The Beauty of BCBS 239

BCBS 239 is the commonly-referenced name of a publication released in January 2013 by the Basel Committee on Banking Supervision (a committee of the BIS, or Bank for International Settlements). Its full title is "Principles for effective risk data aggregation and risk reporting".

The publication, which is 28 pages long is available here:
http://www.bis.org/publ/bcbs239.pdf

If you work in a large bank and are not familiar with BCBS 239, it may behoove you to read it.  If you work in risk management, data warehousing or compliance, you're probably already familiar with it.   But if you work in the back office, middle office, or a business line and are struggling with the challenge of unavailable, incomplete, or undocumented data, BCBS 239 can be an important tool in getting your requests taken seriously by your institution's executive management, or data management and IT bureaucracy.

Who wrote BCBS 239?
BCBS 239 was written by a committee of representatives from the financial regulators in 13 countries.  That includes the FRB and OCC in the US, the FSA in UK, and the JFSA and BOJ in Japan.  If you work in a large financial institution, you probably already know the influence these groups have over the project portfolio and purse-strings of your bank.

What does BCBS 239 say?
BCBS 239 lays out 14 principles about risk data, summarized in 4 groups, and further subdivided into 89 paragraphs.  There is a summary of the principles in annex 2 of the document.  But I found that some of the most interesting and useful language is in the detail itself.

BCBS 239 is surprisingly direct in saying what many line-level practitioners have been saying and thinking for years: it shouldn't be so damned hard to get the information I need from my bank's systems on a daily basis.  And I should be able to depend on the accuracy and completeness of that information.  Unfortunately, in today's world of split-second searches over billions of websites and self-driving cars, that is not the reality in most large financial institutions.

BCBS spells out principles that should be no-brainers.  But they are often not followed today.  It's good that the authorities have spelled them out, so that they can be used as ammunition by business users who actually need good data to get a job done.

Here are some of my favorite "no-brainers" that I'm glad to see confirmed by the committee:

• "Controls surrounding risk data should be as robust as those applicable to accounting data."(Principle 3 Accuracy and Integrity, paragraph 36a).  
• "Risk data should be reconciled with bank's sources, including accounting data where appropriate, to ensure that the risk data is accurate." (Principle 3 Accuracy and Integrity, paragraph 36c).
• "Supervisors expect banks' data to be materially complete, with any exceptions identified and explained." (Principle 4 Completeness, paragraph 43).

To me this means a bank must allocate and hold accountable actual staff to make sure the data in the data warehouse is correct and reconciled.  Plenty of staff.  Think how many people are dedicated to making sure the accounting data is correct: Comptrollers, Sarbanes-Oxley compliance people, internal auditors, etc.  And the "risk data" is arguably more varied and complex than accounting data.

• "A bank should establish integrated data taxonomies and architecture across the banking group...."  (Principle 2 Data architecture and IT infrastructure, paragraph 33)
• "A bank should develop an inventory and classification of risk data items which includes a reference to the concepts used to elaborate the reports." (Principle 9 Clarity & Usefulness, paragraph 67)

In other words, the data in the warehouse needs to be well-organized and documented--not just a mish-mash of incompatible records from different source systems.

• Principle 6 Adaptability – A bank should be able to generate aggregate risk data to meet a broad range of on-demand, ad hoc risk management reporting requests, including requests during stress/crisis situations, requests due to changing internal needs and requests to meet supervisory queries.
• "A bank should routinely test its ability to produce accurate reports within established timeframes, particularly in a stress/crisis situation." (Principle 10, Frequency, paragraph 70)
• "Some position / exposure information may be needed immediately (intraday)...." (Principle 10, Frequency, paragraph 70)

In other words, it's not acceptable for IT to demand a project and special budget just to produce some reports for the business.  The data must be available and usable in advance.

Conclusion
For years, those of us who work on the ground in financial institutions have heard statements from data practitioners about the strategic importance of data, and read vague statements of policy and principle from our data and IT organizations.  But at the same time the actual data we see is often incomplete, poorly organized, or inaccurate, and the day to day tasks needed to clean up the mess are never prioritized.

BCBS 239 is a clear and straightforward document that tells G-SIBs and other financial institutions to actually use 21st century technology to deliver practical results.  While it may be a challenge to implement at most banks, it is a challenge whose time has come.

