Arbitrage and Monopolies

I cannot think of a more worthwhile read for those who are interested in credit markets and banking (and don't have the money to subscribe to Grant's Interest Rate Observer) than The Institutional Risk Analyst.

This week's article discusses credit arbitrage and bubbles. I think the key passage of this essay is:

The "bank monopoly" problem was well-outlined in Adam Smith's treatise and well-documented in the past decade by the Cruikshank Report in the U.K. (March, 2000). In simplest terms, whenever the arbitrage process that balances markets is monopolized, crises become commonplace. It is almost definitional that a financial market monopolist cannot "hedge" its "bets." As with the famous Hunt brothers' attempt to corner the silver market, when a monopolist buyer decides to sell, there are no other buyers, so the value of the monopolized commodity falls rapidly. When that commodity is loans, the result is a financial crisis. It is the alternation of "shoot the moon" and "fire sale" which arises when government policy monopolizes credit markets that causes financial markets to vacillate between euphoric bubbles and climactic crises.

I think that it is foolish for policy makers to believe that they can regulate or legislate away volatility, and absolve the markets of booms and busts. Economic booms and busts are offshoots of human behavior: human creativity, fears, greed - all these aspects lead to the change for better or worse.

Jails and Prisons - controlling the population

This a very thoughtful article on maintaining order in jails from the City Journal. It brings up something that I have thought a lot of, and that is prison reform.

I am a big believer of locking up violent criminals for a long, long time. However, I think how prisons are run today is disgraceful. Gangs are the de facto rulers of many institutions. Drugs and contraband are rampant. Rapes are prevalent. We should have prisons where contraband and rape is rare, violence is minimal, and the guards control the prison, not the prisoners.

I think that it is something that needs to be addressed, but is not a priority. The electorate generally wants people locked up for crime, which is understandable. But, the current prison, as construed, just encourages recidivism, and in many cases is just another criminal location.

This is very interesting to read, and I hope it puts some spotlight on real prison and jail reforms that work.

Net migration out of New York State - and some advice.

A great little article from a great periodical City Journal on the hemorrhaging of people out of New York state. Living in North Carolina - I cannot believe how many Buffalo ex-pats there are down here. It is great as I have a fondness for the city.

However, I have one piece of advice for all the New England refugees down here. Please remember that it was voting for tax and spend big government politicians in your home states that destroyed your economies, and thus the reason why you're down here. We don't want those policies here.

Elucidating Senator Kay Hagen (D-NC)

I was listening to a radio interview with North Carolina Democratic senator Kay Hagen. To say the least it was amusing. She vacillated on whether she would vote for tax increases to pay for a public option. She vacillated on whether she'd vote for any bill with a public option.

What I found was most annoying was her assertion that the present proposals would cut costs by encouraging people to avoid the emergency room and visit their primary physician.

I can tell you that the opposite will happen - based on my experiences in Canada. Assuming we have a "public option" that will pay like medicare - i.e. below market rates, we will eventually see a doctor shortage as prospective doctors will see the hassles and pay not worth the time to go through the education and training required. In Canada, the provincial governments deliberately created a shortage of doctors - believing that doctors, via their billings, were the prime cost driver of public health care. The provincial governments limited the spots in medical schools and capped billings by doctors.

There are three levels of doctor shortages in Canada. If you're in a major metropolitan area - you have to book your appointment with your G.P. several months in advance. If you're in a minor city (i.e. around 100,000) - you may or may not get a doctor. In my case - I called in a few favours from some school friends to get a doctor. So your rolodex is your friend in socialized medicine.

If you're in a rural era - you're SOL. Some practices have lotteries to see which people will become patients. The rest are stuck with the emergency room.

So what happens down here is that if you force everyone to be paid at Medicare rates under a "public option" - you'll have fewer doctors practicing and those without one will be forced to the emergency room - which will raise costs. Go to an emergency room in Canada - most of the people are there for stuff that a G.P. should do - but they don't have one. Because people don't pay out of pocket - they'll abuse the E.R. You see it here with medicaid recipients clogging the emergency rooms.

So Kay Hagen doesn't know what the heck she's talking about.

