Monday, February 20, 2012

Insurance. Or not.

If you have ever wanted to see what a scandal looks like before it comes crashing down, check out the budding Russian insurance industry. Standard & Poor's released last week an interview between an Associate Director of their Financial Services Team and a Russia-based Senior Insurance Analyst.

The video clip, entitled Russian Insurance: High Country Risk and Frail Market Framework is instructive. It describes an insurance sector in Russia that is growing rapidlyfaster than GDP growthin a market where insurance penetration is one-tenth the norm in Europe.

But it is the details that are interesting. Russian insurers are facing high country risk is the theme. The industry is not profitable, largely because 40% of premium costs are paid out to agents and brokers. The industry, the analyst goes on, is highly concentrated and therefore there is significant price competitionnote that this is not an inherently logical statement, as high concentration generally offers greater pricing control, but be that as it may.

And at the end of the day, the high up-front costs, coupled with price pressures create an industry that has very low capitalization. And this is a risk for the industry. This is the conclusion of the report.

S&P, along with its brethren bond rating agencies, are struggling to maintain their independence and freedom from federal oversight domestically, even as they areas illustrated by this videoworking diligently to expand their franchises into new, international markets. Their franchise is about independent analysis in the interest of the investing public.

This report has all of the attributes of a dispassionate industry analysis, from which industry participants or investors might glean valuable insights. The report suggests that this might be a good time to become an insurance broker or agent. Or perhaps pursue a roll-up to gain greater price control. Or perhaps simply to short the stocks of Russian insurance companies before some insured event wipes them out.

But somehow, on the heals of a financial disaster in which the rating agencies were implicated for ignoring key risks that would have broad public repercussions, they seem to be falling into the same pattern here. The key conclusion of this report by S&Pthat the industry is undercapitalized and is not taking prudent steps to build capital and set aside risk reserves—is eerily familiar. The collapse of AIG, and indeed the entire credit default swap market, was characterized by the under pricing of risk, while participants took out huge "profits" on the front end.

Yet nowhere do either of the representatives of S&P suggest that the Russian insurance sector shares these attributes. This report seems to missor simply ignore—this salient point that seems to be a valid conclusion of the Russian industry as they describe it: That the sale of insurance without the careful construction of actuarial risk reserve is a business that borders on fraud. And with 40% paid out up front, it might be a lucrative fraud at that.

Friday, February 17, 2012


This week, four years after the collapse of Bear Stearns, the two hedge fund managers who helped bring about its demise, Ralph Cioffi and Matthew Tannin, agreed to pay $1 million to settle a civil suit brought by the Securities and Exchange Commission. No doubt Cioffi and Tannin made many, many times the amount of their pending restitution during those heady years before the 2008 collapse, and even the presiding U.S. District Court Judge Frederick Block suggested that the settlement amounted to “chump change.” But chump change was the bid on the table, and it looks like the SEC will take what it can get. And as has become customary in these arrangements, Cioffi and Tannin will walk away without any admission of wrongdoing.

The world of finance is indeed a rigged game. As the world of finance came crashing down four years ago, aggregate losses on Wall Street and in the banking sector totaled in the trillions, exceeding the combined profitability of the industry over the previous century. That the Fed made over $7 trillion available to restore our financial system, as tabulated by Bloomberg, was only made more obscene by the fact that billions were restored to the balance sheets of our banks—including Goldman and Morgan Stanley who essentially became banks just so they could benefit from Fed largesse—filtered through a risk-free carry trade from which massive bonuses were deducted before flowing to bank capital accounts.

Americans are not stupid. They know a rigged game when they see it. But if the past four years have proven nothing else, it is that the tightly interwoven relationship between Washington and Wall Street has survived the collapse as strong as ever. From the outset of the crisis—when the banks succeeded in stonewalling the sale of toxic assets and instead got the public dollars for free—the major banks have succeeded at almost every turn in defending their interests. Four years later, the industry is more concentrated than ever, trillions of dollars of derivatives trading remains opaque and the industry culture of privatized profits and socialized risk has been codified into law.

Like the Cioffi-Tannin case, last week’s “settlement” with mortgage brokers, whose patent fraud contributed to the housing bubble and ensuing collapse, was embarrassing—whether one believes it was supposed to constitute compensation for damages, restitution for conduct, or deterrence against future abuse. That settlement, approved by 49 participating states' attorneys general, was one more example of a resurgent finance industry that has walked away largely unscathed from the havoc it wrought.

