Thoughts (original and otherwise) on the Banking Crisis

So yet another week passes and we see ourselves in deeper and deeper into this, as yet named, financial crisis (somehow “Sub-Prime” just doesn’t seem adequate anymore, the generic ‘2007-08 Banking Crisis’ will probably be what we settle on.)

And this topic has certainly been on the minds of many of my fellow classmates (primarily because of recruiting) and faculty members (primarily the value of their 401k’s I guess) here at school.  In fact, our school felt it necessary to host no less than separate 2 discussions on the crisis on consecutive days to given everyone a forum to discuss and share their views and opinions.

To you, the inquisitive reader, I thought I would take a couple of minutes to jot down some of the jumble of thoughts on the banking crisis:

“What is the root cause of the banking crisis?”  A broad and vague question posed to me by my social enterprise professor on the 2nd day of class – prolly more to seek out answers he could reuse by polling the collective intelligence of the class for answers – rather than as part of his lesson plan.

• My first response was: “Relaxed borrowing standards for home mortgages to the point that any fool and his dog could take out a loan.”  If you inherently believe in  having free markets that are efficient and will allocate resources to areas that maximize economic return of the participants than this has to be your starting point.  I’m not going to blame the banks for their securitization and structuring activities – this made money and therefore was worth doing, this was the invisible hand at work.  Which brings me a corollary:
• If it’s legal and it makes money (and yes securitizing and repackaging home loans made a boatload of money for them), the investment banks will do it.  The nature and structure of investment banking remuneration (i.e.  focus on big year-end bonuses) rewards bankers for taking risks that pay off in the short-run, long-run risks be damned.  This creates a culture which increases systemic volatility as all the bankers race to get a share of their slice of the pie (in whatever is the latest reward of scene of the day) before the party ends.
• Profit-driven Debt rating agencies which had massive conflict of interests that corrupted their ability to fairly rate debt and that assigned investment grade ratings to the eventually toxic mortgage-backed securities and CDO’s.
• The regulatory environment was all of:
  • too outdated (current structure of financial regulation has not been updated since the 1930’s)
  • too slow or cumbersome (perhaps the US’ rules-based regulatory framework should be sunset in favor of the UK’s principles-first regulatory framework to financial innovation can be automatically matched instead of waiting for lawyers to update the books)
  • too weakened by successive cuts in the funding of the regulatory agencies

to be able to respond.

What about the issues of low historic yields distorting the markets? I heard this sentiment several times and I agree that this definitely contributed to our problems but I don’t agree its the root cause.  As the Fed (re Alan Greenspan) kept rates artificially low for too long (remember Greenspan’s argument that productivity gains from info tech would allow for lower rates of natural unemployment?) this distorted the capital markets.

Related to  Alan Greenspan’s low-rate management policy of the overnight Fed Funds rate were the lessons learned from the Asian Financial Crisis of 1997-98 which instilled a “best practice” of running current account surplus, stockpiling foreign currency reserves and maintaining weaker currency in order to stave off a repeat of ’97-’98.  Of course this had the unintended consequence of flattening out the rest of the US debt market’s yield curve as Asian countries furiously bought treasuries to park their current account surplus and keep their currency relative weaker.

Asset managers, with their trillions of dollars, could no longer rely on a decent real interest rate from the bond markets to earn a reasonable return for their income-seeking fundholders eventually turned to more risky ‘alternative investments’ fueling a boom in hedge funds and private equity.

(These hedge funds with their “2 and 20” payout structure likely contributed additional volatility in the capital markets by fostering a ‘go-big or go-home’ mentality as these fund managers sought outsize risks in order to make outsize gains for their 20% carry.)

Where do we go from here?

I guess this is where things get interesting.  A lot of folks talked about the notion of ‘delevering’ or essentially borrowing less.

For example – now that Goldman and Morgan are commercial banks, they are going to have to run their operations and balance sheets like them.  Whereas they are currently levered 40 and 33 to 1 respectively, they will now have to come in-line with the rest of the commercial banks at 10.   Which means selling off 66% to 75% of their assets (i.e. loans to their customers).  This does imply that GS and MS are now likely to be less profitable and less valuable as they can only lend (and collect interest income) on 1/4 to 1/3 what they could previously have done?

