Cut Out The Middleman If You Dare

We are living during an economic revolution wherein the “middleman” is being eliminated. In most cases this is good news. If you need a cab you now call Uber where both the driver and the passenger benefit. Cab companies no longer have a monopoly on who can drive and, most importantly, who can obtain a license (medallion) to do so. Uber opened the industry to millions of people who wanted to drive a cab and earn some money on the side but for whom obtaining a license was cost prohibitive and oftentimes a political impossibility.

Airbnb is another example of a company that has so benefited. Historically, if you needed a place to stay in a town you were unfamiliar with you had to go through a hotel booking site. No longer. Airbnb opened that market by allowing homeowners to rent out rooms and, in many cases, their whole house.

There are many other such examples but its not always the case.

Within the field of institutional finance it has been a disaster. Investment banks use to act as the middleman when it came to clearing transactions; but, with the advent of Dodd-Frank and the elimination of investment banks, there are no middlemen to clear trades. Nowhere is this more disastrous than in the bond market.

In life, the things we know are dwarfed by the things we don’t.  The bond market is boring to most people as they feel it has little consequence in their lives. In fact, the bond market greatly affects all of our lives. In 2008, it was the collapse of bond market that almost precipitated the entire destruction of our financial system. Therefore, its safe to say the bond market is something we should definitely try to understand.

Let’s do a basic primer.

The bond market is really the main determinate of what sets the rate for money.  Any time you need to buy a car, a house or apply for a credit card, the rate that applies is determined by current bond market rates. Thus the speed, quality and efficiency of the bond market affects all consumers in a variety of economic activities.

Prior to the bond market collapse of 2007-2008, investment banks would act as an intermediary for all bond transactions. When the market was selling off, bond traders at investment banks would come in and buy the bonds and act as a stabilizing effect on the markets. They did so because the market would reward them for assuming this risk.

However, after the collapse of 2008, investment banks ceased to exist, They were transformed into commercial banks. Under regulatory oversight and applicable law, commercial banks can’t use depositors’ monies for speculative purposes. In addition, the banks were further prohibited from taking speculative positions and could only transact when they had an available buyer and available seller on the other side.

Since these changes have been implemented, very little secondary trading takes place. Mutual funds and pension funds now know that when they buy a bond there is a good chance they will have to hold that instrument until maturity. They know it will be very hard to sell their bond holdings. These investment funds have very little turnover in their portfolios and are assuming greater and greater risk as a result.

Currently, with low volatility and low yields, nobody seems to be worried too much about this problem; but, crisis always hits the financial markets and what’s ahead will be no different. Although there has not been a financial crisis since 2008,  during the previous ten years there were four major shocks to the system: dot com bust in 2000; the Russian crisis in 1998; Long Term Capital bust in 1998, and the Asian crisis in 1997. The fact is: booms and busts are part of, and natural to, the credit cycle.

We have already seen a glimpse of what is to come with the collapse of the Third Avenue Focused Credit Fund in 2015. Given the problems the fund endured, it had to unwind. However, it took over two years to get the investors their money back. Why? Because the investors were trapped. There were no ready and willing buyers to buy those distressed assets. The fund was not huge. It had about five billion in assets. Imagine the problems that will come when a much larger funds needs to be liquidated. Now think about those investors who could not get their money out and had to raise liquidity to meet their own obligations in other ways.

What happens when you cut out the middleman out of the bond market is that panic ensues.

Here in the U.S., we have been quick to embrace many of the new technologies that eliminated the need for a middleman. But let’s be clear. Investment banks did very well for years clearing bond trades. Now that mechanism no longer exists. We are entering uncharted territory and this lack of a middleman should worry us all. What happens when a large pension fund is forced to sell off some of its assets and isn’t able to meet its redemption needs?  Are we going to tell the retirees to wait two years for their liquidity?

The technocrats point to Uber and Airbnb as companies that have benefited us all by cutting out the middleman. But, uh oh!, very few if any of these companies are making any money. The bet on these companies is that one day they will make money. Even titans like Amazon, Netflix and Tesla have struggled to make money because they have had to spend a fortune on growth. Such companies could only exist in an environment like the current one… where the financial markets are so distorted they can borrow unlimited amounts of money to fuel their growth.