Late last year, another U.S. District Judge, Jed Rakoff, stood up for the dignity of society—someone had to—when he rejected a Securities and Exchange Commission settlement with Citigroup. It was one of those many cases floating around these days where one of our leading banks sold bundles of mortgage-backed securities to investors, while secretly betting against those same securities. Rakoff rejected the proposed settlement as “pocket change,” and “neither fair, nor reasonable, nor adequate, nor in the public interest.” But the real source of Rakoff’s wrath, like Block’s this week, was that the Citi settlement included no admission of wrongdoing.

And so the game goes on. No one admits to any wrongdoing, and four years later almost nothing has changed.

Last month, the Brits demonstrated the old school way of handling these matters when Sir Fred Goodwin, the head of British banking giant Royal Bank of Scotland was stripped of his knighthood by the Queen. Sir Fred—now just Fred—led RBS from the pinnacle of success—it was the largest bank in the world for a time prior to the 2008 collapse—to total collapse, and an ensuing bailout by the British government.

The Queen's action to restore the honor of the realm came upon the advice of a secretive Whitehall star chamber “responsible for maintaining the integrity of the honors system” after Goodwin and the RBS board were collectively exculpated of any responsibility for the collapse by British bank regulators. To put the gravity of de-knighting in context, others who have been similarly judged to have “brought the honours system into disrepute” and shared Fred's fate include the famous British mole Anthony Blunt and dictators Nicolae Ceausescu and Robert Mugabe.

We, of course, have no queen, no honor system, and certainly no humility among our financial titans.

This week, our finance industry is on the attack again. The industry target now is the Volcker rule—the proposed rule that would limit the ability of banks to trade for their own account. Leading the attack has been JPMorgan CEO Jamie Dimon, who has turned to thinly veiled derision of Paul Volcker, as Dimon continues to make the case for scale and opacity in banking.

For his part, Paul Volcker views the eponymous rule is a political compromise at best, as he has long advocated a return to the Glass-Steagall restrictions that would fully segregate commercial and investment banking. And for good reason. Concentration and risk in the banking system has grown steadily since Clinton-era deregulation, and only increased since 2008. Today, the four largest U.S. banks hold over 50% of the assets of the banking system and the four banks most active in the largely unregulated and opaque derivatives market hold 94% of the $250 trillion volume of financial derivatives in the U.S. banking system.

Since the financial collapse, the industry has won nearly every round as it has sought to protect its privileges and power. While many might complain about the dizzying complexity of Dodd-Frank legislation, the truth is that the industry beat back the most substantive restrictions on derivatives trading as well as any constraints on size or leverage. If it can minimize the effect of the Volcker rule, the industry will have protected the two greatest sources of profitability for the big banks—derivatives and proprietary trading—despite those being the greatest sources of risk to the public and the farthest away from the public purpose of the banking system.

This Friday, in an assault on the Volcker rule that might on the surface seem to have been in support of Dimon, the Wall Street Journal editorial board ultimately made the case instead for breaking up the large banks. The Journal editorial rightly argued that Dodd-Frank promotes the illusion that an increasingly complex regulatory apparatus can prevent systemic failure. It is simply not reasonable to imagine that regulators can begin to track and monitor, much less regulate, the complex risks embedded on bank balance sheetshidden away in collateral rules, language arbitrage and collateral valuation.

While the Journal rails against the extent to which the banking industry problem stem from monetary policy and Congressional meddling, in its penultimate paragraph, the Journal concludes that a real solution requires "a Congressional plan either for allowing large banks to fail or for breaking them up."

But too-big-to-fail is a product of the size and systemic importance of banks such as JPMorgan. This is not a question of Dodd-Frank or public disdain for bailouts. It is simply the truth. Given that truth, the remaining option, as the wisdom of the Journal editorial board suggests, is that the banks should be broken up. Then, perhaps, the Volcker rule, as half-baked and problematic as Jamie Dimon insists it is, would not be necessary, and once again we can have a banking system that serves the public interest, instead of the other way around.

Saturday, February 11, 2012

The Apple-Foxconn affair.

Apple aficionados suffered a blow a couple of weeks ago. All of those beautiful products, it turns out, are the product of an industrial complex that is nothing if not one step removed from slave labor.

But of course there is nothing new here. Walmart has long prospered as a company that found ways to drive down the cost of stuff that Americans want. And China has long been the place where companies to go to drive down cost.

For several decades, dating back to the post World War II years, relatively unfettered access to the American consumer has been the means for pulling Asian workers out of deep poverty. Japan emerged as an industrial colossus under the tutelage of Edward Deming. The Asian tigers came next. Vietnam and Sri Lanka have nibbled around the edges, while China embraced the export-led economic development model under Deng Xiaoping.