Making it Look Easy: How Warren Buffett Did It

Article: The Economist, The Secrets of Buffett's Success

Interesting article in this week's Economist about a study of how Warren Buffett has managed to make such successful investments over a long period of time, and stock-picking has very little to do with it.  It comes down to two simple factors:

1) He concentrates on stocks with low betas (ie, low risk, low return stocks).  According to the article, these stocks perform better on a risk-adjusted basis than high flying stocks. (Possibly, I guess, because investors who are looking to get rich quick overlook them, so they are in less demand.)

2) He leverages his portfolio (ie, borrows money to buy more stock).  His source of funds is not loans or bonds, but insurance premiums, which gives him an extremely low funding cost.

This makes a lot of sense, especially if you read Buffett's annual shareholder letter, which always describes with glee the free float he gets from his insurance businesses.  (Letters are available here, and well worth reading).

Now that I know the secret, I just have to get hold of a massively successful insurance company.

Obama's Economics Report Card

Article: The Economist, Barack Obama's Economic Record

Well worth reading.

The Quandary of Air Conditioning

Article: New York Times, The Cost of Cool by Elisabeth Rosenthal

Here's another vicious circle for you: as the populations of tropical developing nations move into the middle class, they will demand air conditioned homes, offices and cars, just like Americans do.  This will  contribute to global warming, which will further increase the demand for air conditioning, until... What?

Elisabeth Rosenthal's article is informative and thought-provoking.  It does not simply bash our decadent comfort-seeking life-style, but notes that air conditioning brings benefits for our health and productivity, and seems to be a requirement for modern knowledge workers, especially in hot climates.  This is a quandary, for which there is no simple obvious solution.

One more thing to puzzle and worry about...

http://graphics8.nytimes.com/images/2012/08/19/opinion/19rosenthal_chart/19rosenthal_chart-custom1.png

World Jewish Population

Very interesting special special report in this week's Economist on Judaism and the Jews, including the graphic below.  The total Jewish world population of 13.6 million is similar to that of the country of Zambia, or the city of Karachi, Pakistan.

from The Economist magazine www.economist.com

Is There Life After Fifty?

Article: The Economist, Schumpeter, Enterprising Oldies

This article, which is short and well worth reading gave me some hope.  Zuckerberg and company aside, it gives a bunch of examples and reasons why entrepreneurship and other creative endeavors are not only for the young-- not by a long shot.  For example:

• Dane Stangler of the Kauffman Foundation found that highest rate of entrepreneurial activity was in the 55-64 age group.  Lowest was in the 20-34 age group.
• Ray Croc started McDonald's in his 50's.
• Colonel Harland Sanders started KFC in his 60's.
• The Stones, Dylan, Paul McCartney, Leonard Cohen: still going strong.
• Arianna Huffington founded the Huffington Post at age 54.
• Marc Pincus founded Zynga at age 41.

Six Latin American Countries Without Ambassadors

Article: U.S. Sway Clipped In Latin America, Nicolas Casey, Wall Street Journal

Can you name the six Latin American countries whose ambassadorial appointments have been held up in Congress?  They are:

• Barbados
• Ecuador
• El Salvador
• Nicaragua
• Urugay
• Venezuela

Article also has a nice map...

Economic Growth: Get the Picture?

Regarding the economy, sometimes a simple picture is very helpful.  This is from Friday's Wall Street Journal:

(Recovery Doesn't Feature Typical Snapback in Growth, WSJ, 1/27/2012)

Italy: Roubini Had it Right Five Years Ago

For about two years I have watched the performance of my (mostly American) stock portfolio gyrate, more or less in sync with the news about the PIIGS of Europe.  The latest scary news has been all about Italy: rising bond yields implying an imminent inability to roll over their debt, leading to a possible default.   What surprises me is that the gyrations have been similar in scale to what we saw recently when all the scary news was about Greece.  It strikes me as odd since Italy's economy (and debt) is somewhere on the order of five times the size of Greece's.  I guess you could say the market has been taking the Italian news in stride, or perhaps that the market always knew that the Italian bad news was somehow "baked into" the Greek bad news. Interesting though, that you don't hear much about Spain anymore.  Unemployment there is abysmal, but they seem to be making serious efforts to shore up their banking system, and of course their debt is only around 60% of GDP, as opposed to Italy's 120%.  (see my article and chart: What is Going On in the Eurozone?)

