Global Custodian Blog

Retirement and Energy Independence: Two Issues to Be Addressed

Submitted by Jim Casella on Sun, 01/08/2012 - 09:15.

This weekend of NFL wild-card football has provided significant entertainment, with the New Orleans Saints, lead by Drew Brees, advancing to play the resurgent San Francisco 49ers, the Houston Texans advancing for the first time to Baltimore to play the Ravens, the New York Giants, lead by the other Manning, once again headed to Lambeau Field in Green Bay to face the defending Super Bowl champion and their MVP, Aaron Rodgers, and the surprising Denver Broncos and the amazing Tim Tebow are headed to New England, after an overtime victory against the Steelers, to play the Patriots and their field general Tom Brady.

We will end a great weekend and holiday season of football with the BCS National Championship title game tomorrow evening, when #2 Alabama will challenge #1 LSU. In an SEC regular season game in November, LSU came out on top in overtime, 9-6, in the game of the century. Can LSU, coached by Les Miles, beat a Nick Saban team twice in the same season?

In between the wild-card games we had two more Republican presidential debates in New Hampshire, where the first primary of the 2012 election will take place this week. After listening to the questions posed to the candidates in both debates as well as several of the earlier Republican debates, it struck me that the two issues that probably mean the most to the U.S. over time were not being addressed.

The first one is the funding of retirement. This is a global issue that goes well beyond the U.S. election. In the U.S. the impending retirement of the baby boom generation needs to be addressed by both parties, particularly with regards to Social Security funding requirements and Medicare, as well as what retirement resources individuals will need as they live longer. These entitlement programs and their funding requirements cannot be ignored.

The other issue that has just started to be discussed nationally is energy independence. Recently, the Deloitte Center for Energy Solutions conducted a poll and released the results at their annual oil and gas conference in Houston on December 15. Eight out of 10 respondents linked gas with job creation and economic revival. “Specifically, 83% of respondents agree that gas development can stimulate U.S. job growth, and 79% believe the gas development can help revitalize the economies of the states and communities.” (Oil & Gas Journal www.ogj.com) While there are environmental risks, the majority of the respondents believe that the long-term reward of energy independence from shale gas far outweighs the risks. In 2005, shale gas made up a very small share of domestic natural gas production but has surged beyond 20% recently. The positive impact on the health of our economy over the next several decades, when combined with newer green technologies, cannot be overstated.

These two issues are ones that I would like to see President Obama and his likely challenger Mitt Romney address when they meet in the fall to debate, prior to the November election.

Prime Minister David Cameron's London 2012

Submitted by Jim Casella on Tue, 01/03/2012 - 18:30.

In my last column in early December, I forecast that the U.S. recovery would continue, which was confirmed later in the month. I also forecast that even though the Eurozone would enter a mild recession while the member countries continued to wrestle with the debt crisis, the United Kingdom would experience slow growth but would not join the countries on the continent in recession. Shortly after this column appeared Prime Minister David Cameron became the target of French President Nicolas Sarkozy's ire when he stood alone at the December EU summit and did not vote for the new treaty. Cameron made this decision "after failing to secure safeguards for the U.K.'s financial services sector." (WSJ December 22, 2011) A survey by the Institute of Directors showed that the U.K. business community strongly supported this decision, with 77% of the business leaders surveyed agreeing with his veto. (WSJ December 22, 2011)
 
With the financial services sector being a key driver of the U.K. economy, his lonely stance is to be applauded, particularly in London. I sense that over time we will come to see Prime Minister Cameron's decision lead to a faster recovery for the U.K. when combined with the austerity measures he instituted upon his election victory.
 
In his annual New Year's message, the Prime Minister acknowledged that 2012 would be a challenging year. "I know how difficult it will be to get through this...with ordinary families worried about what 2012 might bring. There are fears about jobs and paying the bills. The search for work has become difficult, particularly for young people. And rising prices have hit household budgets. I get that. We are taking action on both fronts." (FT January 2, 2012) He did find reason for some optimism, though, with the forthcoming summer Olympics in London and the Queen's Diamond Jubilee. He stated that there was an "extraordinary incentive to look outward, look onwards and to look our best. This will be the year Britain sees the world and the world sees Britain. It must be the year we go for it-the year the coalition government I lead does everything it takes to get our country up to strength." (WSJ January 2, 2012)
 
We at Asset International share Prime Minister Cameron's guarded optimism about the long-term growth prospects for the U.K.'s role as a financial engine, and we will continue to invest and expand our business in London in 2012. Our editorial and commercial teams have both been strengthened over the past several months. In late January and early February I will be spending time with my colleagues in our new London offices at 200 Aldersgate Street in The City.
 
Happy New Year!

Balance sheets never lie

Submitted by Dominic Hobson on Thu, 12/29/2011 - 12:45.

The idea of finance as a parasite that lives at the expense of the real economy is an old one. More than two millennia before Occupy Wall Street declared itself “not anti-capital, just anti-theft,” and Occupy London launched a “campaign for monetary reform,” Aristotle warned that money-changing and lending at interest were perversions of the natural human inclination to satisfy wants and needs through production and exchange. What is worrying about the revival of this brand of thinking is not that it is misguided but that it resonates powerfully enough with the public and politicians to inhibit a truly searching investigation of the nature and consequences of the current systems of money and credit.

It is easy to conclude that finance is not part of the real economy. Economies grow by producing more for less, through the division of labor. This takes place not only on the local scale but on a global scale, through international trade. The result of producing more for less through the division of labor is a surplus, which in a modern economy takes the form not only of sacks of grain, but capital. This capital is then recycled into the real economy by a complex ecosystem of financial intermediaries made up of banks, broker-dealers, fund managers, insurers and institutional and retail investors, using an equally complex infrastructure of exchanges, clearing houses, depositories and national and international payments systems.
This financial ecosystem has evolved a long way away from “real” economic activities such as growing food, extracting minerals, processing raw materials in factories and transporting finished goods by land and sea. But this does not mean financial intermediaries and financial markets are not part of the real economy. In fact, they were and are densely involved with agriculture, mining, manufacturing and trade. Investment banking originated in the use of surplus capital to finance international trade through the discounting of bills. This is why they were once known as “merchant” bankers. It was only as their business evolved into the financing of governments (in the bond markets) and companies (in the equity markets) that they became known as “investment” bankers.

Even now, though they operate in highly sophisticated securities markets, investment bankers are still engaged in the origination, issue, underwriting and trading of claims on the revenues of governments and companies. They fund these activities not from capital but by borrowing from commercial banks and investors in the wholesale money markets, pledging the securities they trade as collateral for the loans. In the 1970s, breakthroughs in mathematical techniques and digital technology allowed banks to start trading claims on claims, and even claims on claims on claims, in the real economy. By the time the industry invented the CDO and the CDS, the financial system seemed to most people to have become so remote from the real economy that, far from the banking system servicing the real economy, the real economy appeared to exist only to service the banking system.

Nothing symbolized this apparent inversion better than the Bankers Trust executive who said of Procter & Gamble that “they would never be able to know how much money was taken out” of the derivative contract he sold them. By the time a Goldman Sachs trader confessed to his girlfriend a decade or so later that the financial instruments he was inventing were nothing but “pure intellectual masturbation”—and that even he did not understand their full implications once they were released into the real world—abstraction had reached the point of incomprehension. Yet the $195 million of losses Procter & Gamble incurred on the swaps, or the $1 billion of losses it is alleged were incurred by investors in the liabilities created by Fabrice Tourre, were anything but abstract. They were transfers of value, albeit of a highly circuitous kind, between participants in both the real economy and the financial economy.

Those losses and gains showed up in the profit and loss accounts of the counterparties to the trades. Eventually they showed up in their balance sheets too. And it is there, on the balance sheet, that the inseparability of the real and financial economies is at its most obvious. A balance sheet shows how underlying physical realities such as factories and stocks (assets) are financed by financial abstractions such as equities and bonds (liabilities). A balance sheet shows how capital (liabilities) is invested in productive people and machinery (assets) to generate the income that produces the profits that appear in the profit and loss account—and which eventually return to the balance sheet as additions to capital or dividends awaiting disbursement to shareholders (liabilities). The balance sheet is also where money dies, as productive assets are depreciated, or amortized, until they need to be replaced. On a balance sheet, in other words, the real and the financial are simply different expressions of a single phenomenon.

This insight offers an illuminating perspective on the current financial crisis. Why? Because a balance sheet, unlike a banking system, cannot be overcapitalized. Its assets and liabilities must balance. An excess of capital cannot build up on a balance sheet because a successful business cannot simply accumulate capital. It must put capital to work by building offices or factories, and filling them with people to make goods or machines, or provide services. If a business cannot think of anything remunerative to do with the capital it accumulates, it must return it to shareholders, so that they can invest it with another company that can find a profitable use for it. Ultimately, balance sheets insist that capital be put to use. Despite the strictures of Aristotle, capital cannot breed capital. The rate of interest reflects the ability of capital to earn a return in the real economy, and must by definition be lower than the return available in the real economy.

Fund managers know this. It is why (fees apart) they wish to put the capital entrusted to them to work in the markets rather than leave it in the bank. They know that only capital invested in productive activities, by however circuitous and abstracted a route through the financial markets, can breed more capital. The current balance sheets of the major central banks make this point plainly. That of the Federal Reserve has inflated by 218% in the last four years. The balance sheet of the Bank of England has grown by 197%, and that of the European Central Bank by 88%. But the accumulation of cash deposits at central banks is not the surplus capital generated by productive economies. It is something else entirely: money printed by central banks, returned to central banks by commercial banks too nervous even to lend it to each other, let alone invest it in the real economy. Nothing could illustrate more completely the breakdown of the links between the financial and the real economies than these massive accumulations of trillions of dollars of excess capital on the balance sheets of the central banks.

These piles of cash are the reductio ad absurdum of the monetarist-Keynesian consensus—essentially, maintaining a narrow gap between total spending and real output—that has governed orthodox economic policymaking since the 1970s. This orthodoxy holds that what causes economic downturns is shortages of money—not just notes and coins but bank deposits, which are the most important form of money. By this, the orthodoxy does not mean that nations can enrich themselves by printing money. Even unreconstructed Keynesians recognize that, in the long run, real output depends on real input—which is one reason why the consensus is open to the accusation of mistaking effect for cause. What follows is that money is not wealth. It simply measures, or reflects, wealth. This is well captured in the classic description of inflation as “too much money chasing too few goods.” Once the quantity of money is growing faster than production, it affects only the price level. If the quantity of money could be synchronized perfectly with the quantity of goods and services—if it was an exact reflection of the quantity of goods and services—money would be neutral.

Yet experience shows money is not neutral. The quantity of money does affect the real economy as well as the price level. The Great Depression, according to Milton Friedman and Anna Schwartz, was actually caused by a collapse of bank deposits. This is almost the only history modern central bankers know, which is why they have inflated the supply of money through quantitative easing, or buying assets from the private sector and paying for them by creating money on their own balance sheets, then depositing it in the bank accounts of the sellers. The limited impact of their efforts so far is a reminder of how hard it is to translate an obvious insight (keeping money in balance with production avoids both inflation and deflation) into practical policy measures. The problem is the complexity of the main transmission mechanism from money growth into real activity: bank credit. Because people in the real economy are continually creating money (by taking out loans) while others are destroying money (by repaying loans), the relationship between money and credit is extremely volatile, hard to monitor and almost impossible to predict.

Judging by the management of monetary policy during each of the many boom-to-bust cycles that have occurred since the mid-1970s alone, a better understanding of the relationship between money and credit would be a useful addition to the sum of human knowledge. In present circumstances, the creation of money is the exclusive preserve of the state (through the central bank) while credit is a creation of the private sector (through the commercial banks). The creation of credit is not controlled directly by the central banks but by indirect means only: the capital ratios agreed under successive Basel regimes and the accompanying liquidity requirements that force banks to hold cash and near-cash instruments so that they can meet obligations as they fall due. On this view, the issue of credit and the issue of money are separate activities. Yet it might be wiser to view money and credit as simply different expressions of the same phenomenon, just as they appear on a balance sheet. A house bought with mortgage or a motor car purchased with a loan secured on the vehicle requires a bank to issue money. That money, paid into a bank by the seller, is returned to the banking system as a deposit, creating scope for more lending.

This process creates the risk that the banks will issue more credit than there are goods and services to buy, causing asset price inflation of exactly the kind that occurred between 2002 and 2007. Orthodox monetary policy has sought to control this risk by limiting the issue of bank credit as a multiple of a fairly narrow measure of money, as measured by cash deposits and (in some jurisdictions) near-cash instruments such as repos and certificates of deposit. Orthodox policy also assumes that there is a natural constraint on the unlimited creation of credit, in the shape of a shortage of sufficiently profitable opportunities for investment, and so on the appetite to borrow. But this is to underestimate the dynamic nature of the interaction between money and credit, in which cause and effect become indistinguishable. Crudely speaking, because every loan creates a deposit, it encourages more lending. As money becomes more plentiful, it becomes cheaper, and the range of investments that appear to be profitable expands. The appetite to borrow outgrows any limit, natural or unnatural.

In short, an imbalance develops between the investment opportunities in the real economy and the volume of credit available to finance them from the financial economy. This is exactly how the real and the financial economies have interacted at all times since modern systems of banking and finance came into being in the 19th century. The entire pattern of economic fluctuation in history, of successive cycles of boom and bust, is the same. There is a movement from an excessive inflation of capital values relative to their income-producing capacity, followed by an excessive deflation of capital values relative to their income-producing capacity. In each case, the manufacture of credit on a narrow base of money issued by the central banks pushes the price of capital to a series of excessive highs, followed by a series of excessive lows. Given this history, treating money and credit not as part of a single process but as separately controllable elements is nonsensical. Accountants who draw up corporate balance sheets know that instinctively. Bankers, and central bankers, it seems, do not.

The irony is that bankers talk about their balance sheets a lot. They all employ credit committees and risk managers whose role is to ration the balance sheet between competing claims. For certain banks, particularly in this environment, the strength of their balance sheet has become their main competitive differentiator. Central bankers have encouraged them in this view, forcing them to increase the proportion of capital they hold relative to their assets, despite the fact this contradicts their policy of increasing the supply of money. Even now, banks are tightening credit lines and selling loan portfolios to fund managers to improve their capital ratios, reducing the volume of loans that turn into deposits, and so destroying money. Yet the way in which banks and central banks manage their balance sheets is startling in its utter disregard for common-or-garden prudence (another favorite word in the banking industry).

Most companies manage their balance sheets to ensure that the capital of the business is not eroded, and that any gains paid out to staff or shareholders are paid out of profits rather than capital. Banks and central banks do it differently. As their balance sheets inflate during the boom, banks engage in the excessive distribution of illusory gains to staff (as bonuses) and shareholders (as dividends). In the bust, those illusory gains come back to haunt the balance sheet as losses, eating capital and sinking share prices. In essence, the ability of banks to produce credit, almost at will, allows them to eat capital while appearing to generate income from lending money. If their creditworthiness shrinks to the point at which they cannot fund their balance sheets, they are then rescued by the central banks. By printing money, the central banks appropriate the capital of entire populations, generally through the subsequent inflation.

