Regulation Archives

Bond Insurance…or Not?

Sure, it has been in the rumor mill for a while now. But, now that the French and Germans have imposed their vision of a “voluntary writedown” on private investors, it is still amazing to see the lengths that the authorities will go to declare the event a non-default.

The Wall Street Journal has a good blog on the subject: “So, about that insurance you bought on Greek Debt…” which covers the key details.

For the market, the dance will go on. Anyone who might suggest that this little manouver will disrupt the fragile fabric of the market is more than a little desperate for attention.

For investors, this little drama should serve as a “Caveat Emptor”. Not all investments are created equally and not all of them have the rights to the underlying assets that their promoters might hint at. When commentators brush off the risk of an ETN, which is backed by the sponsoring bank’s balance sheet, versus an ETF, which should be backed by assets that are subject to periodic audit, think back to the “smart money” hedge funds who will soon have to explain to investors why they were unable to capitalize on a sure thing like Greece’s default (oops, sorry, voluntary restructuring).

Taiwan and Hedge Funds

Last week, the Bloomberg News Team started connecting the dots and found our namecards.

Taiwan is one of the key nexus points for the global Information Technology (IT) supply chain. It looks like the SEC in the US is starting to focus on that aspect.

I thought this article was well thought out and was happy to provide background information.

Cash Is An Asset Class

In a recent Op-Ed for the Wall Street Journal, Charles Schwab homes in on the biggest problems in the US economy today…the impact of artificially low interest rates. For most investors, economists and politicians, the idea that there is something wrong with low interest rates is on a par with the old saw that “one can never be too rich or too thin”.

Does that mean that Charles Schwab is crazy? After all, he is advocating allowing interest rates to find their equilibrium level (likely higher than the current Quantitative Easing inspired rates) at a time when economic growth is running well below potential. What does Mr. Schwab see that others have missed? What he has zeroed in on is that Money is an Asset Class. The sooner we treat it as one, the sooner we should see a return to trend economic growth.

The Price of Money – Supply

The first thing Mr. Schwab sees is that the supply of money, from a pricing point of view, is not exactly the same thing as “money supply” (aka. M1, M2 or M3). Money as a commodity can only add to GDP when it changes hands. Therefore, velocity of money has to be considered when evaluating the price of money.

To get velocity, divide the numbers on the top line of this table:


Source: Bureau of Economic Analysis

By these numbers (or choose M1, M2 or M3 from Shadowstats)…

Base Money

Source: St. Louis Federal Reserve Bank

The second important point that Mr. Schwab touches upon is the nature of the transactions. To put it simply, some types of transactions create money and others destroy money. When you pay for groceries with your credit card, you create money in the system. When you pay off your credit balance in full at the end of the money, you destroy money in the system. Also, if you fail to pay your credit card and the bank closes your account and writes off the balance, money is also destroyed. So, to maintain a healthy growing GDP (which is politically desirable), the Fed must monitor the supply of new money created and destroyed in the system and the velocity of that money. If something changes to drastically, the Fed is empowered to add or draw liquidity from the short end of the interest rate curve to influence the overall chain of events. However, it seems that the Fed may have overstepped from fine-tuning to dominating the market.

The Price of Money – Demand

But what happens when the banks borrow money from the Fed at 0% to 0.25% and turn around to buy Treasuries to earn the spread (yield curve)? In the long run, the profits earned will be used to shore up the bank balance sheets and allow them to slowly write assets (loans) down to their real values. No one can say for sure whether this will be a net creative or destructive exercise in terms of money supply but one thing is for sure, the money is not finding its way into the real economy (except as staff compensation and dividends) so the net impact on velocity is a drag. Can we blame the banks for acting rationally? Not really as they are looking at the risk and cost of acquiring assets vs. the spread that they can earn. The risk and cost of attracting new credit card, home equity business, construction and small business loans (assets from the bank point of view) has risen dramatically over the past two years while the spread has shrunk (due primarily to government intervention, regulation and threatened regulation). The risk and cost of flipping Treasuries with the Federal Reserve has fallen to practically nothing while spread remains very attractive (particularly on a geared basis).
So, by enacting the Quantitative Easing program, the Federal Reserve has saved the banking patients from the worst effects of the Global Financial Crisis. However, by continuing to increase the base money supply and hold interest rates at artificially low levels with its Quantitative Easing program, the Federal Reserve has disrupted the market setting mechanism for money.

What Mr. Schwab has missed is that savers, the ultimate suppliers of capital, are not being tricked into high risk assets because of the low interest rate. They are rationally taking their cue from the biggest, most committed and least price sensitive buyer in the market (the Federal Reserve). In fact, many have been all too happy to chase and profit from the bubble. How can we measure the bubble? Well, just invert the yield on a ten year treasury. At the end of March, the yield touched 4% or a Price/Earnings ratio of 25x. The latest reading is 2.54% which doesn’t sound dramatic until you realize that number translates into a Price/Earnings ratio of 39x. Sounds pricey until you realize that there was good money to be made in that trade. What Mr. Schwab is actually concerned about is the sustainability of the rally and how much his investors are going to give back when the bubble pops or deflates (ie. interest rates start to rise).