Broader implications to the US economy is that money supply will be tighter, less money flowing around as regulations will (hopefully?) rein in irresponsible lending.

In the medium run, low-yield market distortion could see itself worked out as foreign investors – re Japan and China switch their target instrument of treasuries into alternate and equity investments and out of US dollars into more diversified basket of currencies – this latter treend is already happening and will likely continue.  This will of course have implications on the alternative investments financial management industry.

Longer-term, of course, there is another looming issue which seems to have submerged back from mass consciousness – that of the twin deficits (budget deficit and current account deficit) triggering US-confidence crisis which result in spiking interest rates and falling US dollar (I guess that is already happening) as foreign investors turn their back on US economy.  The potential saving grace here is that given the risk adversity of these investors and the unsettled state of the world and other economies, the US still represents the safest destination for investors…for now.

 

CDN$1 = USD$1: Canada on the Threshold

Today was a great day for the Canadian Loonie.

Today was the day that 1 Loonie was worth 1 greenback. In fact, briefly the Loonie was worth MORE than the greenback.

Let’s put this into perspective: in my lifetime the Loonie has never traded this high before so for me, this is a lifetime event.

Personally, this is going to make my grad school education just a little bit more palatable and I’m certainly glad I held off converting my loonies to greenbacks until now. But other than this small personal benefit, I thought I’d take a moment to assess what exactly all this means for the Great White North.

Canada on the Threshold

Already manufacturers from Ontario to BC are crying out in pain, and I’m sure we’ll be hearing that much more from the CDN news outlets in the future, I really have little sympathy for this nonsense. Instead I would urge them and the country as whole to take this historic opportunity to rethink who they are.

It’s absolutely clear now that Canadians and Canadian companies should no longer see themselves as a low cost outsourcers to the United States.  If Canadians really wanted the better life with the world class social program they have been screaming at their government to deliver, they better start trying to build a world class economy that can support it.

That’s what the Brits did in the 90’s with Blair’s Third Way economics. That’s what Canada needs to do now.

It’s not that we haven’t been trying but the whole 60 cent dollar gave Canadian businesses a crutch they could complacently lean on. Why try to improve the processes and product quality of your company when you this natural low cost advantage working for you?

And the results show. Canada’s productivity growth has perpetually ranked below that of the US since, no surprise, 1980 – just several years after the Loonie started tanking. By PPP, Canadians earn on average $8000 less per person. For a country that is better educated and blessed with more natural resources than its southern neighbour, this is atrocious.

Well back to the future, Loonie companies have a new reality they have to adjust to – a world in which they can’t rely anymore on being cheap. So here’s a quick list of suggestions:

1. Invest in Information Technology. Did you know that the much of the US productivity growth in the 90’s was driven by massive IT investments? And yes I know Canadian companies couldn’t similarly invest at the time since the Loonie was in the crapper.  And yes, I know, IT has for a long time been really expensive and risky to do. But that’s no longer the case. with a $1+ Loonie, IT costs as much to you as well an US company does. Moreover, software manufactures from Microsoft, to Oracle to SAP are falling over themselves to go after smaller companies, companies more like what a typical Canadian company looks like.
2. Labour productivity matters. This might be cultural, but yes, there are better ways of doing things sometimes. Maybe Canadians workers and middle managers are too nice or they aren’t thinking and like to keep their head down and do things the same way they were done 5, 10 even 20 years ago but this has to change. That’s not enough anymore. Execs needs to be pushing harder to work smarter. Your company’s survival depends on it.
3. Invest in mangement talent. Having worked in both Canadian and US companies, I can tell you, Canadian companies could benefit from an upgrade in management talent. I can’t exactly put my finger on it but I can say that US managers seemed to have a more strategic view and make better quality decisions. This was a major motivation for my decision to go back to grad school. In Canada, the % of MBA’s in the workforce is significantly lower than than in the US. Maybe I’m biased but I think this makes a difference. With a $1+ loonie, now is a great time to invest in some human capital – maybe you can re-import some top flight US-educated expats back. (hint hint)
4. Stop getting bought out. For all the PE funds and global companies that bought out Canadian HQ, congrats – you could not have timed your moves better. I guess it helped that there was this niggling loophole in the Canadian tax code to help you fund all these acquisitions. For the remaining Canadian companies out there -stop selling yourself short. You’re better than that and should be looking to be a player in the global economy instead of the wallflower waiting to get picked up by the player. Speak of which…
5. Start looking at Foreign Acquisions. It’s sad to say but I’m not sure the whole $1+ dollar think will be a permanent fixture. As such, you could use this opportunity while costs are relatively low, to snap up promising foreign companies that could diversify your income, give you scale economies or get access to proprietary capabilities or resources to be the next engine of growth for your company. Carpe Diem!
6. Start Innovating again. Hey guess what – one of the biggest IPO’s in the 2007 was Lululemon (NASDAQ: LULU) a little company from Vancouver! How did LULU do it? It created a whole new niche category in atheletic apparel, something totally unique from what was already in the marketplace. Today, LuLu is worth as much as Oakley and it’s offerings are taking the US market by storm. Canada as a whole needs more LULU’s and needs to spend more time innovating, thinking up new products, retail concepts or processes instead of building call centers to take US jobs. Speaking of innovating…
7. Canadian Venture Capitalists – starting funding again! Your job is gamble (in an intelligent, calculated way) with other people’s money – not lock your funds in T-Bills. Go forth and fund the next RIM, Crystal Decisions and ATI’s! Your loonies go further now and setting up that critical SiliValley sales office is now a whole lot cheaper.