Meanwhile, browsing through Nobel laureate Paul Krugman's economics blog, I was pointed to this very interesting piece written in 2006 by Nouriel Roubini.  Please read it.  At an economic conference at Davos in 2006, Italian finance minister Giulio Tremonti tried to shout down Roubini when he gave an accurate and prescient analysis of the challenges which would be facing Italy if they did not make serious reforms to their economies; basically he compared Italy to Argentina, and said they were going down the same road.  

Of course Roubini turns out to be right, and the entire Berlusconi administration comes out looking like ineffective, corrupt children, who had been placed in charge of a $2 trillion economy.  Nice work, guys.

What Should Wall Street Do? Disappear!

The latest "Schumpeter" column in The Economist makes the case that large financial firms ("Wall Street") have not been doing enough to defend themselves against the onslaught of criticism coming out of the Occupy Wall Street movement. He says that banking is important to the economy: "....people still need loans and somewhere to park their savings.  Companies...need investment banking to help them manage their finances and grow."

Yes, but....For a long time, Wall Street has not been about maximizing social utility, and bank chiefs--who are by and large the same cast of characters that crashed the financial system to begin with-- have not been thinking about these things.  Instead they have been thinking about how to make a killing either by selling a new opaque, fee-laden product, or by taking advantage of some informational edge to make money trading in the market.

It is easy to make a case that the plain vanilla services that banks offer -- taking deposits, making loans (not repackaging them and selling them off right away), even helping companies issue stocks and bonds--are a public good.  The problem is, this is not how hot-shot Wall Street bankers got rich over the last 20 years.  They did it by trading, or through financial engineering.  And the only reason they were able to do this is because they were able to convince our public guardians to look the other way, and somehow convince the public that it was all part of a healthy, vigorous free-market system.

Paul Volcker has it right; banks should not be trading with government-insured deposits.  I believe they should  not resist putting derivatives onto exchanges where they would trade efficiently with the lowest spread possible. And probably credit default swaps should be regulated as insurance contracts, which would effectively make them illegal.

"Middle class Wall Street"--brokerage, custody, retail banking--has been shrinking for decades as a result of technology.  But Wall Street as a whole has been growing, as firms take advantage of deregulation to make money in ways that offer very little public benefit.  Can Jon Corzine make the case that by having his firm, MF Global, invest $6 billion in European bonds on a capital base of $500 million he was somehow benefiting society?  I would like to hear that.

Yes, modern society needs banks.  But it does not need super-sized institutions whose main source of profits is trading, it does not need opaque and gargantuan over-the-counter derivatives markets, and it does not need regulated institutions making leveraged bets and paying out 7-figure bonuses.

Technology should be making the banking industry shrink every year.  Profits should be shrinking, not just jobs.  Yes, this would be bad for places like New York in the short term.  But in the long term it will be good for society as a whole, as borrowers, lenders and investors are matched together at the lowest cost possible.  And New York has recovered from worse dislocations than this.

A truly free market should lead to less money for Wall Street middle men, not more, as their margins and fees are squeezed through competition.  Of course, if all profit is squeezed out, then banks will go under, which will hurt society.  So the case can be made for regulating banks as a public utility, allowing them to maintain a certain profit margin in exchange for submitting to price controls and strong regulatory oversight--like what is done with power plants and railroads.

If a Lloyd Blankfein or a Jamie Dimon wants to come out and make the argument for downsizing trading, profits and bonuses and returning banking to the conservative, risk-averse, highly regulated activity it once was, then I'm sure America will be most grateful, and protests may even calm down.  But we know how these guys made their money, and how they continue to make it.  There is no reason to expect them to change.  They will continue to keep their heads down, pay their lawyers and lobbyists, and keep raking it in for as long as it lasts.

Looking Good, Barack!

This has been a good couple of weeks for President Obama.

With just over a year to go to the election, any prediction I make now could well be dead wrong.  But for now, the President's prospects are looking good.

