 | | The Daily Reckoning | Monday, May 14, 2012 |
- A report on the markets: both cocktail and stock-based...
- A closer look at what really happened over at JPMorgan last week...
- Plus, Bill Bonner on the benefits of holding cash, and the incredible growth rate of the US financial industry
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|  | | | | A Choice in the Matter | | The Difference Between Market and Government Swindles | | |  | | Joel Bowman | Reckoning today from São Paulo, Brazil...
What’s going on in the markets?
Well, a gloriously strong chávena de café at one of this city’s many colorful, street side vendors (not Starbucks) will set you back one Brazilian real, or around fifty cents. In other words, pretty cheap. A Caipirinha on the deck of what is surely the most unique hotel bar your editor has recently visited, however, will cost you the equivalent of maybe forty chávenas de café — about twenty dollars. Still, you pay for the view...and for the city skyline in the background.
As for those other markets — the kind with ticker symbols and stock charts — they’re a bit harder to get a handle on. The little arrows have been almost exclusively red this month...and the little squiggly lines tracking index performance have been trending almost exclusively south. In fact, the Dow achieved its so-far high for May at 1pm on the very first day. Since then it’s been down...down...down...
Gold is lower too...down another $15 an ounce overnight. The Midas metal is back to where it began the year, at about $1,565. But how could that be? Aren’t central banks around the world working furiously to debase their flimsy fiat notes? And aren’t the Chinese buying the stuff hand over fist? As Eric Fry showed last week, the squiggly line representing the Middle Kingdom’s monthly gold imports from Hong Kong is trending almost exclusively upward.
Yes, Fellow Reckoner, it’s tough to know quite what’s going on in those other markets. Government-caused distortions abound. Price fixing — including for the price of money itself! — sends strange signals to buyers and sellers, convincing them to do things they ordinarily wouldn’t do. Like buy a house they could never afford or speculate in the stock market instead of save their hard-earned for a rainy day. Thus are false booms fueled...and real corrections avoided. For a time...
At least when we pay outrageous prices for a cocktail at a tourist trap we know we’re being taken for a ride. But it’s a ride we’re willing to pay for. Conversely, when the state takes us for a ride, we don’t have any choice. That’s why we have to look for alternative investments...market workarounds...contrarian viewpoints...
Speaking of which, we received the following “letter” from a Fellow Reckoner in response to our Lysander Spooner vs. the USPS musing last week. Writes our friend David S...
Glad to have an excuse to write to you about my own area of research — postal history. We talked a little about postal history near the end of the Rancho Santana Sessions in March.
The Wikipedia article that you cited is inaccurate in part. The United States Post Office did not have a 12-cent stamp in 1844 when Spooner started his American Letter Mail Company; in fact it had yet to issue any stamps. A few local postmasters were permitted to experiment with stamps in 1845; the first national postage stamps in the United States were issued in 1847. In 1844, when Spooner started his company the letter rates in the US were based upon distance and the number of sheets of paper, ranging from 6 cents under 30 miles to 25 cents over 400 miles for a single sheet of paper. And, none of the rates were 12 cents. Since envelopes counted as a second sheet of paper, they were not generally used.
The Post Office Act of 1845, besides strengthening the monopoly on letter mail, reduced the postage rates to 5 cents per half ounce under 300 miles and 10 cents per half ounce over 300 miles. By matching the rates of the private mail companies (there were others besides Spooner) it was easier for the government to force them out of business.
By the time the 3-cent letter rate was established in 1851, Spooner had sold his mail business and moved on to other things. That rate reduction was not so much in response to Spooner as to other reformers. And, the 3-cent rate was not short-lived, but in fact rates were reduced even more. The 3-cent letter rate continued until 1883 when it was reduced to 2 cents; the rate was essentially halved in 1885 when the weight step was raised from half an ounce to a full ounce. The 2-cent per ounce rate lasted from 1885 until 1932 except for a couple years during World War I when the letter rate was 3 cents to raise money for the war effort.
All of this is simply factual background on postal operations in the 1840s — it does not change the essential points about Spooner’s argument against the Post Office Department (as it was known then, the USPS dates to 1971) or refute your conclusions about private business. I just like to see the story accurately told.
There is however, one additional point to consider when seeking to understand Spooner. He was an abolitionist and cheap postage was a major focus of that movement until the 1851 3-cent rate. They needed cheaper rates of postage for mailing anti-slavery tracts. So in many respects the cheap postage reformers of the 1840s were more interested in their other agendas than just in reforming the Post Office. For more on this perspective, you might read my paper, “Cheap Postage: A Tool for Social Reform” published by the Smithsonian two years ago in their postal history anthology. Mine is the final paper in the volume.
