at least 2 decades every student in Universities, MBA or CFA courses throughout the world learns that there is no value in analyzing a business; markets are efficient and reflect all relevant information. You cannot know more than the market does! This premise contradicts reality and increasingly so as our asset markets are more and more starved of the information that makes them efficient in the first place. It also implicitly dismisses the point that investment is not about knowledge but about judgment. There is no model that can simulate the future. But just as the entrepreneur builds a business based on reasonable expectations so is investment about judging and valuing businesses and supplying them with capital, long-term capital.

If active investment decisions are made at all they have become extremely short-term. Beating the market has become a marginal game of arbitrage and a race against time which has found its pinnacle in the utter madness of high frequency trading with thousands of trades per milliseconds. High frequency trading in the USA has been measured to account for more than two thirds of all trades. Liquidity is good, but putting the cart before the horse is not.

Surprisingly, despite the premise of the models, the industry still goes about analyzing companies and industries, producing mountains of reports and organizing dozens of conferences where analysts, investors and companies meet and discuss business fundamentals. However, the primary focus is the previous and the next quarter. Even if the fundamentally informed asset manager was intent to select the best investment he is generally stopped by his institutional straight jacket that doesn’t allow for a meaningful deviation from the benchmark and discourages independent thought and decision making, compelling him to diversify his investments beyond the possibility of a meaningful understanding of any individual holding and beyond the hope to ever create any performance for clients.

It is no surprise that passive exchange traded fund investment has been booming and fee structures are collapsing, a trend that pretty much started with the introduction of the modern portfolio theory.

John Kay, Professor at the London School of Economics wrote in his report on the UK equity market, “equity markets are bedeviled by a split between principals and agents”. He describes that the market lacks long-term investors, owners of businesses. In the paper he explains that he purposefully omits the word “owner” as he feels it has become a concept too foreign and too complicated for today’s financial markets!?!

Yet, more ownership is exactly what we need, ownership of businesses and ownership and responsibility for the decisions we make. For many inside as well as outside finance this is common sense. Yet, how do we get there?

The popularity and the high demand for RI is based on the recognition that we value long-term goals, that we want to live in a sustainable world and that we have to re-establish the corresponding mechanisms and processes in a market that has lost its long eye in the pits of short-term hyperactivity.

Unfortunately our agent in charge of executing this demand, our financial industry appears today unfit to perform the task. Its short-term, detached investment processes are just the opposite of what is needed namely long-term thinking, long-term processes and engagement with business managers. Individual asset managers need to be enabled to concentrate their efforts rather than to diversify and spread their resources too thinly. We want asset managers that are exposed to their judgment. The generally substantial number of managers involved in the allocation of any ultimate client portfolio leaves more than enough room to achieve the much desired diversification.

RI is about more than building databases on RI criteria, ESG performance, rankings and screens. It is about knowing and committing to a business. It is about engaging with management and about supporting its efforts for responsible and sustainable value creation.

Therefore, I believe that if we are serious about RI we should ask the financial industry to lead the way, applying the criteria by which it judges its investments on itself will lend it the necessary credibility in the first place.

This means that asset management (as much as the financial industry as a whole) needs to rebuild institutional structures and symmetric incentive systems that hold up to simple economics and to common sense. It also means a commitment to long term investment processes and to building resources that can execute them.

Certainly, time and capital is needed to build credible organizations and products. However, the potential market for responsibly and actively managed equities is estimated by the IMF and the UN at USD 20 to 25 trillion, which translates into a several hundred billion dollar revenue proposition for the industry. It will be hard pressed to find an alternative way from under its collapsing fee and profitability structures.

RI offers asset management an enormous opportunity not merely to repair its damaged image but its rapidly decaying business model.

 

 

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Switzerland’s Opportunity

July 6th, 2012 — 2:02am

The global financial crisis is deepening again. Angela Merkel has caved to the political pressures and has taken out the (presumably) last restrictions on the EURO money printing presses. Perhaps there are some who view this as positive but market action does not support this view, thus far. The impact of ever larger monetary action on global asset markets has been decreasing over time as the necessary structural reforms have not been politically feasible, essentially leaving the global economy with even more debt than 5 years ago. Merkel’s face about, rather than a positive, may be more of a sign of desperation.

Much of the European Union is in dire straits, probably already in recession again. Globally, the state of all large economies has visibly deteriorated since the crisis broke 5 years ago: China, Japan, the USA, as well as the EU, all of them are facing increasingly limited and tough policy options. Unfortunately, everyone seems resolved to fighting the symptoms of too much debt with yet more debt, by now for most too much to be able to grow out of it.

However, there are a few countries standing strong in the storm such as Norway, Singapore or Switzerland. Sure they are too small to make a difference, even as a group. In fact, they are so small and economically tied into the global economy that is seems they will hardly be able to avoid the fallout, or will they?

Renowned economics professor Peter Bernholz explained in a recent interview how Switzerland may be able to avoid the worst, perhaps even turn the crisis into an opportunity. (for the German speakers here is the full interview http://www.fuw.ch/article/snb-kritiker-handeln-unverantwortlich/ ).

In essence Prof. Bernholz suggests that the Swiss Central Bank starts investing its growing balance sheet into real assets such as high quality businesses, raw materials or land.

How does that help Switzerland?

Switzerland is a small and wealthy economic island in the center of Europe. Obviously, today the Swiss are more than pleased for not being part of the European Monetary Union. However, despite its rock – solid fundamentals and scores of high quality businesses (perhaps with the exception of the risk posed by UBS and CS), the country is by no means immune to the fate of its neighbors and trade partners. Economically, Switzerland is by no means an island but globally intertwined and thus exposed to its partners’ health.

Ironically, on the financial plane, its stand-out strengths can quickly turn into risks.  Today, Switzerland remains as one of very few havens of fundamental strengths and stability, a place where markets look for shelter as and when things deteriorate elsewhere. But, for a country the size of Switzerland, global capital movements can very quickly become a big problem. In the 1970ies even negative interest rates to the tune of 12% (!) were struggling to stave off the flood.

Since 2008 the Swiss frank has appreciated from 1.6 CHF/EUR to 1.2, where the exchange rate was fixed by the Swiss Central bank in August 2011 after it briefly traded at parity. As Prof. Bernholz points out in the Interview, it may proof extremely difficult, i.e. costly to defend this rate when things take a turn for the worse again.

However, in order not to endanger its export economy, the Swiss need to depreciate its currency roughly in line with its trade partners whose policy direction has been – and is likely to remain – to reduce their debt by currency devaluation. In essence, that would require the Swiss to follow suit and risk to ruin their rock solid financial status.

Keeping the frank from appreciating means that the Central Bank has to meet demand for Swiss Franks with newly issued currency for which it receives foreign assets, mostly in the form of IOU’s from foreign governments, the EU, the USA. In order for this new currency not to expand the Swiss domestic money base (and create inflationary pressure) it then needs to buy back Swiss Franks from the market, mostly by issuing Swiss Government bonds. This means that the Swiss Central Bank will need to expand its balance sheet by buying foreign debt paid for with Swiss debt, the deeper the crisis, the larger this balance sheet will become.

Until recently, it was assumed that EU bonds or US government bonds are risk free. However, during the past 5 years debt levels have increased to a level that put this assumption in question as government policies show no signs of changing direction. Prof. Bernholz is openly questioning the future quality of US and EU government bonds and suggests that if Switzerland is forced to buy up these papers it should not keep them on its balance sheet but reinvest them into assets that will withstand the inflationary policies in Europe, the US, Britain, China and Australia.

Prof. Bernholz is not suggesting something completely novel as the experience of China or Signapore shows. Switzerland could very well end up the big winner in a crisis that is becoming increasingly daunting for many of its trade partners.

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Finance and Responsibility

June 7th, 2012 — 5:03am

JP Morgan keeps the spotlight. Since the story of the “London Whale” broke the USD 2 billion loss has reportedly increased to about USD 7 billion. Still not an existential sum for JP (the last word on this is not spoken) but Jamie Dimon has been facing a “fire-storm” of criticism amid calls to resign. But that is just a façade isn’t it?   If you have time, have a look at how congressmen gave Jamie a “grilling”.   Outright shocking, not even an appearance of any sort of due diligence. Instead a revelation of who really is in charge! Risk management in our financial system becoming the central topic of discussion? Dream on!

How can Mr. Dimon (or should he) be responsible for a balance sheet worth USD 2’500 billion, the yearly output of a G7 economy? Never mind that neither he nor anyone else for that matter is able to explain to us how he does it. Whatever it is, it is not working. Yet, big bankers continue to make the argument that big is necessary, not convincing anyone.

One reason for avoiding the discussion on risk management is that any sensible reflection easily reveals the fundamental flaws at work, that for instance the aggregation of vastly different functions without adequate institutional structures and incentives creates a fundamentally flawed business model. A business which cannot survive without being guaranteed by a third party and one which cannot be expected to implement any sort of risk management worth its name.

At least, so it appears, the consensus for some form of structural change is strengthening.  But, there is the fear that doing it without caution might damage our economies. While we consider it, we might also take into account that every time some Government comes out with a big rescue package, the debt-load increases and with it the ultimate costs of the exercise. How to tear off a band-aid?

