Saturday, December 24, 2011

2012: Images from the Crystal ball

At the doorstep of 2012, I am here again looking at the crystal ball. There are signs

Reworking the Macro 
  1. The Eurozone faces tremendous challenges at the moment. 2012 will see the aftermath of the crisis. I imagine the Euro leaders will be able to patch things back, but substantial political sovereignty will have to be ceded. One hopes the sovereignty will be returned post the resolution of the crisis. In any case, Eurozone will spend the next year in hibernation.
  2. As I mentioned in previous post, there are currently two systems - Eurozone system and US-China system. 2012 will see stresses in the US-China system rise dramatically. I think as if rhyming with 2011, we will see stress in US-China system next year same time.
  3. We may see Chinese economy under stress. I am not sure how much will happen next year but China is unusually fast. I think we will see slowing of China - about 5-6% growth level.
  4. The Arab world will experience post-purchase dissonance with respect to new-found political setup. In worst case it means some new dictators will come up and uprising may start all over again or there may be bigger political discussions.
Financial markets
  1. I see increased synchronization - both globally amongst markets and within markets among stocks. Thus, old places to hide may not actually work. 
  2. From the investor standpoint, we will be forced to be more in cash or cash equivalents.  Correspondingly, even when invested, we must look to highly liquid names. I was hoping to see derivative markets in their full splendor at such times, but MF Global and lack of counter-party settlement systems keeps check on the system. 
  3. The other fall-out of this is steeper moves - on upside and downside. It means we can make or lose money super-quick. Markets may rise 20% in a month, fall 20% in the next. We should see more talk about Vix.
  4. Funds with specific low-cash rules should find it difficult. I think in general, the strict rule-based fund management should take a beating. Fund managers with broader mandate are likely to deploy the capital better. 

All in all an interesting year ahead. My best wishes to you all and I will see you next year. Merry Christmas, Happy new Year and happy holidays. Cheers

Thursday, December 22, 2011

Comparing Euro with US-China - MMT

Edward Harrison points to a Randall Wray post about MMT, sovereign debt crisis in Eurozone.

Randall refers to difference in location of monetary policy, within the sovereign in case of UK and outside the sovereign in case of France (with ECB), leading to reduced risk of default. Randall refers to this as one main source of problems of the Eurozone.

However, Euro area is not the only problem. When it comes to difference between where monetary policy is located and where fiscal policy is located, we have two examples of this model operating currently- Euro model and US-China model. Both are at risk, different risk, but definitely at risk.

In principle, US-China model has a similar monetary-fiscal policy situation to Euro area. US sets the monetary policy and that policy trickles down to set of countries that peg their currencies to US Dollar. I have only used China as representative, in reality many more countries peg their currencies to USD and this group is bigger than the Euro-group.[1]

The issues is if you have given up monetary sovereignty, you are eventually forced to give up broad level fiscal sovereignty as well. So a system where monetary policy is regional, you must have a regional fiscal policy at least at a broad level. It all boils down to congruence between fiscal and monetary policy.

The persistence with this monetary-fiscal distortion polarizes the participants creating a production pole and consumption pole. In case of Euro area, we have Germany and Greece as representative poles. In case of US-China model the respective poles are China and US.

Now the difference is Germany, the production pole, has larger influence over monetary policy[2] in Eurozone while its corresponding pole China, has no say in policy of US. 

In the US-China case, US does not seem to have a problem. But actually it does. The model requires the China-group to keep buying US treasuries. This allows US more monetary policy room but forces these countries to absorb, either through government or overseas investment, this impact. It masks the problems of US till one fine day US suffers a heart attack. Further imagine the policy environment if Greece ran the policy in Eurozone. I won't go into more detail here but suffice to say this model is equally broken.

  1. Euro as a group, single entity, also has a similar arrangement. Here Euro-group occupies the position of US and few countries peg their currencies to Euro. In addition, Euro is also influenced by its value with respect to USD. It is sort of a complex fractal. We will leave aside these complications for the moment.
  2. Apologies to those who believe monetary policy is truly independent. And, of course - there is no Santa Claus - it was your parents all along.

Friday, December 16, 2011

Uncomplicate the Taxes

High sovereign debt implies increase in taxes in the near future. However, Barack Obama, who wanted to raise taxes, is facing stiff resistance from the Republicans. So also

There are specific problems with our tax system 
First, it is very difficult to calculate the best tax rate or the lowest tax one can pay through the system. Second, taxes have unintended consequences. They sometimes promote or prevent marriages, home purchases, bigger cars, etc. Government has no business interfering with the lives of taxpayers in such a way. Third, taxes are unfair. The rich often pay lower taxes than the poor. Fourth, there is no way to measure return on taxes just as we measure return on capital. Finally taxes are high because they are paying for over-regulation by government or they are paying for large governments.

