Death by Bubble

Economist Andy Xie says Lehman Brothers died in vain and that it’s just a matter of time before we get hit by another deadly bubble. His guest post at Caijing Magazine is just so dead on that you must go read it.

There has been plenty to learn from last year’s miserable economy and near collapse of key financial markets but U.S. policy makers appear to rebuilding the same system with the same ghastly mistakes in place. We cannot afford to be complacent about this because if it’s done, another huge mishap can’t be far behind. Xie explains that the entire financial system is one big Lehman now and has become much more costly to bail out.

So Lehman died in vain. Today, governments and central banks are celebrating their victorious stabilizing of the global financial system. To achieve the same, they could have saved Lehman with US$ 50 billion. Instead, they have spent trillions of dollars — probably more than US$ 10 trillion when we get the final tally — to reach the same objective. Meanwhile, a broader goal to reform the financial system has seen absolutely no progress.

‘Absolutely no progress’ may actually be an optimistic estimate of the current situation. No progress would mean, to me, we’re not rebuilding the same time bomb. Xie’s article is remarkable in that it deconstructs the arguments one-by-one that we’re hearing that things are really changing, What we actually have is the proverbial shuffling of the chairs on the financial Titantic.

Top executives on Wall Street talk about having cut leverage by half. That is actually due to an expanding equity capital base rather than shrinking assets. According to the Federal Reserve, total debt for the financial sector was US$ 16.5 trillion in the second quarter 2009 — about the same as the US$ 16.6 trillion reported one year earlier. After the Lehman collapse, financial sector leverage increased due to Fed support. It has come down as the Fed pulled back some support, creating the perception of deleveraging. The basic conclusion is that financial sector debt is the same as it was a year ago, and the reduction in leverage is due to equity base expansion, partly due to government funding.

This, of course, leads to the most fundamental question of all. What happens when the government funding disappears? I admit that I see no end to that infusion unless the Fed or some other central bank becomes spooked by the possibility of inflation. These institutions would have to be rebalancing their portfolios in lieu of all the M&A activity they’ve undertaken this year to be able to live with out cheap government funds. Some of them may be repaying the TARP funds, but the real deal happens when Quantitative Easing and ZIRP ends. We’ve had no indication from the FOMC or Bernanke that that’s in the works any time soon but I can tell you, one little glimpse of inflation and the game ends there.

Now, here’s my favorite point. It’s this bull market where the shadow banking system profits from churning and running up your own portfolio by selling it back and forth between the parent and subsidiaries to create a false sense of momentum.

…financial institutions are operating as before. Institutions led in reporting profit gains in the first half 2009 during a period of global economic contraction. When corporate earnings expand in a shrinking economy, redistribution plays a role. Most of these strong earnings came from trading income, which is really all about getting in and out of financial markets at the right time. With assets backed up by US$ 16.5 trillion in debt, a 1 percent asset appreciation would lead to US$ 16.5 billion in profits. Considering how much financial markets rose in the first half, strong profits were easy to imagine.

Trading gains are a form of income redistribution. In the best scenario, smart traders buy assets ahead of others because they see a stronger economy ahead. Such redistribution comes from giving a bigger share of the future growth to those who are willing to take risk ahead of others. Past experience, however, demonstrates that most trading profits involve redistributions from many to a few in zero-sum bubbles. The trick is to get the credulous masses to join the bubble game at high prices. When the bubble bursts, even though asset prices may be the same as they were at the beginning, most people lose money to the few. What’s occurring now is another bubble that is again redistributing income from the masses to the few.

Yup, there it is. The idea that many of the bigger players are just trying to run up the market enough to entice the suckers back near the top. Catch the one about redistribution? We’re basically using cheap money to finance the reverse Robin Hood scenario one more time.

…financial supervision has not changed. After the Lehman crash, most governments were talking about strengthening financial regulations and regulatory agencies, and possibly establishing an international regulatory body. The developments in the past year have actually made financial supervision worse. To support financial institutions, the U.S. government suspended mark-to-market accounting rules for assets on the books of financial institutions, which has allowed them to report profits.

Revamping the financial system has been reduced to political moves over regulating banker salaries. If this could be done, incentives for financial institutions to manufacture bubbles would be removed. But it can’t be done. Financial professionals can be based anywhere in the world, and there will always be some countries willing to host them. Because of such competitive concerns, a global consensus on regulating pay for financial professionals is unlikely.