We, the consumers, we the public, we are those who ultimately pay for everything, including for those who work in the financial industry we all realize that we are being had. Decisions are not anymore the result of logic and experience, they are rooted in an apparently deeply flawed political process. We are all cynical about the efficiency of governments, but things are worse than that. Governments are not just inefficient, nowadays they are also being ruled by corporate interests, nowhere more visibly than in the USA, where companies are now on the way to being considered people and bribery is constitutional and institutionalized.

What is the solution to such dire conditions?   More democracy and more democratic participation! We the people have to change the structures and processes for our decision makers, with checks and balances and better incentives for our key representatives, both government and corporate to think and act for us and the values we set for them. Today, our system has become far too short-term. There is a reason for the great popularity of responsible and sustainable investment. We are hoping they will help the system back into a more balanced process.  Still, the forces of change are not strong enough. Bankers are in charge and continue as they were.  This crisis, that is now 5 years old, did not come out of the blue. Many people saw it coming. In fact the discussions about the dangers and imbalances building up went back at least a decade. But change was out of everyone’s hand and continues to be. Unfortunately, change continues to be a matter of pain and the pain, so it seems, is not (yet) big enough!

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JPMorgan, Canary in the Coalmine ?

May 18th, 2012 — 2:22am

Never mind JP Morgan, one is tempted to think while reading John Mauldin’s latest letter. After all JPMs balance sheet looks pristine in comparison and it will very likely not be among the first to fall. European banks are in front of this queue!

John lays out the size of the problem Europe and its banks are facing. I can recommend John’s newsletter highly. I have been following John for a very long time, since his beginnings as an economic commentator. By now he is a superstar in investment circles, not least because he had always warned from what was to come. His long-time “muddle through” forecast has been a very accurate estimation. It could all have been so much worse… but it is hardly over!

John has as balanced a view that I know in the world of economics. He reads and distils tons of information and gives you the thoughts of some of the best minds around. So, if you don’t follow him, check it out (ps, i don’t get any commission).

Happy Week!
Stephan


Waving the White Flag

By John Mauldin, May 12, 2012

Article

A common mistake that people make when trying to design something completely foolproof is to underestimate the ingenuity of complete fools.
- Douglas Adams, The Hitchhiker’s Guide to the Galaxy

For quite some time in this letter I have been making the case that for the eurozone to survive, the European Central Bank would have to print more money than any of us can now imagine. That the sentiment among European leaders was that they were prepared for such a move was clear – except for Germany, which is haunted by fears of a return to the days of the Weimar Republic and hyperinflation.

When Germany agreed to a fixed monetary union and a European Central Bank, it was with the clear understanding that it would be run along the lines of the German central bank, the Bundesbank. The members of the Bundesbank and the German members of the ECB were most outspoken about the need for a conservative monetary policy that would keep a clamp on inflation.

Read on: http://www.johnmauldin.com/frontlinethoughts/waving-the-white-flag

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London Whale squeezing JP Morgan

May 15th, 2012 — 8:08am

“It just shows they can’t manage risk — and if JPMorgan can’t, no one can,”

Simon Johnson, former chief economist for the International Monetary Fund.


What happened?

In essence, one of the many bets that JP Morgan makes grew very large: USD 100 billion large. Iksil a.k.a. the London Whale, one JPMs traders was caught out on a limb with a huge bet he made. The details of this bet and how it relates to the bank’s balance sheet are yet unclear but it seems we know enough to risk some observations.

Iksil built a large stake in investment-grade corporate bonds that had been discussed for weeks prior in the markets due to its size. Iksil’s central bet was a sale of insurance contracts, CDS (Credit Default Swaps) on an investment grade corporate bond index (CDX IG9) with the interesting feature that this index is being recalculated every 6 months to fit the definition of investment grade, i.e. it cannot default by default unless.. well, it can certainly fluctuate in price. I personally think that in the current environment the bet made in fact a lot of sense. But, it grew so large that it skewed prices for the underlying index up to 20 basis points (0.2%), enough for rival traders to set up positions against Iksil. On a 100 billion position a market move of 2 percent amounts to USD 2 billion. When Iksil was down USD 2 billion, management pulled the plug. That means it went public but it remains to be seen how and when or if they will be able to unwind this whale before it inflicts much more pain than is visible now. If you are interested in a lot more detail, check this out..

http://www.marketplace.org/topics/business/easy-street/jp-morgans-loss-explainer

So, what does this mean ?

Is Iksil the “Tip of the ice-berg” or just a blip, normal static in a global financial circus?

If Simon Johnson is right, he is the Tip of the iceberg! Is he right?

I would agree but… the famous but, bankers will find it easy to talk this one down, to explain it away. For one, the loss may be large but not in relation to the firm’s size. Management (I am assuming they knew) took a calculated bet and stopped it out fairly early. JP Morgan has total assets of roughly USD 2.3 trillion and a capital base of USD 175 billion, 7.5% of assets and is one of the world’s best capitalized banks. JPMs capital covers the loss 60 times and the company’s annual profit in 2011 was USD 20 billion.  So, the numbers are big, but JP Morgan is bigger.

It might seem that this is just what our banks are doing today. So, don’t worry! DON’T WORRY?

I think at this point just about everyone but the bankers is worried about the iceberg that the credit flood is still hiding. There are millions of trades like this one on and off the books of banks and finance companies just like JPM, amounting to a total exposure that has been estimated at between 600 and 1000 trillion, thousands of times larger than the trade at hand. For comparison, global GDP is at around USD 60 trillion. At the core of this are banks that have become far too large and far too leveraged.

In the case of JPMorgan, a total of USD 800 billion (more than a third of JPMs book and more than JPMs core commercial banking book) of trading assets and securities are directly exposed to liquid asset markets.  A mere 20% correction would wipe out JPMs entire capital. Thus Chairman Bernanke is the doing everything he can to keep asset prices afloat with periodic liquidity gushes and interest carry subsidies to the banks who hold these assets.

So, the question may be not so much why the trade could get so big but why there was a trade at all. Would the trade have happened if the trader had to raise capital for it?

Bankers have yet to explain how they justify the historic aberration in the leverage they run

…while at the same time exposing themselves to riskier assets?

…with decision makers that are asymmetrically incentivized to take large risks?

…risks they don’t own themselves?

It used to be that these kind of trades were made by bankers who were partners in a business they owned. They owned their decisions, they owned the capital and the consequences, both good and bad. Today the risk is not anymore owned by the decision maker, he only takes the upside. The downside is covered by the taxpayer.

Our financial industry seems to be in a show case principal agency breakdown ripe with conflict of interests and asymmetric incentives .

It appears the risk management we need first and foremost is on the level of the regulator to provide a framework that fosters a sound and sustainable system. The popular idea of Responsible and Sustainable Investment seems of particular importance for our financial industry.

But wait,…. one level up?.. in the Board of the New York Fed, we meet again with no other than Mr. Jamie Dimon.  I believe we deserve to hear from Mr. Dimon what his understanding of risk management is. I believe he should explain whose risk he is managing? And how?

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Austerity Killing Growth?

May 2nd, 2012 — 5:39am

Dr. Jim Walker, www.asianom.com

I am doubling down with Dr. Jim, who delivers another of his useful insights.  Europe is in a pickle and Austerity is the new expression that is meant to lead to lower debts via reduced spending and higher taxes. But austerity threatens to choke an already weak economy and perhaps make matters even worse by creating a viciously contracting feedback loops. Dr. Jim has an important angle, will politicians catch on?

Austerity and growth – Mutual reinforcement

The UK’s double-dip recession proves that ‘austerity’ doesn’t work. Spain’s unemployment rate has hit 24.4%, further proof that ‘austerity’ doesn’t work. All across Europe, as governments fall at an increasingly rapid clip, the debate is now turning to ‘too much austerity, not enough growth’. But let’s hold on just one minute and challenge the increasingly accepted wisdom (as Robert Wenzel so bravely did at the New York Fed last week) that ‘austerity’ and ‘growth’ are somehow mutually exclusive economic conditions. In the current debate austerity is all about cutting back on fiscal deficits. And, as we know from the data, in places like France, Italy, Spain etc, government spending accounts for around 50% of GDP so when it retrenches the measured GDP numbers tend to go down. Especially if the private sector – the minority element in GDP in many of these countries – is not in rude health. The argument goes that, since the private sector shows no signs of offsetting the reduced fiscal spending, all that fiscal austerity will end up doing is reducing ‘growth’ and thus inducing recession. After all, the evidence is all around us, isn’t it? Well, no.