Better simplify the tax system
It might be better if tax was simplified into just one tax, either on income or consumption. Incomes should not be classified according to their sources. All incoming cash flow should be treated as income. There should be no part exemption what so ever. Government can define a level of income below which tax rate is nil. Above that income, taxes should be at one single rate. The only flexibility in policy will be to determine what rate should be.

The common argument is about the beneficial taxes on cigarettes. Those are not taxes. Those are penalties imposed on cigarette manufacturers for damaging lives of people. Those should be recovered as penalties and directed towards treatment of heart and lung diseases.

Tax filing has been made easy. What is difficult is to figure how much tax
 we have to pay. That has to be easier. We need to protect individuals from complexity in taxes. Just like the Consumer Financial Protection Agency (CFPA) is trying to simplify credit card agreements, it should also simplify tax calculations.

Thursday, December 15, 2011

The Rakoff manifesto

Judge Rakoff's principle based on Contract rights and duties vs. legal rights and duties

Two types of rights (and/or duties)

First are rights created out of mutual agreement, called contractual rights. These exists separately outside the law. Only when there is dispute, the law intervenes. Even then, law only intervenes to clarify what is the real agreement between the parties and has it been honored. Contractual rights exist within the boundaries of law - sort of like a playground where you are free to do what you want so long as you don't hurt anyone. Second are rights created by law. These are typically like the classrooms of strict schools - ordered and disciplined, everything is straitjacketed here. Punishment is imposed by the law to those who transgress the rights of others or duties imposed on them. 

Important consideration is that contractual rights cannot infringe legal rights. Thus contracts to commit illegal acts are void.

Settlement agreement with SEC
Settlement agreements, though contractual in nature, affect rights created by law when settlement is about illegal activity. Hence I agree with Judge Rakoff, one cannot have a settlement and also be considered not guilty. 

I think Judge Rakoff is on the right track. 
  1. You cannot settle away an illegal act. And more so when the parties to settlement are not the only ones who are affected. The problem occurs when the other parties are kept in the dark and have no clue they have suffered from illegal acts. The SEC is duty-bound to expose such acts not merely settle them out. Hence the para "But the S.E.C., of all agencies, has a duty, inherent in its statutory mission, to see that the truth emerges; and if it fails to do so, this Court must not, in the name of deference or convenience, grant judicial enforcement to the agency’s contrivances."
  2. Courts are not house of power that can be called at the whim of parties. In the particular case, SEC wanted the courts to apply injunctive relief to which the counter-party, Citi Group had agreed. The role of the Court was that of an umpire. 

Wednesday, December 14, 2011

Basics: General Investment strategy

A very basic view of investment strategy is given below. I will need to explain a few terms below, but do spend time with this chart. In a nut-shell, that is all there is to investment.

Here are some basics you need to keep in mind before using that chart:

  1. We first need to do research to understand what is a good company and a bad company. I prefer to meet the management before conclusively tipping myself into either category. Companies with hints of fraud (refer to John Hempton's treatise on Chinese companies and some other fraudsters).
  2. Unclear company refers to company which cannot be classified as either. 
    • It does mean that you have conclusively eliminated the possibility of apparent fraud. Yet, something about such companies do not feel right. (yes, feel!). 
    • Alternatively, you are not convinced about the business models of such companies, though the companies may be upright and well governed.
  3. I presume we will know about bear and bull markets. Unclear markets are typically directionless markets or range bound markets.
  4. Uncertain investment strategy means, you cannot invest without substantial research. I must repeat SUBSTANTIAL research. It means unless you have a full scale financial model with sensitivities to various scenarios, macro and industry forecasts, appreciation of changing minor trends, met customers, suppliers, industry experts etc, you cannot take a call. It is like a minefield, you are taking a risk and analytical advantage can alleviate some of the risk.
  5. Going Long for uncertain companies in bull market has one disclaimer that such companies must not have fraud-flags, even feeling types. Ideal strategy for that box is "uncertain".
  6. Companies move in an out of categories. But if a company goes bad, it rarely turns good. I know people will dispute this, but that is my experience. Better stay away or go short.
  7. Ideal chart is 3-D where another axis, industry, needs to be included. This parameters takes into account business cycles. One can logically interpolate my strategy from this chart and apply it to business cycle. If someone can make me a 3D chart please email me or leave a comment.

