Theft in The Financial Markets

Many people in positions of  power tend to think of themselves as being God-like.


No where is this more apparent than among the financial and government planners who beset the West. Educated at the best schools and responsible for the finances of the rich and powerful, it is understandable that they think of themselves way. They have come to believe, due to their education and responsibilities, that they know better than mere mortals. This hubris and arrogance was given credence in part by a British economist named John Keynes.

Keynes developed an economic model of thought which asserted that the government had a rightful role to play in the financial markets. Central to Keynes’s theory was the premise that the economy was just a matter of inputs and outputs that could be tinkered with to effect greater efficiency. The main thrust of Keynes’s argument was that whenever the economy stalled the government had an obligation to inject money into the economy to get it moving again.  Keynes’s theory is known as “Keynesian economics” and his disciples now act as the main policy makers in the West.

Today, it is standard practice for government officials to start meddling in the private sector whenever there is a slowdown. They cite Keynesian economics for their actions. During recessionary times, government officials will increase public spending, create more public works projects and inject money into the banking system. President Franklin Roosevelt and Barack Obama, both presidents during recessionary periods,  resorted to massive government spending to aid the economy.

Keynesian economics has become the dominant form of monetary policy today in government circles. The way policy makers inject money into the economy is by lowering the cost of money. They do this by manipulating the financial markets. The idea behind it is that cheaper money will stimulate the economy and create new jobs.

For example, during the last eight years, most major central banks have been buying their own debt to lower the yields. But these lower yields have not spurred any economic activity. Rather, it has caused actual investors to earn less interest income. If government bonds actually yielded something tangible, private investors would be earning a return on their money and putting that money to productive use. But since that money is not going to individual investors, the economy is continuing to stall.

The slower growth that we have seen over the last few years has pushed the government to enact more and more policies for even cheaper money. The end result is that, in many countries, we now see negative interest rates.

Figuring out what interest rates should be is not hard.  Take GDP growth (currently 2%) and add  2.5% for inflation and you get your money which should be 4.5%.  However, currently bond yields are only 2.15%. The difference between 4.5% and 2.15% rates is the money that is being stolen by these bad policies. Given the size of the market, we are talking billions of dollars that are not flowing into the private sector.

For some reason, this theft by the government is never reported as such. Instead, we use the terms “quantitative easing”, “buy backs” and stimulus packages to mask the central planners’ actions.  Call it what you will, its theft.

Pension funds, IRA’s, and retirement plans all use the rates on the bond market to plan their investments. However, because the bond markets have been so distorted by government interference, the yields that investors were expecting are no longer there. Investors have been forced to speculate and invest more heavily in the market to recoup this “stolen” money.

The scope of this government manipulation of global stock and bonds markets is enormous —larger than the U.S. government’s manipulation of housing prices when they kept rates low and used Fannie Mae and Freddie Mac to back housing loans. Most economist believe central banks around the world have created more than $11 trillion in new money, all of which has been invested in financial securities, real estate and commodities. The amount of government investment and intervention has never before been done on such a massive scale.

There is simply no way for this to end well.

Eventually, markets  always correct themselves. The U.S. stock market is trading at record highs and at record-high valuations; but, earnings have fallen for five straight quarters. This simple observation is obvious to many but somehow not to our elected leaders. The world’s major economies are groaning with inflated securities prices and a debt burden they can not afford.

Who knows what will happen when investors realize that the party has ended? When investors scramble for the exits, there will be nowhere to go. By law (The Volcker Rule and others) banks will not be able to act as as intermediary for the majority of these trades.

We have forgotten the seed of all growth is capital. Capital is essentially the surplus from our economic activity which is then used to fund future growth. With rates being what they are, investors are being forced to risk and speculate in the markets and not save that all  important seed —  capital. Our government policies are discouraging capital formation.

When the market implodes, and it will, there will be no capital stored up to start over. It will all have been destroyed. So while we’re distracted by demonstrations and the illusory insanity of politics, the very foundation of our thriving nation has been eroded right before our eyes by the very people we trust to use good judgment in protecting it.