The first thing to realise is that governments do not add to growth, full stop. Growth is all about production – of goods and services – and what makes that production occur. Government spending is all about consumption, which cannot take place before the goods and services are produced, and an arbitrary redistribution of income to the sectors that government favours or wants to take care of (we are not arguing that this transfer should cease, all we are saying is that is what it is). Government takes money from the productive segments of the economy and transfers it to, for the most part, unproductive segments. It is when that burden of transfer, either in the form of current taxation or interest and principal payments on its borrowing (future taxation), becomes large that the productive sector begins to shut down. In the Austrian scheme of things the most important growth driver in the economy is clear: profits. Without the profit motive there is no incentive for private business to become established, produce and grow. And if there is no private business formation there is no wage generation, no employment growth and no income source to use to demand goods and services. In order for the economy to grow, not just in Europe but everywhere, it should be government’s prime focus to create an environment where profit can be maximised and encouraged. Lower taxes, fewer regulations, reduced bureaucratic costs, more flexible labour markets, decreased subsidies and correct price signals (including market-determined rather than central bank-determined interest and exchange rates) all enhance that environment. Austerity that focuses on reducing these costs, which includes reducing the disincentives to work that unemployment and other transfer benefits encourage, will be a growth enhancer, not reducer. The problem with Europe is that it is simply the wrong type of austerity eg, tax hikes on the rich, that is being imposed because that is the easy, populist option. And as for the calls to reverse the austerity? Productive, private sector growth would be undoubtedly the biggest victim of that approach

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Robert Wenzel Trashes the FED!

May 1st, 2012 — 5:29am

“Let’s have one good meal here. Let’s make it a feast. Then I ask you, I plead with you, I beg you all, walk out of here with me, never to come back. It’s the moral and ethical thing to do. Nothing good goes on in this place. Let’s lock the doors and leave the building to the spiders, moths and four-legged rats.”

What better day than Labour Day to deliver a rebellious speech?

Courtesy of good friend Dr. Jim Walker.

“Robert Wenzel, editor and publisher of the Economic Policy Journal, recently delivered a stunning speech at the New York Fed. Contemporary political, economic, and financial discourse has been corrupted over the years of serial asset bubbles by all kinds of candy coated half-truths and outright distortions. Plain speaking is long overdue, and no surprise that often comes from the mouths of Austrian School economists – but usually not from so far behind enemy lines. Below we reprint only the most potent passages, including closing recommendations that cut right to the chase. This was truly an act of courage, and maybe even a few people in the room got the message.”

Robert Wenzel,

“I simply do not understand most of the thinking that goes on here at the Fed and I do not understand how this thinking can go on when in my view it smacks up against reality.

“In the science of physics, we know that ice freezes at 32 degrees. We can predict with immense accuracy exactly how far a rocket ship will travel filled with 500 gallons of fuel. There is preciseness because there are constants, which do not change and upon which equations can be constructed.

“There are no such constants in the field of economics since the science of economics deals with human action, which can change at any time. If potato prices remain the same for 10 weeks, it does not mean they will be the same the following day. I defy anyone in this room to provide me with a constant in the field of economics that has the same unchanging constancy that exists in the fields of physics or chemistry.

“And yet, in paper after paper here at the Federal Reserve, I see equations built as though constants do exist…(People) create equations based on this belief an then attempt to trade on these equations…the result was the blow up of the fund Long Term Capital Management, a blow up that resulted in high level meetings in this very building.

“Austrian Business cycle theorists are regularly ignored by the Fed, yet they have the best records with regard to spotting overall downturns, and further they specifically recognized the developing housing bubble.

“The noose is tightening on your organization, vast amounts of money printing are now required to keep your manipulated economy afloat. It will ultimately result in huge price inflation, or, if you stop printing, another massive economic crash will occur. There is no other way out.

“I beg you all, walk out of here with me, never to come back. It’s the moral and ethical thing to do. Nothing good goes on in this place. Let’s lock the doors and leave the building to the spiders, moths, and four-legged rats.”

The full text of Robert’s Austrian School cri de coeur at the New York Fed may be found in the following link – may we suggest you consider reading it, then re-reading it, then distributing it widely and then disseminating it to your clients too:

http://www.economicpolicyjournal.com/2012/04/my-speech-delivered-at-new-york-federal.html

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Financial Regulation: Fresh Perspectives Needed

April 6th, 2010 — 3:06pm

In the US, the healthcare bill has passed and general attention is shifting back to the economy and financial industry regulation. As in healthcare, the stakes are high, for both the general public and the financial industry. As in health-care business interests are fighting hard for every inch and as in healthcare they are defending the indefensible.


Only, the subject matter seems much more complex for outsiders and politicians. The public’s lack of knowledge on finance is being brutally abused to engender fear and control the outcome. Even if more and more politicians seem to resist the power of the lobbyists, we are all stunned by the President’s insistence that the old guard determines the agenda (Paul Volcker aside).
Often we hear that this old guard, including the bankers we bailed out are the only ones who understand the issues. Are we really that gullible? There are enough financial professionals inside and outside banking who understand the issues and see the need for change.
The necessity of serious structural changes in the financial industry is blatantly obvious, it seems, to everyone I speak to, but it is tough giving up such a large, the largest source of income! So, the solution is tinkering at the edges, singling out a few bad apples, referring to hedge funds or the shadow banking system. Fact is however, that it was our large “Blue Chip” commercial banks, each of the top 10 is by itself larger than the global hedge fund industry combined, who spiraled themselves and our system out of control. The global top 20 banks doubled their balance sheets between 2004 and 2007 to $40 trillion, close to global GDP.
How did they do it? Simply put, they started to use their triple A rated commercial banking balance sheet (which is generally a very low risk business) to underwrite more adventurous business units. Their triple A ratings allowed them to raise funds at the lowest possible rate and invest in every kind of asset or arbitrage opportunity, anywhere. Multiplying leverage, their expansions were breathtaking.
And, everything was under control with world class risk management tools, all of which came to rely on the single assumption that all information is contained in the price of an asset. One of the important side effects of the expanding leverage was that the liquidity it created and the resulting smoothing of market action lead to historically low volatility, i.e. low risks while real economic risks clearly pointed in the opposite direction.
Independent businesses or hedge funds found it harder and harder to compete with the banks’ muscle and capital. Banks took over and consolidated leadership across finance and in the process crowded out a diverse and multifaceted financial industry.
However, by “industrializing” decision making these now “too big to fail” banks have eroded the market’s raison d’etre, the efficient allocation of risk and capital. How did our global banks, now Super HedgeFunds convince us that they knew how to integrate and effectively manage a myriad of investments and businesses and risk structures across virtually all of finance? They never had to convince anyone, not a regulator or a client, they just did it and increasing profitability was their proof of ability.
Now, they have walked us into a financial crisis and based on the facts their businesses and their risk models have failed. I do not believe this to be a so-called “black swan” event as it was not a surprise to most, in fact it was expected.
I do not know of a coherent explanation why we need the structure and service these bands provide. Nor do I understand how they plan to address their risk management going forward. I believe that banks have a need to explain themselves.
As to the regulator and monetary authorities the risk is the decision making process. There are plenty of sensible and intelligent people around but as outside government, incentives play a big role in decision-making. When we have the same people, with the same incentives, can we hope for change?.
Quant finance has brought many useful tools and products to finance. That is one reason why I don’t support product bans, which stifles and misdirects innovation. We neglected transparency and oversight while expanding to fast. But Quant finance has taken over and with it short-term processes and short-term thinking. We have lost the long eye of the market, the long-term thinking, the strategic awareness and long term investment processes.
Maybe Mr. Krugman is right in that we don’t have to break up our universal banks, maybe a sensible regulatory framework will do the trick all by itself and disintegrate these “too big to fail” businesses. But, what kind of hope to achieve reform with the old guard still in charge? …, it’ll be a fudge and a squeeze!

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Governance

February 20th, 2010 — 6:13pm

Good Corporate Governance demands that our large universal banks be broken up!

Over the years we have come to accept corporate scandals as normal fare in our capitalistic system. Still, when they are uncovered, these cases are nowadays generally dealt with little tolerance.

In the ultimate conclusion the ongoing financial crisis was caused by a monumental failure of governance. The discussion on re-regulation is thus a case of implementing a sensible system of governance. So, how are we doing? Are we on the right track? If not, why?

We know all about the breakdown of checks and balances in property lending, the rating agencies with perverse incentives and lack of independence or insurance companies who crossed over into capital markets without capital and/or know-how.

Certainly, some sensible changes seem under way, yet we continue to pull a blind eye on the largest and most harmful failures of corporate governance: the Federal Reserve and Commercial Banking.

The Federal Reserve is the institution at the top of our global financial system that has not only failed to govern the system but is itself a case of bad governance. Yet, it is not even questioned, instead it is being hailed as the savior from the crisis and an expansion of its role is being discussed.

Commercial banks on the other hand are fighting Paul Volcker and a growing number of elder bankers such as John Reed ex Citi, Nicholas Brady ex Dillon Read and head of Treasury under Reagan or John Bogle ex Vanguard who are pushing aggressively for a new version of Glass Steagall.

The bankers’ main counter to a break-up is the threat of a depression.  I cannot support this argument. How could restoring rules in place before the crisis was built be any worse than what we have now?  But it is true that there has to be a basic global arrangement. Finance more than any other industry is enormously fungible and globally mobile. Any country’s solitary action would simply lead to migration. Thus, on top of all the local hurdles, we need to come together and agree on a minimum standard for corporate governance within our global system.

When Glass Steagall was abolished in 1999, commercial banks expanded into everything that promised to lift profitability, from proprietary trading and investment to investment banking, investment advice, asset management, insurance and financial engineering. At that time European banks were already happily at it. However, instead of the world following the US with a good idea, the US followed the world with a profitable idea.