Saturday, December 10, 2011

Fraud and illegality in the Crisis

Till recently, that is about a year ago, I believed that substantial part of causes of the crisis were a result of mistakes, incompetence and lack of understanding. However, stark evidence is emerging as to substantial fraud and illegal dealings.  

  • First was the Robo-signing scandal (which still thrives) where banks first signed thousands of mortgage applications without any background checks. When a lender behaves in such a manner, he has clearly acquiesced to default.
  • Then there was a random credit card fees scandal that Elizabeth Warren talked about. To be sure this was known before but the scale, I realised later, was huge!
  • There were some hints, particularly how Eliot Spitzer was sidelined when pursing the money trail. Eliot Spitzer was also to blame, in my opinion, he should have kept his pants zipped.
  • Next came Madoff which was more accounting scandal in the family of Enron. One might have thought we had learnt our lessons but that was clearly naive thinking.
  • Then came Bloomberg expose about secret Fed facilities to big banks. The problem here is the way Fed is structured as against normal central banks. In many ways Fed looks like a club of bankers rather than a government sponsored, independent controller of monetary policy. Fed reform is critical and I find both Senate and the House, i.e. the Congress lacking in will and expertise. 
  • Further, we get the news that Treasury secretary Hank Paulson had a closed door meeting about possible liquidation of Freddie and Fannie while claiming they were healthy to the public.
  • The ultimate was expose about Congress being allowed to trade on inside information. This is becoming tragic. This is US we are talking about not some banana republic. 
  • Then, the way MF Global was handled, the way client money was dealt with.

One important common ingredient has been how effectively democracy has been subverted by these forces. MF Global showcases how financial institutions are able to subvert the right to property, a fundamental right at the core of democracy, by allowing financial institution to use personal money to further their cause. Janet Tavakoli's recent article is right - this is class 1 fraud

Finally, I am surprised at my naivete. I also wonder why no one has yet gone to jail.

Thursday, December 08, 2011

Elite Bonds are equivalent to sub-prime SIVs

Germany and France are mulling elite bonds - essentially government bonds issued by AAA rated countries of EU to finance sub-prime countries of EU.

I read this as equivalent to sub-prime SIVs at the height of Sub-Prime Crisis. At that time, sub-prime loans were bundled with prime loans to create a fiction of higher ratings. The assumption was that these individual component loans are not correlated.

I see the same problem with elite bonds though mechanism is a little different. A curtain is drawn over the component EU states to give illusion of AAA ratings to the Greek Debt. If we have learnt something from the sub-prime crisis this bond issue should fail. 

However, I don't think we have learnt any thing from it. So prepare for a Christmas surge in global equity markets.

Monday, December 05, 2011

Walkout - Rethinking Economics

A Harvard class of Introductory Economics recently walked out of Prof. Mankiw's lecture on introductory economics. Prof. Mankiw posted a response yesterday stating that it is a simple introductory course and not a doctrine and should be approached as method or a tool. Peter Dorman countered that there are essential gaps in introductory economics and the course needs to change, a small protest does push things in right direction.

I think the protest was wrong but I disagree with Mankiw.

I think the first main malady economics suffers is listening. A lot of economists talk about Keynes - Hayek debate as though it is equivalent to the intellectual volleying we are having today. Let us remember Keynes and Hayek actually listened to each other. Most economists I read are almost blind to other side. It is like left-inclined and right-inclined economists are playing rock-paper-scissors. 

Economists fraternity must realise lack of listening skill is what is wrong with economists. The Harvard students, in their first class itself, showed exactly this tendency. That is what saddens me.

Here are some of my thoughts about economics.
  1. Teachers must present to the students the entire spectrum left to right, and let them choose. In Chicago, Milton Friedman and fellow Professor used to do exactly that. Friedman is known rightist while his colleague taught the leftist view.
  2. While I like professors taking side they believe in, I think a reverse role-play would do world of good. It would have been good to have Milton Friedman teaching leftist view, in true spirit. It would have done him a world of good.
  3. Keynesian economics, as I understand it, was forming on base of data, information, ideas, theories and other socio-cultural inputs. I think that is what economics must try to be. If he had lived longer, I believe, you may have seen Keynes disagree with current bailouts.
  4. Economics and economists are too literal. They just focus on the written word and many times leave out the context thus missing the meaning. They are worse than law students. Scientists, on the other hand, can focus on written word because they have a language of mathematics that allows them to do so. If economics needs a language the current variety of mathematics is definitely inadequate.