While Apple users have been beating their breasts over the revelations of labor conditions and suicides that sullied their glass screens, the truth is that Foxconn is just the most recent incarnation of outsourced manufacturing plants—textiles and Nike shoes come to mind—where working conditions are below American standards.

While the Apple-Foxcomm story has focused attention on the plight of workers living in dormitories who can be summoned to their work stations in a manner of minutes, the story has also become part of the debate about whether the U.S. should seek to bring back manufacturing jobs or should instead accept the conclusions reached by some economists that not only does America not need manufacturing jobs, but it can no longer expect to have them.

Nobel laureate Joseph Stiglitz argued recently that our difficulties recovering from the 2008 collapse are a function of our migration from a manufacturing to a service economy. While this migration has been ongoing for years, Stiglitz has concluded that the trend is irreversible. His historical metaphor is the Great Depression, which he suggests was prolonged because the nation was in the midst of a permanent transition from an agrarian economy to manufacturing, as a revolution in farm productivity required a large segment of the labor force to leave the farm.

The problem with this deterministic conclusion that America can no longer support a manufacturing sector is that it seems to ignore the facts surrounding the decline that we have experienced. In his recent article, Stiglitz notes that at the beginning of the Great Depression, one-fifth of all Americans worked on farms, while today “2 percent of Americans produce more food than we can consume.” This is a stark contrast with trends in the U.S. manufacturing sector. Manufacturing employment, which approximated 18.7 million in 1980 has declined by 37%, or 7 million jobs, in the ensuing years. However, the increase in labor productivity over that timeframe—8% in real terms—explains little of the decline. Unlike the comparison with agriculture, where we continue to produce more than we consume, most of the decline in manufacturing jobs correlated with the steady increase in our imports of manufactured goods and our steadily growing merchandise trade deficit.

The chart below, based on data from the Bureau of Economic Analysis, illustrates the growth in personal spending on manufactured goods in the United States over the past three decades, and the parallel growth in the share of that spending that is on imported goods. These changes happened over a fifty-year period. Going back to the 1960s, we imported about 10% of the stuff we buy. By the end of the 1970s—a period of significant declines in core industries such as steel and automobiles—this number grew to over 25%. As illustrated here, the trend continued to the current day, and we now import around 60% of the stuff we buy.

Over the same timeframe, as illustrated below, the merchandise trade deficit—the value of goods we import less the value we export—exploded. By the time of the 2008 collapse, the trade deficit in manufactured goods translated into 3.5 million “lost” jobs, if one applies a constant metric of labor productivity to the value of that trade deficit.

This is where Stiglitz’ comparison with the Depression era migration from an agrarian economy breaks down. As he duly notes, the economics of food production has changed, and today America’s agricultural sector feeds the nation and sustains a healthy trade surplus as well, with a far smaller share of the American workforce. In contrast, the decline in manufacturing jobs reflects the opening of world labor markets. Unlike agriculture, we are not self-supporting in manufactured goods, we have simply decided to buy abroad what we once made at home.

This shift has been embraced across our society. For private industry, outsourcing to Asia has been driven by profit maximizing behavior and the pressures of surviving in competitive markets. For consumers, innovations in retail from Walmart to have fed the urge to get the greatest value for the lowest price. And for politicians—Democrats and Republicans alike—embracing globalization was part of the post-Cold War tradeoff: We open our markets, and the world competes economically and reduces the threat of nuclear conflict.

The notion that American industry, consumers and politicians were co-conspiring in the destruction of the American working class was a discussion relegated to the margins of public discourse, championed among others by union leaders, Dennis Kucinich on the left, Pat Buchanan on the right and Ross Perot, while largely dismissed by the mainstream media.

While Apple has been pilloried from National Public Radio to the New York Times for its effective support of a slave economy, most electronics consumer goods are now imported. The irony of the Apple story is that the Chinese labor content may well not be the cost driver that we presume it to be. As in many other industries, the costs of what is in the box can be a relatively small share of total costs, when product development, marketing, packaging and profits are taken into account.

This, of course, is why China is not particularly happy with their role in the Apple supply chain. When the profits of Apple products are divided up, far more of it flows to Cupertino than to Chengdu. And that is the reality of modern manufacturing. Based on National Science Foundation data on the value chain of the iPad, for example, final assembly in China captures only $8 of the $424 wholesale price. The U.S. captures $150 for product design and marketing, as well as $12 for manufactured components, while other nations, including Japan, Korea and the Taiwan, capture $76 for other manufactured components.