If politicians were sold on a model of dispersing or diversifying risks, in actuality risk became more concentrated. The financial system is not like the car industry, it is more like the transportation industry. Imagine a company were to build trains, planes, cars, boats and bicycles. The difficulties of integrating a full range of financial businesses and risks into one balance sheet have been fully exposed by this crisis.

It is not money or the financial system per se that creates innovation, growth and an improvement in the quality of our lives. Finance is merely the means to an end, the tool to create the optimum condition for valuable production or services. If, as is the case today, the lubricant, the catalyst within a system accounts for 40% of a system’s value, something has gone horribly wrong. The numbers are staggering and they point squarely at the banks, the global top 20 of which managed a combined balance sheet of more than $40 trillion in 2007 with their core businesses shrunk to often less than 20%. Bernie Maddoff may be an attractive Media target but his $50 billion fraud looks rather unsubstantial.

Bankers made the argument that spreading their wings into different areas of finance would help them diversify their business risks, i.e. reduce the volatility of their cash flows. The assumption is correct but it does not result in proper risk management, often quite the opposite. The supposedly reduced risks, indicated by a reduction in cash-flow and market-price volatility justified banks to expand businesses and leverage further in a reflexive cycle fed by derivative structures and the Federal Reserve. The ultimate result of this madness is that the stability of the system has come to rely on the ability to expand liquidity instead of sound structures that rest on sensible governance structures.

One of the most clear-cut distinctions between business models and risk structures in finance can be made between businesses dealing primarily with deterministic services and those that deal with an array of (often uncollateralized) uncertainties and time-frames that are not deterministic by definition.

Commercial banking concerns itself with largely deterministic, low risk finance. Banks take deposits, offer transaction and payment services and lend money attached to low-risk collateral. Commercial banking is very local and relationship based. The process is simple, involved, yet factory-like, with pretty much one contract matching the next, administered and overseen by a well-run back office in a secure and organized process. With all the ancillary functions—trade finance, foreign exchange, capital market access, payment services—a large national or global bank is a layered and multifaceted bureaucratic organization. Technology and experience have matured commercial banking into a commoditized, fairly low margin business whose risk is defined principally by overall economic stability and the leverage it is allowed to take on.

As such commercial banks are not set up to analyze or take non-collateralized risks, i.e. to manage funds and advise on investment. The management of non-collateralized risks and longer time-frames is generally very specialized, independent and most successful in entrepreneurial set-ups.

Fortunately, commercial banking is quite easily definable and detachable from the rest, in particular as there doesn’t have to be a strong line of separation. I see no reason not to allow commercial banks to engage in trading, investment banking, insurance or any other financial services that a client of theirs might require, as long as they remain marginal and account for less than 20% of the business, compared to often up to 80% today.

There is no alternative to ultimately breaking up these behemoths and contrary to what bankers have us believe, it is not difficult and not nearly as dangerous as the course we are pursuing now. It is not primarily a matter of technicalities, or global economic Armageddon, it is a matter of political will… to be continued

7 comments » | Eye of the Storm, financial Crisis, Regulation

Creating Jobs

February 1st, 2010 — 10:25am

At the State of the Union, last week the President again delivered an inspiring speech. Certainly, one feels compelled to follow the lead. His number one priority in 2010 is to revive the economy and to create jobs. Yet, as convincing as the President lays out his plan, it smacks of Sisyphus and contrary to his opening remarks avoids the tough but necessary choices.

Looking back one year, the President’s assessment is that an economic crisis of the scale of a (Great) Depression, was avoided. However, irrespective of stock-market prices and the few positive signs of economic revival he can point to, the fact remains that the US economy remains flat on its back. Worse, the fundamental causes of this developing crisis remain firmly in place. The architects of the “successful” rescue plan are showered with praise for providing the financial system with the equivalent of a huge adrenalin shot, which achieved no more than to stop the decline and send the liquid asset markets into a frenzy. One year on we are looking at the highest stock market valuation in a century of data (Dow Jones and S&P, based on four quarter trailing earnings). Wall Street said thank you with record bonuses and Time Magazine celebrated with the man of the year, Ben Bernanke.

Despite the “good news”, the President concedes, much has to be done. He lays out his plan in some detail, mentioning small businesses, tax breaks and credits, lending programs, infrastructure programs, clean energy investments and importantly, investment in education.  Most sensible observers – outside the silly right wing supply side clique – agree with the President on the necessity of these programs. Although, the devil will be in the details and there is more than just a whiff of government activism. The President’s plans are not simply an attempt to create jobs but are in my view essential to rebuild the country’s basic infrastructure that has been wholly neglected during the past decades. Despite dim-witted proclamations of still too many political leaders blindly misquoting Thatcherism or Reaganomics, there is a role to be played by government (besides waging war) such as the provision of basic infrastructure, basic education, fundamental research or a sensible regulatory frameworks. The notion that industries should regulate themselves is unjustifiable, self-serving non-sense.

As the President further points out, his measures have been (and will be) insufficient to make up for all the jobs lost and in bringing back the economy to a sustainable growth path. As many ideas that spring from his creative mind, disappointingly, the President’s carefully avoids addressing the country’s historic level of debt that has to be digested and reduced. He dares not mention the realities of this inevitability, its deflationary and destructive reality for asset prices as well as economic growth. The US alone has accumulated a debt close to 4 times its GDP, mostly carried by its financial institutions and its consumers. Put that into relation to 1.6 times GDP prior the Great Depression. And, as I have been pointing out time and again, this enormous liability was built on the backdrop of investment and risk management tools that have corrupted any semblance to efficient markets during the past couple of decades (you will find a more detailed analysis of this in the book) and have divorced finance from the real economy.  It is truly a monumental mess. Our leaders dare not mention it.

Any sensible strategy to heal our economy has to focus on the financial industry and its key agent, the Fed and how to reduce the exorbitant levels of debt they have accumulated. Yet, the subject was a paltry side-note in the President’s speech. Now, that might have been a political decision. Admittedly, more recently, the President has spoken with a new-found toughness in dealing with special interest groups and Wallstreet in particular, demanding a “fee” of more than 100 billion from the large banks as well as regulatory changes. A modern version of Glass-Steagall seems to be in discussion, finally! and Paul Volcker is given a stronger voice (he hits the nail on the head in the New York Times http://www.nytimes.com/2010/01/31/opinion/31volcker.html?).  Yet, shockingly, there is hardly any mention of the Fed and the fundamental reform that is needed to restore some semblance of sensible monetary management. In fact, Fed Chairman Bernanke has just been reappointed, which endorses the policies that have led us into this mess and assume that they have saved us from a further bigger mess. However, if that leaves us hopeful for any reform at all in our financial system, it will be half-hearted at best and while politics justifies half-heartedness as pragmatism, in this particular case, half-heartedness will most definitely make matters worse.

On the one hand, not splitting up our universal banks (into good banks and bad banks) means that the entire financial system that is visibly and predictably retrenching in deflationary mode will be forced into even greater cut-backs. On the other hand, the practices and risk models applied on Wallstreet will continue to distort our financial system’s processes, reinforce its detachment from the real economy and propagate the excesses of the past. All the while, the Fed will be allowed to continue to conduct its monetary policy of the most foolish sort, steering us straight into the abyss.

With absolute certainty the US (and much of the rest of the world) finds itself in the early stages of a deflationary de-leveraging process. There is no point in fooling ourselves, this will be painful for Wallstreet and Mainstreet. However, fighting inevitability with frantic activity, makes this much more painful for the real economy than is necessary. The President tells us about his conviction that he is absolutely sure to have done the right thing, the necessary thing even though it was “as popular as a root-canal” to everyone involved. Henry Paulson, one of the architects of these policies and former Chairman of Goldman Sachs admits today that they had “no idea what they had to do”. Listening to Larry Summers, giving interviews in Davos gives no indication that he knows any more, a year and a half on.

And so the big plan they came up was to save a number of large commercial banks, which had really become oversized hedge-funds. Although they had no idea what to do, they came to the conclusion they needed to “save” a few global financial superstores to save the world. But it was not the necessary thing to do, nor the right thing to do, it was the easy thing to do: there is no way back, hence full steam ahead, continuing in the tracks of the same policies that have arguably caused the crisis in the first place.

The necessary and courageous strategy fundamental to saving the financial system would have been and continues to be splitting off the commercial banking books from the mostly toxic and leveraged “asset plays”. This means removing the essential commercial banking businesses from the crushing weight of their often many times larger and more “profitable” hedge fund businesses. If we indeed want the economy to start creating jobs, it will not be without the help of a healthy commercial banking system. Saving the monstrous hedge funds that we have allowed to build achieves the opposite, as it inevitably paralyses lending further.  When we fight deflation, we have to fight the deflation of our commercial banking system and the subsequent deflation of our (still healthy) businesses and shield them as much as possible from the necessary and unavoidable deflation of the towers of debt we have built, mostly on non-cash flow generating bets. Most of these “too big to fail” bets are about as far removed from the real economy as we can imagine. We haven’t saved the system, we pumped air into it, jobless fluff.