So much for Keynes

Over the past year or so, much of the press and the political class have been talking about how Keynesian policies are making a comeback. Things like government spending to stimulate the economy, etc are all in vogue now.

Although I think Keynes general theory does not work, I understand the intuitiveness of his theory. I think that the key premise of the his theory is that government needs to be counter-cyclical to the economy. In other words, governments should be hiking taxes/cutting spending/removing stimulus in up cycles and increasing spending/cutting taxes/adding stimulus during downcycles. The premise being, that government would temper the excesses of up cycles by pulling excess capital out of the market by fiscal policies and the severity of down cycles would be minimized as well.

Once again, the destroyer of most economic and political theories is once again - human nature. Recent history has shown how politicians cannot help themselves. During the up cycles through 1991-2007, federal and state governments slashed taxes and ramped up government programs - goosing an economy fueled by artificially low rates. Now, that times are tough - these same governments are cutting spending and raising taxes (at least on a state level, the federal government is raising taxes and increasing spending), which will not help one bit.

The problem is that politicians are incapable of not expanding the scope of government: they are addicted to increasing spending and incapable of cutting it. The taxes are just the result of this problem. This is why Keynes belief that government spending must be counter-cyclical cannot be a reality.

Missing in the "health care reform debate"

I'm not the only one to notice that when the Democrats talk about how medical costs are spiraling out of control and how the government needs to fix it - they never mention the direct and indirect costs of lawsuits on costs. Notice that this is not addressed at all? Obama talks about all these "unnecessary tests being done of dubious worth" - but what he doesn't mention is that many doctors do all these questionable tests as a form a defensive medicine, i.e. to protect themselves from lawsuits. Simple example - you can thank people like John Edwards for the increase in Caesarian sections - all the lawsuits alleging cerebral palsy from normal childbirth have led more and more OB/GYNs to avoid the lawsuit risk and just go with the C-section. Yes they cost more - but it avoids all the litigation costs and the increase in malpractice insurance. Unless this is addressed - no other reform will reduce costs.

Boy I miss these ads.

I certainly would rather see these ads than all the Viagara, Cialis, KY Jelly, Yaz, Trojan, and Valtrex ads currently running.

Market tidbits

• The equity markets are quite overvalued.  When the S&P 500 was below 800, I started seeing some decent valuations of various non-financial equities.   This is a bear market rally, in the sense that earnings can not, and will not, support the valuation levels of today.
• Don't let bank earnings fool you - a good chunk the Q1 profits by the major banks were derived by mortgage origination fees from people refinancing into 4.5% 30-year fixed mortgages.  Pretty well anybody who was creditworthy who could refinance pretty well did.  Second, thanks to the Federal government going trillions of dollars into debt, long-term rates are on the upswing (I have posted earlier that I think this is the beginning of a 20-30 year trend) along with mortgage rates - so that revenue will dry up.  There are still unrealized credit losses in the commercial loan sector and some parts of the home mortgage market.
• Obama's tax proposals will be another job killer.   Corporate tax increases like the elimination of parts of the foreign income deferral (a.k.a. Subpart F of the Internal Revenue Code), personal income tax hikes, possible cap and trade legislation, talk of a VAT, etc - this will depress earnings as the economy tanks.
• Bank stress tests mean nothing - due to two key issues.  First, nobody really knows the fair market value of the CDOs now on the books of these entities, and second, the problem now are Credit Default Swaps.  Credit Default Swaps helped down AIG, LEH, and Bear Stearns, and there is a real need for regulatory reform here.   The problem is that JP Morgan and Goldman Sachs are playing the Treasury and Fed in order to keep their market share and revenues from this business.   See the Institutional Risk Analyst for more on this.