The big story, of course, is Thursday's killing of Muammar Qaddafi, Libyan strongman, "mad dog of the Middle East", and one of America's main bogey-men since the Reagan administration.  Does Obama get the credit for this?  Sure he does; his Administration's plan in Libya was brilliant in its "less-is-more" low-key simplicity-- the polar opposite of his predecessor's big spending, big talking and far less effective efforts in Iraq.  Obama spent around $1 billion in Libya (about 0.1% of the Iraq war), and let the allies do most of the heavy lifting and take most of the credit.  But does anyone seriously think this could have succeeded without U.S. technological and political backing?

Then, there is yesterday's news that we will be pulling all troops out of Iraq by the end of the year, finally cleaning up Bush's worst foreign-policy mess, just as Obama said he would.  Sure, critics warn of a resurgent and dangerous Iran, and the dangers it poses in the region.  But if this is the fear, Obama has rapidly proven that he is the best man to deal with the threat -- with his successful targeting of senior al-Qaeda figures (remember Osama Bin-Laden?)  and aggressive drone strikes in Pakistan and Yemen he has shown that he is no weakling, and Iran discounts him as an adversary at their own risk.

Whether polls show it or not, military and foreign policy is the most important job of any President, and Obama is now second to none on this front.  Who can challenge him when it comes to our security and vital interests: Romney? Perry? Cain?  Hah!

As far as the economy goes, most say that this will decide the election.  But this has been a good week for Obama as well, with the recent signing of free trade agreements with Korea, Colombia and Panama (in descending order of economic importance).  This won't turn the economy around on a dime, but will increase overall prosperity for years to come, and is an issue that has always had broad bipartisan centrist support.  And, as reported in today's Wall Street Journal, it has helped lead to a "thaw" in the Senate, which has allowed the confirmation of several judges and other officials that had been "held" for Senate approval for months.

Speaking of the economy, I think the nation is coming to realize that we are in the midst of a long slog, as Americans become more thrifty and save more, reducing consumption, and thus slowing economic growth (see today's WSJ, Spenders Become Savers, Hurting Recovery, by Jon Hilsenrath and Ruth Simon).   I believe this might be the beginning of a more sane, sustainable economy, one that is not based on living in a bigger house than you really need, having more (and bigger) cars and appliances than you can use, and financing them with debt.  Yes, commerce and dreaming big are American values, but so are modesty, simplicity, spirituality and sacrifice.  The idealist in me thinks that Americans can live happier and better lives without a high economic growth rate fueled by ever-increasing consumption.  But one of the keys has to be a more equitable distribution of wealth.

There is a national heritage that we are all part of, and which contributes in large part to our well-being as individuals.  In this I would include our roads, our national parks, our education system, our social security system, our system of medical care (which is now close to 50% publicly funded), not to mention our rich history and culture.  By concentrating on these things, we build wealth for the entire country that we can all share in, and that cannot be taken away from any American.  The days of a consumption-based economy, where the middle class buys more than they need, and the rich make a killing off their unnecessary purchases are over.

I hope that people are coming to realize that Republican policies that aim to take us back to this type of consumption-based economy are not appropriate in today's world.  I hope that the widespread public support for the "Occupy Wall Street" movement are a symptom of this realization.  So far, Obama is the only candidate who seems to get this, and offer something approaching a reasonable way forward.

High Frequency Trading: Have Transaction Costs Gotten Too Low?

Article: Wall Street Journal, A Call to Pull Reins on Rapid-Fire Trade, Scott Patterson

This article from today's paper is about Thomas Peterffy, chief executive of Interactive Brokers, and one of the inventors of high frequency trading.  Now he's turned against the practice which he helped invent, and says it's bad for the market.  (It also hurts his business.)  He blames high frequency trading for the flash crash of May 2010, when the market dropped by 1,000 (10%)  points before rebounding a few minutes later.

There is an orthodoxy that practices like high frequency trading make markets more efficient through an arbitrage mechanism.  As traders exploit inefficiencies to make a profit, they tend to squeeze those inefficiencies out of the market, thus making trading more efficient (cheaper) for everyone else.

But I wonder...

Transaction costs in the stock market have been dropping for decades.  Technology enables huge numbers of shares to be bought and sold with very little human intervention--cheaply.  Over the years this has caused the loss of lots of middle-class Wall Street  jobs.  But this has been the way of the world at least since the industrial revolution.