Allowing our banks, i.e their hedge-fund books to be exposed to the market mechanism would certainly bring down asset prices in a hurry and would likely result in a bit of a shock to the system. Let us remember though, asset prices are a price tag of the economy, they don’t determine or create value, they price it. Who wants to argue the real economy would stop in its track and we would all go home and retire because assets are re-priced? Indeed, a continuance of current liquidity pumping and fiscal bail-outs is sure to paralyze the financial system, and over time deflate our (still) healthy businesses; then we can go home and retire.

Sisyphus is busy plugging the holes punched into the system over the past decades, frantically distributing “sand-bags” and “duct tape”. He is a well-meaning and hard-working fellow but we cannot close our eyes to the root problems of this crisis. Current policy lacks a clear strategy, it is an accumulation of tactical measures that is likely to create less jobs than are being destroyed by the lack of decisiveness and spine in dealing with the financial system. Job creation leads through the financial system!

Comments Off | Eye of the Storm, financial Crisis, Monetary Policy, Regulation

Man of the Year!…………………………. The Baron of Munchhausen

January 7th, 2010 — 6:00pm

Happy New Year!!!
Baron of Munchhausen
{PDF}

And yet again this blogger was side-tracked by the intensity of starting up businesses. I sure hope to be able to write more in 2010. Although somewhat belated, I don’t want to miss wishing you and your loved ones great health, abundant wealth and happiness in the New Year ahead.

During this reflective season the words of a wise friend of mine came to mind, “our dreams and aspirations are the blueprints to our lives”, a good thought to start my year.

As much as I believe in the basic truth of these words, there are some things that remain (for now) impossible for us humans, like teleporting or turning lead into gold.

As we begin a new year, markets, media, pundits and officials are united in celebration of a crisis behind us. The Economist calls it the “Great Stabilisation”. Mainstreet, small businesses and the growing rank of unemployed are asked to be patient, after all employment is never the first statistic to turn around. Demand will eventually return, somehow, as it always has, irrespective of the fact that in recent years it was driven entirely by an unsustainable credit expansion.

And there it is, the word “unsustainable”. Ben Bernanke along with the ruling interests disagrees, believing it is all a matter of liquidity and confidence, as they have “proven” for decades now. If everyone just believes that there are no limits to credit, it will make it true.

Consensus economic and stock-market expectations are far too optimistic. They limit their expectations to past “crisis” that were all “solved” by injecting liquidity into the system. The difference today is that this liquidity doesn’t flow through to the real system anymore. It stops at the banks and reverses flow into the central bank. The only life-blood that reaches Main street comes in the form of silly consumption driven programs such as “Cash for Clunckers”. TARP money spent on investment is almost negligible.

While the economy has become too risky for the financial gatekeepers, Ben Bernanke rides to the rescue in making financial  “investment” (once more) a sure bet, even at zero interest rates.

It created the dollar carry: “investors” (banks, in one form or another) are taking credit at zero interest in a currency (the dollar) that is driven down by the FED’s degrading balance sheet and fiscal debt expansion as it trades its pristine assets with the rubbish the market has accumulated during the heydays of the subprime mania. In essence, any hedge fund trading the rebound is paid to leverage itself up with what is effectively a net negative interest rate. As Bernanke promised in his infamous “Helicopter Speech” the game doesn’t stop at zero interest rate…. at least not as long as it holds.

Markets are up, risk indicators down, bonuses large, economy? Not as bad as it used to be, conclusion: crisis averted, hail Time Magazine’s man of the year Ben Bernanke.

Given the enormous interventions and consumption promoting activities in the US (and elsewhere), I find the scale of the “rebound” is rather disappointing.

Retail sales are still a good 10% below last year’s, durable goods orders in the US have hardly recovered, down 23% from last year, construction spending is down 13 percent and still sliding, housing starts are at minus 30% and flat-lining.

Whether signs of recovery are large, small or in-existing, Credit, the main driving force behind the demand that defined almost a decade of economic growth is contracting and will continue to do so. Consumer credit is contracting the fastest, delinquencies have exploded to 9% and credit card limits are cut almost across the board. The only party that is expanding credit is the government. The FHA (Federal Homeloan Agency) is underwriting mortgages as if there is no tomorrow with down-payments of as little as 3.5% while 25% of their loans given out just 2 years ago are delinquent. Maxine Waters, California Congresswoman, rightly points out “Let’s be clear. Without FHA there would be no mortgage market today.”

Unfortunately, as inflationary as the government’s intention much of its actions are deflationary by definition as total money (money plus credit) in the system as a whole continues to contract.

Re-regulating the financial system, no matter how benign, is deflationary. Although I do applaud the increasing popularity of bringing Glass-Steagall back, any form of it will be deflationary.

Far from signaling the end of the recession, the story of the financial markets in 2009 brings to mind the great Baron of Munchhausen, who, in one of his famous fantasies pulls himself and his horse out of a swamp by his own hair.

Liquidity propelled stock-markets are supposed to pull the economy out of its deleveraging mode with the gracious help of the FED and yet another carry trade.

Whatever the economic benefit or efficiency of this new credit, according to the Fed chief, fresh leverage is supposed to fix the economy. A formula that has been working for a long, long time but unfortunately, not unlike drug addiction, the system screams for every larger dosis  with ever increasing leverage needed to create the same effect.  In the 1960ies a dollar of debt taken on resulted in more than 60 cents of real economic growth. In the past 10 years one dollar of new debt meant no more than 14 cents of real growth. Shall we guess the efficiency of the current government driven debt expansion? Our debt is already 3 times the size it was before the Great Depression. What has gotten into us?

At the center of this financial madness are the large universal banks that have even increased their size and dominance since the crisis started not by lending but by swallowing smaller, less important institutions. And our financial superstores are largely left to continue as they were, managing huge balance sheets with the same silly risk models that are to a large extent responsible for this crisis.

And as to our monetary leadership, it seems ironic that a band of modern day Keynesians with their utter disregard for a coherent theory of capital and risk has been left in charge of a financial system that has become all about capital and risk.

Existing risk models had been discredited long before the crisis and have yet to be addressed by any of the new financial regulations announced.  Not in any of Mr. Bernanke’s analysis of the Great Depression have I found reference to the effects of leverage, the size and quality of debt as a major factor in both economic and monetary management. Why is everybody assuming investment during the past 30 years on the wings of modern financial theories was so immensely efficient? In many professional experts’ view quite the opposite is actuality.

It is no secret that liquidity stabilizes markets. That is its inherent quality, no magic!  However, we should not confuse market stabilization with a reduction of risk. Unless we are experiencing an historic break, the productive underbelly of our economy is driven by investments and cash flows and not fictitious asset valuations conjured up with ever-increasing leverage.  Unless Baron Munchhausen’s tale has a happy ending stockmarkets will eventually reverse south, possibly quite viciously.

Quite often I am being asked where to put money when everything is so gloomy. Indeed it is a bit tricky, gone are the days of buy and hold and everything is going up. The way down will be a bumpy ride. As a stock-picker I have always relied on company specific investments and cared less about the general environment. And that is what I am doing, but say you have excess funds, in the long-run, I would buy a lot of gold, physical Gold. Although, short term, I believe we will see a sizeable correction in Gold during the next 6 months as financial deleveraging accelerates. In a deleveraging environment generally liquid markets move highly correlated. I see that monetary push that pulled the carry trade is exhausted. The Fed will stop the mortgage train in March. What happens to the carry trade and markets when the long expected relief rally in the dollar takes off is clear. All asset markets correct, US treasury bills will be the safe haven >> ergo buy US 10 year T bills. No stocks, no fringe securitized paper, no commodities.

During the course of this probably quite long bear market (low in 2012/2013 as a guess), one will have to be nimble and reassess the risks on an ongoing basis. It could get wild.

Next to all this gloominess, I can see many reasons to be optimistic for our future. One of them is technological change that is visibly accelerating and is transforming our lives in many positive ways. When I find time next to write, I will share some of my thoughts on the bright future I see ahead.

Until then, keep safe and enjoy the moment. HsO

7 comments » | Eye of the Storm, financial Crisis, fiscal policy, Monetary Policy, Regulation

Energy, An Overview

November 18th, 2009 — 6:35am

Energy an Overview PDF

In 2007, world consumption in energy was equivalent to 90 billions of barrels of oil or expressed in electrical output, about 55,000 terawatt hours (1 terawatt is 1000 gigawatts, 1 gigawatt is 1000 megawatts, 1 megawatt is 1000 kilowatts). This is the equivalent of the yearly output of 30,000 normal-sized power plants (600 MW).

World Energy Production80% of world energy is created by fossil fuels: 32% by oil, 21% by gas, and 26% by coal. Hydroelectric and nuclear energy contribute a bit more than 5% each and the burning of biomass (mainly firewood) about 9% (0.46% of which biofuels), leaving 1.9% (2008 figure) from renewable energies such as solar, wind, marine and geothermal sources.

Roughly one-third of the 90 billion barrels of oil equivalent in primary energy consumption is in electricity, of which two thirds is generated by burning fossil fuels. Coal accounts for 42% of world electricity production. Nuclear energy and hydro energy account for roughly 15% each. Biomass accounts for 1.1% and renewable energy sources for 1.3% of world electricity production.