How will we know when to change gears?

The current circumstances are politically maintained so a large part of the change will have to be political. The US mid-term elections are a potential catalyst. But, there may also be international events which drive changes in thinking over at the Fed and in the White House.

The comparison with Japan over the last 20 years is instructive:

  1. On the downside, the Quantitative Easing experiment in the US has proven that the advice American policy makers gave Japan 10, 15 and 20 years ago works no better in the US than it did in Japan as a long term policy.
  2. On the upside, the US political tradition is not as consensus and faction driven as Japan’s. There is every reason to believe that the political winds in the US will change in far less than the two decades in which Japan has tolerated its current economic malaise.

How can the Fund King System help?

The Fund King System is a risk seeking asset timing model but it is structured against excessive volatility. As such, it can offer a good method for approaching the markets. For example, if you had followed the ranking changes from July 12th to now, you would have allocated some of your capital into TLH, the ETF that invests in 10-20 year US Treasuries. As you can see from the Yahoo Finance chart below, you would have made a not too shabby 5.4% in just under 3 months…a return that happens to coincide with the far more volatile S&P500 (represented here by the SPY ETF). During that period, TLH remained in one of the top ranking slots while SPY languished in the bottom half. The difference was the extra volatility which weighed against SPY in the Fund King System.

Yahoo Finance Chart

Source: Yahoo Finance

If you have not done so already, go to our PortfolioSelect feature and set up your own system today.


For any American who travels in Europe or Japan, one of the more striking contrasts comes with the train system. The trains are a clean, efficient and even enjoyable form of intercity transport. The nagging question for decades is why we don’t have the same level of train service in the US.

French Train

There are many reasons (cultural, geographic, and political) but the one I want to zero in on is featherbedding because some of the issues tie directly to today’s financial industry and has implications for us as investors.

Up until the 1940s, railroads (passenger and freight) were every bit as prevalent in the US as they were in Europe. However, in the 1950’s, the technology of transport started to change once again. On the railway front, new safety and management techniques were developed and implemented to improve the efficiency of the railroads for both passengers and freight. At the same time, the airline industry, the long haul trucking industry and the interstate system were also developing quickly to compete for business.

By and large, the railway industry responded to the outside pressure by imposing barriers, complex work rules and unnecessary procedures to stem the employment losses which resulted from the productivity enhancing new technologies. Whether those rules were imposed from a federal level (Interstate Commerce Commission) or by railway unions (featherbedding), the results were the same. Cabooses rode at the back of every freight train with a full crew well into the 1980s in both the US and Canada, decades after their usefulness had been replaced by simple technologies. In one famous business study of the Union Pacific Railroad, it was found that 14 layers of approval were required to ship a product on a freight car even though the stationmaster on site had all the information and tools necessary. Featherbedding not only involved creating make-work schemes for unionized staff, it also meant creating overly complex procedures and overpaying for management as well.

Mainstream economists are not particularly bothered by the practice of “featherbedding” or at least not the bits that arise from collective bargaining rather than government regulation. The comfort with the practice rests on the idea of “economic rents” (profit in excess of what one might expect theoretically) and how the “economic rents” are shared. Whether it goes to the CEO, shareholders or the staff, it is income and is generally treated the same in most models. That is fine for a short time when an industry is making large profits (or even super-normal profits, if you subscribe to that notion). The car companies formerly know at the Big Three were able to sustain multiple layers of featherbedding for decades while European, Japanese and now Korean car makers chipped away at the US market. On the government side, the politically protected and overmanned US Post Office, with offices in every zip code, was unable conceive of much less offer overnight delivery. A small company called Federal Express operating after hours from the airport in Memphis invented a whole new business service in that gap.

What does all this have to do with Finance?

Well, the same things that happened to the Railroad, Automobile and US Post Office are happening now to the large financial firms. Just as people from the 40’s couldn’t imagine a world without the big railways, people from the 60’s couldn’t picture a car industry not dominated by Detroit and people from the 70’s could not imagine anyone but the postman delivering a letter, we are now faced with the TBTF (Too Big To Fail) financial giants.

There was a time before debit cards and PayPal when we depended upon bank tellers to get cash and checkbooks to pay bills. The need for solid banks with vaults in every town was obvious. Financial information was difficult to gather and analyze, so there was a significant premium attached to those firms which had the scope to do the job. Size was all important. With size comes complexity but also efficiencies which, in a fully competitive market, are passed as savings to the consumer. But stocks are not socks and bank accounts are not household appliances (despite an early to mid-80s diversification attempt by Sears). The industry, always piously invoking concern for the security of the public’s money entrusted to these same institutions, erected legal, statutory, industry and procedural barriers to entry in order to maintain pricing power. The fact that much of the excess profits thus created ended up in bonus pools has in no small way shaped the career trajectory of most MBA graduates in the last two decades.