But at the same time, a small number of people have enriched themselves to an unprecedented degree by exploiting every informational and technological advantage they could find.  From big trading desks at companies like Goldman Sachs whose alumni staff the Fed and the Treasury Department, to hedge funds which somehow in an "efficient market" are able to charge many times more than what the average mutual fund manager charges --because their rich clients must believe they know something or someone that no one else does-- to high frequency traders, who somehow manage to turn a profit just by trading faster than anyone else.

It seems to me that if Wall Street is fatter than ever (in absolute terms, and as a percentage of GDP), then markets must be less efficient than ever--because after all, Wall Street is just a middle man between savers and borrowers.  The less money the middle man gets, the more efficient the market is, right?  Is "market efficiency" just a shibboleth that those who exploit an unfair advantage utter to defend their racket?

It's not really a mystery how high frequency traders make money.  They act as "market makers", taking the opposite side of the trade for all who are ready to buy or sell, as long as you're willing to accept their spread,  which is a market maker's legitimate source of profit.  Market makers provide a service; they are always there if you need to sell quickly to raise cash.  They earn a spread in return for taking the risk that they will get stuck with a toxic inventory of plummeting stock.

But in most markets, at least traditionally, market makers are regulated, and expected to step up as buyers of last resort in times of market stress.  As I read, high frequency traders are different because they stop trading and leave the market as soon as conditions get rocky.  So they really are not market makers in the traditional sense.  They make a market when it suits them, then step away when it doesn't.  This might be OK if they were small players, but high frequency trading is now over 50% of U.S. equity volume.  So they have an undue influence on the equity markets, and contribute nothing but this so-called "market efficiency" which mysteriously manages to produce more super wealthy individuals than ever before.

There are various ways to deal with this problem.  Thomas Peterffy proposes putting a 1/10 second delay on all exchange orders, which would eliminate the high-frequency houses' speed advantage, and stop their orders from getting in front of legitimate regulated market makers' orders (like Interactive Brokers).

Another solution that occurs to me is to raise transaction costs by imposing a modest tax on each trade.  Those off us who buy shares because we actually want to have them will hardly notice.  But those who churn the market for profit will have to slow down.  And the tax could be used for something good, like fighting off bank lobbyists and splitting up some of the big players, so they have less influence and pose less systemic risk.

But I think the best solution is for the SEC to simply do its job.  If you are pumping thousands of trades through the market each day, then you are a de facto market maker, and need to be regulated as such.  The SEC's mandate is to ensure fair and orderly markets.  If certain players are making profits through activities which destabilize markets and create more risk all around, then they need to be warned, and then banned from the markets if they continue.

To my loyal readers, I apologize for the 17 days that have passed since my last post.  After a wonderful, though truncated visit to the island of Shikoku, Japan, I am now gainfully employed which is interesting, but makes out-sized claims on my time.

Good News, Trade Pacts Moving Forward

Article: Wall Street Journal, Disputed Trade Pacts Advance, by Elizabeth Wilson

According to the WSJ, trade pacts with South Korea, Colombia and Panama could be passed by mid-October.  These pacts have been a source of political conflict for five years.  The main sticking point has been the extension of "Trade Adjusted Assistance" or TAA, a U.S. program which gives extended unemployment benefits to workers displaced by globalization.  The article says that the White House and Congress are near an agreement on a scaled-back version of TAA, and the President could send the three trade pacts to Congress early this week.

I believe this is good news for the United States, as well as Korea, Colombia and Panama.  Economists agree that free trade is a win-win, that increases overall wealth and prosperity, as each country is able to use its comparative advantage to produce those goods and services that it can make most efficiently, and trade them openly.  The article says that this pact could boost U.S. exports by $13 billion annually, with most of the gains ($11 billion) coming from Korea.

For Obama, this one is a no-brainer, and shows that he is serious about sound economic policy.  Better late than never, I say.  Now it's time for tax simplification....

from wsj.com

Let's Eliminate the Corporate Tax

Article: Wall Street Journal, A Short History of the Income Tax, John Steele Gordon

Lately there has been a lot of talk about corporations who do not pay their fair share of tax, big oil getting all matter of tax-based subsidies, General Electric  paying an effective tax rate of 0% last year, etc.