If anything, the NSF data—and China's chagrine—reflect a world in which the economic returns to design and innovation far exceed the benefits that accrue to the line workers who manufacture the product. This is one part of the phenomenon of growing inequality, and would seem to mitigate the complaint that is often made that America no longer "makes things." We may not make things, but we think them up and as the NSF data suggests, to the designers go the spoils.

Yet there is no fundamental reason that the decline in manufacturing jobs in America should be deemed inevitable and permanent. For all the talk about the number of engineers in China, the fundamental issue remains price. As a friend who is a consulting engineer who works with Apple in China has commented, “Yeah, they have engineers, but the driver is cost, cost, cost. And the labor quality is awful. We lose a lot of product and have to stay on top of everything, but at $27 per day, you can afford a lot of management.”

This argument conflicts with Stiglitz deterministic thesis. Just as manufacturing jobs left the United States, they can come back as economic conditions change. As wage rates rise in other countries, one competitive advantage of outsourcing shrinks. And if nations—from China to Taiwan—migrate away from their practice of pegging their currencies to the dollar, foreign currency risk exposure will offset some of the cost advantages of outsourcing. And today, as newly industrialized nations like Brazil have seen their own manufacturing sectors ravaged by mercantilist competitors, there is a growing understanding for the need for order and fair rules to govern the forces of globalization.

The Apple-Foxconn affair spooked consumers of Apple products—at least for a news cycle or two. Like Claude Rains in Rick’s Cabaret, we were shocked to confront the reality of labor conditions in China. But the story was less about China than about us. That Foxconn could put eight thousand workers to work within thirty minutes to accommodate a last minute design change by Steve Jobs was not—as Jobs suggested in a meeting with President Obama—an argument for why those jobs could never come back to America, but rather it was illustrative of the astonishing narcissism of the Apple world.

It is true, no American factory could deliver for Apple as Foxconn did. But on the other hand, there really was no need to. That story was less about what Foxconn could deliver than what Foxconn’s customer had the audacity to demand.

This story raised the question of whether we care where our products are made. The answer is unclear, however many Americans have long cared about purchasing cars made in this country, and Clint Eastwood's Super Bowl ad has raised awareness of this question. What is clear is that if Americans care about where their products are made, companies will care. Therefore, even as the President promoted tax credits for insourcing—the new word for bringing those jobs back—perhaps another step would be to build on the power of choice. Perhaps not all Americans care where their products are made, but many certainly do. But even if one does care, it tends to be difficult to find out.

Perhaps a simple step would be for companies to provide that information to consumers. Even if it was voluntary labeling, knowing who chose to provide information to their customers would tell many of us all we need to know. Then we could find out whether the Apple story really changed anything, and whether consumers might be willing to take more into account that the last dollar saved if it enables us to sustain a diversified economy into the future.

Sunday, February 05, 2012

Speaking Greek.

“The pace and composition of the deleveraging process needs to be consistent with the macroeconomic scenario of the adjustment program and should not jeopardize the provision of adequate levels of credit to the economy.”

Thus spoke one European finance official this weekend, as one more confab of ministers from the eurohood gathered to assure the world that all is proceeding apace toward “a more balanced monetary union governance model and effective firewalls.”

The tendency to speak in finance jargon—one is reminded of the incomprehensible utterances of Alan Greenspan—may suggest to some that they have the problem under control. However, the lack of frank discussion of the underlying issues suggests instead that they have a tiger by the tail and are making it up as they go along.

Each week now brings new assurances that a deal is imminent, and yet as the weeks go by it is becoming harder and harder to imagine that after all of the complex negotiations, the end will not be more straightforward: Greece defaults and exits the eurozone.

It may be inevitable, and it may be for the best. Maybe not for Germany, maybe not for the banks, but for Greece.

The United States began as poorly structured fiscal union. The debts of the nation and the debts of the states were comingled and the boundaries of responsibility poorly defined. Like Europe, the United States is a federation with a single currency and centralized monetary policy, but with fiscal authority retained at the state level. And early on, there were periods of fiscal crisis that were first resolved with the federal government assuming the debts of the states. But it was only after state defaults on their own debts that long-term stability was achieved, as new working rules—established under state constitutions—were established that clearly delineated the responsibilities of the states and of the central government.