All through the 80’s, 90’s and 2000’s Canada has been content to be a economic colony and low cost nearshoring location for the US. Today, marks the opportunity, however fleeting, to step out from that role and become that world-class ‘North American’ tiger economy it has the potential to be.

Canada stands on the threshold. Whether it chooses to cross it or step away depends on how well it responds to the challenges and opportunities presented by $1 loonie.

Go Canucks.

 

Freakonomics: Somalia as a Telco Nirvana; Why Illiteracy is Bad for Marketing Spends & How God is Good for Your Checkbook

The Economist really hit a home run of sorts for their volume and quality of interesting tidbits relating life to the dismal science for their last issue of 2005.  Lots of good material to all of those incoming students to Larry Smith’s Intro to Economics classes at UWateroo for next term.

First off is this gem relating how lack of any government regulation in (because failed states don’t have any governments) created conditions for something of a renaissance in the Telco services in Somalia:

[The] collapsed state [of Somalia] provided a curious competitive advantage [for Telco operators].

No government means no state telecoms company to worry about, no corrupt ministry officials to pay off (there is no ministry), and the freedom to choose the best-value equipment. Taxes, payable to a tentative local authority or strongman, are seldom more than 5%, security is another 5% (more in Mogadishu), and customs duties are next to nothing. There is no need to pay for licences, or to pay to put up masts.  It is a vivid illustration of the way in which governments, for all their lip service to extending communications, can often be more of a hindrance than a help.

Also interesting is impact of illiteracy on the efficacy of Marketing spends:

[One Somalia mobile operator] expanded its reach across the country, drawing in customers with its low prices. You can call anywhere on the planet on [its] mobile for $0.30 a minute. Pricing is especially important in Somalia…because many potential customers are illiterate and so immune to advertising.

I didn’t occur to me, until now, about the importance of literacy to the development of modern economies for their ability to increase the effectiveness and sophistication of marketing efforts and thus increase aggregate demand in society. (Larry Smith would be probably be proud though I think Bob Krider, my Marketing Strategy prof from SFU would be probably be evincing some kind of audible disdain for that last comment.)  Society teaches its citizens to read so they can read up on all the wonderful things they should want to and do buy thus pumping up the society’s economy.

This other item discusses how one’s religious devotion in North America is good for you.

At the microeconomic level, several studies have concluded that religious participation is associated with lower rates of crime, drug use and so forth. Richard Freeman, another Harvard economist, found 20 years ago that churchgoing black youths were more likely to attend school and less likely to commit crimes or use drugs.

Okay that’s kind of obvious but did you know going to Church is good for your checkbook?  This researcher used a novel statistical technique to try to prove causality between going to church and income:

Mr Gruber finds that [after some statistical alchemy, in an urban population in the US]  a 8.5% rise in churchgoing… leads to a 0.9% rise in income. 

Well you can read all the gory details about that here.