Liquidity is Drying Up In The Bond Market

After the financial crisis in 2008, our benevolent leaders gave us the Dodd-Frank Bill, which as they said would clean up the banking system once and for all.

liquidity crisis

One of the main changes Dodd-Frank implemented was that banks would no longer be able to take risk. In short, banks would no longer be able to use depositors’ funds for bank risk-taking activities. Before the law was passed, banks were the facilitators of trade and acted as warehouses for all of the financial instruments that needed to be bought, sold and exchanged. For the most part, banks did a fantastic job at that because they had the credit lines and expertise to analyze all forms of financial instruments.

For example, if a hedge fund collapsed and needed to be liquidated, the banks would go in and buy off the assets and then sell off the pieces to other investors. In many ways, they acted like clean up crews…clearing the debris thus allowing the markets to function once again.

Now, with changes in the law, banks are not allowed to warehouse financial instruments. If they are asked to buy a bond, they can no longer hold it on their books. By law, they have to sell it right away. If the banks cannot immediately find a ready and willing buyer , the trade doesn’t happen. Even in cases where the seller offers discounts of over 25%, the banks cannot buy if there is not another buyer on the other side.

To many, this might seem to be a welcome safeguard to protect the financial system. In reality, this safeguard is causing a major logjam of financial instruments that need to be sold but can’t. The same way beavers can cause major damage to rivers and streams by clogging up the flow of water…lack of liquidity in the financial markets can do the same thing.

The real problem is in the bond market where bonds are held in both ETF’s and mutual funds that offer daily liquidity.

What happens when investors want to sell their funds and get their money back?  The banks are no longer there to provide liquidity.  The Wall Street Journal recently conducted a simple survey of several major bond funds run by institutional investors like Blackrock, Dodge & Cox, and Vanguard. It found plenty of examples of these funds holding bonds that no one can sell right now and some that will take nearly a year to sell.

So, on one side, we have investors who have been told, and are proceeding on the presumption, that they can get their money out in a few days time. However, professional bond investors know that, for many bonds, it will take over a year to liquidate those instruments to pay back their investors.

Something is going to give.

The U.S. population is so accustomed to getting our funds whenever we want them that we no longer have any idea or understanding of how and where liquidity occurs. Investors who have mutual funds believe they can sell theirs assets and get paid within three days.  Right now, while you can still sell your mutual funds and get cash out because the markets can handle nominal redemptions, we are heading for a moment when any type of significant turn of events, financial or otherwise, that will affect the the bond market will make it impossible to liquidate and get your cash.

Think I’m crazy? Mutual funds are already beginning to offer discounts to investors for immediate cash. U.K.-based fund Aberdeen Asset Management, is taking a different approach. It’s allowing investors to redeem their cash from the 3.4 billion-pound U.K.-property fund with just one catch: You take a 17% haircut.”

This whole turn of events has me deeply concerned. I could even say depressed.

What disgusts me most about this whole situation, and the upcoming financial calamity that will ensue, is that people actually believed Senator Dodd and Congressman Frank when they enacted the law.  Lawmakers are neither kings nor gods…although they often see themselves that way.  Just because they create a law to stop something doesn’t mean it will work. The forces of nature, like the forces of the financial markets, are always greater than the laws and regulations their overseers like to create.

Part of the problem is the financial media, especially CNBC, which allows buffoons like Barney Frank to have a platform on their network. Had the network performed their duties, their due diligence, their research as serious journalists should…and challenged Frank on the stupidity of his proposal, maybe the bill would never have been enacted into law.

Once again, our lawmakers have created greater risk in the financial markets than existed prior to 2008 and certainly more risk and weakness than need be. Protect yourself and build up a cash reserve that will help you overcome this liquidity crunch that will, certainly, eventually surface.


No Speculators Allowed

Storage Wars is a great show about capitalism. I love it!

Storage WarsThe premise of the show is that buyers  bid on storage units that have been foreclosed. The people who originally owned the storage units have gone into arrears and are no longer able to pay for the units.