To that extent, the complaint of the protestors in New York and London is justified. Banks and central banks are indeed powerful arbiters of the fates of developed nations. Yet they are as much exemplars of the condition of our civilization as authors of it. Credit, it is increasingly obvious, is interchangeable with money. Spending capital, by selling claims on real assets in the form of credit, has become a form of monetary income for everybody. Mortgages and motor cars are merely the most prominent instances. But money is still not wealth. As they see their capital expropriated through some yet-to-be-decided combination of debt and currency devaluations, tax rises and inflation, the citizens of the United States and Western Europe will rediscover that fact. To become wealthy, they needed to put their capital to work creating new goods and services, not mortgage it in order to consume more goods and services yesterday and today. Capital used to be accumulated to be spent. Now it is being spent before it is even accumulated.

None of this changes anything fundamental. The purpose of production is still consumption. What makes economies grow is still borrowing, not lending. But not everybody can be a rentier, earning their living from lending or investing money. In the end, somebody has to use it productively, because even capital is subject to the second law of thermodynamics. It is not permanent. In a universe subject to the inexorability of rising levels of entropy, all businesses and all portfolios are nothing more than temporary islands of evanescent order. This is why, in the long run, accumulating and owning capital is much less important to the progress of our species than using it. The accumulation of manufactured money at the central banks of the developed world is a measure of the brokenness of the connections between the real and the financial economies. With so many unmet wants and needs in the world, and so many unfulfilled lives, what is happening to our way of life is not a depression or even a recession. It is a tragedy of the bitterest and most unforgivable kind.

California Reference Wines and Global Trade

Submitted by Jim Casella on Mon, 12/12/2011 - 12:30.

As we move further into the holiday season, it is clear that we have avoided a double-dip recession in the U.S., which was on everyone’s mind this spring, but the global economy remains under pressure, particularly in the Eurozone where long-term solutions remain elusive. It will be difficult to avoid a European recession in 2012. I sense that we will still be looking at various solutions in January, but that France and Germany, together, will finally find a way to bridge their different views and move to save the Euro. A recession in the largest European countries should not be too prolonged and the U.K. economy should manage to avoid the collateral damage and show moderate growth.

I have not written much this year on wine, but sense that we could all use some holiday cheer as we look toward the New Year! One aspect of the wine trade that has not escaped the global economic forces is that the auction market, based on demand for first-growth French wines, in particular, has shifted from New York to Hong Kong to serve the growing market in China. Over the years, I have been both a buyer and a seller at Acker Auctions, www.ackerauctions.com, in New York City. Today it is clear that their largest volume auctions, in terms of dollar volume, all take place in Hong Kong where they established an office several years ago. (Two new auctions in Hong Kong will take place this week and you can bid via the Internet at www.ackerasia.com.) This trend will continue as we embark on 2012.

As Mary Claire and I prepare to head back to the Bay Area for the holidays, I thought an update on two longtime California reference wines might prove valuable.

Williams Selyem
For many years, this Sonoma-based winery set the standard for California Pinot Noir. When the ownership changed hands in the late ‘90s from the founders to the Dyson family, a number of new challengers emerged. At this point, though, with Kathe and John as proprietors and Bob Cabral serving as Director of Winemaking and General Manager, Williams Selyem is clearly the reference standard for outstanding California Pinot Noir. This is a mailing list that you want to be on for their twice a year releases. Their limited Chardonnay releases are truly hidden gems, as well. www.williamsselyem.com

Turley Wine Cellars
I have been a fan of Turley Zinfandels for years, going back to the early ‘90s. They continue to impress me with their releases, which are also twice a year. This is another mailing list that you should get on. Proprietor Larry Turley and winemaker Ehren Jordan continue to be an unbeatable team.

Start building your Williams Selyem Pinot Noir and Turley Zinfandel collections in the New Year. Your wine collection and your companion dinners will truly be enhanced. www.turleywines.com

Happy Holidays!

Building a global information services company

Submitted by Jim Casella on Tue, 11/22/2011 - 10:11.

When I left Reed Business Information in January 2007, I had a plan. I wanted to build an integrated professional information services company with a strong, single-market focus. I believed the capability to create deeper and richer business intelligence and analytics—combined with marketing services opportunities—made a single-market focus a more attractive option than a media company serving a variety of unrelated markets.

At the start, I met with many private equity teams to determine which one would be the best fit. I understood that securing the capital commitment from a private equity fund was just the first step in a process that would be at least a five-year commitment. You need to choose your partner carefully to ensure a successful outcome.

In this selection process I looked for a track record of success from a private equity partner. I also checked references, because you know the private equity funds will be doing the same on you. In the end I decided to partner with Austin Ventures' Growth Equity team. In talking with the CEOs of Austin Ventures' existing portfolio companies, I found they were very positive. I also thought it was attractive that Austin Ventures did not overleverage its deals; this fact would allow me to sleep at night!

In March 2007, Austin Ventures and I established a holding company, Case Interactive Media; opened an office; and began the search for a platform company. We looked at potential acqusitions in the energy, healthcare, information technology, institutional finance and legal, and marketing services sectors.

We built market maps for each vertical and then talked with investment bankers to determine what companies might be coming to market. In early spring 2008, we narrowed our focus to institutional finance and legal. Unfortunately, this was just about the time that Bear Stearns was having severe trouble. The crisis accelerated over the summer with the collapse of Lehman Brothers, and the credit markets went into a deep freeze.

It was clear that we were looking to place a contrary bet. We knew that some of the great fortunes were built during difficult times, when someone with cash could buy while others were sidelined. We also believed that the financial markets would recover and, when they did, we would be well-positioned.

Our first acquisition was Asset International, a deal that closed in December 2008. We found the company's brands, Plan Sponsor and Plan Adviser, to be demographically attractive with their focus on the retirement part of the market. We also saw the opportunity to move much more quickly on the digital front with additional capital.

While Asset International was headquartered in Stamford, Conn., one of the company's core brands, Global Custodian, was based in London. This was important, because we wanted to build our platform around the two large global money centers: New York and London. Having a global platform was important to me, and I think it should be increasingly important to many more b-to-b media brands. It takes capital; but, based on my years at IDG, I knew that “geocloning” brands was the right approach. After all, IDG's Computerworld thrives in scores of countries.

While first quarter 2009 was one of the worst periods in recent memory, we set about building our company for the long term. Later that spring, we completed the acquisition of The Trade. Based in London, The Trade had a focus on Europe and the Asia/Pacific region. For Asset International, we always wanted a balance between marketing vehicles and data and analytics products. In spring 2009 we began the acquisition process for Strategic Insight, a company that provides the mutual fund industry with business intelligence analytics and advisory services. We opened a London office, followed by one in Hong Kong. We expanded Strategic Insight's global footprint with the acquisition of Plan for Life in Australia early this year. Today, more than 50% of our business is data and analytics.

Overall, our revenue has more than doubled in the past two years, and we are preparing to launch Philanthropy Management early in 2012 with a team based both in London and New York. Additionally, we will also be bringing The Trade to the U.S. market in 2012.

Eurozone Woes and Two Interesting Ideas from my London Trip

Submitted by Jim Casella on Tue, 10/25/2011 - 10:01.

While European economies continue to weaken and the U.S. manages very slow growth that has kept unemployment over 9%, it appears that the 17 sovereign countries that comprise the Eurozone are unable to commit to a comprehensive solution to Greece’s crushing debt load. The Greek problems have been known to everyone for close to two years, but during this time it has proved impossible to put together a comprehensive solution, particularly one that the two largest members of the Eurozone, France and Germany, can support. When it became obvious on Friday that French President Nicolas Sarkozy and German Chancellor Angela Merkel could not reach an agreement on a comprehensive solution prior to this weekend’s summit in Brussels, world leaders, including British Prime Minister David Cameron, U.S. President Barack Obama, and China’s Premier Wen Jiabao all reached out to the major players and called on them to restore confidence in the euro, the common currency that the 17 nations share.

While Sarkozy and Merkel continue to debate the proper course, the underpinnings of the global economy weaken. (FT October 21, 2011) One of the stumbling blocks is the size of the haircut that bondholders will have to take on the Greek debt. “Germany is insisting that Greece’s private-sector bondholders take a big hit to reduce Greece’s debt to a more sustainable level, a proposal that France and the ECB are resisting for fear that it could accelerate bond investors’ flight from Southern Europe.” (WSJ October 22, 2011) Some believe that the bondholders could be facing a 50%-60% haircut, which is significantly larger than the previously agreed to 21% negotiated only three months ago. (FT October 21, 2011) The Greek parliament has approved the austerity measures required for the bailout, but the weight of these measures combined with a lack of confidence has led to a much more severe contraction than anticipated. There is a sense that it could take at least a decade for Greece to restructure its economy and not need bailout funds from the other Eurozone members.

This weekend’s summit, followed by a second one later in the week and the G20 summit in Cannes early next month, will be watched closely by the world. The global markets demand a solution that restores confidence in the euro. I will be flying late on Monday to Barcelona, Spain, where we will launch Plan Sponsor’s European Conference: Uncommon Solutions for Pension Schemes.

On a more positive note, when I was in London two weeks ago the Conservative party was holding their annual conference and I watched with interest as George Osborne, the Chancellor of the Exchequer, unveiled a plan to help small businesses. “There is more the government itself can do to get credit flowing and encourage investment…Everyone knows Britain’s small firms are struggling to get credit and banks are weak. So as part of my determination to get the economy moving I have set the Treasury to work on ways to inject money directly into parts of the economy that need it, such as small businesses.” (FT October 3, 2011)

As I have written previously, entrepreneurial small businesses are the ones that create new jobs and are necessary if we want to significantly lower the stubbornly high unemployment rate. We need more creative ideas from our government leaders to assist these engines of job creation.

Finally, I trust most of us occasionally dine alone on long business trips and are faced with a rather limited choice of wines by the glass, if we choose to have two glasses of wine with our meal. On my last night in London, I was dining by myself on a Friday evening in Amaranto, in the refurbished Four Seasons London, and discovered a very innovative approach to this issue. Approximately 50% of the wines on their list are offered by the glass with a two glass minimum. This covers the cost of the wine for the establishment, with the possibility of selling the remaining two glasses to another diner. I spotted a wine I have had before, from Tenuta Argentiera, a small Tuscan producer located in the Bolgheri region, and with my two glasses enjoyed a wonderful meal prior to flying back to New York early on Saturday morning.

Welcome to Catatonia

Submitted by Dominic Hobson on Fri, 10/07/2011 - 13:12.

Custodian banks are now in the fourth year of a prolonged crisis. The stock prices of all of the stand-alone global custodian banks are 50% below where they stood when Lehman Brothers failed in September 2008. With revenues yet to advance on the levels achieved three years ago, and opportunities for growth without acquisition far from evident, it is not obvious why anybody should invest in a custodian bank today. The owners of every business must from time to time ask themselves whether they are invested in the wrong assets through the wrong businesses run in the wrong way by the wrong people. Certainly the response of the leaders of the industry to its current difficulties is a curious mixture of Wilkins Micawber and Sam Ward. On the one hand, they seem content to wait for interest rates to revive, leverage to return, hedge funds to wax and retirement savings to resume their steady accumulation. On the other hand, their lobbyists are swarming across Capitol Hill, the Berlaymont and Westminster to blunt the impact of regulation. As thinkers trivial and profound have noted for centuries, every problem presents an opportunity, but custodian bankers seem determined to deal with the problem only, by waiting or paying for it to go away. Yet a combination of waiting for the restoration of the status quo ante, plus expensive lobbying of politicians and regulators to preserve as much of the past as possible, scarcely amounts to a stratagem, let alone a strategy.

A strategy is by definition forward-looking, not backward-looking. If the industry cannot envisage a future other than one that looks as much like the past as possible, it is by definition refusing to accept that anything fundamental changed between 2007 and 2009. It is not surprising. Most business leaders are more adept at exploiting what they know than identifying what is growing. If they think about the future at all, it is only as an extrapolation of the past. Even the newest information is processed through existing preconceptions. The result is a bias to conservatism, even conformity. The result is an industry trapped by the unimaginative strategies it adopted during the bull market. Its leadership then operated on the belief that the business was commoditized, and that the only sustainable source of growth in revenue and profit was through the reduction of competition through consolidation, and the lowering of costs through economies of scale. Positive feedback from this approach further reduced the incentive to think. As revenues in the core business of safekeeping were allowed to stagnate, it encouraged the belief that the industry was commoditized. Though the strategy worked, it was not for the reason senior executives assumed. Growth came not from consolidation and the lowering of costs but from cyclical windfalls: securities lending, net interest margin and foreign exchange. It left the industry singularly ill prepared for the shock of the financial crisis.

Even now, the leaders of the industry remain convinced that current market conditions are a temporary aberration. The possibility that the world has changed, and their business needs to change with it, is not one they are prepared to entertain. Their strategy is simply to do more of the same: cut costs, buy other businesses and look to lend more cash and securities. Some custodian CEOs have even accepted that more of the same will be done to them. Though they would never admit the possibility to staff, they fully expect to be merged or acquired. Yet it is entirely possible that the world really has changed, and changed permanently. If it has, regulation - routinely named by custodians as their top priority - is the least of the problems they confront. Equity markets are still below the level at which they peaked at the height of the TMT boom. Despite the efforts of governments and central banks to restart the credit cycle with zero rates of interest, and oceans of printed money, real economies remain unresponsive and unbalanced. All of the factors that made custody such a lucrative business through the last credit cycle - rising markets, positive rates of interest, high leverage, short selling and frenetic transactional activity at spreads the clients never saw or understood - may not return for years, if not decades. In many areas, a mixture of electronic trading platforms, central counterparties and central securities depositories threaten disintermediation of the custodians from the bulk of the business that remains.

Most importantly of all, clients are distrustful. However unfairly, custodians are part of an industry that has acquired a reputation among clients for being less than straightforward about how it gets paid. Paradoxically, this is also the principal opportunity custodians now confront. With the possible exception of corporate actions, it is difficult for a custodian bank to differentiate itself through the quality of its clearing and settlement, safekeeping, asset servicing, corporate trust, fund accounting or transfer agency services. Indeed, clients often prefer to purchase inferior versions of these services in order to gain access to something they genuinely value, such as credit or creditworthiness, or local market presence. The real differentiator now is not what services a custodian provides but how it provides them. That custodian bank that can make its customers trust it, persuade them that its values as well as its incentives coincide with theirs, and convince them that it acts on those values as well as talks about them, is the one that is best positioned for the evolution of the marketplace. Given the starting point - confidence in the banking industry has evaporated - the journey back to a position of trust will be long and circuitous. But there are two obvious steps that custodians could take to start that journey now.