Prior to the improvements in technology and information availability, there was nothing much one could do about the situation. Indeed, financial services grew from 4% of the US economy in the 1970’s to 8.3% in 2006. From a pretax profit point of view, growth was even more dramatic, rising from 13% of pretax profits in 1980 to 27% in 2007. Demand for financial services increased and the industry responded by doubling as a proportion of the US economy. Some of that growth was necessary but as the accompanying graph to the Stern Report shows, the future trajectory is far from assured.

From Stern Business School Blog

So, what will drive change? On the one hand, deleveraging should reduce the demand for financial services and products as the US consumer rediscovers savings and reduces risk appetite. On the other hand, the ability to access information and track investments on a personal computer is superior to what was available on the most high end dealing floors only a few years ago. The industry is already responding by offering financial products at significantly lower cost (low or no-load mutual funds, ETFs, low commission trading, online banking and other services). Although only time will tell, the initial indications are that the low cost products can be as good or better than the older, high cost products that they replace. We have already seen the exit of many hedge fund managers who were unable to deliver on the core promise to make money in all types of markets. Like the HELOC junkies in the residential market, it appears that most hedge funds grew primarily on the back of the loose money regime and benevolent markets that largely prevailed from the Asian and LTCM crises onwards.

How will this affect you?

Since long term investment returns can be severely impacted by costs (fees paid out are not available for compounding over multiple years of investing), the ability to find the right product at the right cost will be more important than ever. Mutual funds with 5% loads, insurance products with 8% fees baked in and 2/20 hedge funds will still exist. The question is whether they continue to offer value for money or whether the extra money you pay over a lower cost option is only going towards featherbedding someone else’s retirement.

The financial technology is changing and how you react as a consumer of financial products will have a large impact on the final result of your investment program. Companies and individuals who did not take advantage of the advances in long haul trucking, overnight delivery, air travel and efficient Japanese cars definitely missed out on opportunities. The same thing is happening today in the financial arena. Not all new products will be good ones and certainly some of the old ones deserve their reputations but a critical evaluation of those products will lead to better investment outcomes.

Many in the financial industry can’t or won’t see the shift. They are blinded by their own self interest which, when challenged, is recast as a greater societal interest. Over and over again, we have been told that America needs a strong steel industry, a strong auto manufacturing industry, a strong textile industry, a strong semiconductor industry, a strong pharmaceutical industry and so on. While these may be true statements, often the price for maintaining strength beyond what the market can bear comes in the form of protectionist barriers (in the manufacturing areas) , direct taxpayer subsidy (in the case of the TARP or the car companies) or indirect cost (in the case of the current quantitative easing program). The risk of massive financial failure means that we will never know what would have happened if a Resolution Trust regime had been imposed to wind down overextended bank balance sheets (certainly lending shrank anyway). The cash has been printed and doled out, the bonds have been issued and the debt will be on the books for us and future generations to pay as taxpayers.

But as consumers of investment services, we need not further subsidize the financial industry by continuing to buy overpriced product. With the information and technologies available today, the ability to pay for the investment value actually provided has increased dramatically. If you chose not to take advantage of these new capabilities, you certainly won’t hear any complaints from TBTF financial institutions. But don’t expect any “thank you” cards either. One critical element of “featherbedding” is the sense of institutional entitlement that drives the implementation and maintenance of such schemes well beyond their economic justification.

UK Broker sells Danish Stock to a Norwegian Counterparty and settles in Swedish Krona

The title of this post is not newsworthy. It happens regularly. Despite all 4 nations having their own currencies, exchanges and regulatory regimes, this trade could happen with little fanfare. Maybe a little cajoling of the settlement department, but nothing ground-breaking.

Now try this: “Thai Broker sells Hong Kong Stock to a Korean counterparty and settles in Japanese Yen”
This would make headlines, because it crosses rigid regulatory, currency and exchange boundaries. Asia is further from a unified capital market environment than ever, and the walls are set to be built HIGHER, not lower.
This article calls for Increased Regional Integration is a pipe dream. It will never happen. FundKing has nearly 5 decades of combined experience in Asia, and understands full well that these ideas will meet with an extradition amount of resistance. Corruption, along with typical market distortions that occur when “The Government” has a large pecuniary interest in the economic outcomes, will tilt the results in a way that will preserve the local monopolies of financial institutions and exchanges.

The impact of this will be to create huge gaps between countries that only large global financial institutions can bridge. Spreads will be wide, and remain wide, as these intermediaries benefit from this regulatory arbitrage for at least a decade. Institutions such as HSBC and Standard Chartered, which derive large portions of their income from Asia, will see the biggest gains relative to their total bottom line.
What does this mean for smaller Asian firms looking to table regional capital markets? It means they must curry favor with a bank which has a large regional presence, and understand that they will be locked into this relationship. The conflicts this presents, on so many levels, will serve to stifle small and mid-cap company growth, and keep it at current levels, when it could potentially be a source of some of the most explosive creative growth the world has ever seen.


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