Three concepts destroying our financial culture …

It’s easy to get all tangled up in talk about derivatives, leverage and debt. Often times their overall impact on markets is misunderstood.

In recent months I’ve suggested a derivatives problem could eventually roil some of the world’s major banks, and a debt problem could overwhelm the efforts to backstop Sovereign economies. And we all understand the dangers of leverage, I think …

I read a good article in the June edition of The Atlantic suggesting it’s irresponsible to blame high leverage for the financial crisis of 2008. Specifically, it was not simply the high debt-to-equity ratios (leverage) that allowed things to get so bad. Going further, it was not the change in the rules by the SEC in 2004 that allowed banks to increase their leverage either.

Make no mistake: Leverage is a powerful piece of the puzzle because it exacerbates the potential losses as well as the potential rewards. That is why leverage remains among the components I, and every analyst worth his salt, will consider when developing investment ideas.

But leverage is not the real issue in this point I want to make.

Deregulation Is Often to Blame

Think hard — how many times have you heard that we wouldn’t be in this mess if banks were not freed up to take on excess leverage and risk? If only the deregulation of the financial system didn’t happen, financial institutions would have been more closely surveyed and this whole boom and bust could have been avoided. Right?

Not quite …

You see, the aforementioned rule change in 2004 was scrutinized by several economists, analysts and journalists and credited for playing a meaningful role in causing the crisis because firms could increase their leverage. Indeed, the debt-to-equity ratios sat at near 30-to-1 ahead of the crisis. Compared to the much-publicized 12-to-1 in 2004, that’s a dramatic jump.

But it wasn’t perfectly representative of the situation because of the fact that commentators including Nobel Prize winner Joseph Stiglitz, former SEC directors and economists, and former vice chairman of the Board of Governors of the Federal Reserve System Alan Blinder all failed to address two important details:

1. SEC regulation actually increased, as the commission assumed additional oversight responsibility for holding companies beyond just their broker-dealer subsidiaries, and they adopted new requirements for holding companies to report their capital adequacy.
2. There have been several periods (e.g. the 1990s) where leverage has been equally as high as the levels said to have sparked the financial crisis.

Well, besides the fact that regulation usually never seems to solve its intended problems, it could perhaps bring worse unintended consequences to bear …

Incentivizing the Risk-Takers

The Atlantic also puts forth a trend of “going public” as what created disincentives to manage risk. To paraphrase: No longer is it about sharing the liability found in a partnership and containing risks to keep the business alive. Instead, it is about generating fees, profits and bonuses with other people’s money.

But to broaden the picture, we have to consider the culture of risk-taking that’s led to our current shaky global financial system. The mentality is pervasive.

As we’ve come to find out in the episodes since the 2008 financial crisis, financiers seek out all kinds of opportunities when their personal risk seems relatively limited. You may remember the mortgage-backed securities laced with subprime loans. Even though little was understood about the actual value of those subprime tranches, those things really got popular when everyone began to believe housing prices would never fall.

Popular now are credit default swaps (CDS), or bets that a company (or a group of companies) or Sovereign won’t be able to meet its debt payments at some to-be-determined point in time. But there may be more going on behind the scenes in the CDS market than meets the eye.

We all know that JP Morgan recently disclosed a large investment loss. And while they quickly tried to explain it away as a poorly managed trade or two, it probably says more about their investment culture than they’re letting on. In fact, it’s possible they are finding ways — either through their own manipulation or via a complicit partner in crime — to value their investments that overstate gains and understate losses.

Can you blame them? Yes, you can blame them for their deceptive and illegal tactics. Indeed they are the easiest to blame, but they’re not only to blame.

And that brings me to …

Three Concepts Destroying
Our Financial Culture

By no means is this list exhaustive, but it embodies some of the key components serving to hollow out our financial culture and incentivize financial market risk:

First, growth at all costs

Whether we’re talking about publicly-traded companies or national economies, the only data point that has come to matter is growth. Is the company generating profits? Is GDP growing fast enough? The off-balance sheet items reflective of a company’s true illnesses or a country’s deficit-spending don’t seem to matter at all because they don’t matter right now.

We should be talking about economic health at all costs. But instead we’re brainwashed by growth, growth, growth. Common sense tells us a policy of non-stop growth is unsustainable.

Second, the myth of equality

Public figures have generally accepted a responsibility to bring prosperity to everyone, which is perhaps the motivation behind the ‘growth at all costs’ mentality. Only their naturally progressive approach doesn’t alleviate the problem; it perpetuates the problem.

The result of this myth, when accepted by a country dependent on debt and deficit spending, is to continue their profligate ways and tax the productive players of a society in order to distribute to underproductive players. The myth generates action that allegedly supports growth. But it’s hard to expect this drive for so-called equality can contribute to a foundation for financial and economic prosperity.

Third, the supposed wealth effect

In times of hardship, when consumers and businesses are tightening their belts and the public sector has become exhausted, the wealth effect can serve to boost economic activity. In the early part of the last decade, rising real estate values represented a wealth effect that allowed consumers to tap the equity in their homes for paying down debt, financing purchases or making new investments. Gone are those days.

The wealth effect discussed now is from rising stock market valuations. The Federal Reserve has clearly developed a policy in which the wealth effect factors greatly. The problem: Capital overlooks real, productive assets and instead moves into financial assets.

Don’t get me wrong — the above three are very broad concepts. But ultimately they reflect the culture of our economy, real and financial, as dictated by policymakers. When I attend conference calls on which fellow attendees are pinning the ultimate direction of markets entirely on central bank policy, I can’t help but think we’ve reached a point of overdependence where:

  Financial institutions bear little risk, but reap significant reward, in making huge lop-sided trading bets.

  Governments bear little risk, but capture additional influence, in generating growth through evermore debt.

  Consumers bear little risk, but find additional flexibility, in managing their personal balance sheets.

But everyone faces plenty of risk when the wealth effect flops, which is why I hesitate.

The Federal Reserve, in their mission to spur growth, make money affordable for everyone, and generate capital gains for traders, has almost single-handedly pushed investors out the risk curve since conservative investments yield next to nothing while risky investments pay out. Except that payout has ground to a halt recently, and it could very easily leave investors hung out to dry.

In watching the markets roll over to varying degrees this year, the trader in me is inclined to think a technical, corrective bounce is in order. But bounce or no bounce, the make-up of the U.S. and global financial system is such that everything could become unwound very quickly.

That means economic growth; that means JP Morgan’s CDS exposure; that means the entire Spanish banking system; that means consumer confidence; that means Chinese manufacturing; that means the financialization of commodities; that means major currency values.

Unless of course the Fed acts.

Best wishes,

JR

P.S. Despite the fact the U.S. has its own major problems, the dollar is winning hands down against other major currencies. Our World Currency Trader members have been able to take advantage of the dollar’s strength. In fact, this week they had the chance to close out a position with combined gains of up to 105.6 percent (two trades before commissions) on a dollar trade! And last week it was 61.1 percent. Click here to see how you can join them, RISK-FREE.