The first is to eliminate the conflicts of interest that plague the hybrid agent-principal business model custodians have developed. Over the last 20 years, custodians have cut the price of the core, off-balance sheet, feeearning businesses of safekeeping and asset servicing in return for the right to exploit assets in custody through stock loan, net interest margin and foreign exchange bargains. By agreeing to act purely as a fee-based agent in the cash, foreign exchange and securities lending markets, custodians could eliminate the temptation to widen the spreads they take from client portfolios when they execute the business directly. Custodians of this kind would continue to charge fees for collecting income and tax reclaims, processing entitlements and voting stock. But they would also be paid fees for obtaining on behalf of clients the optimum combination of safety and return for their cash; the best rates and the most reliable sources of credit; the ideal combination of size and price for trade execution; the cheapest rates of exchange; and the highest prices for lending their portfolios. None of this is incompatible with continuing to benefit from rising asset prices through ad valorem fees. It has the further benefit of eliminating the risk of ostensibly off-balance sheet risks finding their way on to the balance sheet when backstop facilities are called in (as with conduits) or a client litigates (as in securities lending and foreign exchange). Being less capital intensive, agentonly custody will also be cheaper to provide in an era when the cost of capital is likely to increase. It is also well suited to an environment in which regulators are increasingly inclined to separate utility banking from socalled casino banking.

The second step custodians could take is to be more open. Openness will to some extent be a natural consequence of reversion to an agency model, since there will be no need to conceal the true price of services from clients any more. There is a cant word for openness - transparency - that is widely used in the custody industry today, but it should not be confused with the real thing. True openness is not the creature of the compliance department. It entails taking the risk of telling clients, competitors, employees, suppliers and even journalists what is wrong with the business as well as what is right with it, and what it cannot do as well as what it can. Genuine openness entails taking the risk of losing control of critical business information, including the prices at which business is being done. This is the paradox of openness. By taking the risk of trusting people, custodians will themselves become more trustworthy. The benefits will not show up immediately. But they will over time, through reduced distrust and complexity in negotiations with clients, increased repeat business and greater innovation at lower risk through the formation of deeper relationships with clients. Trust will also lower the cost of capital, because investors will have a better understanding of the costs, revenues and risks the business is facing, and so help to restore confidence in the banking system as a whole. Trust cannot be earned unless an organization encourages its people to hide nothing, including information and insights that are to its disadvantage. It entails not just telling the truth, but refusing to lie. It is, in a word, integrity.

In an industry as compromised as modern banking, it ought to be obvious that the principled provider - the provider who chooses to do the right thing - will be at a competitive advantage. Unfortunately, I see little evidence that the necessary changes in the mental universe of custodian bankers has yet taken place. The surveys that we run and publish in the magazine offer an intriguing contemporary insight into the moral and cultural condition of custodian banks. The providers that build the survey process into their relationships with their customers, and ensure that customers understand they take the findings seriously, tend to get better results. But they are a small minority. Only a handful of banks make the modest investment required to obtain full details of the scores and comments, even though customers have often made dozens of lengthy and well-considered comments on their people and services. Some banks are confident that they have told their customers what to say and have no need to hear the ventriloquist. More believe they know already what their customers think. If the survey results differ from their own perceptions, or the results of an internal survey, it is our methodology that is at fault. It is not unknown for providers to demand "withdrawal" from a survey after they have seen their results, on grounds the poor outcome could not possibly be a true reflection of either their capabilities or the opinion of their clients. The overwhelming majority of service providers are still interested not in finding out what their customers think, but only in ensuring that the results reflect how they think of themselves.

In fact, every survey we run is now reduced to an arms race between the efforts of the majority of service providers to manipulate the outcome and our own efforts to preserve the integrity of the process. There is no survey in which we have not had to make elaborate modifications to the methodologies in order to counter the fact that providers are completing questionnaires on behalf of their clients, or making sure they are present when they do so, or even fabricating responses. In some surveys, we are now disposing of hundreds of junk responses of this kind and doubtless failing to eliminate many more that are too subtly concealed. The only information conveyed by the perfect and near-perfect scores that some providers insist upon is that such institutions are not interested in information they did not manufacture themselves. It is an infallible rule of our survey process that, if an institution makes even a fraction of personal remuneration contingent on the result, ethics are immaterial. It is hard to know how seriously to take the individuals who say that a poor result will lead to their dismissal, but it speaks volumes about the culture of the organizations that employ them. In short, our surveys are a small but disquieting gauge of the continuing propensity of custodians to lie to themselves, and to make their staff and their clients complicit in their lies.

As to openness, the prospect is no more pleasing. One of the main reasons why custodians find it so hard to conceive of doing things differently is that they have chosen to keep themselves in a state of dense ignorance about their industry, and so of their competitive position within it. The prices they charge for their services are completely unknown. Even the structures of the fees they charge are kept deliberately vague. As to trading revenues, a custodian would rather field a lawsuit than disclose the price at which a foreign exchange bargain was struck. Details of the value of new business won, which were the subject of league table compilations in other parts of the banking industry 40 years ago, remain hidden from view. (I have myself read several Kafkaesque press releases in which even the name of the client was withheld.) The only figure likely to be disclosed is the one that serves a sales or marketing purpose. The 14-digit numbers given for assets in custody are the classic example of the genre. Repeated attempts to make these large figures more useful by breaking them down between different geographies (even international and domestic) or client perspectives (buy- or sell-side) or forms of safekeeping (own branches or third parties) or client types (pension funds or fund managers) or business lines (corporate trust or fund administration) or nature (affiliated or independent) or distance (internal or external) are greeted as if they were requests for a statement of sexual preferences.

Information given by the few forwardthinking banks is rendered useless by the majority that stonewall impertinent inquiries with tired formulae such as "proprietary information" or "not disclosed" or (my personal favorite) "client confidentiality." It would be a marvel that regulators allow custodians to make such lavish claims about the size of their businesses without substantiating them, were it not for the fact that the regulators are complicit. Secrecy is a plague that affects the whole of the banking industry because the central banks know that in a fractional reserve banking system every bank is technically insolvent every day. They continue to worry that, if creditors had enough information to work out what risks a bank were really running, it would provoke a run on the entire banking system. This superstition has somehow survived the crisis of 2007-08, when it was precisely the fact that nobody knew who owned what that desiccated the markets in short-term liquidity.

It is impossible to think of a more complete demonstration of the want of trust in the banking industry than the events of 2007 and 2008, when no bank would lend to any other bank for fear of what that bank might be hiding from its creditors. In the end, of course, only central banks with the power to manufacture money would lend, and they remain a disturbingly large source of funding for banks today. Banks are lucky that they operate in an environment so privileged that politicians will dragoon taxpayers into bailing them out rather than allow them to fail in the way that Digital Equipment Corporation or the Polaroid Corporation was allowed to fail. But eternal life is not promised to businesses within banks, or to particular banks within the banking industry. The securities services businesses of the major international banks are a trifle within their organizations as a whole, and the stand-alone custodian banks are too small to be invulnerable to acquisition. If bankruptcy is not a possibility, acquisition, disposal or breakup is. Even in the custodian banking industry, there is no such thing as perpetual safety or stability. But if custodians lack control over how the markets will evolve, they can at least redesign their organizations to evolve more successfully within those markets. Unfortunately, there is as yet no sign that they have understood either the gravity of their position or the need to exercise what ingenuity they have to escape their current predicament.

Deleveraging with Pain

Submitted by Jim Casella on Wed, 09/21/2011 - 14:37.

As we observe the still-unresolved Greek debt crisis, it is important to realize that the deleveraging we are undergoing in the Euro Zone, the U.K. and the U.S. is a painful process. The New York Times carried an Associated Press story, "I.M.F. Slashes Growth Outlook for U.S. and Europe": "The fund said it expected the American economy to grow just 1.5 percent this year and 1.8 percent in 2012. That's down from its June forecast of 2.5 percent in 2011 and 2.7 percent next year. The International Monetary Fund also lowered its outlook for the 17 European Union countries that use the euro. It predicted 1.6 percent growth this year and 1.1 percent next year, down from its June projections of 2 percent and 1.7 percent respectively... Over all, the International Monetary Fund predicted global growth of 4 percent for both years. Stronger growth in China, India, Brazil and other developing countries should offset weaker output in the United States and Europe... American and European policy makers need to act more decisively to cut budget deficits, the report said, and European officials need to ensure that the region's banks have enough capital to withstand the debt crisis... Olivier Blanchard, the organization's chief economist said, 'President Obama's proposal to cut taxes and spend more on infrastructure should provide much-needed short-term stimulus. But that initiative needs to be paired with a longer-term plan to reduce the deficit. The timing of the budget cuts is key. Budget cuts cannot be too fast or it will kill growth. It cannot be too slow or it will kill credibility.' " (AP, September 20, 2011)

This painful and slow-moving process in Greece and the European Union has been going on much longer than the debate in the U.S. over raising the debt ceiling. Landon Thomas Jr. wrote in yesterday's New York Times, "But some economists believe default may be inevitable - and that it may actually be better for Greece and, despite a short-term shock to the system, perhaps eventually for Europe as well. They are beginning to wonder whether the consequences of a default or a more radical debt restructuring, dire as that may be, would be no worse for Greece than the miserable path it is currently on... What would the impact of a default by Greece be on Italy? In a new sign of trouble for the country (Italy), Standard & Poor's on Monday cut Italy's credit rating by one notch to A, citing its weakening economy and limited political response." ("Greece Nears the Precipice, Raising Fear," NYT, September 19, 2011) On Tuesday it was reported in the Wall Street Journal, "The European Central Bank stepped in to the market to buy Italian government bonds Tuesday after a sovereign-rating downgrade by Standard & Poor's Corp. raised new concerns about Italy's solvency amid a slowing economy." (WSJ, September 20, 2011)

The impact of an outright default on the European banks is unknown, but it is being suggested, "Bailing out the banks will be crucial if Greece either defaults or imposes a hard restructuring, whereby banks would be forced to take a larger loss on their holdings compared with the fairly benign 21 percent losses that they are now being asked to accept as part of the second, 109 billion euro bailout package set for Greece in June." (NYT, September 19, 2011) If Greece does default, will they remain within the European Union with its common currency, the euro, or would they exit the euro zone and return to their former currency the drachma and then devalue their currency versus the rest of Europe?

It is clear that this deleveraging process is very painful on all levels. Finding the right balance between stimulating growth and embracing austerity is playing out on a daily basis. Unfortunately, no one group or political party seems to have found the right balance and the frustration level grows both within the financial community and the individuals who cannot find productive work in this high unemployment environment. Deleveraging is a surgical process that must be done with care to insure that the western economies do not repeat Japan's lost decade.

Entrepreneurial Persistence: Steve Jobs

Submitted by Jim Casella on Sat, 08/27/2011 - 14:40.

As we awaited Hurricane Irene's arrival Saturday evening in New York City, it was a good time to reflect on how we can restore growth to a sluggish global economy and the important role entrepreneurs need to play. Two weeks ago I wrote, Entrepreneurs & a Week of Volatility in the U.S. & U.K.! and stated, "I believe that we need to unleash entrepreneurs in both the U.S. & U.K. and let them, once again, create the jobs that will drive more revenue into the government coffers from an engaged workforce that has been idled by unemployment for too long."

What separates entrepreneurs from corporate business managers? Why are they able to translate their visions into enterprises that end up growing much faster than the average large corporation and in the process create many new jobs and opportunities for growth for their employees?

With Steve Jobs stepping down this past week as CEO of Apple and moving to the role of Chairman of the Board, I thought back to the first time I met Steve. It was in the spring of 1992 and I had recently moved to the Bay Area to join IDG as President of InfoWorld. I was teamed with Bob Metcalfe by Pat McGovern, the founder and guiding force behind IDG. Bob joined InfoWorld as Chairman and Publisher. His tech credentials were outstanding. He had worked at Xerox PARC and was the inventor of Ethernet. He went on to found 3Com, one of the early networking companies. One day early in our tenure my phone rang and Bob asked me to come down the hall to his office. As I entered, I saw someone on the floor with his back to me tearing pages out of a number of magazines that were scattered on the floor in front of him. He briefly turned to see who had entered the room and Bob introduced me to Steve, who then went back to tearing pages out of issues of NeXTWorld.

This was during his years of exodus from Apple, when John Sculley had convinced the board to allow him to remove Steve, one of the co-founders of Apple, from the company. Steve knew Bob and was making a pitch on why we, InfoWorld, would be a much better publishing partner for NeXT than the division of IDG that was publishing NeXTWorld. What struck me was Steve's enthusiasm for a computing platform that never gained much traction. That platform would eventually provide the foundation for a new Mac OS X operating system when when Steve returned to Apple in 1996 with the acquisition of NeXT by Apple.

In many ways, the spring of 1992 was the midpoint for Jobs in his exile from Apple and yet one could sense that he still had a unique sense of confidence and a desire to have the world share his vision. At that point he was not the iconic innovator the world has come to admire, but an entrepreneur trying to gain recognition and market share for his latest venture.

I realized many years later that his persistence, when combined with his creativity and innovative sense of style, set him apart from many of the other entrepreneurs in Silicon Valley. You knew in speaking with him that failure was not an option. There would be setbacks and detours along the way, but Steve Jobs was determined to bring his vision to the rest of the world, well beyond The Valley. Shortly after he returned to Apple with the purchase of NeXT and had taken over as CEO of Apple, I had an appointment with him along with two other colleagues (I was then a board member of Mac Publishing, a joint venture between IDG and Ziff Davis). We went to see him regarding the Mac clones, which at the time were providing significant advertising dollars to our publication and also providing market share growth for the Macintosh. Steve listened and was cordial and then one week later made a decision with regards to licensing that effectively ended the clones. He knew where he was headed and partners were not part of his plan.

Today we celebrate his brilliance for the launch of the iPod, iPhone and iPad and for creating the most valuable company in America, based on market capitalization, but his persistence was what carried him through those middle years in the '80s and early '90s and allowed him to triumphantly reach the pinnacle of success as an entrepreneurial legend.

Entrepreneurs and a Week of Volatility in the U.S. & U.K.!

Submitted by Jim Casella on Sat, 08/13/2011 - 17:12.

Normally, the dog days of summer are a quiet time around the globe, when there are always preparations under way for the fall. For example, on Thursday evening the first preseason National Football League games were played. With the players strike at an end and a new 10-year collective bargaining agreement in place, the teams are starting to prepare for the regular season. Even the baseball division and wild card races do not normally draw much attention until September, but this year it has been different.