World Electricity ProductionThese numbers show that despite the efforts of many major governments since Kyoto 1997, the contribution of renewable energy sources to our energy supply is still negligible.

Many point to a lack of commitment, coordination and political will as the reason for this paltry progress. In energy, as much as elsewhere, decisions are habitually driven by vested interests, frequently based on incomplete or “tailored” information and all too often not in the best interest of the propagated goals.

However, the reasons why so-called renewable energy sources will hardly make a serious dent into carbon emissions for at least another 30 years are not political; there are large technological and economic hurdles.

Any assumptions of us slowing down our total consumption can safely be discarded. The energy needs of an awakening emerging world are a force much stronger than any potential reduction of emissions attempted by all energy saving programs combined. China alone is building 50 to 60 Gigawatts electricity generating power a year, 70% of it with coal. This is the entire production of a large country such as the United Kingdom.

At the same time, all renewable resources have important drawbacks. Hydro and geothermal are not expandable to significant degree.

Solar is technologically not ready and has enormous negative capital and energy balances, i.e. solar still consumes enormous resources to create. The expansion of polysilicon, its main supply has large lead-times, technological hurdles and high capital intensity.

Wind is commercially viable onshore, but the costs and landmass involved to make this a serious alternative are enormous. Additionally, wind – like solar and other renewables – cannot be used as a base-load provider. They suffer from intermittency, and therefore cannot guarantee a stable supply.

If, and admittedly that is quite a big if, the predictions and assumptions of Al Gore turn out to be true, the only real way to deal with carbon emissions is to focus on cleaning up fossil fuel energy, primarily Coal. There are solutions, they are not cheap, but they are ready, tested and in operation.

In addition, coalbed methane may be developed into a sizeable gas provider. The use of gas substituting for coal or oil reduces emissions significantly.

With respect to renewable energy, it looks as if wind-power could become significant fairly quickly (within 20 years) and deliver up to 5% of global primary energy as an auxiliary source. It is, however, important to note that the cost of creating this capacity would in current dollars and technology amount to approximately $500 billion.

5 comments » | Energy

Risk and Uncertainty

November 13th, 2009 — 7:48am

Rik And Uncertainty (PDF)

Paul McCulley of Pimco very eloquently describes the mechanics (and contradictions) of the ongoing government orchestrated asset bubble from the Bond market’s perspective.

He also muses about the future of finance, declaring the efficient market hypothesis all but dead and describes the dawn of behavioral finance. Bond guys continue to be, so it seems, much more attuned to the risks we run in our system.

One big unanswered question remains: how do we best frame our financial system to most efficiently handle risk and uncertainty to optimize the stability of our capitalistic financial system?

Correctly, finally, the efficient market theory seems to become recognized as the poison it is. Toxic it is especially in the hands of universal financial superstores who, with the help of this dubious theory have crowded out an atomistic and entrepreneurial institutional landscape. Much of finance needs to be much nimbler, quick footed and the incentive of ownership to handle the all-important but somewhat elusive influence of uncertainty. Of course adequate and independent regulative oversight is important but that is an issue for another time.

Equally, and as repeatedly impressed upon us throughout history, the ability to “handle” uncertainty is strongly correlated with leverage. The higher the leverage, the more volatility and destructive reflexive potential is allowed to grow in the system. This is quite the opposite of what is being portrayed by the risk models inherent the efficient market theory. As Paul McCulley explains, this seeming paradox can be observed live in today’s bond and equity markets. Additional liquidity reduces volatility and the perception of risk in the system. Risk can be handled by government to behave as it likes it to (at least for a while and sometimes for a long while).

On this count both the Fed and our large commercial banks (and not so much the non-bank financials who are in governments’ cross-hairs) are responsible for building up unprecedented leverage in the system. Thereby they increased risks, those real and more long-term risks, and directly reduced the ability of the financial system to deal with the system’s inherent uncertainty.

Now, in 2009, governments around the world (led by the Fed) have decided that there is only one way out of it: push on, accelerate, “guns” blazing, i.e. pumping liquidity (leverage) even if it means putting the entire financial system and governments’ financial position at risk. Even when it means that the systemic maltreatment of risk is allowed to continue; even when it means to contradict the steady advice of history. The path taken is not to re-establish markets’ proper functioning but to broaden its unholy suspension.

Unfortunately, this irresponsible policy is not simply a domestic US problem. Global monetary policy is under the leadership of the Fed and a certain Ben Bernanke. Despite grave doubts and resistance, in particular from mainland Europe, there is not much they can do in the current system where the dollar is the reserve currency and most everyone has built a US export dependency. Willingly or not, they all are compelled to follow Big Ben’s lead, a man whose academic rigor and credentials as a central banker are more than just questionable. (Fred Sheehan, Marc Faber on Ben Bernanke. I am not sure whether this global liquidity experiment will be to the advantage of the more timid participants such as Europe; they may end up with the short end of the stick.

One thing is sure; we are not dealing with the origins and root causes of this crisis. Instead we are moving farther and farther away from being able to handle the risks and uncertainties in our system.

Buckle up!

Comments Off | financial Crisis

World Energy Policy, Copenhagen 2009

November 11th, 2009 — 8:20am

Copenhagen 2009 PDF

In December 2009 Copenhagen will host the Climate Change Conference in what is hoped by many to be the single most important environmental event since Kyoto back in 1997.

Media and politics is dominated by a great deal of half-truths and erroneous beliefs about our global energy economy and its impact on our environment. Above all, the impact on our much revered GDP growth is generally being exaggerated. This is particularly apparent when held against the fall-out created by the irresponsible handling of other issues and industries such as the current hot beds, finance and health. A well-informed, well-coordinated plan to clean up our planet and invest in future energy generation has the potential to create millions of jobs globally and to substantially improve our quality of life.

Whether or not global warming is caused by carbon emissions, the fact is we are polluting our planet. Today’s global energy policies are ill coordinated and mostly ill conceived. An economic analysis of the energy industry—reveals some shocking shortfalls and surprising conclusions. In a series of short articles I will try to provide a basic background to facilitate a more informed discussion on the subject.

Although certain alternative energies hold great hopes for the future, most are unlikely to become a valid alternative to fossil fuels for the foreseeable future. As a group, excluding hydropower, they account for no more than 1.3% of current energy production, and it is unlikely they’ll reach the 5% mark by 2030. An acceleration beyond that point should not be ruled out, but a number of technological and economic constraints are inherent in all currently available alternative energies.

The alternative economy can under no feasible circumstances make a serious dent into fossil-fuel energy production in the next 30 years, nor can nuclear or hydro power. They will remain an alternative for a long, long time, for reasons as various as physical availability, supply channel complexities, technological constraints, intermittency, high capital costs, and high inherent energy intensity.

If we are truly serious about cleaning up our planet decisively and immediately, the only feasible short-term solution I can see is to reduce the polluting qualities of fossil fuels, coal in particular. The cleaning of coal (carbon capture and storage, or CCS) as well as an accelerated extraction of coal-bed methane have a potentially much larger impact on carbon emissions than any renewable energy resource (including wind) over the next few decades.

Coal accounts for one quarter of total global energy consumption and over 40% of electricity production. It is our largest polluter and, according to Westhall Capital, emits 30% more pollutants than oil and almost double the pollutants of gas. Roughly, coal is responsible for 40% of global emissions of carbons and other pollutants. Any realistic and serious attempt to engineer a significant reduction in carbon emissions in the next 30 years will have to include carbon capture and storage (CCS).

Total installed coal capacity on the planet equals approximately 2,500 GW (gigawatts). According to the most recent calculations, retrofitting half of all coal plants on earth, approximately 1250 GW capacity, would cost us somewhere between $1 trillion to $1.5 trillion, plus an additional yearly expenditure of $100 billion to fit each new plant. Within 10 years the world could reduce carbon emissions by 20% for a total cost of about 3% of global GDP and in future build clean coal plants for an annual (additional) cost of no more than 0.2% of global GDP. Both CCS as well as coal-bed methane have reached technological maturity. Coal-bed methane has the added benefit of shifting our energy balance away from oil and away from our most unstable sources of supply. The U.S. holds an estimated 29% of global coal reserves; Russia, China, India, Australia, and South Africa together account for 50%.

For all our great achievements, we have yet to summon the political will to admit and react to the fact that we are abusing the resources of our planet because the market doesn’t force us to pay for some of them. We refuse to reverse a historic tax break for fear of slowing down our GDP growth. So far the scale of political commitment to reduce polluting emissions of energy production has been extremely small: CYKE, an independent research outfit, estimates alternative energy subsidies amount to between $50billion and $100billionn per annum globally (0.1% – 0.2% of global GDP); the market for carbon trading is worth about $120billionn per annum; and carbon taxes, with a few exceptions such as France, don’t really exist yet.

Is it not time to finally and in earnest start to internalize the external costs of our energy production? It will cost the GDP economy, but it will benefit the GQP (gross quality product) economy.