Random Thoughts

• Any "reform" coming out of Washington is not that.  This is because Congress and the regulatory bodies are captive to the groups they regulate.  Regulatory Capture is nothing new, but it will cost us more.  TARP and OTC derivative "reforms" are there to benefit a handful of broker dealers.  Credit Card "reform" does not really hurt the major issuers.  Education "reform" will never injure the teacher's unions, etc.  This leads to a fundamental question about regulation - more regulation begets more regulatory capture.   Simple principle based systems may be the way to go.
• Requiring U.S. based corporations to immediately pay U.S. income tax on foreign earnings is a major job killer if current rates stay.  Most countries tax on a territorial basis (i.e. you earn in our country, you pay tax in our country), while the U.S. taxes on worldwide income (regardless of where it is earned, if you are a U.S. based group of companies).  You will see a lot a major multinationals "invert" whereby their corporate parent becomes domiciled overseas and the U.S. operations become a subsidiary in order to avoid this onerous tax burden.  You will see a lot of talent, jobs, etc move overseas - the type of people and jobs this country needs to compete going forward.   Obama and Congress' punitive measure will be a huge gain for Hong Kong, Singapore, Dubai, Zurich, Dublin, and other less taxed and regulated financial centers.
• How the heck does changing fuel economy standards to 39 mpg by 2016 keep any jobs here?   The current cost structure for the big 3 means that they have a $1,500-$2,000 legacy cost per car for retiree pension and health care benefits (this will probably drop a bit, but the bailout of GM and MOPAR is really a bailout of the UAW as they have not made the same degree of concessions as everyone else).  So the government will force the automakers here to build cars no one wants to buy at a price where they can make a profit without a huge taxpayer subsidy.   The new generation of fuel efficient cars of the big 3, few will be manufactured here because of the labor costs.  We, the taxpayer, will be on hook for propping up the UAW.  The more sensible solution would be to jack up fuel taxes - but that won't happen, or just let the market solve it - as the spike from last summer showed that people will switch to smaller, more fuel efficient cars.
• State governments will always have structural deficit problems until they get rid of defined benefit pension plans and generous retiree health care benefits for government employees.   The problems that the Big 3 have with the UAW pension and benefits is a precursor of what will happen to state and local governments unless this is addressed.
• I went to a mayoral candidate's debate the other day, and both the Democrat and Republican repeated pledges to "invest", whether it be "light rail", "affordable housing", or "good schools".   Most of the questions were about neighborhood issues, where the candidates pandered.   I stood up, and was the only one to ask "You talk about 'investing' in this and that, but I have not heard a single word of how you are going to pay for this.  When I hear politicians talk about 'investment', I cringe as I know my taxes will go up to pay for this.  How are you going to pay for this without going into debt or raising my taxes?"
• For a good read on the follies of "light rail" and "smart growth", get Randall O'Toole's "Best Laid Plans". Seems that the common theme over light rail plans in the U.S. is that they go at least 50% over budget and never meet their overly optimistic ridership projections and are bound to be a money pit.

The illusion of CDS regulation

I cannot recommend enough reading through the Institutional Risk Analytics newsletter.   This is the source for understanding bank solvency and the regulatory issues surrounding the current banking problems.  This particular piece discusses how the major investment banks have hijacked the process of regulating credit default swaps.  Another prime example of how regulators are held captive by the industries they regulate.  Here's a tidbit:

Why such a desperate battle for the OTC derivatives markets? For the world's largest banks, the OTC derivatives markets are the last remaining source of supra-normal profits - and also perhaps the single largest source of systemic risk in the global financial markets. Without OTC derivatives, Bear Stearns, Lehman Brothers and AIG would never have failed, but without the excessive rents earned by JPMorgan Chase (NYSE:JPM) and the remaining legacy OTC dealers, the largest banks cannot survive. No matter how good an operator JPM CEO Jamie Dimon may be, his bank is DOA without its near-monopoly in OTC derivatives -- yet that same business may eventually destroy JPM.

The key thing for the public and the Congress to understand is that the "profits" earned from these unregulated derivatives markets are illusory and do not cover the true risk of OTC derivatives. Put another way, on a systemic basis, risk-adjusted profits from OTC derivatives are not positive over time. As with the current crisis, the net loss from the periodic collapse of what is best described as gaming activity gets off-loaded onto the taxpayer, thus OTC derivatives must be seen as any other speculative activity, namely a net loss to the economy and society. But unlike taking a punt on a pony at the racetrack, bank dealings in OTC derivatives vastly increase systemic risk, make all banks unstable and threatens the viability of the real economy.