In London, Prime Minister David Cameron had to cut short his Tuscany vacation because of several nights of rioting and looting in London, which soon spread to several other cities in the U.K. Fortunately, by mid-week there was a strong show of force by the police and an uneasy calm had been restored to the London streets. It is expected that the police will maintain their force of 16,000 police officers on the London streets throughout this weekend. We also have learned that the governing coalition will consult with Bill Bratton, chairman of the private security firm Kroll and the former police chief of Boston, New York and Los Angeles, where he has a successful history of dealing with youth violence. (Financial Times, August 13, 2011)

In the U.S., Standard & Poor's (S&P) moved to downgrade the U.S. bond rating from AAA to AA+. This followed an agreement to raise the debt ceiling, after months of political theatre, that no one on either the Democrat or Republican side of the aisle seemed to embrace. The Congress headed home for a five-week summer recess and President Obama seemed in no rush to call them back. Global stock markets reacted with volatility that had never been seen before, with swings of 400+ points in either direction to the Dow Jones average. On Tuesday the U.S. Federal Reserve board announced that the economy was in such a precarious state that they were committed to keeping interest rates at historical lows of near zero until at least mid-2013. (Wall Street Journal, August 13, 2011, "This Time, Maybe the U.S. Is Japan")

Buried among all of this news on Friday, I noticed the article, "Shrinking in a Bad Economy: America's Entrepreneur Class." (WSJ, August 12, 2011) "Which leads to the question: Will the damage done by the weak economy have a long-lasting effect, discouraging the next generation of entrepreneurs?" The article contrasts the strong growth of "Silicon Valley and tech hubs throughout the U.S." with the "meat and potatoes economy." "You have a real dichotomy between the technology and Web-based economy versus the meat and potatoes economy," says Steven Kaplan, who teaches entrepreneurship at the University of Chicago Booth School of Business.

I believe that we need to unleash entrepreneurs in both the U.S. & U.K. and let them, once again, create the jobs that will drive more revenue into the government coffers from an engaged workforce that has been idled by unemployment for too long. Our practical Mayor of New York, Mike Bloomberg, joined the debate on his weekly WOR radio show. "Taxes should be increased for everyone - not just the rich - to break the logjam in Washington over how to reduce the deficit. So if you want to raise taxes, don't pick one class of people and say, 'I think they have too much money,' or 'I don't think they have enough money or whatever. Raise everybody's taxes 1 or 2 percent, whatever it was." (NY Post August 12, 2011) We need political leaders in the U.S. and U.K. that will not play on our divisions but will bring us together to solve the structural issues that are holding back our economic growth. Many of us long for the days of Margaret Thatcher and Ronald Reagan, who together brought an end to malaise of the late '70s and early '80s and put us on a path of strong economic growth that lasted into the early '90s.

The unbearable reality

Submitted by Dominic Hobson on Fri, 08/12/2011 - 11:59.

A striking but unremarked phenomenon of our times is the paucity of portfolio investment into emerging markets. The fact that the mature stock markets of the developed world are weak is only the most immediate of the reasons to invest in emerging markets. The populations of Western Europe, North America and Japan are also aging and must live off dividends and interest, not salaries and wages. Emerging markets, on the other hand, are full of young people and unmet needs. The senescent rich of the northern hemisphere should be living off returns to capital and labor in emerging markets that are, in the cases of China and India at least, four or five times what can be earned in the developed world. It is not as if there is a shortage of emerging market funds in which to invest, or direct or proxy stocks offering exposure to the superior rates of growth in emerging markets, yet this apparently obvious opportunity is showing up in neither stock nor fund market returns in the developed world. Of course, savings have doubtless gone into wrong-headed investments, emerging market authorities do not always make it easy to invest, domestic interest groups resist foreign competition and a wide variety of nefarious practices make it impossible for foreign companies to succeed. But there is also something far more discomfiting at work, which has much to tell us of how the great commercial civilizations of the Atlantic have colluded in their own euthanasia.

One symptom of this is immigration. If markets were working properly, the capital of Europe and North America would be investing in the developing world. Instead, the labor of the developing world is coming to Europe and North America. A second curiosity is even more contrary. Far from the savings of the developed world flowing to the emerging markets, capital is actually moving in the opposite direction. The United States in particular is devouring the savings of China, Russia and the Middle East to fund its budget and current account deficits. This year, the budget deficit of the United States is expected to hit $1.5 trillion. The Institute of International Finance estimates that total net private sector capital flows to all emerging markets last year totaled $825 billion, or just over half the amount the United States government will borrow this year from savers at home and, increasingly, abroad. If the foreign exchange reserves held by emerging market central banks are offset against those private sector flows, a substantial net flow of capital from the emerging markets to the developed world is visible. Of the emerging market foreign exchange reserves whose currency the IMF can identify, nearly 60% ($1.5 trillion, as it happens) are denominated in US dollars. Most of the remainder is denominated in euros, sterling and yen.

Governments, in the United States and several of the major nation-states of Western Europe, are now equivalent to timeshare salesmen, their choices devoid of any moral or political content. Every question reduces to an issue of financing. It helps that their counterparts in the emerging markets are happy to play the role of latter-day Colbertists, piling up dollars as greedily as Rumpelstiltskin spun gold. Even Germany and Japan, the two developed economies that run large current account surpluses, have not invested much in emerging markets. The result is a world turned upside down. Instead of the aging inhabitants of the developed economies as the rentiers of the world, living off the higher returns of the emerging markets, the emerging market state has become the patron of the United States and the European Union. The overwhelming majority of developed economy assets held by emerging market investors are not equities or direct investment, but government debt. And the overwhelming majority of the holders of those assets are not individuals or families or fund managers or companies but state entities such as central banks and sovereign wealth funds. What is happening to the flows of capital around the world is not a market process at all but a horrible symbiosis between the degraded democratic politics of the northern hemisphere and the despotic politics of China, Russia and the Middle East.

It is not a bargain that encourages good behavior by either party. Illiberal governments ensure that wealth, which could be put to much more productive use in private hands, accumulates in the hands of gangsters sympathetic to the incumbent regime or state-controlled institutions that can divert it to the pursuit of dangerous ideological or geopolitical ends. For elected politicians, on the other hand, borrowing is spending without taxation. It is of course no more than deferred taxation, but a tax deferred is a vote gained. In fact, the current scapegoating of bankers and the sustained legislative and regulatory assault on the financial markets by elected politicians is a more than usually disgusting variety of political hypocrisy. It is impossible to disentangle the development of modern democratic government from the growth of sophisticated financial markets in which elected governments can borrow. A century ago public spending accounted for just 13% of GDP in Britain and Germany, then the prototypical welfare states. In France the state ate just 9% of the national income, and in the United States it consumed a mere 8%. The respective proportions today are 50%, 45%, 55% and 41%. Public expenditure now averages 44% across the OECD. In the United States, the net financial liabilities of the government currently total 75% of the national income, more than twice the level of a decade ago. Across the euro area, the equivalent figure is 60%.

There is no better measure of how democratic government fosters the illusion that budgetary constraints can be escaped, and so ultimately comes to rest upon it. In tracing the linkages between this fiscal incontinence and the monetary incontinence that was the ultimate cause of the financial crisis of 2007-09 it is hard to distinguish cause and effect. There is now universal agreement that interest rates in the United States and Europe remained too low for monetary conditions from 2001 to 2007. But the fact that deficits could be funded at lower rates of interest was obviously material to decision-making by the government as well as the private sector. Cheap money encouraged borrowing by making senseless investments look viable, and fueled asset price booms in housing and stock markets. But the credit boom could not have been put into effect without state control of the central bank and state underwriting of the banking system. Far from acknowledging this truth, and their own direct responsibility for the disaster, the central banks of the world present themselves as the principal victims of the behavior of the commercial banks, and the saviors of the world from an even greater disaster.

If ever there was a demonstration of the impossibility of centralized control of changes in the demand for money, it occurred over the last full economic cycle between 2001 and 2009. Only a special brand of shamelessness has freed the same central banks that completely misjudged monetary conditions in the boom to use exactly the same tools to fix the crisis as those that caused it in the first place. They have again manipulated the rate of interest to punish savers and reward spenders, and they have embarked on a massive inflation of the money supply. Both are designed to restart the credit cycle, not least by stoking a revival of the stock market. Whether the inflation of the money supply is a measure of the recklessness of central bankers or the desperateness of the situation scarcely matters, but it is certainly lavish. In April 2000, when the dot-com bubble imploded, the monetary base of the United States stood at $578.5 billion. By the time the financial crisis began in earnest in June 2007 it was up by more than two-fifths to $826.5 billion. Four years later, it stands at $2.65 trillion. In other words, the United States has "printed" an additional $1.8 trillion in the last four years alone, a sum equivalent to three times the entire monetary base just a decade ago. Similar "quantitative easing" programs are in place in the United Kingdom and Continental Europe.

A drunk would call this a hair-of-the-dog-that-bit-you. There are more sophisticated explanations of why it makes sense to cure the after-effects of a speculative bubble by reflating the bubble with increases in the supply of money, which in turn encourages companies and consumers to borrow from banks at low rates of interest. But, like drinking to cure a hangover, they testify to an unwillingness to address the underlying structural problems of western capitalism in general, and Anglo-Saxon capitalism in particular. The belief that artificial expansions of money and credit offer a shortcut to growth, enabling whole economies to bypass the sacrifice of saving for investment and the discipline of work, is so entrenched that its critics are treated by mainstream economics as bumpkins and imbeciles. Nobody now considers it extraordinary that almost any European or American adult with a job can buy a new house or motorcar as soon as he or she wants it, paying for it not out of savings or even current earnings but by borrowing from future earnings. Yet it was impossible as recently as the 1960s.

Even the extraordinary prospect of impoverished workers in developed economies making the necessary sacrifices of time and money to fund debt-financed consumption by wealthy consumers in developed economies can be explained by policymakers and mainstream commentators as if it were a problem of shallow causation and recent provenance, susceptible to remedy by a handful of obvious policy changes. The usual term employed is "global imbalances." It implies that, if only the Chinese government would allow the renminbi to find its true value, or the oil-producing nations would not restrict the production of gasoline, these imbalances would disappear. There is even a view that the law of comparative advantage is at work in this process. In other words, that the overgrown financial services industries of Western Europe and North America are a symptom not of politico-economic corruption, but a reflection of the labor cost advantage of less developed economies. There is no sense of any structural or historical or moral dimension to what is happening at all. Yet what is happening is that the developed economies are losing their capacity to create wealth.

Repeated revolutions of the credit cycle destroy real wealth as well as paper wealth and gradually erode the productive potential of an economy. Most obviously, they do this through the arbitrary transfer of wealth from people who bought at the top of the cycle to people who sold at the top of the cycle. Less obviously, the spectacular returns available in financial markets diverted real resources of land, labor and capital into speculative housing and stock market investments. Now, by refusing to allow the market to flush its system of misguided investments by injecting more money and credit into the system, the central banks risk turning the economies of Europe and North America into western hemisphere versions of Japan: places where a prolonged credit boom is followed by nothing but a prolonged period of stagnation in the real economy as the authorities refuse to acknowledge the consequences of their own handiwork.

Indeed, it can plausibly be argued that they are Japan already. The average annual rate of growth of the economy of the United States in the long golden era that lasted from 1950 to the first oil crisis in 1974 was 2.45%. In the years that followed, down to the end of the dot-com bubble, it was 1.86%. The equivalent figures for Germany are 5.02% and 1.58%; for France, 4.04% and 1.72%; for the United Kingdom 2.42% and 1.93%; for Europe as a whole, 3.92% and 1.77%. In other words, most of these economies are growing at a third to a half of the rate they managed in the 1950s and 1960s. These apparently small differences actually matter a great deal. If the national income of the United States grows at 1.86% instead of 2.45% for the next ten years, Americans will be $1 trillion worse off in 2021. Yet real economic growth in the United States over the last ten years has averaged only 2.2%. In the same period, Germany and France have managed just 0.9% a year, and the United Kingdom 1.4%. Much of the growth that did occur measured only the power of oceans of credit to sustain housing and consumption booms. It is no secret that the average American or European has scarcely gained at all from the economic "growth" that has occurred since the 1990s. The system has successfully concealed this reality from them through a vast expansion of credit. Nowhere was this more true than the United States, where the value of all personal, commercial and public sector debt increased 32-fold between 1970 and 2007, with no sector increasing faster than financial services, where the impact of increased leverage was most direct.

That leverage created an extraordinary level of risk, but an equally extraordinary degree of profitability in the financial markets, all of which was reversed in the crisis. Not that this is completely understood, for not all of that reversal is apparent yet. This is because much of the misguided investment can still be financed, even if only at the central bank. When the crisis began in August 2007, the total assets of the Federal Reserve stood at $869 billion. They now stand at well over $2 trillion. In the same period, the balance sheet of the Eurosystem has inflated from EUR1.25 trillion to EUR2 trillion, and that of the Bank of England from GBP81 billion to GBP237 billion. The dirty secret of the financial services industry is that the banks are still sitting on trillions of assets whose valuations rely on nothing but their own mark-to-market models and the willingness of the central banks to fund them. In a world in which emerging markets save more than they spend, but developed economies spend more than they save, and economies are not growing fast enough to create new wealth, what has happened to the balance sheets of the central banks is a microcosm of what is happening to the world. Even worthless assets can be financed for a remarkably long time, but wealth must in the end be transferred from borrowers to lenders, or borrowers must default. This has happened and is happening already to banks, fund managers, investment banks, consumers and pensioners that borrowed heavily against rising asset values in the boom.

It serves as a sharp reminder that credit is never wealth, only a claim on wealth. Borrowing to invest in the hope that value of the assets will always stay ahead of the value of the principal is not just a risky substitute for acquiring real savings by deferring gratification, investing them in more productive technologies and working hard. Credit is a drug that draws a veil across the reality that resources are scarce and, if we have more of one thing, we cannot have more of another. Ultimately, the only source of wealth is productivity, or getting more output from the same amount of input. Productivity is created by the steady interaction of physical technologies (the wheel, the steam engine, the internal combustion engine, the microchip) with the social technology economists call the division of labor. In the 40 years that have elapsed since the end of the golden era in the early 1970s, credit, and the asset price inflation it creates, has served to obscure this tiresome reality from the inhabitants of the developed economies of the world. Their creditors in the emerging markets may or may not be about to foreclose on them, but it is hard to ignore the growing body of evidence that an overgrown financial services sector is not after all a measure of success, or even of failure, but simply a symptom of a mass retreat from reality by the citizens of the west, orchestrated by their governments and facilitated by their central banks.

Post-Trade Infrastructure: A Board-Level Topic

Submitted by Marianne Brown on Fri, 08/12/2011 - 09:40.

The middle office was traditionally left out in the cold in comparison to the board level attention once given to the front office, but the collapse of Lehman in 2008 put an end to that. Post-trade topics have firmly secured their presence in the boardroom. Typically, ownership of this topic tends to be CROs and CTOs, but the subject can often venture as far up as the COO. This is because a robust middle-office is seen, particularly by policymakers, as an area where credit, counterparty and operational risk can be measured and reduced. It is also viewed as a significant enabler in providing greater transparency to investors across the trade life cycle.

More than ever, market participants must demonstrate that they have both an accurate and holistic view of their collateral exposures, as well as the ability to measure their counterparty risk at any given moment. In the boardroom, conversations around risk management are a common topic. Often these conversations involve Audit Committees, who may be responsible for identifying the company’s risk profile and, with the support of management, ensuring the business has reporting and metrics capabilities to stay within that profile.