I enjoy your columns and I am always happy to discuss postal history. | Thanks for the corrections, David. We’re always happy to discover new and more accurate information...especially when it comes from our Fellow Reckoners.
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| | The Daily Reckoning Presents | | A Big Oops at JP Morgan! | | |  | | Dan Amoss | Congratulations, Federal Reserve! Your zero interest rate policy tempted the world’s most-sophisticated bank to create its own toxic blend of interest income in the derivatives markets.
JPMorgan made headlines late last week for a $2 billion trading loss that’s likely to grow over time. Today, the bank’s CIO fell on his sword for the trading gaffe. Ina Drew, a 30-year veteran of the firm decided today was a good day to “retire” from his trading desk.
JP Morgan’s costly error was the result of “reaching for yield,” just like retirees all over the US are doing. When traditional fixed income securities like Treasuries and CDs provide almost no yield whatsoever, the only remaining option is to reach in to riskier markets to try to find some yield. Reaching for yield — overpaying for income-producing securities in a low-rate environment — usually leads to a painful tumble off the proverbial ladder.
As part of the banking crisis fallout, the Federal Reserve pushed interest rates down close to zero, and is telling investors to expect zero rates until 2014. Savers will have gone six years without interest income, all so the Fed can implement its grand experiment to rebalance portfolios away from cash and US Treasuries.
“We’ll buy the Treasuries,” the Fed implicitly says to investors, “so you can push up the stock market to create a wealth effect for the economy.” This begs the question: What happens if the Fed decides to unwind its gigantic Treasury portfolio? Wouldn’t that reverse the stock market wealth effect at warp speed? The answer is yes, but here’s the dirty secret: The Fed is never going to unwind its portfolio. It’s going to be forced by investors (and Congress) to keep the reserves it has injected into the banking system intact, so it can keep rates low on the US national debt. That’s why we’ve been looking for short ideas that would suffer in an environment of rising commodity costs.
It’s inevitable and unfortunate that retirees starved for yield are overpaying for risky assets like REITs, junk bonds and even financial products that create “synthetic” yield. A synthetic yield means a yield created by derivatives, rather than the underlying security. These derivatives often cap upside returns in exchange for higher current income. As such, these structured products are essentially a slow return of capital masquerading as income. Some annuity products sold to retirees fit this description.
Back to JPMorgan, and the specifics of its $2 billion trading mishap. This is important, because it’s a consequence of our still- broken financial system...
JPMorgan last night warned in its 10-Q that it’s going to take an earnings hit in the second quarter from trades in its Chief Investment Office (CIO). CEO Jamie Dimon felt the need to schedule an impromptu conference call explaining the impending losses from CIO’s hedging activities.
JPMorgan’s Treasury and CIO department is tasked with investing the bank’s excess cash, while hedging the credit risk that exists on the rest of the bank’s $2.3 trillion balance sheet. Most people forget that banks are among the biggest fixed-income investors, and are suffering in a low-interest rate environment along with retirees. It’s hard to shed a tear, I know. So JPM decided it was a good idea to play along with the Fed’s encouragement to exit low-yielding securities and move out along the risk spectrum to invest its excess cash to enhance shareholder returns.
JPM’s $1.1 trillion in deposits exceed its loan portfolio by $407 billion, so it has lots of excess cash looking for a return. At March 31, CIO managed a $374 billion portfolio of securities — presumably in a manner that hedges JPM’s credit risk. There is derivative exposure too, as we discover in the 10-Q. The CIO can create synthetic credit risk by shorting credit default swaps, in which it would collect insurance premiums from underwriting the default risk on a specific entity. The result is synthetic interest income if everything is peachy and default doesn’t occur; if not, the result is repeated margin calls and a complete blowup if the reference entity defaults. Think a mini version of AIG in 2008.
Jamie Dimon refused to provide any detail about the derivative trades on the conference call, but we can guess. Here is my guess: JPM owns a boatload of credit risk. Therefore, if CIO were trying to offset this risk, it would probably sell short credit default swap insurance (CDS). Some of the biggest rises in CDS spreads since March 31 were in European banks. If CIO was short a basket of CDS on European credit indexes that included European banks, then its hedging activities could wind up inflicting large losses. If so, the CIO would have had to post more and more margin with its counterparty as the trade went against it. At some point, Dimon was informed of this unpleasant reality and decided to unwind the losing trade and break the news in the 10-Q.