Europe—or more precisely the eurozone—was created with similar failures to define boundaries of responsibility. It is not surprising that nations bound together with a common currency, but each retaining spending authority, would find themselves subject to fiscal pressure. This problem was exacerbated by the implied debt guarantees that allowed each state to borrow freely, while giving the banks and other investors little incentive to make credit decisions reflective of each country's management of its fiscal affairs.

The European experience mirrors the experience of nations that have pegged their currency to the dollar. There are benefits of maintaining a common currency, but the peg cannot be sustained if a nation fails to manage their affairs—such as was the case of Argentina—or if they outperform the nation to which they have pegged their currency—such as Taiwan and Singapore. In either cases, market forces will exert pressure over time to move away from the peg and allow their currency to depreciate or appreciate until a new balance is achieved.

Greece is the Argentina of Europe, and enjoyed the benefits that access to a common currency offered, until it was no longer able to pay its bills. Argentina finally defaulted a decade ago, but not before its families of means squirreled their pesos away in dollars stashed in foreign banks—much as Greeks are doing today.

There was no impediment to Argentina’s ultimate default. The currency market did for Argentina all of those things that are being demanded of Greece today. Everything was adjusted downward in real terms. Salaries and pensions—public sector and private alike—funding public services. The population became poorer, their futures cast into doubt, but unlike Greece, no public official had to cast a ballot.

Each week, the Germans—along with their junior partners in France—are putting the hammer to the Greeks. Cut public sector spending. Cut worker salaries. Cut pensions. Sell the airports and trains. And this week demands to cut private sector salaries by 25%. Now, German ministers have taken the final, inevitable step and suggested that Greece must have a fiscal overlord to set budgets and spending levels.

While the world has focused on Greece's failures—with the implication that it was German beneficence that allowed Greek participation in the euro in the first place—it is easy to loose sight of the fact that Germany has been the greatest beneficiary of the creation of the eurozone. The advent of the common currency eurozone with 330 million people created a massive, captive market for the German export machine. After China and ahead of the United States, Germany is the second largest exporting nation on earth, and the bulk of what it sells is to other European countries. There are no innocents in this morality tale. All those Greek bonds and Italian bonds and Spanish bonds and other bonds that are now at risk were issued to sustain an economic bubble of consumerism from which German exporters were among the largest beneficiaries. If Greece lied on its application for admission, the Germans had good reason to look the other way.

Those who have benefited from the euro want it to survive this crisis. Failure is not an option—insisted European Central Bank member this weekend. It is not an option for Germany, whose currency would skyrocket if the eurozone nations went their separate ways, punishing its export-dependent economy. It is not an option for France, for whom the euro is the key both to containing the German colossus with which it has fought several wars and to creating a counterweight to U.S. global power and prestige. It is not an option for China, that badly needs an alternative currency to the dollar for its massive foreign currency holdings.

And then there are the financial imperatives of achieving an orderly unwinding of the exposure of the European banks to Greek default risk. Each week, we are assured, a deal to restructure Greek debt—theoretically averting a default—is almost done. The parameters of such a deal are not in question. The banks holding Greek bonds would write off more than half of the value of their bonds against their fictitious capital reserves—fictitious because those reserves have been invested in sovereign euro-denominated bonds, among which are these very same Greek bonds. Hedge funds will be strong-armed into accepting the same deal, though their write-offs will be against their own—rather than other people’s—money.

But essential to the suggested resolution would be the forbearance by the ISDA—the International Swap Dealers Association—in pronouncing that no "credit event" has taken place, such that those same banks will not have to pay out on credit event losses as the sellers of credit default swaps against those same Greek bonds. Such an outcome would seem to be unlikely based on the merits, but in a world that has dangerously comingled the financial and the political, anything is possible.

For all of this—to sustain the illusions that are Europe and the stability of its banks—all that is asked of Greece is that it voluntary cede its powers of democracy and self-determination. Yes, Greeks can still elect their leaders, but those leaders will no longer control the destiny of the nation.

But even if a default by Greece on its March 20th bond payment is diverted, nothing will actually have been solved. At best, a new package of loans will be arranged, and the default will be delayed until some later date.

This solution is backwards. Instead of affirming Greece's responsibility for its own choices, it will have been stripped of its sovereignty. Instead of having to face up to the challenge of building its own future with real rules—as ultimately each nation must—it will move forward instead as a vassal state to its Franco-German overlords.

Perhaps it is time to gather those ministers and elected leaders into a room and tell them to go home. For all of their sakes, perhaps it is time that they open their eyes and let Greece be Greece. Better now than later, because all is not proceeding according to plan.

Because there is no plan. They are just making it up as they go along.