Often, high volume and complex asset classes are still being recorded and confirmed in excel spreadsheets, via email or fax. These methods typically do not satisfy the risk management goals and requirements for the business around timely, clear and succinct information about counterparty, asset or market risk. Risk exposures must operate within the pre-defined limits set by the firm and as a result of this, the management and mitigation of risk via an automated middle-office is now firmly on the board’s agenda. Although regulation may not mandate specific processing requirements, the timeframe for calculating and reporting risk, while enabling an accurate audit trail, makes automation inevitable.

Despite this, there is still a great deal of divergence in how the middle office operates across geographies, asset classes and firms. This impacts and influences discussions about investment in post-trade infrastructures. In the absence of harmonized regulation, for example across buy-side and sell-side firms, there is a lack of commonality in the drivers which rationalize and standardize behaviors relating to the middle-office. The buy-side and sell-side are not subject to the same regulatory requirements, and this has created a significant difference in levels of post-trade investment between these market participants.

Over the next 12 months, we envision that market participants – including the board of directors at firms – will be working even more closely with global policymakers, regulators and their peers to ensure that standards, workflows and processes are developed in tandem with industry and business needs.

US GDP Revised Down and the Debate Continues

Submitted by Jim Casella on Sun, 07/31/2011 - 09:40.

In the middle of the countdown to default and the ongoing search for political compromise, we learned yesterday that the U.S. gross domestic product (GDP) grew at an annual rate of less than 1 percent in the first half of ‘11. The government reported that the economy grew at only 1.3% in the 2nd quarter and the first quarter was revised down to .4%. (WSJ July 30, 2011) The economy is languishing and there should be no question why the unemployment rate remains stubbornly above 9%. There is a lack of business & consumer confidence brought about by the dysfunction in our nation’s capital, Washington D.C. John McDermott wrote in the Financial Times yesterday regarding the GDP figures: “Perhaps this will jolt lawmakers into getting their pony on. S&P and Nasdaq futures fell on the news, while - of course- yields fell on 10-year US Treasuries. Brent crude futures were down. The US dollar was at a four-month low against the Japanese yen. Over to you, Washington.”

The financial crisis and “Great Recession” were brought about by the bursting of the housing bubble, but during all of the debate about the debt ceiling have we heard any one of our political leaders come out with a plan to rebuild the domestic housing market and the jobs that were lost when this industry cratered? For several years while I was at Reed Business, I sat on the advisory board of Harvard University’s Joint Center for Housing Studies www.jchs.harvard.edu as the representative of Reed Construction Data. This was during the bubble years of ‘04 & ‘05 and the housing leadership was well represented on the advisory board, including all of the major home builders & their suppliers. The Joint Center for Housing Studies has been researching and tracking the U.S. housing market since the end of World War II. This period up until the crisis was one of ever-expanding home ownership in the U.S. Both political parties strongly supported this policy until the crash. Now as we look for a recovery, which continues to be elusive, we do not hear the leadership of either party advocating programs to put the residential housing market back on a growth path.

There is no question that solving our current debt crisis requires both increased revenues over time and decreased spending. The revenue growth, though, cannot be realized by continuing to raise the tax rate on the wealthy (now defined as those who make over $250,000 per year) at a time when our economy is moving towards another recession. Restoring job growth is where increased revenues will come from. Leadership in both parties should start by addressing our dormant residential housing market. On the spending side of the equation, we need to address the ongoing cost of our three wars: Iraq, Afghanistan & Libya.

Acting Responsibly

Submitted by Jim Casella on Mon, 07/18/2011 - 10:59.

I have enjoyed my several weeks in Blackhawk, but I am preparing to return to New York City on Monday. The first two weeks of July are normally a quiet time for news, with many families starting vacations that often go into August. In most years this is true for New York, Washington D.C. and London, but this year it has been very different.

Back in July of ‘07, I wrote, CRM from the Expert, Thomas Keller. In this entry, I wrote about an early July trip to the French Laundry and a wonderful several days Mary Claire & I spent in Napa Valley with friends. I concluded with, “Now I am back at work looking for ‘high growth’ media acquisitions, on the west coast for another week & I must admit that I find it a bit odd that Rupert Murdoch’s offer for Dow Jones has not been accepted by the Bancrost family or their representatives and the board of Dow Jones. I join the former CEO of Dow Jones, Peter R. Kann, in wondering why Ron Burkle, a supermarket magnate & Eric Greenspan, former CEO of Intermix, the original parent of MySpace, would make better owners than Mr. Murdoch, who has spent his entire career in the media space & clearly wants to invest and expand the Wall Street Journal franchise.”

We have learned over the past two weeks that the News of the World phone-hacking scandal has not only put the company that Rupert Murdoch and his family control, News Corp, at risk, but the coalition government of David Cameron and Nick Clegg also finds itself in a very difficult position. After some early stonewalling by Rupert & James Murdoch two weeks ago, we have seen the 150+ year-old Sunday tabloid fold with more than 200 employees losing their jobs. We have seen Rebekah Brooks try unsuccessfully to hang on to her position and finally resign from News Corp toward the end of the week (she was arrested on Sunday in connection with the scandal). And Les Hinton, a longtime Murdoch executive & confidant, ended the week by resigning from his CEO position at Dow Jones. (Many of the reported phone-hacking activities began on his watch as the executive responsible for News of the World.) By the end of the week the Murdochs had also withdrawn their bid to acquire the 60%+ of British Sky Broadcasting they do not own. Clearly, though, their 39% ownership has given them, up until now, effective control under James Murdoch. Both Murdochs have now agreed to testify before Parliament, after initially rejecting this approach, but only after being summoned. Damage control has also become necessary in the U.S., where their broadcast holdings require government licenses. (FT July 15, 2011) They have turned to the Washington D.C. firm, Williams & Connolly and their well-known criminal defense lawyer, Brendan V. Sullivan Jr. for advice & counsel. (NYT July 16, 2011)

I would not bet against the Murdochs remaining in control of News Corp, although some have speculated that Rupert Murdoch could be forced to give up the CEO title & abandon his dream of having his children succeed him in controlling the company he has built over the past half century. I sense, though, that the days of one man and his media holdings having so much influence & access to our political leaders in the U.K. & the U.S. are at an end. We need to hold the officers of our public corporations, particularly those that control significant media assets, to a high standard of behavior and the same is true of those that we elect to public office to represent us. We should never have to question if they have been acting responsibly, especially over long periods of time. In the end, Murdoch has been successful because he is tenacious & persistent and this will probably carry the day, but at 80 years old his reach & influence will be decreased and this will be at a real cost, not only to him & his family, but to his employees, his shareholders and the public’s trust, which has been betrayed.

Monaco Fund Forum International 2011 – A Review

Submitted by Jim Casella on Mon, 07/04/2011 - 13:10.

This is a guest blog post by Daniel Enskat, Strategic Insight’s Head of Global Consulting and Senior Managing Director.

The Monaco Fund Forum International is always of major importance for the industry – in its 21st year, it is the world’s largest asset management event, and Julian Kirby, Jenny Adams, Ed Jones and team again outdid themselves.

It also was a major event for Strategic Insight and Asset International this year, since we came to Monaco with almost a dozen representatives, including our chairman and CEO, Jim Casella.

Jag, Rita, Mike, Jason, Jamie, Lise, Andreas, Ilaria and other colleagues from AI attended – at the same time, we had a big Strategic Insight event in NY on Monday/Tuesday as well, led by Avi Nachmany, Kevin and the US team, with close to 200 senior executives of the US fund industry – a big week all around.

SI booth - from left, Ilaria, Andreas, Lise, Jamie
Monday, Distribution Day

I always very much enjoy Monday’s distribution summit, as it brings together fund selectors, advisors, clients and asset managers. It was a pleasure to again see Alex Hoctor-Duncan of Blackrock host the day, and to give the opening speech on Monday on “Understanding the Needs of the New Global Professional Fund Buyer By Region and Sector” – stay tuned for a detailed writeup of the discussion and speech, including the Q&A with the audience.

Next up were two panels, “How Close Do You Need To Get To The End Customer?”, moderated by Mark Tennant, with an expert panel including Adrian Weiss (Citi), Roger Sanders (Lighthouse Group), Gary Shaughnessy (Fidelity), Carlo Gentili (Nextam), and Edward Troughton (Alliance Trust), and “Platforms are Here to Stay, But 2,000+ Retail Funds Aren’t”, moderated by Edward S. Glyn (Swift), with Borja Largo (Allfunds), Laurent Auchlin (LODH), Holly Mackay (Platforum), David Bower (iShares), Jean-Paul Mazoyer (Amundi) and Charlotte Denery (Fundquest/BNP).

Of special interest to me, after having touched on brand and client service in addition to performance as key fund manager selection criteria post-crisis, was the pre-lunch guest speech by Rita Clifton, chair(wo)man of Interbrand, on the future of brands.

Rita quoted examples from Interbrand’s work on the top 100 global brands, conducted annually, along with case studies of Apple, Google and other fast growing brands. All of this of course tied in nicely with the blogs I have done on those firms in recent months, linking them to the asset management world.

Then it was off to a lunch meeting with clients and various other meetings mostly over coffee throughout the day, so I couldn’t listen to all afternoon discussions for Monday. But the team was present as I tried to drop in in between meetings as often as possible.

Highlights included: wholesale distribution strategies with Richard Romer-Lee (OBSR), Taylan Turan (HSBC), Koen Bougard (AXA Bank), Jean-Francois Hautemulle (Unicredit Private Bank), Pete Davis (Zurich Financial) and Roy Smale (Wellington); and a late afternoon multi-manager discussion chaired by Roland Meerdter (Propinquity), with Jamie MacLeod (Berry AM), Alan Durrant (National Bank of Abu Dhabi), Stephane Corsaletti (ABN Amro PB), Bernard Aybran (Invesco Europe), and Allan Lorentzen (Danske Bank).

After that it was off to an unforgettable evening hosted by Franklin Templeton’s Vijay Advani and Jamie Hammond, featuring Mark Mobius and his team at the Chateau de la chevre d’or in Eze, with a special seven-course tasting menu overlooking the cote d’azur. It was a great evening with many close friends and clients – Mark and team shared their views on emerging markets, and the discussions amongst the attendees covered the world many times over.

Tuesday, Main Conference Day One

KPMG’s Tom Brown hosted the first day of the main conference, and it started off with two bangs: first, John Micklethwait, Editor in Chief for the Economist, layed out his framework for the West and the Emerging Economies, followed by a CEO roundtable moderated by Mark Tennant, with Jamie Broderick (JP Morgan), Elizabeth Corley (AGI) and James Charrington (Blackrock) addressing issues around “Future-Proofing the Industry – Giants of Fund Management Respond”.

After the coffee break and a few informal meetings I went back to the auditorium to listen to another CEO panel moderated by Jose Benjamin Longree (Citi), with Willie Watt (Martin Currie), Rudolf Apenbrink (HSBC), Juan Alcaraz (Santander) and Hugh Willis (BlueBay).

Rudolf used to run HSBC in Asia and is now back in Europe, so he had a lot of important global views, Juan after heading up Allfunds was put in charge of Santander overall and has strong exposure in LatAm. I was especially interested as well in Hugh’s comments, after having written a piece on “David & Goliath in global asset management” a few weeks ago, including a case study of BlueBay.

The Fund Forum Interview 2011: The View From Asia

Up next was the “FundForum Interview 2011: The View From Asia”, where I had the pleasure to speak with Vijay Advani (Franklin Templeton) and Tim McCarthy (Nikko). Tim and Vijay are probably the most knowledgable executives on Asia and how the region links to the US, Europe and the rest of the world. Tim was a senior executive with Schwab and Fidelity in the US, and spent many years all over Asia before taking over the role of CEO & Chairman for Nikko Asset Management. Vijay now runs Franklin Templeton globally out of San Mateo, but in reality spent many years building the business for the firm in Asia as well and practically lives on a plane.

DSE in discussion with Vijay Advani & Tim McCarthy

I will publish a thought leadership piece with their views soon, including key observations on how to approach Asia, how it fits into a global organization, how to make it profitable and how important Asia will be in the next decade vis-a-vis other regions.

DSE in discussion with Vijay Advani & Tim McCarthy
The interview concluded the main morning session in the auditorium – after lunch it would continue with four different breakout streams on topics including UCITS, Product Development, Investment Strategy and Asset Allocation.

My afternoon was packed with client and prospect meetings, alongside media discussions, followed by dinner hosted by KPMG and Citi, one at Beaulieu-sur-Mer, the other one at the Hermitage. When deciding between two extremely appealing options, especially when friends such as Tom Brown and Jervis Smith are inviting, go for the third one: dinner with the whole team nearby, hosted by Jim – being able to spend quality time with the whole team of global analysts and client managers is a rare opportunity. We had great food and laughed a lot, the perfect finish to a busy first conference day (technically the second day).

Wednesday, Main Conference Day Two

Day two was chaired by Patrick Colle (BNP), and it featured a packed morning with many highlights, including Neeraj Sahai (Citi), a CEO panel moderated by Jervis Smith “towards the investment driven organisation” with Martin Gilbert (Aberdeen), Andrew Fisher (Towry), Katherine Garrett-Cox (Alliance Trust) and Jim McCaughan (Principal), and then the Guest Asset Manager of the Year Interview by Ross Westgate (CNBC), with Larry Fink (Blackrock).

Among many other important comments, Larry most notably talked about the main focus for Blackrock in coming years being to build a powerful brand.

Indeed, Alex on Monday in his remarks had talked about Brand and Service Alpha in addition to Performance Alpha for Blackrock, and, curiously, Blackrock was the only manager at the forum that tweeted on all sessions throughout the week.

After a great client lunch at Avenue 31 with Roger Moore at the table next to us, I have to remind the waiters that I am not on French Riviera time and leave the table at 2:22pm to head over to my last speaking engagement for the week at 2:30pm, a panel and presentation on UCITS vs. Asia Fund Passport in the Emerging Markets Distribution stream. In recent weeks we had published numerous research pieces on emerging markets and especially Latin America, so I look forward to this more intimate panel.

I also have the pleasure of doing this stream with Camille Thommes, General Manager for Alfi. After polling the room on their specific interests, which include Asia Fund Passport, trends in Latin America, Dublin vs. Luxembourg and the potential of local passports for individual markets such as China, my senior HK-based research analyst Lise Carpenter gives a short overview of UCITS data, and then we get into the discussion.

The advantage of a smaller room with only one hundred or so people is that everyone is more specifically interested in the topic and has important views to share, so we turn it into a town hall style discussion with open Q&A.

Tomorrow we will publish an in-depth analysis of the topic, stay tuned.

After this last official engagement at the forum I continue with a few media interviews, a television appearance with EFAMA president JB de Franssu on UCITS, and then head over to the American Bar at the Hotel de Paris with Jim to meet one of our clients for a drink, before taking a taxi to the gala dinner by the pool at the Monte Carlo Beach Club.