In all of it, it is crucial for the USA to understand that the world needs it to reclaim its leadership role in energy. Who else but the largest, richest, strongest, and most-polluting economy can stand up and change the game, and then elevate it to the next level? A committed participation is likely to bring in other important polluters such as China and India. Energy policy must finally receive the top priority it deserves.

Strategically, we must come together as a global community and step beyond the special interests that dominate local politics. We must better coordinate our investment in the future energy economy and agree on a system (cap and trade and/or taxes) that puts a price on the resources we are squandering today.

Tactically, to reduce carbon emissions in the short-run the only realistic choice we have is to clean coal.

3 comments » | Energy

The Mother of all Asset Bubbles

November 7th, 2009 — 6:54am

Mother of all Asset Bubbles (PDF)

On November 1, Nouriel Roubini published a must read article in the Financial times titled “The Mother of all Carry Trades”.

He describes excellently what is going on in the markets and how another globally synchronized asset bubble is created by the reckless policies of the US Fed. Roubini Mother of all Carry Trades PDF, Link.

In short, Mr. Roubini explains how the financial markets have figured out a way to orchestrate an asset boom that is even more divorced from the real economy than the prior bubbles. The Fed has held interest rates near zero since Dec 2008 and has stated on Nov 4, 2009 that it will only consider raising rates if it sees a pick-up in “inflation” (which to Fed is the core CPI) or “resource utilization” (presumably employment). It also pursues quantitative easing via asset purchases that expanded its balance sheet from $800 billion in 2008 to now $2’000 billion.

In essence the Fed has created a situation where one can borrow at hugely negative interest rates (zero nominal rates coupled with a dollar depreciation) in the comfort of contracting risk premia (contracting “risks” are a happy byproduct of liquidity pushes in the world of modern finance, irrespective of and detached from real risks). The Fed is thus successfully stemming a deflation of assets with a supercharged version of its policies that created the credit mountain and asset bubble pre 2007.

Many will think to themselves that this is folly, wrong, even reckless, on so many fronts but what is the alternative? All alternatives are painful. It is very naïve, even irresponsible to assume that current policies wont be painful merely because our leaders’ horizon doesn’t extend beyond their next election cycle.

The Fed, Wallstreet and political authorities continue to hope that eventually their liquidity pushing will result in renewed economic growth. But what evidence is there that their policies are working or have ever worked?

Since 1999, in the greatest expansion of credit in human history, total credit in the US economy alone more than doubled in size from $25 trillion to now more than $55 trillion. This is close to 4 times US GDP and in relative terms 2.5 times more than prior the Great Depression.

This huge expansion in liquidity was not recognized as hyper-inflationary, as the choice of measure for inflation was and continues to be the core CPI, which for the time being continues to be only marginally affected by the liquidity generated. It was primarily asset markets such as stocks and properties that expanded at breakneck speed, despite visible deterioration of economic strength.

In the credit mania up to 2007 the American consumer still participated, somewhat. But he is done, no more expansion for him. Although his real income had hardly expanded throughout the past decades, rising property and stock prices allowed him to expand his demand by increasing debt and push consumption relative to GDP to a record 73% (USA). That compares with global averages in the low 60ies.  However, as we can guess, the great leveraged boom was almost completely void of real economic substance.

In the period from 1999 to 2007, to create one dollar of real economic growth, more than seven dollars of credit was needed. Compare that to approximately 1.5 dollars of credit needed for every dollar of real growth generated back in the 1960ies.

John Mauldin shows that without mortgage equity withdrawals, the average annual growth in the US economy from 1999 to 2007 would have averaged a measly 0.5%.

Today, two years into the crisis, the Fed and politician are still trying to convince themselves that if they only push more and more credit, no matter in what form or shape, the economy will revive eventually. After 10 years of reckless monetary expansion, they simply up the ante, creating conditions for the mother of all asset bubbles without regard to history and foolishly convince themselves to know how to land this supernova of credit softly in the arms of the next economic expansion.

Is there any doubt that the US consumer has to reduce spending and leverage in the coming years and adjust his demand to levels in line with real income pattern? This will be doubled down by huge demographic effects that are starting to kick in just about now.

Is there any doubt about the real economic impact of these inevitabilities?

The American economy has been weakening to near exhaustion with ever larger liquidity infusions necessary to keep it alive. Last quarter’s positive real GDP growth of 3.5% is not the sign of recovery that is happily cheered on by a Fed and a market hell-bent to ignore the quite obvious internal weakness of this figure which is driven by an inventory cycle and silly fiscal schemes such as the “cash for clunkers” program which merely borrowed a little more consumption from the future.

Crucially, however, personal expenditures and income figures remain weak, as is employment. Investment continues to decrease as is lending, accelerating its contraction from 3.9% yoy in September to 6.8% in October. Who would expect rising  investments when capacity utilization is at record low levels? Equally weak were the internals of an overall positive, but largely meaningless ISM report.

Banks, commercial banks that is, are tuned into the economic realities and they have been forced to adjust their assessment of risks and outlooks for cash flow generation. History teaches us that they will only start to lend again when they can see the cash flows well on track to recovery. As the consumer has to scale back there is no reason to expect these cash flows to come even close to the levels of the height of the boom.

But if lending is not possible or profitable in the real economy banks, that is their “hedge fund” like divisions simple leverage themselves up in a hugely profitable carry trade and pay themselves handsome bonuses, completely ignorant (or defiant) of the risks they accumulate yet again. After all, they can safely assume that in the next crisis we, the government will be there to pick up the pieces yet again.

It is very clear where Ben Bernanke, the head and brains behind this operation is leading the US and the world economy. For him, debt doesn’t matter, even if it is deployed completely divorced from any economic reality whatsoever. As long as asset prices measured in dollars are keeping up all is well for him and those who derive their income from turning those assets for a fee.

Mark Faber, one of those countless marginalized professionals who have been right every step of the way puts it as follows, “Personally, I think the future will be a total disaster….massive government debt defaults, and the impoverishment of large segments of Western society. But what I don’t know is whether this final collapse, which is inevitable, will occur tomorrow, or in five or ten years, and whether it will occur with the Dow at 100,000 and gold at US$50,000 per ounce or even confiscated, or with the Dow at 3000 and gold at US$ 1000.”

17 comments » | financial Crisis

Reforming Banks II, United Kingdom

November 4th, 2009 — 1:49am

Reforming Banks II, United Kingdom

UK authorities have announced that they will break up two of its banks, the ones it now controls, Royal Bank of Scotland (RBS) and Lloyds. Back in 2006, RBS was the world’s largest bank as measured by the size of its balance sheet, which then amounted to $3’700 billion. RBS was also by far the fastest growing large bank in the years up to the crisis. No wonder it is in trouble, again. RBS and Lloyds are to be supplied with a total of $88 billion in capital, almost $50 billion from government funds.

Rightfully, the government should start to influence how these banks are run. However, the direction this influence takes doesn’t follow sound logic but advice from these banks’ competitors and supposedly pressures from the European Union competition authorities.

According to the Financial Times, RBS is held to sell its insurance businesses (Direct Line, Churchill and Green Flag), its small business operations in England and Wales, and its Global Merchant Acquiring business and Sempra, a commodities trading business. Lloyds will be forced to sell some of its retail banking operations and its Intelligent Finance online business.

Most everyone agrees that our financial superstores will have to be reduced with the goal to eliminate the hazard of businesses that are too big to fail. It is however preposterous to sell this effort with arguments of competitive policies which are nowhere near the center of our issues we have with banking today. Simplistically reducing bank’s size doesn’t change the fact that these banks run business lines for which they lack competence and institutional structures. The issue is not that that we have had commercial banks dominating a particular area or of commercial banking or too much concentration in any area of finance.

The issue is that our largest financial businesses try to run every kind of banking and financial service there is and are, not surprisingly, in over their heads.
Of course and without any delay, compatriot Joe Ackerman, CEO of Deutsche bank and supposed spokesman for our financial superstores has taken a stand against the “totally misguided” downsizing, calling it “unacceptable”.

He is right in one thing, the problem of too big to fail will not be solved by asking a bank with a $3’700 billion balance sheet to sell some branches and fringe businesses in which competitive authorities find “too much” concentration. It will still resemble an over-sized hedge fund, itself larger than the global hedge fund industry combined. RBS will remain intertwined and interconnected in the globally fungible world of finance. It will still run businesses for which it is utterly unqualified. And it will continue to do so with risk management tools that are sophisticated only to a non-mathematician and wholly inadequate, to put it very mildly.

Even though Mr. Ackerman is right, UK authorities are “totally misguided” in their action, his outrage only counters the advice given by his colluding peers across the aisle in a farcical charade that diverts attention from the real solutions, which would arguably be much more drastic for Mr. Ackerman and his peers.

I for one do not want to hear from Mr. Ackerman again until he explains how he manages his bank and its risks and tells us how his sophisticated models have failed him and his peers so miserably. I want him to explain the more than controversial concept of Value at Risk (VAR) to the public and why he believes he can be everything to everyone: an Investment Banker, an Asset Manager, a Private Banker, an Insurer, a Commercial Banker, a Derivatives Trader, a Broker and an Adviser on most everything the world of finance has to offer today.