When Democrats go after millionaires and billionaires, corporate jet owners and the like, and ask them to pay their fair share, I'm all for it.  The gap between rich and poor in this country is greater than it's ever been, and rich folks have been making a sport out of hiring talented tax advisers to game our country's Byzantine tax code for decades.

But when it comes to bashing corporations, and asking them to pay more, I have mixed emotions.  Corporations are not people.  But they do hire people.  They pay wages, produce useful goods, add value and innovate.  And they are highly regulated--depending on the industry.

But the key fact is that corporations are owned by individuals, and individuals are taxed.  So why tax corporations as well as individuals?  In the interest of simplicity and fairness, lets' just stop taxing corporations.  Instead, let's impose a truly progressive tax on all individual earnings--including on the money that people earn from their corporate investments.    Then we could stop doing silly things like taxing capital gains and dividend income at a lower rate than ordinary income.   If we did this, Warren Buffet would be paying a higher tax rate than his secretary, and all would be right with the world.  And we would see a massive shrinkage in the the tax compliance industry--a wasteful drag on our nation's productivity.

Graphic from www.taxpolicycenter.org
Note the small portion of revenue that corporate tax actually comprises.....

Not only that, but we would see the U.S. become much more competitive as a location for corporate headquarters.  This could only be good for employment.

Mr. Steele's article notes that the Corporate Income Tax was instituted in the early 20th Century as a stop-gap measure.  Unfortunately, it was never phased out.  I hope that Mr. Obama will take up tax simplification, as he promised.  It is an issue with bi-partisan support, which can do the country a world of good.  And I hope he will give serious consideration to the simple but dramatic step of eliminating the corporate tax altogether.

More to Worry About: Russia Commits to Chernobyl-Style Reactors

Article: Wall Street Journal, Russia to Extend Life of Aging Reactors, by David Crawford and Rebecca Smith

To take my mind off the 400+ drop in the Dow Jones Industrial Average, I was thumbing through the international section of the paper, and found this article about nuclear reactors in Russia.

Despite Western pressure to shut them down, there are still 11 Chernobyl-style reactors, also known RMBK reactors, operating in Russia.  All of them are on the Western edge of Russia, near the cities of St. Petersburg (pop. 4.8 million), Smolensk (pop. 327,000) and Kursk (pop. 415,000).  These reactors originally had a life-span of 30 years; they have now been extended to 45 years.

from www.wsj.com

As per the article: "Many Western nuclear experts believe the RMBK reactors are among the world's most dangerous and still suffer from fundamental design shortcomings."  Such as:

• No containment structure to keep in radiation in case of an accident.  A containment structure is a standard feature on modern nuclear reactors.
• No central crucible to hold fuel rods.  Each fuel rod sits in its own tube, so engineers have to monitor and maintain 1,000 separate tubes, instead of one central crucible.

Although Russia is rich in natural gas, they are reluctant to replace their aging stock of Soviet-era nuclear reactors with natural gas plants, because they prefer to export their natural gas for profit.

I hope that Europe will become less reliant on Russian natural gas soon, and that this will change the equation.  In the meantime, let's all keep our fingers crossed.

The Human Cost of Greece's Debt Crisis

Article: Wall Street Journal, Greek Crisis Exacts Cruelest Toll, by Marcus Walker

This front page article in today's WSJ tells the tragic story of Vaggelis Petrakis, a hard-working family man from Crete who had a company that supplied vegetables to hotels and supermarkets. He was brought low by a “credit economy”, namely clients who paid him with 6-month postdated checks. I won’t paraphrase the story; you’re better off clicking on the link and reading the original.

The article quotes Constantine Michalos, president of the Athens Chamber of Commerce and Industry, who says that the practice of paying with post-dated checks exploded in Greece in the 1990's. "This was a para-banking system of enormous size. It is one of the main reasons for the crisis."

(There was also an interview with Michalos on CNBC today, where he says that about 80,000 small business have gone under in Greece over the last year)

Walker's article notes that the suicide rate in Greece has roughly doubled since the beginning of the crisis.