A short but powerful thunderstorm wreaks havoc and puts the drinks in jeopardy, but this being the riviera, it is all over a few minutes later. At around 10pm we head back to the hotel and have a final round (or two) of mixed berry mojitos with the team.

We call it a night at about midnight.

I spend Thursday writing by the pool and on the phone, and then catch the Friday morning flight back to NY for a few days in the office, before being up in the air again on Thursday, this time to Colombia.

Good bye Monaco.

A want of honor

Submitted by Dominic Hobson on Mon, 06/27/2011 - 11:50.

Politics is a notoriously ignoble profession. But in any gainful pursuit the temptation to behave dishonorably is as common as the opportunity to do the right thing. In financial markets, where the sums are large, leverage multiplies returns and insiders always know more than outsiders, the temptations are commensurately greater. As I look back over the decade or so that separates the activities of Fabulous Fab in the structured credit boom of the 21st century from those of Bernard Ebbers in the TMT boom of the 1990s, or the dozen years that divide Jerome Kerviel from Nick Leeson, or the 25 years that divide Raj Rajaratnam from Ivan Boesky, or even the near-100 years that lie between Charles Ponzi and Bernie Madoff, one fact is obvious. Markets change, but human nature does not. Doubtless our inner being is evolving into something better in the longer term, but clearly not fast enough to make a difference in three generations, let alone one. From this perspective, the rising tide of regulation, like the rising population of the prisons, is no more than another measure of the fallen state of man. Yet if the old Adam in all of us is immortal, the uselessness of regulation is a given, for even the introduction of the death penalty for being on both sides of a structured credit trade could not change human nature and its practical expression: human behavior.

This is depressingly evident in the compliance industry that regulation has created. Compliance, which is easily the fastest-growing sector in modern financial services, now rivals the credit committee as the true seat of the business prevention department, for it is always safer to say or do nothing than to say or do something. Yet if the compliance industry has any effect on behavior at all, it is perverse. The moral status of investment bankers is reduced to that of children, unable to act in public without seeking the permission of the compliance department beforehand, and even begging regulators to tell them what to do rather than take the risk of working it out for themselves. This process relieves individual bankers of the burden of thought, let alone judgment or responsibility. It leads by default to a manner of business in which compliance is nominal rather than real, whatever is not forbidden is permissible, the only effective constraint is the fear of discovery and imprisonment, and behavior falls to the standards set by the regulators instead of rising to the ideals laid down by moral philosophy. Thanks in large part to pervasive systems of regulation, the culture of modern investment banking is one in which regulatory fines have come to be seen as part of the cost of doing business - a sort of tax, and not a source of shame. The culture of compliance has created a business without honor.

In this sense, the contempt of the public for the profession of banking is not unjustified, for honor accrues only to those who are worthy of respect, and bankers have ceased to respect even themselves. This is dishonor defined, for to be without honor is to be treated without respect. Though investment bankers are often exceptionally gifted, brilliant at their work and invariably rich, even their most ardent apologist would not claim that they currently command popular respect. A variety of embarrassing public performances by senior figures has persuaded the public that bankers demand respect without the inconvenience of being worthy of it. They have become, in the popular estimation, shameless. However unfairly, bankers are widely regarded as adhering to no code of life or morals other than money. That is why the extended metaphors of Matt Taibbi resonate so widely with the intelligent reading public. Moral conservatives argue that this shamelessness originates in the rootless cosmopolitanism of modern bankers, who can no longer sense the boundaries set by membership of an ethnic or national or religious or social group capable of enforcing a set of moral standards without recourse to regulation or the law. In fact, the predicament of the investment banking industry is worse than that. The shameless behavior of certain investment bankers (and not a few of their clients) does not contradict the collective morality of the group. Rather, it reflects it.

Too many investment bankers seem to have shed any concern about how others see them, or even how they see themselves. Self-respect, as well as the respect of others, is in abeyance. The internal email correspondences that have found their way into the public domain suggest that many in Wall Street and the City are riding a river of moral sewage, with humor but without embarrassment. Expectations in financial markets are now so low that it is possible to behave dishonorably simply because colleagues or competitors are thought to be doing the same. When even those of the highest status in the profession make Tony Blair-like pronouncements about the need to consign awkward questions to the past, it is not just a failure of leadership, but an abdication of it. If the leaders of great banks and investment banks are seen to act without honor, there is no reason to expect individuals at any level in their organizations or the industry as a whole to act honorably. This infectious behavior is partly pecuniary in nature (it becomes widely believed that wealth cannot be gained honestly) and partly sociological (high status is no longer synonymous with a reputation for honorable dealing). But it is by these means that the honorable individual becomes a rarity, and honorable behavior eccentric or perverse. It may even be that investment banking, like electoral politics, now attracts more than its proportionate share of dishonorable individuals precisely because its moral code is seen to be so lax.

It follows that the return of investment banking to the ranks of the honorable professions will follow the steepest of paths. It will be circuitous as well as arduous. The moral capital accumulated by the Victorians is spent, and the evangelical tradition that was its motive force is broken. Trying to mend a broken moral tradition, warned Wittgenstein, is akin to mending the web of a spider by hand. Yet there is solid material with which to build. Most importantly, the moral revolution required is not one of understanding. All the important moral arguments were settled thousands of years ago. Rather, what is needful is the willingness to live and work by the light of those settled moral beliefs. What must change, in other words, is not morals but moral behavior. The most direct means of altering behavior is regulation. Yet regulation, which operates not inwardly but by the fear of punishment, is more a part of the problem than any part of the solution. Biology and anthropology teach us that the most powerful incentive to good behavior is what Adam discovered and modern investment bankers must rediscover. This is the sense of honor, or, to adopt its obverse, shame. To lie or cheat or steal or just treat colleagues badly without feeling ashamed is the province of the psychopath. Everybody else can respond to the call to honor.

The utility of honor is best understood by one of the few social institutions to command near-universal respect even in the debased moral culture of today: the military. In the uniquely demanding circumstances of the battlefield, honor is the only motive of effective action, and the sole defense against brutality. Regulators, as well as investment bankers, could learn much from it. On a battlefield, the incentives to act could scarcely be slighter, or the disincentives greater. Yet it is there, where the shame of dishonor overcomes the fear of annihilation, that men and women surpass themselves most often. The contrast with the behavior of the leaders of our great investment banks under fire in the fall of 2008 - sacrificing staff and clients to save themselves, and demanding rescue by their fellow citizens - could not be starker. Unlike investment banks, whose hierarchies are surprisingly open in both directions, the military is of course unashamedly hierarchical. In recognition of the special demands that are placed upon it, the military is granted a certificate of exemption from the democratic assumption that all human beings are entitled to equal respect, as a natural right bestowed on everybody by virtue of their humanity alone, and owed by every human being to every other human being. It elevates some over others by means of intricate gradations of rank.

Some say this limits the value of the military as an example, though that is debatable. Whether or not it is true, even a less unequal institution than the armed forces can find a place for honor, for some will fail to live up even to the dignity that is owned by every human being. After all, Bernie Madoff and Raj Rajaratnam lost their dignity as well as their liberty and their fortune. Honor is nevertheless hard to imbue in a culture where enormous sums are bestowed on individuals who cannot by any rational measure (though many have been tried) be seen to have earned or deserved them. It is not surprising that the recipients are inclined to believe that their wealth is also the measure of their merit. But the usual criticism made of this phenomenon - that so much esteem has accrued to the rich and successful that it implies disrespect for less lucky people, and less remunerative lines of work - is misplaced. Far from attenuating the worship of material success, by making all worthy of equal respect, the egalitarian outlook removes a constraint. Perversely, by spawning the meritocratic notion that the best jobs should always go to the greatest talents, egalitarian democracy has encouraged the belief (and selfbelief) that highly paid financial intermediaries are enjoying nothing but their just desserts. Think how many investment bankers consider their humble origins a sufficient defense of their large rewards. On this view of the world, the only defensible hierarchy, pruriently measured on an annual basis by Fortune, magazine and the Sunday Times, is the hierarchy of money.

The result is a paradoxical culture, of plutocratic egalitarianism. In a world in which all men and women are for the first time in history regarded as equal, money has come closer than at any time to becoming the measure of all things. The modern rich dress and comport themselves, and pursue the same interests in sex, shopping and sport, as everybody else. The difference is a matter of scale only. Even charitable donation, which financial market plutocrats have adopted wholesale, is no more than another means of purchasing the esteem of others. One reason dishonorable behavior is so commonplace in financial markets is that it is not disreputable abroad. Comforting as it is to believe that the Madoffs and the Rajaratnams are rogue individuals, the truth is that they are Caliban to our Prospero. Our laxity is not without cost. Regulation is consequence first, and cause second. Its steady insinuation into commercial and social life, as the state pursues its interminable quest to ordain the terms and even the outcome of every transaction by law, has reduced the scope of self-regulation to vanishing point. The informal constraints on dishonorable behavior have withered in lockstep with the advancing power of regulation and law. Where the scope for self-government is so narrow, the room for self-indulgence is wide. To tame it, governments have only the bludgeon of regulation and the law. Bankers, like any human being, have a far subtler weapon at their disposal. For a free man, as Demosthenes put it, the greatest compulsive force is shame. Only slaves are compelled by chains.

Shame sets people free because it is the source of self-government. The first fruits of disobedience have clung to our nature with remarkable tenacity precisely because of their social utility. Shame remains, as Carlyle once put it, the "soil of all virtue, of good manners, and good morals." Until investment bankers rediscover its lessons, they cannot be free of the encroachments of the state on their business, for they will lack the means of self-control. But shame is more than a means of liberation. It offers also a return to a more dignified position in the estimation of the public. By behaving honorably, bankers can shed not only the incubus of the state, but become worthy of an elevated status that is currently dependent on wealth alone. There is much to be said for the pursuit of money (of the many and varied occupations of our species, it is among the least harmful) but its possession cannot rest soundly on the shutting-out of unwelcome criticism, the purchase of politicians and the parody of possessive individualism that passes for leadership in so many investment banks today. Here hierarchy, as military castes have always known, has more useful advice than equality. By placing adherence to virtue above lineage, the chivalric ideal of the military hierarchies that dominated medieval Europe ensured that those at the top of the social hierarchy remained always worthy of respect, or lost all status. Likewise, the appeal to honor was at the heart of Bushido, the unwritten code of the samurai. "When others speak all manner of evil things against you, return not evil for evil," reads a saying of Ogawa, which ought to resonate with quiet insistence throughout the banking halls of the world. "Rather reflect that you were not more faithful in the discharge of your duties."

Monaco: Fund Forum International 2011

Submitted by Jim Casella on Mon, 06/27/2011 - 11:35.

It has been a number of years since I have traveled to Monaco. Unfortunately, Mary Claire and I were not invited to the second significant European royal wedding of the summer, taking place next weekend, between Prince Albert of Monaco and Charlene Wittstock of South Africa. She is a former teacher and Olympic swimmer, having represented South Africa at the 2000 Olympic games in Sydney. He is the son of Prince Rainier III, who passed away in 2005, and the legendary Grace Kelly. I trust Mary Claire would have adjusted her scheduled visit with our grandson AJ in Boston if an invitation to the wedding had been extended! There may not be a lovelier spot on the continent than Monaco with its fabled history and vistas, as well as the exquisite Monte Carlo Casino, which only enhances the charm.

I am heading to Monaco tomorrow to join 10 members of our Strategic Insight team for Fund Forum International 2011, which is billed as The World’s Largest Asset Management Event. Daniel Enskat, who directs our global advisory and consulting services, will open the Distribution Summit on Monday morning with a presentation entitled, New Research: A Global Survey of the New Professional Fund Buyer & Their Changing Product Requirements. Daniel will also conduct a fireside chat on Tuesday entitled, The View from Asia. He will interview Vijay C. Advani, Executive Vice President, Global Advisory & Distribution for Franklin Templeton and Timothy F. McCarthy, Chairman and CEO of Nikko Asset Management. Several thousand industry professionals will be in attendance.

Strategic Insight will showcase several of our new global studies that were just released, as well as our newest Simfund Global: Data & Analytics Workflow Tools. I am also looking forward to a dinner on Wednesday evening with John Lee, Founder and Publisher of The Trade and Richard Schwartz, who will be joining us full time to work on an exciting launch for the wealth management sector scheduled to debut in early 2012. I will provide more details and color as we get closer to the launch.

I will be back in New York on Friday and travel to the Bay Area with Mary Claire on Saturday for the long 4th of July weekend. It has been too long since I played a round of golf at Blackhawk!

Global Communities and Redemption

Submitted by Jim Casella on Tue, 06/21/2011 - 10:23.

During the recent global financial crisis there were many predictions that live events, whether they were conferences or large expositions, would not recover until 2012 at the earliest, based on the fact that they are considered trailing indicators of a recovery. Historically this has been tied to the commitment and reservation process. Professional communities, though, have proven much more resilient in 2011 than forecast. They have demonstrated again that in our online world live events that bring them together to discuss challenges and opportunities with their peers, as well as with experts and providers of products and services, are very important to them.

Asset International’s global conferences are a very important part of our growth strategy and provide us with the opportunity to bring together financial professionals and the partners that provide them with the products, tools and services that are essential to their profession. This past week Nevin Adams, Alison Cooke-Mintzer and other members of the Plan Sponsor team, including Charlie Ruffel, the founder of Plan Sponsor and a board member of Asset International, produced an outstanding event for the U.S. Plan Sponsor community. Once again it was held at the Fairmont Hotel in Chicago, where Asset International’s Carol Popkins and her team made certain that the event logistics lived up to their promise and provided an excellent venue for the attendees. Foster Wright and our sales team insured that our sponsors received appropriate recognition and were able to meet with their clients in an excellent environment.

As we move further into the year, we have the following lineup of events between now and October:

Strategic Insight Fund Trends 2011 – June 27-28
This event will be produced by Avi Nachmany, Loren Fox and other members of the SI team. It is a one and a half day event and will be held at Chelsea Piers. Bill Dwyer, President of LPL Financial, will deliver a keynote address.

Plan Adviser National Conference – September 12-14
This is the premiere event for the Plan Adviser community and Ali and Nevin will team, once again, to produce it in Orlando, Florida. It has clearly established itself as the major event for advisers in the U.S.

aiCIO Summit – September 22-23
After an outstanding event in New York City in May, Kip McDaniel and his team will hold our 2nd annual event in London. The aiCIO Summit Series has established itself as a must-attend event for chief investment officers globally.

Plan Sponsor European Conference – October 25-27
Nevin Adams will team with Katherine Blackler to launch this event in Barcelona, Spain. It will be held at the Hotel Arts. I am confident that this will become the premiere retirement event in Europe. This event is supported by the strong presence we have developed in London for aiTrade, Global Custodian, Strategic Insight and Plan Sponsor Europe. In the late Fall we will be moving into new office space in The City, which will allow all of Asset International’s London employees to be together.