The show is really a glimpse into the dark underside of the housing crash. What we get to witness is the complete liquidation of ones person’s life and all of their possessions. During the housing crash, when foreclosures were rampant, owners moved their possessions into storage units in the hopes of reclaiming their assets once the economy improved.

But that never happened. The storage owners eventually gave up on paying for their personal belongings and left their property for the storage companies to liquidate.

The liquidation starts when the  auctioneer opens the unit and allows the buyers to peer into the units. Inspection of the goods and opening the boxes to verify the items worth is not permitted.  Bidders can look but cannot touch. So, for example,  if there is a safe in the unit, the buyer can not inspect the contents of the safe. There might be millions of dollars inside…or nothing.

Before the auction, the buyers take a quick scan and gauge if the unit owners may have money.  The presence of a piano  might signal that the family had money and, therefore, that the unopened boxes might have value. To the contrary, a unit with Tupperware lying around might be a signal that the person was from a middle class or poor background. Sometimes the signals are correct; other times they can throw the bidder off where he or she ends up paying too much for a unit.

Needless to say, the show is fascinating because the information is imperfect and even the best of buyers make mistakes.

The storage buyers are essentially like vultures picking at the last remnants of a rotting carcass… sucking off the last bits of flesh at the bone. The auction is a total liquidation of someone’s tragedy. The show is both beautiful and tragic. The tragedy in the liquidation. The beauty is the creation of new wealth.

In some cases bid winners of the units have founds gold coins, memorable collectibles and jewelry. Other times the boxes might contain worthless clothes, pictures and housewares with no value.

The second part of the show, equally fascinating, is when the buyers of the units then go to get their newly acquired items valued and sold. It can be a crap shoot as a seemingly simple item can be turn out to have significant value.. In one show, one of the shows stars liquidated a box of yo-yos for over $2,000 dollars.

A typical transaction involving valuation might go as follows:

  • Storage owner: How much is the piece worth?
  • Appraiser: Given the condition and the uniqueness of the item, I would value it at $500.
  • Storage owner: $500 wow , that is  a lot higher than I thought. Great I would like to sell it.
  • Appraiser: I agree the item is worth $500 but I can only pay you $250 for it.
  • Storage Owner: $250, that seems low you just told me it was worth $500
  • Appraiser: It is worth $500 but I can only pay $250. I need to make a profit on this transaction. I will be taking the risk of storing it and marketing it and if I don’t sell it I am out the full amount.
  • Storage owner. Fair enough, sold.

The show is very instructive. It shows that both parties need to make money in order for the transaction to be successful. If the appraiser can not make any money on the transaction, he will not buy the item.

Which leads me to something very interesting that is happening in the bond market that is halting the trading flow and liquidity of bonds.

Around 10 years ago the bond market was, for the most part, unregulated. Trades were negotiated between buyers and sellers. On any  given day a bond could trade with a variance of 5 points or more. In addition, the trades did not have to be reported right away. Consequently, there was always an element of price discovery that took place in pricing up the security correctly. Significant variations in price could have been the result of liquidity, risk or straight greed.

Given the variance of prices, fund managers and the regulators got upset. They felt it was unfair to have such huge price variances in the market so they came up with a system called TRACE, whereby all of the prices of the trades had to be reported immediately. Now when a trade takes place everybody knows what the price is immediately. Fund mangers and regulators are now happy because there is much less variance in bond prices.

But there has been a downside to all of this: less trading. Even though the market has perfect information, trading has come to a halt. Perfect information has taken away the need to speculate.

A typical transaction now looks like this:

Fund Manger: I need a bid on 50 million Brazil 5 year bonds.

Trader: I can pay you 99.5 for those bonds

Fund Manager: The bonds last traded were just reported at 100.10 and I want to sell there.

Trader: If I pay you 100.10, I can’t make any money. Once the trade gets reported, the market will now know that there is a trader who now has to sell 50 million of these bonds and they will move the prices lower. So I will be taking a risk and need to be paid for doing so.