This morning on CNBC, I saw an interview with Mark Grant, Managing Director of Southwest Securities, who said that total Greek debt, including sovereign, corporate and municipal debt is around $1.1 trillion, roughly 3.5 times their annual GDP -- much larger than the sovereign debt alone, which was reported as $454 billion at the end of 2010 (143% of GDP).

Notwithstanding the outcome of the European debt crisis, it looks like Greece is in for a hell of a de-leveraging, which will weight down their economy for years to come.

What is Going on in the Eurozone?

Fiscal problems in the euro zone have been a primary cause for the gyrations in the U.S. stock market this year and last.  There is an element of panic that a default by one or more countries (ie, Greece) and/ or financial institutions (Societe Generale?) will cause a cascading "contagion" in the markets, similar to what happened with the bankruptcy of Lehman in 2008.  Whenever the euro zone countries step up to do something, often through the efforts of the European Central Bank, or ECB, the market goes up.  When they are seen as hanging back, markets go down.

This week, we have seen markets go up on what seems to be a concerted effort by the ECB along with other major central banks.  Today it was announced that 3-month USD loans will be made available to European banks who have been having problems placing their commercial paper, which has traditionally been an important source of US dollar funding for them (See AP Story, ECB to Provide Banks with Dollar Loans).  And in a CNBC interview yesterday, U.S. Treasury Secretary Tim Geithner was unambiguous in his statement that Europe would not allow its major financial institutions to default a la Lehman -- Europe is by and large less market oriented than the U.S., and not so concerned about "moral hazard".  (See No European Lehman-Like Collapse?)  

There seems to be a growing consensus that Greece will default and probably exit the euro--its bonds are now yielding 25%-- that this will not be the catastrophe some have been fearing, and that Germany will eventually face the inevitable choices that it has to make in order to save the euro experiment--more central planning of fiscal policy, including some kind of central euro treasury.    (See George Soros' article in The New York Review of Books, Does the Euro Have a Future?)

Nothing is decided yet, but markets have been moving up this week on these less-than apocalyptic assumptions.  As of this writing, the Dow is up over 100 points today (1%) and over 350 points since Wednesday (about 3%).

There will surely be more ups and downs on this roller coaster in the future, but as an investor, it is nice to see gains.  Hopefully they will last.

Is Wall Street Shrinking?

Articles:
Wall Street Journal, BofA Readies the Knife, by Dan Fitzpatrick
CNN Money, More Layoffs Looming on Wall Street, by Maureen Farrell

The Wall Street Journal reports that Bank of America is planning to cut $5 billion in costs by the end of 2013, including the elimination of about 30,000 jobs.  CNN reports that their major competitors will probably follow suit.

Is Wall Street shrinking?  Well, it depends how you measure it.  If you look at the number of people employed, yes it is.  Those of us who are producers and even consumers of financial products have seen great increases in efficiency over the years--everything from online brokerage, to ATM machines, to exchange traded funds, to decimalization have allowed Wall Street to service investors more cheaply than ever before.  As the below chart shows, the number of people dedicated to finance has barely budged since 1998 (the first year that the Bureau of Economic Analysis makes figures available), and is now trending downward.

To the extent that Wall Street is part of the "overhead" of our economy, and produces no real wealth, that is good news.   (Although this is little consolation if you are a BofA teller who gets laid off).

But look at the green line on the graph.  This is the percentage of GDP that is produced by the financial industry, which has been going nowhere but up for decades. Except for a few down years, GDP has been steadily increasing over those years, so we are seeing finance making up a steadily larger piece of a steadily growing pie, and doing it without employing more people.  In other words, some people are making a lot more money.  And who are these people?  Shareholders?  You wouldn't know it by me!  Tentatively (until someone proves me wrong) I think we are talking about individuals with out-sized compensations: hedge fund managers, traders, C-suite executives, lawyers.

And again, to the extent that financial services produce no real wealth, and are part of the overhead of our economy (which I believe is the case), this is done at an overall cost to our prosperity as a society.  How has this happened?  I guess that a big part of the answer is "financial innovation", which is a fancy word for getting more people to borrow more money at a higher cost than ever before.  For individuals this means things like new types of mortgages, home equity loans, and credit cards.  On the corporate side there are things like securitization, over the counter derivatives, credit default swaps, all generating hidden fees and spreads which over the years have greatly outpaced any efficiency gains coming from automation and downsizing of clerks.