Professional and Political Golf
Last August I wrote in Changing of the Guard & Inspiration, “The generational challenge has been laid down to Tiger Woods by the Irish golfer Rory McIlroy, who on May 2nd, just before his 21st birthday, ran away from the field at the Quail Hollow Championship.”

McIlroy appeared poised to win his first major tournament in April at The Masters. He entered Sunday with a commanding lead, but then suffered one of the worst collapses in Masters’ history. He shot an 80, which was the highest score by the leader on Saturday since 1956, when Ken Venturi also shot 80 and lost to Jack Burke by one stroke. McIlroy was looking for redemption at the 111th U.S. Open this week at the fabled Congressional course in Bethesda, Maryland. He once again took a commanding lead into Sunday and this time found redemption and his first major tournament victory, winning by a commanding margin at 16 under, 8 strokes better than Jason Day of Australia. With McIlroy only 22 years old and Day just 23 years old, a generational transition has taken place in professional golf. In the process, McIlroy set or tied many U.S. Open records.

Finally, in the spirit of the U.S. Open being held in the Washington D.C. metropolitan area this year, President Obama several weeks ago extended an invitation to Speaker of the House John Boehner. They partnered to take on Vice President Biden and Governor John Kasich, a Republican from Ohio, Speaker Boehner’s home state. They played at Andrews Air Force Base. Scores were not revealed, but the Obama/Boehner team won $2 each from Biden/Kasich. While this outing may not turn out to be the start of a relationship like the fabled relationship between President Ronald Reagan and Speaker of the House Tip O’Neill, it did demonstrate that both parties are starting to understand that there needs to be a bipartisan approach to many of the challenges that face us today.

Basel III and Bank Capital Requirements

Submitted by Jim Casella on Wed, 06/08/2011 - 09:58.

Two weeks ago I sat in my hotel room in Boston and watched HBO’s “Too Big to Fail,” a made-for-television movie by Andrew Ross Sorkin, The characters of Hank Paulson, played by William Hurt, and Ben Bernanke, played by Paul Giamatti, brought back memories of the Fall of ‘08 when our financial world was spinning out of control. (Giamatti is one of my favorite character actors and I particularly enjoyed him as Miles in “Sideways.”) I had read Sorkin’s book and lived through those harrowing days of the Lehman Brothers’ collapse and the freezing of our global credit markets–and still the movie brought back many vivid memories, including Hank Paulson kneeling before Nancy Pelosi. This was during the time that Austin Ventures and Case Interactive Media were negotiating to acquire Asset International. We took a deep breath, moved forward and have not regretted one day of our investment in the financial information services sector. Although there were moments during the first quarter of ‘09 when the road in front of us looked treacherous, we firmly believed that we could navigate our way as we built the company and moved into the global markets.

Back in January 2010, I wrote in TARP Payback: Act II: “On Thursday of this past week, President Obama and his financial team took aim again at our 50 largest financial institutions, those with more than $50B in assets, by proposing a new Bank Tax…. President Obama has called this new tax ‘a financial crisis responsibility fee’… I sense that this populist appeal will play well with both main street Democrats and Tea Party Republicans, but it will not strengthen our financial institutions during a recovery cycle and will probably result in curtailed lending and could end up being passed on to companies and consumers. If both parties were really interested in avoiding a replay of the risk taking that lead to the meltdown of the global financial system, they would be trying to find ways to strengthen the capital base of these institutions and avoid the amount of leverage that resulted in the risk taking in the first place. I believe that the leaders of our largest financial institutions would react positively to a call to strengthen their capital base, as opposed to being singled out again for blame and to pay for the government’s decision to bail out the automotive industry.”

In November 2010 the Group of 20 endorsed the Basel III global regulatory standards. In an opinion piece in the Wall Street Journal, Michael Barnier, the European Commissioner for Internal Market and Services, wrote, “Specifically, Basel III will mandate significantly higher capital requirements and new liquidity standards, so that banks can withstand financial shocks and longer-term funding stress–and better absorb potential losses. Banks will also be subject to measures to discourage excessive leverage.” While there are many other components of Basel III that will be debated in the coming weeks and months, I still believe that increasing the capital requirements for our largest banks will allow them to restore growth and avoid a replay of those harrowing days during the Fall of ‘08. (“Basel III Will Bolster Banks,” WSJ, June 2, 2011)

Professional Sports Rivalry
Starting tonight the Boston Red Sox and New York Yankees start a 3 game series in the Bronx. After Boston’s very slow start to the season and the Yankees being swept in their last series, the American League East has returned to normal and the Yankees take a slim 1 game first place lead into this evening’s game. There is not a better rivalry in professional sports.

Part 1 of the T+2 Checklist: Greater Automation for the Buy Side

Submitted by Tony Freeman on Thu, 05/26/2011 - 14:15.

In a recent industry webinar hosted by Omgeo on the Countdown to T+2, a panel of sell-side, buy-side and other industry participants discussed the prerequisites for the achievement of shorter settlement cycles across Europe. These operational prerequisites include higher levels of automation across the industry as well as securities lending processing, harmonisation of trade fails and faster confirmation of trades - something we refer to as Same Day Affirmation (SDA).

The need for higher levels of automation on the buy-side was a theme that reoccurred throughout the discussion on T+2. Historically, the buy-side has been less focused than the sell-side on automation of middle and back-office functions. Whilst some buy-side firms have made significant progress in automating trade lifecycle processes, overall, there remains a surprisingly large amount of manual processing in settlement stages.

Shorter settlement cycles – which require greater automation as a prerequisite for implementation – should have a substantial impact on the operational efficiencies of medium to smaller sized IMs and the brokers and custodians who service them. In truth, the buy-side – driven by the need to fulfill best execution obligations set by MiFID – has prioritized automation in the front office over the middle and back office and a disconnect now exists in the importance that has been placed on the automation of the settlement function, despite MiFID obligations extending to this area.

What the panel discussions did highlight is that the harmonisation of settlement cycles is not exclusively a back and middle-office issue. High-speed trading is now capable of sub-millisecond execution and yet settlement takes two or even three days to complete - and three days of credit risk exposure is not favoured in anyone’s book. The CSD consultation paper in absolute terms demonstrates the requirements for buy and sell-side to have a more holistic view of trade-flow processes which includes all parts of the trading lifecycle.

A recording of the industry webinar discussion is available at www.omgeo.com.

Boston and California Wine Country

Submitted by Jim Casella on Mon, 05/23/2011 - 15:02.

As we approach Memorial Day, I am working in Boston this week and next. We decided last fall that our expanding client base in Boston, along with a growing number of employees, required an office to insure that we could provide the strong client service that distinguishes Asset International as a company. I am pleased to report that our new office, which will house our Boston-based team, is open for business at 255 State Street. We are within walking distance of many of our largest clients and look forward to working closely with them on both their business intelligence and marketing services needs. I trust that many of us based in New York or Stamford will also find ourselves spending time working out of our new office as well.

As many of you know, both Mary Claire and I have strong ties to Boston and this past week we added a new one. I am delighted to report that on May 18th our first grandchild was born, Angelo James Casella or “AJ,” as he is being called by his parents, Stephanie and Jordan. This insures that our visits to Boston will be extra special and more frequent!

While we will not be in the Bay Area this weekend, I would like to share with you two relatively new boutique wineries: Favia Wines and Mark Herold Wines.

Favia Wines
Annie Favia, formerly of Abreu, and her husband Andy Erickson, the winemaker for Screaming Eagle and Arietta, among others, started their winery several years ago. In addition to Cabernet Sauvignon wines that are released in the fall, they produce outstanding Rhone-style wines. In spite of the small production quantities you can get on their mailing list! I recently joined their list and have tasted their 2008 Quarzo, Amador Syrah. This wine is a blend of four distinctive clones of Syrah. They produced 154 cases.

I also tasted their 2008 Rompecabezas, which is done in a southern Rhone style and is 28% Grenache, 28% Mouverde and 44% Syrah. They produced 174 cases.

These were two of the finest bottles of wine I had this spring. Both of these wines are approximately $65 each. I am looking forward to tasting their Cabernet releases this fall. Their previous releases have been given excellent scores by Robert Parker’s Wine Advocate. www.faviawine.com

Mark Herold Wines
Mark Herold may be known to some of you as the former proprietor of Merus Wines, as well as the consultant on other wineries, including Kobalt. These were two of my longtime favorite Cabernet Sauvignon releases, but a divorce brought about the sale of Merus. He has resurfaced recently with two new releases: 2008 Acha and 2008 Flux. The Acha is a Rhone-style blend of Tempranillo, Grenache, Graciano, Carignan and Syrah. It retails for approximately $45. Flux is a blend of Grenache, Syrah, Carignan and Petite Sirah and retails for approximately $30.

In addition, he recently released a 2009 Collide. This wine is a big spicy red and is a blend of Tempranillo, Cabernet Sauvignon, Graciano and Petite Sirah. This release is not on his website, but can be purchased from Back Room Wines. (Ask for Dan Dawson the proprietor, (877) 322-2576 or www.backroomwines.com.) It retails for $32.00. If you run into a problem getting on to Mark Herold’s mailing list, Dan also carries their other releases, as well as the Favia wines reviewed above. I have ordered from him on several occasions and have been very pleased with the quality of his service. www.markheroldwines.com
Enjoy the long Memorial Day weekend!

Global Commodities Yield Turbulence and the Arab Spring

Submitted by Jim Casella on Tue, 05/10/2011 - 16:18.

Last Sunday evening as I returned to my hotel room after attending the opening reception and dinner at American Business Media’s annual event in Austin, Texas, my cell phone rang and Mary Claire told me to turn on my television — President Obama would be announcing shortly that after almost 10 years since 9/11, Osama bin Laden, the mastermind behind a day that will live on infamously in history as the worst attack on American soil, had been discovered living in Pakistan and had been taken out by a team of U.S. Navy Seals. President Obama and his team of advisors were roundly congratulated from both sides of the aisle in Congress on their bold move and the success of the mission. A strong message was sent around the world that America will protect its interests and carry through with its stated commitments.

The next day, May 2nd, Rania Abouzeid reported from Beirut for TIME: “How the Arab Spring Made Bin Laden an Afterthought“: “There were no banners hailing Osama bin Laden in Egypt’s Tahrir Square; no photos of his deputy Ayman al-Zawahiri at anti-government protests in Tunisia, Libya or even Yemen, a key staging ground for Al-Qaeda in the Arabian Peninsula and bin Laden’s ancestral home…But these militant groups no longer define the Middle East. The Arab Spring is shaking up the region in a manner not seen since Mark Sykes and Francois Picot took to a map with their markets in 1916 and divided up the moribund Ottoman Empire into spheres of interest between Britain and France.”

It looks like the Arab Spring will continue into summer with the developing stalemate in Libya and the ongoing crackdown in Syria. The world’s commodity markets will continue to be driven up and down by shifting sentiments and speculation on what the future may yield. Alan Abelson wrote in his famed Barron’s column, “How thoughtless of Osama Bin Laden! Yes, we know he was a holy terror and all that, but you’d expect a sliver of manners and consideration for others would have rubbed off on him after all those years of hobnobbing with kings and princes. But, no, he had to get himself shot dead in the head and never mind it might wreak havoc on the oil market….Why, the hubbub was so great that it did something even such eminences as Ben Bernanke and Tim Geithner have been conspicuously powerless to achieve — it miraculously revived the supine dollar, which had suffered weeks on end of dizzying vertigo…The unexpected rise of the greenback in response to the dispatch of the odious bin Laden, helped set off a pinch of pandemonium throughout the commodities realm, reaching into the heretofore sacrosanct precincts of gold and silver. Those precious metals had been on a tear spurred in no small measure by gathering fears of inflation fed by the shrinking value of the dollar. When the buck bucked up, such fears diminished enough to trigger a selling stampede.” (Up and Down Wall Street: “Hi-Yo Silver,” Barron’s, May 7, 2011)

On Saturday the Wall Street Journal summarized the week: “Despite Friday’s gains, the Dow Jones Industrial Average fell 1.3% for the week. Oil prices fell 15%, closing at $97.18 a barrel. Silver closed Friday at $35.28 an ounce, a fall of 27% for the week — the metal’s largest percent decline in more than 30 years. Gold fell 4.2%, and copper lost 4.9%.” (”Silver Crashes, Stocks Slide,” WSJ, May 8, 2011)

Against this background Der Spiegel’s website reported that Greece might default and was considering quitting the Euro Zone. This was denied by all, but U.S. treasuries continued to rise. (Barron’s May 7, 2011)

Our own aiCIO reported on May 4th in “PIMCO’s Gross Urges Investors to ‘Revolt’ Against US Government, Buy EM Debt“: In face of rising inflation, Bill Gross, founder and co-chief investment officer of Pacific Investment Management Corporation (PIMCO), is urging investors to embrace local-currency emerging market debt. Gross also counseled in his May Letter, The Caine Mutiny (Part 2): “If AAA quality is your requirement, then Canadian or Australian bonds may also fit your horizon.”

I am looking forward to seeing how the global commodity, currency and bond markets behave this week!

The German Growth Engine and China

Submitted by Jim Casella on Fri, 04/29/2011 - 12:11.

According to data released this past Thursday, “German unemployment fell to its lowest level in two decades in April.” After years of running double-digit unemployment, the total number of unemployed fell below 3 million people for the first time since 1992. Germany’s economy benefited from the strong export of autos and other products. (NY Times 4/28/11) Their unemployment rate now stands at 7.1%. While this strong performance has raised concern regarding inflation, which this month was reported at 2.6% versus the European Central Bank’s target of 2%, it is clear that not only is the German economy on a separate growth path from the rest of Europe, but it is also traveling along a very different path than the United States, where earlier today it was reported that the first quarter GDP slowed to an annual rate of 1.8%. This decline followed an expansion of 3.1% in the fourth quarter of 2010. The confluence of bad weather and a huge increase in oil prices, based on the constant unrest in the Middle East, clearly contributed to this contraction. (NY Times 4/28/11) While most economists are hoping that this decline will reverse itself as the year progresses, I am concerned that if imported oil prices remain high in the second quarter and we continue, once again, talking about raising tax rates, we will find the U.S. economy slowing further than forecast. We seem to have forgotten why we did not raise the tax rates at the end of 2010.

The other real difference in approach to exports between Germany and the United States is that while the Germans took advantage of the weak Euro in 2010 to expand their export trade, particularly of autos to China, the United States went to great lengths to lecture the Chinese about keeping the Renminbi artificially low to increase their own exports. China has clearly been willing, until recently, to trade off a lower unemployment rate for a higher inflation rate. During the past quarter they have started to shift their focus and have raised interest rates in an effort to lower inflation. The more practical German approach has clearly worked to revive the German growth engine, which should help to improve many of the other European economies as long as inflation can be kept at approximately 2.5%. BMW, Volkswagen and Mercedes Benz are all posting record sales in China.