JPM’s conference call was a stark reminder that investing in large derivatives-trading banks (the “Too Big to Fails”) is investing in a volatile cocktail of credit risk. Executives manage this credit risk with minimal disclosure about what types of risk they’re taking. “Just trust us,” is what they say. “We have sophisticated ‘Value at Risk’ models managed by rocket scientists,” they say. As you recall from the financial crisis, this was a formula that blew up spectacularly.
Jamie Dimon was very defensive and combative in response to questions on the call. He couldn’t provide specifics about the mark- to-market loss lurking in the CIO trading books — for obvious reasons: Other traders on Wall Street, like sharks smelling the scent of blood, would make JPMorgan’s exit from these underwater derivatives positions an even-more painful experience, while pocketing derivatives trading profits.
We won’t know any more detail until JPM reports its second quarter, when Dimon promised to provide more detail — presumably after unwinding the losing trades. This episode is one of many flashing signs that the global banking system is more fragile than advertised. JPM has built a reputation as one of the better risk managers among the world’s largest banks. If JPM had this surprise, what derivatives accidents lie in wait at other banks? With the eurozone on the verge of heightened drama and bank restructurings, I don’t think stock market bulls want to find out.
Finally, I’d be remiss to not mention our wonderful financial system regulators. Using the logic of the idiots (Dodd and Frank) that supposedly “reformed” Wall Street after the financial crisis, what we need now is another new regulatory agency. Dodd-Frank was a thin coat of paint over a cracked and broken banking system; since it failed to accurately diagnose the causes of the financial crisis, it was a dud and a nuisance from day one.
More legal complexity, more wasted money and red tape and more lack of regulator accountability is what we got, when in reality, a big part of the problem was regulators not policing activities at the Too Big to Fail banks. Here’s an idea — one that banking history expert Jim Grant has been pushing for years: It’s called “capitalism.” Take away the subsidies and bailouts for banks, along with the regulatory red tape. If they want to blow themselves up, fine — but losses would fall on the risk managers making those decisions and bank shareholders, not taxpayers or depositors. Push to return the investment banking business back to the partnership model that worked much better. Then, with the senior partners’ capital on the line, we’ll see how many derivatives blowups occur.
Regards,
Dan Amoss
for The Daily Reckoning
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| | | | | | And now over to Bill Bonner who has the rest of today’s reckoning from Baltimore, Maryland... | | When Cash is King: Investing with Risk on the Downside | | |  | | Bill Bonner | China is falling apart.
Bond yields are falling.
Copper is sinking.
Oil is sliding.
US stocks, too, slipped all last week.
Even gold...that old stalwart friend...turned its back on us last week, closing the week at $1,585.
Oh, dear, dear reader...everything is giving way. What can we hold fast to?
Can we count on the lumpen, dear reader?
As you know, when it comes to investing or politics, the humble masses are our North Star...our guiding light. We can depend on them to be almost always wrong. They fall for jingoes and jackasses every time.
“Stocks for the long run,” was a popular appeal back at the end of the ’90s...just before the stock market produced its worst returns in 60 years.
“The War on Terror” was another popular flimflam; it helped separate the public from $4 trillion or so of its money.
And don’t forget “Change,” from the man who changed nothing.
We had given up on stocks. They were too expensive. Besides, as we put it, the stock market had never completed its historic rendezvous with the bottom. Investors hadn’t given up. P/E ratios were still over 12 or 15. Dividend yields were below 3%.
We wanted a P/E below 8...and then we’d start to consider them. Or, give us a dividend yield over 5%.
Most important, we’ll wait until the public is fed up with stocks...convinced that they are a loser’s game.
Well, that day may not be far ahead. USA Today reports:
NEW YORK — On Main Street these days, investing in the stock market is about as popular as watching a scary movie on a 12-inch black- and-white TV.
Wall Street’s long-running story about how stocks are the best way to build wealth seems tired, dated and less believable to many individual investors. Playing the market isn’t as sexy as it used to be. Since the 2008-09 financial crisis, the buy-now mentality has been replaced by a get-me-out, wait-and-see, bonds-are-safer line of thinking.
Stocks remain out of fashion even though the stock market has risen more than 100% since the bear market ended three years ago. It’s up 25% since October and 9% this year.
Retail investors have yanked more than $260 billion out of mutual funds that invest in US stocks since the end of 2008, says the Investment Company Institute, a fund trade group. In contrast, they have funneled more than $800 billion into funds that invest in less- volatile bonds.