Before the markets become rational again, and they will, there will be blood on the streets. Then, once again, markets will reward companies that make money and punish those that don’t. This is the way it has always been during rational times. We will again see the value of companies based upon the merits of their ideas and the profits those ideas generate. We will even see the error of government regulators in taking away the role of investment banks to naturally provide liquidity in the financial markets. Until then, buckle up.


The New Industrial Revolution

I spent the last few days at SXSW here in Austin, where I played around with hundreds of gadgets and electronics from the Maker Fair. If you have never been to one of these expositions, I would highly recommend you check one out. You will be blown away by what is taking place in the field of technology and the changes that are taking place in manufacturing.

3d printer

Over the last few years, there has been a dramatic improvement in the quality and durability of electronic components and plastics. Engineers, artists and creators now have access to three dimensional printers that can produce physical products. We have gone from printing words via printers to printing three dimensional objects by the same process! If you have a machine and the blueprints, which can be found online, you can literally make cups, art, jewelry, parts, even guns… just to name a few. The designs are open sourced, so if you need to make a certain cup you can go online to see if somebody already has uploaded one on the web and then download the file and make your own. In addition, you can create your own design for a product and then upload it online for other people to use.

Over the last thirty years, the U.S has become a laggard in manufacturing for a variety of reasons.  Higher wages, a more onerous regulatory environment and a stronger currency, all of which have made manufacturing physical products here in the U.S almost prohibitive.  However, with the onslaught of 3D printing and some revolutionary changes taking place in the space and auto sector, manufacturing is enjoying a renaissance here in the U.S

At Tesla Motors, founded by Elon Musk, they are starting to produce cars in the U.S. and manufacturing their component parts here as well. What Musk discovered is that most car makers have hundreds of suppliers located all over the world, which makes implementing changes a process of dealing with a myriad of long distance suppliers. Frustrated by the lag time and inefficiencies of such procedures, Musk decided to make and manufacture most of the products right at his plant in California.  As a result, he has been able to speed up production of his autos and make  adjustments quickly.

Musk believes this approach has saved him a fortune.  Older car companies now complain that because he was able to start a car company from scratch, he has been able to revolutionize the manufacturing process. Imagine that!  Car companies are upset that Musk is able to manufacture the majority of his parts here in the U.S.  It was only a few years ago that the same car companies were saying that it was impossible to manufacture cars here in the U.S due to the high costs.

At SpaceX, another company founded by Elon Musk, they have been able to drastically lower the cost of manufacturing rockets. Part of the philosophy of his design and manufacturing strategy is to have the engineers work side by side with the builders of the rockets.  This process allows the engineers to see and fully understand what their designs are like when brought to life. Previously, it was unheard of  to have engineers and builders working side by side; but, SpaceX has made it work and has been able to revitalize the U.S. space industry while simultaneously creating thousands of jobs. One of the main manufacturing achievements of SpaceX has been in being able to weld large sheets of metal without rivets. This advancement not only makes the rockets safer it is also an innovation that will soon accrue to the benefit of other industries as well.

Combine the “Do It Yourself (DIY) Movement” and 3D printing, along with some of the breakthroughs taking place at SpaceX and Tesla Motors, and the U.S has good reason to be optimistic about the resurgence of our manufacturing sector. We have talented engineers and scientists that are revolutionizing many business and technology sectors. One only need look at the gas and oil sector where geologist and engineers, through fracking, changed the whole scope of the extraction process and its end product productivity. This new method of extracting oil has enabled the U.S  to garner untold amounts of oil which had been previously unreachable.

Over the past eight years, the problem facing U.S. businesses, and therefore the GDP, has been the restrictive regulatory policies implemented by the Obama Administration.  These crushing regulations and policies, such as Dodd-Frank and Obamacare, have hamstrung U.S. growth.  I believe, given a change of direction by the Federal government in it’s approach to private sector regulation and taxation, the U.S. economy could well see growth rates in GDP above 3%.  The private sector has made some major strides in manufacturing and technology that I believe could get the U.S economy back on track and begin to create many of those jobs that have been lost if the Federal government will just remove the stranglehold it has placed upon the development and operation of free enterprise.

If not, my prayer is that the government at least steer clear of this truly amazing innovation revolution and allow the U.S. to, once again, be the global leader in manufacturing and an example of free market capitalism functioning at its best.


Steve Clark