Fund Manger: I can’t sell at 99.5 because my boss will want to know why I am selling 60 cents below the market and he will not authorize the trade.

Trader: O.K. No trade.

This conversation is happening all over the world each and every day. Most people could care less about the world bond markets, but they should! It affects and touches all areas of our lives. Bond markets affect the rates we pay on credit cards, home loans, car loans and more.

The government has interfered and determined that if given perfect information, the market players would trade more. But the opposite has happened. They are doing no business. As less and less trading takes place, bond funds are full of positions they cannot sell and are growing more and more bloated. There will come a time when there will be a need to liquidate these excesses.  As it stands right now there is no mechanism for doing so.

Storage units liquidations  are a great example of the free market clearing out excesses and allocating capital and resources to the people best suited for it. But what the government is creating in the bond market by not allowing bonds to clear at a level where both parties can make money is creating a problem that will result in an even bigger crisis than the one we last went through.


Downside of Better Information

I tend to focus on the intricacies of finance because it is so heavily regulated. I use to work in the bond market for many years and know firsthand the impact of bond yields and economic activity.

Bond Market

Banks use to be the hub of bond trading playing an important role in distributing and allocating risk, but as a result of the changes in 2008, namely the Volcker rule, banks play less of a role in the market. Given the destruction of the markets in 2008, banks were told that going forward banks would have to carry much less risk and have much smaller bond portfolios. The result of this is that when banks are asked to trade bonds now, they have  much less inventory to offer and when they buy bonds, then can only buy much smaller amounts now.

So larger trades that use to take place with ease, take much longer now. Pension funds and banks can now longer liquidate their positions with confidence as they once did, which one day will cause a large problem. The regulation that was supposed to keep banks from taking on too much risk has now concentrated all of that risk into the largest bond funds in the world, and these bond funds can now longer sell their bonds as they once did. Over the last 20 years there has been numerous times the bond markets have gotten spooked and have had massive sell offs (1994 pesos crisis, 1998 Asia crisis,2001 tech blowup, 2008 mortgage meltdown) and each time the crash has been worse and more pronounced.  However when the next downturn in the bond markets come ( and they always come) the banks will no longer play the essential role they use to play of distributing and placing bonds throughout the bond market.

There is another huge problem in the bond market that is killing liquidity that no one wants to talk about, and that is the way bond prices are reported. Given that bond prices are traded over the counter, there is no central exchange that records the prices of bonds. The way bond prices were historically reported, was that the banks would send prices to their clients at the end of the day. Over the years the large bond funds did not like this system and they asked the regulators to come in and force the banks to report all the bond trades to a system called “Trace”.

The result of this was that the bond market became very efficient in knowing what the price of the bonds were, in addition the size of the trades were reported as well. Given all of this information portfolio managers became very confident in knowing where all the bond prices were at a given time. Yet instead of the markets becoming more efficient, the market became less so. Banks use to buy large blocks of bonds and for assuming that risk, they expected to make a profit. But, with full price information in the market, banks are no longer willing to bid on bonds.

For example if bond x’s last price on a trade for 2 million bonds was 99, the portfolio manger would expect to sell his bonds at 99 as well. However a bank would be unlikely to buy the bonds at 99 but rather at 98.5 in that the bank would want to make money as well. The portfolio manager might be willing to sell his bonds at 98.5, but he is unable given that he has to justify to his bosses on why he sold his bonds at 98.5 when every one else was getting 99, so no trades get done.

So given the Volker and the advent of Trace, the bond market is a shell of what it use to be. The liquidity has been sapped, eventually this lack of liquidity will make the next downturn much more vicious than the last one we last experienced.

The general consensus is that more regulation and better information is the key to financial stability but in life we always have to deal with unintended consequence of decisions that are made. I would argue the consequences of these two laws/decisions are going to be bad for all of us. I would argue sometimes less control and less regulation actually help the consumer more and make things more efficient.


Steven Clark