Investors’ chronic mistrust of stocks is reigniting fears that an entire generation is unlikely to stash large chunks of cash in the increasingly unpredictable market as they did in the past.
“Investors have suffered a traumatic shock that has caused severe psychological damage and made them more risk-averse,” says Carmine Grigoli, chief investment strategist at Mizuho Securities USA. Current worries, such as the USA’s swelling deficit, Europe’s unresolved debt crisis and slowing growth in China, have done little to ease their anxiety, he adds. | Investors are choosing ‘safe’ bond funds. Hmmm... Is it time to dump bonds and buy stocks? Or dump them both?
We faced this question a few days ago. We got a check — the payout on a deal we did long ago and since forgotten about.
What do to with it? Cash? Bonds? Gold? Stocks? Real Estate?
We chose cash!
Our guess is that we’ll be on our present path...lagging growth...dragging unemployment...sagging yields...for a while longer. How much longer? Damned if we know...
But Treasury yields are already near or at all-time lows. How much lower can they go? Houses are already down to their most affordable level ever...how much cheaper can they get?
As for stocks, our bet is that they can get a lot cheaper. Mr. Market, should he care to undertake such a mission, could drive the Dow from 12,000 down to 6,000...or even lower. And, if he cared to, he could hold prices at that level for years.
So could he push the 10-year Treasury yield all the way to 1% (now about 1.8%) if he wanted to.
Yes, dear reader, there’s still room on the downside. A lot of it.
One of the nice things about being a long-term investor is that you can wait a long time before you make your move. As Warren Buffett says, you don’t have to swing at every pitch. And there’s no penalty, except missed opportunities, for just waiting for the perfect ball to cross the plate.
That’s what’s so nice about cash. It’s a bat. It’s in your hands.
And we wouldn’t be at all surprised to see Mr. Market toss us a powder puff pitch before too long.
And more on US institutions going rogue...
Societies become more complex as they age. Each challenge...or opportunity...is met with a new rig of some sort. A tax. A regulation. An organizational fix.
As time goes by, these fixes act like friction...they slow the machine. They make it hard to move...inflexible and unresponsive. And over time, more people gain access to a fix — each lobbying group and special interest, each with his own bailout or subsidy...and each desperate to hold onto it.
Output is thus shifted to unproductive activities. The real producers are punished — with taxes and regulations — while unproductive activities are rewarded, with bailouts, handouts and sweetheart deals.
The financial industry was 2.5% of the economy when WWII ended. Now, it is 8.5%. How did it get so big? What does it do for all the money?
The answer to the first question is that it grew as the economy became ‘financialized.’ More and more laws were passed granting more and more special favors and protections to the financial industry. Just read the tax code. Go ahead, we dare you! You will find special allowances and deals for the insurance industry on almost every page. And there are rules and regulations for pension funds. And pensions themselves. ERISA. 401k. 501C3. SEC. FDIC. Dodd-Frank. CFPB. Everything is regulated...controlled...protected...
And all of this happened on the back of the biggest expansion of financial instruments in world history. The feds transformed the economy from one that made things...at a profit...to one that just made money. The money supply in the US increased by 1,300% in the 40 years after Richard Nixon ‘shut the gold window’ at the Treasury. That ‘wealth’ did not take the form of new factories in New England or new tractors in the Old South. It went mostly into money instruments...funneled through the financial industry to the rich people who owned financial assets.
Every potential new competitor had to comply with such a mountain of rules and regulations that he quickly gave up. Even if approved, he could not hope to provide a new product. Instead, he could only provide the same approved services and products that the big, entrenched players already had in stock.
John Kay, writing in The Financial Times, explains what would have happened had the computer industry been tied in the same knots.
“If you needed a licence to enter the US computer business, you can imagine the Computer Regulation Agency interviewing Bill Gates and Steve Jobs in the 1970s. What dutiful regulator would allow someone who had not even completed his Harvard degree to sell software to the public?”
Protected. Coddled. The financial industry went rogue. It was supposed to match investors with worthy investments, helping to bring genuine growth and prosperity to the US. Instead, it matched up most of the new money with itself.
The typical American was impoverished. Forty years after America’s money went rogue, he has not a dime’s more earning power per hour. And 4.5 times more debt, adjusted for inflation.
Regards,
Bill Bonner,
for The Daily Reckoning
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Here at The Daily Reckoning, we value your questions and comments. If you would like to send us a few thoughts of your own, please address them to your managing editor at joel@dailyreckoning.com
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