I think the ultimate objective for financial reforms is to make leverage transparent.

Nothing changes if nothing changes. Most of what we see are trading tricks and creative accounting procedures that let them mark to whatever rather they wish rather than what the current market price of the asset.

More than anything, financial markets thrive on transparency and the less transparent we make the U.S. markets, the more likely the capital will flow to the countries eager to embrace reform. I can trade and work a portfolio from a cave in Nepal and avoid all the nice little executive pay regulations set up by anyone’s czar in the Beltway. Any stock traded in any U.S. market, however, needs to meet certain requirements. If those requirements for a consistent process and transparent reporting are better in the Eurozone, that is exactly where my portfolio will go unless I have some type of insider information where I want the rest of the market ignorant.

We learned a lot about how ‘safe’ even the ‘safest’ investments were here in the good ol’ USA as last year’s biggest surprise sink hole turned out to be Money Market Funds. Yup, that’s those things every one puts their pension and rainy day funds into because, well, they’re so darn safe and liquid.

These funds are supposed to be ultra safe for buying triple-A, short-term, liquid debt instruments. The problem was their demand for liquidity. Self-manufactured liquidity provided a false sense of security despite the risks of underlying securities, such as short-term paper issued by investment banks. When that false sense of security was jolted by the Lehman collapse, all rushed to exit at the same time. Without government support, they wouldn’t have been able to get their money back.

This brings Xie to a really good point. It’s not so much our banking system as it is our shadow banking system that’s the problem. That’s where the regulation is required and so far, we’ve seen no new regulations. That’s what the proposed Consumer Financial Protection Agency is supposed to do for is and that’s exactly why the Great Vampire Squid and the other shadowy players are lobbying hard to nix it or cripple it. This is the one good piece of economic policy I’ve seen coming out of the Obama administration and I really don’t want it to fail. Here’s the latest on that via the WSJ.

Ratcheting up his drive to create a new consumer financial protection agency, President Barack Obama took direct aim at the industry groups who oppose his regulatory overhaul, calling their criticism “completely false.”

“Predictably, a lot of the banks and big financial firms don’t like the idea of a consumer agency very much,” Mr. Obama said in remarks prepared for delivery at the White House.

He pointed to a campaign by the U.S. Chamber of Commerce that claims small businesses would be hurt by the new agency.

“This, of course, is completely false — and we’ve made clear that only businesses that offer financial services would be affected by this agency,” Mr. Obama said. He also shot down concerns that the agency would restrict consumer choice and innovation in the financial arena: “Nothing could be further from the truth.”

The consumer agency is one of the main components of the regulatory revamp Mr. Obama wants lawmakers to pass before the end of the year. But it has come under fire from Republicans and Wall Street.

The banking sector has been lobbying to weaken the legislation to strip the agency of the ability to enforce the rules that it writes. Mr. Obama, however, signaled that the agency must be given the teeth to be effective.

Back to Xie for why we have to see this through, even though things appeared to have “settled down”. Remember, things have settled down only because the government is the biggest player in the financing market right now. Xie believes that this current market rally is a bubble and I agree completely. (Just for disclosure purposes, I’ll let you know I pulled my portfolio out of U.S. stocks over the weekend.)

Many investors today think a bubble is inevitable and, when it bursts, another can be created quickly to keep on going with life as usual. What has occurred over the past six months seems to validate this viewpoint. History, however, is not kind to this view. Serial bubble making leads to a bigger economic crisis later. What occurred in the United States in the 1930s and Japan over the past two decades are good examples in that regard. If a new bubble were always available for bailouts, we’d have the ultimate free lunch. But there is no free lunch.

Our serial bubble making began 10 years ago with the Asian Financial Crisis. It led to loose monetary policy in developed economies, especially in the United States, and undervalued exchange rates in developing economies. The inflationary force from this loose monetary policy was kept down by excess capacity or capacity creation in developing economies. The environment for tolerating such a loose monetary environment ends when inflation surges in emerging economies first and developed economies second.

When inflation becomes a political problem and policymakers are forced to respond, money supplies will be cut. After that, no more bubbles.

Exactly, I can’t see Bernanke and the FOMC allowing inflation again. I also can’t see the Chinese (or the Japanese) propping us up if we start monetizing the debt or tolerating inflation again. The bill is already over due. We need stop the bubbles before they completely stop us. We need improved regulation over the shadow banking system before they do is in again.

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