Unfortunately, as long as government is being advised by the very banks it ought to reform, I guess we are fools to expect any independent logic in policy decisions. Even heads (and former heads) of central banks, i.e Mervyn King and Paul Volcker do not seem to have the gravitas to redirect the fateful course we are on.

Comments Off | Eye of the Storm, financial Crisis, fiscal policy, Regulation

Reforming Banks

October 27th, 2009 — 12:59pm

Reforming Banks PDF

If you are interested in more background here are two relevant chapters of  Eye Of The Storm, (16) Asset Management, (17) The UBS Story

First, let me apologize for my long silence on my blog. It wasn’t a leisurely summer as some of you will have enjoyed: rising markets, lots of “Green Shots” and a couple of weeks at the beach, what more can you wish for. Not for me though.
Some of you know that I am not primarily an author and commentator. My entrepreneurial spirit has the tendency to take over and keep me busier than I bargain for. I am involved in a very exciting multimedia project produced by my wife Sandra (Yndico), that also uses the prototype of a, I dare say revolutionary, E-commerce  engine Yndico Store,  produced by a venture in which we have also become involved (facilitating the dawn of the much anticipated social commerce, you can get a little glimpse here:  Magnet).

Certainly, I have been following news and events, the return of the bulls, the inventory cycle, by many mistaken as the end of the economic crisis, and the sad tales and tragedies that gloomed up the summer while the political debate in the US grew beyond silly. Before I start; I have a pdf version of this post attached for all of you who like to read in two columns (I found that I am a much more efficient reader this way as my field of vision does just not cover the full width of a page).
After such a long time, there is much to talk about. Unfortunately, as you might have guessed, I cannot join in the cheerleading of the bulls amid the more than 50% rebound in stock-markets across the planet and all the economic “green shots”. Personally, I expect the next leg down to start any time now as hope gives way to facts and the reality of what we are up against. In the coming weeks I will try to address the important issues we face in our global economy. I will address the misguided fear and expectations of inflation that is taking hold in finance and media and explain why continuing deflation is so much more likely.
I will address the state of the economy and the inventory cycle that is being mistaken as a new dawn announced by the equity-markets’ rebound.
I will talk about China and emerging markets and why most of them are in for an even worse 2010 than the US economy.
I will address the rotten political process (we still call democracy), in which vested interests prevail over logic and facts, in which people who obviously failed are not only being left in charge of their businesses or posts but allowed to define the rules of the future: definitely not the change many voted for and an outright corporate governance night-mare.
And, I will write to you about the dire prospects of current policy direction that further impoverishes Main Street at the expense of Wallstreet that is driven by a misguided fear to take on the rotten structures in banking.
Although this all sounds very gloomy, I am in fact very upbeat about our long-term future. Technological change is clearly accelerating and is opening up huge opportunities. I believe in the ingenuity of people; we have always emerged stronger from any crisis. Today, the $50 trillion question is: who will pay for the mistakes of the past? Current policy direction would have Mainstreet footing the bill. This is glaringly unfair and given the scale of things, the resulting inequalities have the potential to become highly explosive.   There is much to cover indeed.
But, rather than concentrating on the negative, let us start with solutions. Last week, Mervyn King, the governor of the Bank of England took up ex-Fed Chairman Paul Volcker’s demand (voiced back in June) to split up our financial superstores along institutional lines (finally, I dare say). Promptly, Gordon Brown and Alistair Darling rebuked Mr. King, with the argument that the problems in the banking sector are more complex than Mr. King suggests, which is amusing coming from those two. Not surprisingly these two are pinning their hopes on more regulation. More regulation? Well, yes, rather smarter regulation is indeed necessary. Yet, it is precisely the complexity of the system that calls for a good dose of more market orientated measures.
Yes, agreed our regulators and financial “experts” were asleep at the wheel and that has to be changed. But we should not mistake the past 30 years in finance as a period of free-wheeling markets. In fact, quite the opposite is true. With regulators looking the other way, the “big and beautiful” took control and made finance their own, controlling the entire span of financial services in a happy hugely profitable oligopoly, rigging the market to their advantage and in the process distorting some of the most important price signals such risk or interest rates.
The financial industry is characterized by a variety of business structures with different risk profiles and functional dynamics that demand specific organizational and institutional structures, human resources and incentive systems. Described in detail in “Eye of the Storm” (www.eyeofthestormbook.com).
A commercial bank doesn’t have the institutional structures nor the functional abilities to advise anyone on investments (even less to manage assets themselves). HSBC, undoubtedly one of the most prudent and the most successful commercial bank on or planet, thrives on its strategic imperative that its core business doesn’t have the resources or structures to be successful in investment banking.
Yet today, virtually all globally leading commercial banks offer the entire span of services and products our financial industry has to offer and generate the bulk of their earnings in asset management and investment banking.
This was primarily made possible by the abundant tool box of Modern Finance that became wholly accepted, then mis-applied by bankers and cheered on by regulators and central bankers during the past 30 years. With the fall of Glass Steagall in 1999 in the USA, the last bastion of restrictions was lifted, with devastating consequences.
In the three years up to the summer of 2007 alone the top 20 global commercial banks increased their balance sheets by $20 trillion, 150% of US GDP.
Take the case of UBS, a swiss bank. At the end of 2006, UBS was the world’s 7th largest bank with $2’000 billion in assets on its balance sheet (Royal Bank of Scotland was the largest bank with a balance sheet of $3’700 billion). Of these assets straight loans amounted to $260 billion. UBS’ non-core business therefore was (and continues to be) a multiple of its core business. UBS also advised a total of $2500 billion of client assets for a fee.  Thus, in total, this commercial bank exerted influence on $4’500 billion in assets, roughly 10 times its host country’s GDP, 17 times its own core business and 110 times its equity capital. UBS became a hedge fund much larger than the total estimated size of the global hedge fund industry (approximately $3’000 billion).
During the past two decades, UBS and its peers crowded out smaller and better suited firms to handle the risks they ended up taking with misguided inadequate management tools. Smaller, entrepreneurial firms had no chance in the face of the balance sheets and market power of our commercial banks.
In order to even justify being able to manage these astronomical sums, UBS and its peers rely on the mathematical risk models spawned by Modern Finance. These models allowed them to boil down complex and diverse fields of businesses, investments and risks into simple and “precise” formulas. The inadequacies and dangers of the wholesale application of these models had been proven long before 2007. The irresponsibility with which they were applied and condoned by auditors, boards, regulators and central bankers is not open to subjective interpretation. The dangers were clear to everyone yet the money train was simply too big and too strong for anyone to stop.
When it was finally brought to a halt by ever more ridiculous practices, we had amassed the largest pile of credit in human history. In relative terms the USA’s outstanding credit today is 3 times the size it was at the beginning of the Great Depression. Worse, this credit was accumulated to a very large extent by institutions that were as ill-qualified as they come, using tools as unsuitable as anyone could imagine.
Yet, it would be wrong to blame securitization or derivatives for this crisis. Modern Finance and its tools have brought much efficiency and progress to finance, yet in the wrong hands they are wreaking havoc.
Now, as the chickens have come home to roost, these same bankers who mismanaged and rigged the market on a grand scale ask the taxpayer for a bailout. They then turn around and pay themselves large bonuses (based on such ridiculous arguments as to retain top talent), instead of accumulating capital reserves. In addition, not only are they being left in charge of their businesses but also of their own industry’s restructuring. Even Mr. King says he would allow bankers to “write their own will”.  Don’t we all hate men without spine?
It is a corporate governance night-mare that no private business would ever get away with. Our representatives, our politicians need to finally wake up to the monumental risk that commercial bankers pose, a risk that has become even larger in the 2 years since the crisis broke. It is dishonest and shamefully irresponsible to point the finger at hedge funds and non-bank financial institutions, while the truly responsible are declared too big to fail, too delicate to touch and too powerful to replace.
Central bankers, auditors, boardrooms and politicians alike need to finally drop their irresponsible attitude towards the theories of Modern Finance and how they are applied within our banking system.
Restricting commercial banks to commercial banking doesn’t mean the end of Modern Finance or securitization. It means that we are able to nurture a more nimble, fragmented, specialized institutional landscape that functions within a framework of proper incentives, checks and balances and businesses able to properly take and manage risks. Our financial system is indeed too complex for any one institution to handle the entire array of products on offer, in particular commercial banks. Properly framed and managed no institution in our financial industry will be too big to fail.
In closing let me say it again: this crisis was not an unforeseeable “Black Swan” event. We were headed towards the abyss for years with warnings ignored at the levers of power the world over. It is shameful to now stand in front of cameras and say “no one saw this coming” and feed the media and the people half truths and confusing, ill-informed garbage on the workings of the financial system. If you don’t understand it, admit it and step aside! There are enough independent professionals who understand exactly what is going on. This crisis was glaringly obvious to a great many people who have been ignored by greed and arrogance at the expense of every decent hard-working taxpayer.
Whatever self-serving politicians proclaim Mervyn King and Paul Volcker ought to be taken serious. It is our duty to act decisively. It is certain that most bankers wont like it. But everyone else will.
Mervy King Speech
Reaction by Brown and Darling

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