I believe Wall Street needs to shrink more and become more efficient.  But I hope that the next arena for efficiency gains will be fees, spreads and six or seven figure bonuses, not just clerks' salaries.

Bashing President Obama and Pushing Dirty Energy

Article: Wall Street Journal, Canada's Oil Sands are a Jobs Gusher, by Mary O'Grady

I'm glad that in his speech on Thursday President Obama didn't say a word about green energy jobs.  As I said in a previous post, I'm fairly convinced that subsidies for forms of energy that are not yet economically viable (e.g., solar and wind) are a waste of taxpayer money.   (Research, on the other hand, is another story).

It seems like Ms. O'Grady, a columnist for the Wall Street Journal listened to a different speech than I did, or perhaps she didn't listen at all, just trotted out the old cliches one more time.  Here is the first paragraph of her article:
For all its soaring rhetoric, President Obama's "jobs speech" last week didn't demonstrate a lick of insight into why economies grow or how wealth is created. It was merely trademark Obamanomics: using government diktat to move money that's over here, over there.

What is she referring to, exactly?  Cutting payroll taxes?  I thought conservatives believed tax cuts were the key to prosperity.  Investing in infrastructure projects a la Eisenhower?  Investing in education?  Cutting government red tape and streamlining regulation?  Yes, these were the core elements in the President's speech.  

She mentions Alberta's oil sands as an example of the type of exploration that will lead to increased jobs, then blasts Obama for allowing regulators to slow down drilling on Federal lands.  My understanding is that the oil sands remained unexploited for years is because the oil that they contain is filthy, expensive to exploit and high in greenhouse gases and replete with negative environmental effects.  The only reason Canada has had success with this energy source in the last few years is that the cost of imported oil has gotten so high.  But what is the way forward for our energy future?  Clean natural gas from the U.S.?  Maybe.  Dirty tar from Canada?  Highly doubtful.

Ms. O'Grady also mentions that the market tanked 300 points the day after Obama's speech.  Come on!  Anyone following the market that day knows that this move was all about Europe, notably the highly scary resignation of German ECB official Jurgen Stark.  As I recall, the market was up on Friday morning (largely on Obama's well-received speech and plan) before this news hit.

Obama's plan is not the be-all end-all, but it is a practical, centrist step in the right direction, which may actually have a chance of passing.  Given budgetary constraints and a divided government, this may be the best we can hope for right now.  

If Mary O'Grady wants to criticize the speech, perhaps she should start by actually listening to it.  

The USA's Aging Energy Infrastructure

Articles:
Wall Street Journal, Nuclear Backlash Energizes Old Plants, by Rebecca Smith
Wall Street Journal, Gas Pipeline Operators Sweat Test, by Daniel Gilbert

Two articles in Thursday's WSJ about the USA's aging energy infrastructure.

The first points out that the anti-nuclear backlash caused by the Fukushima disaster in Japan is stalling construction of new nuclear reactors around the world, which will have the perverse effect of increasing our reliance on an aging stock of nuclear power plants.  The U.S. produces more nuclear power than any other country in the world, with 104 power plants.   Ground was broken on virtually all of these in the 1970s.  They were originally licensed for use for 40 years, but according to the article, over 70 of the plants have already received 20 year extensions.  Are 60-year-old nuclear reactors safe?  I hope so.  Meanwhile, regulators are conducting research to see if it would be feasible to operate a nuclear reactor for as much as 80 years.

from WSJ.com

The article also points out that the energy industry has been finding it more attractive to construct natural gas fired plants as an alternative to nuclear plants.  This sounds reasonable, except that over 60% of the U.S.'s natural gas pipelines were built before 1970--around 178,000 miles worth.  A large portion of these older pipelines were never subject to pressurized water tests for leaks.  The test became a requirement after 1970.  Now regulators are considering making the industry go back and perform this test on all of the old pipelines.  At between $125,000 and $500,000 per mile, the cost will be in the tens of billions.

I don't have the expertise to say how safe it is to continue using nuclear facilities and gas pipelines for 40, 50, 60 or more years.  But it's pretty surprising to learn how truly old our country's energy infrastructure is.