Would an inflation rate of 2.5% in the United States (excluding gas prices) help to revive a very dormant U.S. residential housing market? Until we revive the housing market our economic recovery will remain very fragile, particularly in the Sun Belt states, where unemployment remains at historically high double-digit rates. We also need to have an export strategy that takes advantage of the weak dollar and is tailored to the fastest growing economy in the world, China.

London and Tradition

Submitted by Jim Casella on Sun, 04/17/2011 - 12:56.

Since I launched Case Interactive Media with Austin Ventures in the spring of 2007 and had the vision of building a global professional information services company, I have focused on a strong foundation in two of the pillars of our global financial system, New York and London. I spend at least one week of every quarter, and sometimes longer, in London, where we have seen our business expand both through acquisition and organic growth. On Saturday, April 2nd Mary Claire and I boarded British Airways at JFK for a nine-day trip to London. The Four Seasons at Park Lane, which had been shut for several years for a major renovation, reopened in January. This stay brought back many fond memories of earlier visits in the ’90s. As one should expect, the Four Seasons’ tradition of a high level of personal service was discreetly evident. Plan Sponsor Europe will hold a kick-off luncheon in May at the Four Seasons at Park Lane to launch our first major European pension event, which will provide insights into the accelerating trend in Europe toward defined contribution pension schemes. The actual event, Plan Sponsor European Conference, will take place October 25th-27th at the Hotel Arts in Barcelona, Spain, which is one of the finest facilities for events in all of Europe. Nevin Adams and his editorial team will produce the event.

On Monday evening, April 4th, Andreas Pfunder, Managing Director Europe for London-based Strategic Insight, arranged for a special introduction to one of the United Kingdom’s greatest traditions, Parliament. Mike Freer MP, a Conservative who was elected in the 2010 general election from the constituency of Finchley and Golders Green, gave us a personal tour. His knowledge of both the House of Lords and the House of Commons and their unique traditions was commanding. He was most gracious with his time, and while he was waiting to return for a vote at 9:00 p.m. he joined Mary Claire, Andreas and I for dinner. Mike represents the same constituency from which Baroness Thatcher launched her extraordinary political career in 1959.

I carried on my own tradition of meeting with clients over the course of the week. Without fail the most valuable insights that I gain into the issues our clients are wrestling with come from these personal meetings. Our major global brands, Simfund Focus from Strategic Insight, Global Custodian, Plan Sponsor Europe and The Trade, are all well represented in London and I always return from these trips with new ideas on how we can improve, even further, our clients’ experience with both our business intelligence products and advisory services, as well as the unique marketing services we are able to provide for them as they strengthen their market position and their own core brands.

As we moved to the weekend, John Lee, an entrepreneur and the founder of The Trade, together with his wife Allison treated us to another tradition, the English countryside. We began with a wonderful lunch at Auberge du Lac in Hertfordshire, which is about 1 hour outside of London, from Mayfair. The weather was delightful, in the mid-60s, as it had been for most of the week. Spring had clearly arrived in London! We then visited Allison and John’s 600+ year-old home, where they have just completed a marvelous renovation. The exposed beams in the center of the home, with their special etchings, provided an insight into a time long ago. One could not help but be reminded of the important tradition of preservation of our past as we sat in the garden and watched the sun slowly set in the west.

In praise of social bandits

Submitted by Dominic Hobson on Tue, 03/29/2011 - 15:18.

Marco Sciarra was a Neapolitan bandit of the late 16th Century. He described himself as an “envoy of God against usurers and the possessors of unproductive wealth.” Short sellers make improbable folk heroes, scourges of big business and the banking industry, or defenders of the disinherited and the dispossessed. But this is only because centuries of establishment propaganda have demonized short sellers as the most antisocial of all capitalists: ones that add nothing to the general stock of wealth but succeed somehow in taking large amounts of it off that most desirable of political and corporate constituencies—the faithful, long-term investor. The truth is more interesting than the myth. Short sellers have far more in common with Marco Sciarra than any of the hypocritical politicians and self-satisfied bureaucrats that are behind the regulation on short selling issued by the European Commission on behalf of the European Parliament and Council in September last year, and which is now approaching the apotheosis of being voted into law. The principal ambitions of this legislative proposal are to codify the wide variety of restrictions on short selling imposed by European regulators at the height of the financial crisis in September 2008. If passed, it will create new powers to restrict short selling on a Europe-wide scale, ban “naked” short selling altogether and force investment banks and fund managers to disclose to regulators any net short position that exceeds 0.2% of the share capital of the issuer and make known to the marketplace any net short position that exceeds 0.5% of share capital.

As even the framers of these proposals concede, the technical case in favor of short selling is invulnerable. Practical experience of dozens of bans on short selling over hundreds of years, including the wide variety imposed (and indeed not imposed) by regulators all over the world in 2008, has proved that the practice is essential to market liquidity. Where short selling is banned or restricted, trading volumes diminish, bid-offer spreads widen and price volatility increases. A string of academic studies has added only statistical rigor to this obvious empirical fact. The deleterious impact of restrictions on short selling is so well-understood that even the authors of the European Commission proposal itself accept “short selling contributes to the efficiency of markets,” and “increases market liquidity,” and that any measures that are enacted by national governments at its behest as a result should not undermine “the benefits that short selling provides to the quality and efficiency of markets.” Yet a recent study by consultants Oliver Wyman of the likely impact of increased disclosure requirements proposed by the European Union predicts that they will reduce the volume of trading activity in affected stocks, increase the volatility of prices, increase the reporting burden on fund managers, decrease the willingness of corporate executives to meet fund managers and divert investment and trading capital from Europe to Asia. If this last trend persists, it will make it harder and more expensive for European companies to raise equity capital. But the likely consequences extend beyond issuers to shareholders. Whether institutional or retail, they face increased trading costs and mark-to-market losses, a reduced ability to hedge the risk of long positions, an increased risk of falling victim to a short squeeze and a straightforward loss of revenue from lending stocks as short positions are curtailed.

True, the Oliver Wyman study was commissioned by one interested party (AIMA), funded by another (Deutsche Bank) and based on a mixture of interviews with a third (hedge fund managers) and data supplied by a fourth (Data Explorers). But an idea should be judged by its enemies as well as its friends. Chief among the opponents of short selling are that breed of politician that believes a country must not only have a large manufacturing sector, but must manufacture certain classes of products, such as airplanes and motor cars; that the purpose of economic activity is not consumption but production; and that it is the role of governments to determine the economic structure of the country, and to formulate industrial strategies to that end. It is not surprising that trade union leaders and CEOs of large corporations are apt to applaud reasoning of this kind, though it is based on economic fallacies of the most primitive kind, for their own interests lie in insulating the status quo from the potentially destructive effects of competition for capital. After all, a short sale is one way of saying that other managers and workers could make better use of the capital. There is opportunism at work as well. It is not surprising that politicians institute bans on short selling whenever a market crashes. Their alternative is to confess that they have mismanaged monetary policy (and in all likelihood fiscal policy as well). Likewise, the CEO of a large company is naturally disinclined to believe that a plunging stock price has anything to do with his or her mismanagement of the assets of the company. As Gordon Gekko famously pointed out in that compelling depiction of an AGM in Wall Street, corporate CEOs have an unhappily long track record of mistaking the resources of the company for their own. Many end up as latter-day possessors of unproductive wealth of the kind that Marco Sciarra sought to repossess in early modern Italy. Sometimes, of course, they are worse than that. But it is short sellers who have the strongest incentive to uncover fraud, accounting problems and other irregularities at large corporations.

Regulators and central bankers know all this, of course. But they also know who their paymasters are, and who allocates jobs in the regulation business. In fact, the Oliver Wyman report includes a revealing remark made to a journalist by Martin Wheatley, the CEO of the Hong Kong Securities and Futures Commission (SFC), who will join the Financial Services Authority (FSA) in London in September this year as managing director of its consumer and markets business unit. “There is always a problem when regulation is politicized,” he says. “You get an odd outcome then. Regulation should be pragmatic. Regulators are really technocrats who take account of predictable outcomes. When they have to respond to political pressure, you get a different result.” Though politicians are always on the lookout for a scapegoat on to which the voters can heap their sins and those of their elected representatives, it is easy to forget that the political pressure does not stem from voters alone, especially in advanced democracies governed by financial-political elites of the kind that now run the United States, the United Kingdom and most of the major states of Western Europe. John Mack, the former CEO and current chairman of Morgan Stanley, achieved a certain notoriety in this respect. It was on Sept. 17, 2008, that he, as CEO of the largest prime broker in the business, told staff that “short sellers are driving our stock down” and that he and his senior colleagues were “taking every step possible to stop this irresponsible action in the market.” Those steps included pressing the Treasury secretary and the chairman of the SEC to do something about it, and short selling of financial stocks was duly suspended 2 days later. The implication that short sellers were the proximate cause of the financial crisis, rather than balance sheets leveraged 30 times or more to acquire oceans of low-quality structured credit manufactured for little purpose other than its financeability, was obviously convenient to all parties. As it happens, far from driving stocks daily to new lows, we now know that hedge funds were actually net buyers of equities in the weeks immediately prior to the collapse of Lehman Brothers on Sept. 15, 2008.

Ironically, given the willingness of even senior public officials to make substantial policy changes on the basis of unsubstantiated claims of the most outlandish kind, it is one of the stated purposes of the European regulation on short selling to increase “transparency.” Yet forcing short sellers to disclose their positions might actually have the opposite effect. Where short selling is not deterred altogether, it will assume synthetic forms, or gravitate to less onerous jurisdictions. It will in all likelihood reduce the quantity of information made available to the markets through diligent research. Hedge fund managers told Oliver Wyman that companies are already freezing them out of their investor relations programs if they find they have a short position in their company stock. A subsidiary aim of the disclosure requirements is to prevent “information asymmetries if other market participants are not adequately informed about the extent to which short selling is affecting prices.” This extraordinary statement makes sense only if the authors believe that selling a stock does not disclose information to the market, or that those who guess correctly that a stock price will fall are in a morally inferior position to those who guess incorrectly that it will rise. True, short selling is a zero-sum game. The profits that accrue to short sellers are exactly equivalent to the losses incurred by those who buy and held the stock that is shorted. But unlike a career in European politics, where the salary of an MEP is taxed at 15% and the permissible expense allowances alone run up to €400,000 a year, short selling does entail risk. A short position has sometimes to be financed, not for days or weeks or even months, but for years. Even then, it might turn out to be wrong, and yield a ruinous loss instead of a massive profit. In fact, the losses on a short position are potentially unlimited: There is no cap on how high a share price can rise. Far from achieving the quixotic aim of preventing short sellers expropriating the wealth of shareholders who chose not to sell, disclosure requirements will expropriate the investment decisions of fund managers and make them available to everybody. There are already plenty of day traders trying to piece together from public information the investment strategies of Warren Buffett and John Paulson, and disclosure will equip them with a further source of data. The proposed European regulation can only enlarge their number, further increasing the mismatch between buyers and sellers.

If a mismatch persists, a market is likely to become directional. Though the authors of the European regulation say they are concerned primarily to avert “an excessive downward spiral in prices leading to a disorderly market and possible systemic risks,” an absence of short sellers is just as likely to lead to an excessive upward spiral in prices. Short sellers put a floor on the decline of any market, because at some level the short sellers must cover their short positions. But they temper also the errors of optimism to which markets are prone. The investment bubbles now inflating in Brazil and China are in desperate need of short sellers to limit the eventual damage. Making it harder to short stocks in Europe is likely only to inflate them further, as allocations are diverted from European markets. Keeping asset price bubbles in check is not the principal role of short sellers, but it is one they are admirably designed to fulfill. They are contrarians by temperament. They are natural dissenters from the consensus. They ask the questions of corporate CEOs that journalists are too lazy to research and too easily corrupted to pose. It is short sellers that find the companies that are lying about their earnings, or the strength of their balance sheet. Enron and Tyco were being shorted long before journalists or regulators or lawyers discovered the management of the companies were not what they purported to be. Short sellers have as much interest in discovering and exposing corporate malfeasance as any investigative reporter, and more resources to pursue it with. They are allies even of the environmental movement and the labor campaigners, for a company that pollutes the landscape or mistreats its employees will see a fall in its share price. In the same way as they rescue investors from incompetent or corrupt management, they rescue voters from incompetent or corrupt governments. It was the hedge fund managers that shorted European currencies hard enough to release European economies from the bondage of the Exchange Rate Mechanism in 1992. In time, they will release them again from their enslavement by the euro.

They will not be thanked for the trouble. Short sellers are, like ticket touts, deeply underappreciated servants of the public interest. There is a growing awareness in the industry of this potentially catastrophic failure of communication. The responses to the Global Custodian survey of securities lending published in this issue are replete with regretful allusions to the negative public image of the practice. The reputation of its twin sister, short selling, stands lower still. Short sellers have allowed people and interests other than their own to shape the public understanding of their character. As a result, they are synonymous not with performing a useful social function, but with excessive rewards, and speculative attacks on long-established currencies and companies. This is the handiwork of politicians and corporate CEOs eager to blot out their own errors of judgment. It is almost certainly futile to hope that the prime brokerage or securities lending or hedge fund industries will spawn an articulate and attractive defender of the practice of short selling. The few that raise their standard are apt to present their case in overly technical terms, and to believe that their opponents are open to persuasion rather than anxious to pin the blame on others. What short sellers need to do is follow the example of Carl Icahn, who transformed himself the corporate raider of the 1980s into the billionaire Robin Hood of the 21st Century. They need to break with the image their opponents have cast for them, and reveal their true nature as rebels and outsiders. They must cease to be people who make out like bandits when corporations and banks mismanage the wealth of others, and become what Eric Hobsbawm called social bandits. These are rebels treated by the establishment as outlaws, and even hounded as criminals, but which the people come to love as the champions of truth, avengers of those whose property is expropriated by others, and liberators of economies from the wealth-destroying projects of power-hungry politicians. In the eyes of the public, they need to become less like Fred Goodwin or Dick Fuld, and more like Marco Sciarra.

Countdown to T+2

Submitted by Tony Freeman on Tue, 03/22/2011 - 15:49.

In the recent consultation paper on the regulation of Central Securities Depositories, the European Commission has advocated T+2 as the favored settlement cycle for Europe. While the markets have become accustomed to divergent cycles, there is substantial evidence that non‐harmonization in this area increases operational risk, which would be mitigated by a move to shorter settlement cycles.

The commission has now published all the responses and most respondents favor the proposal. You can read the public responses here.

The smooth transition to T+2 by a potential deadline of 2012 will be dependent on a number of important operational and environmental prerequisites. That said, if the goal of shorter settlement cycles is to be achieved, market participants will need to re‐engineer operational processes and create higher levels of post trade automation.

For example, in 2010, Omgeo conducted a study that showed that verifying a trade on the day that it has been executed creates much greater settlement efficiency and in fact may be a pre‐requisite for shortened settlement cycles. The full report, Mitigating Operational Risk & Increasing Settlement Efficiency with Same Day Affirmation (SDA) can be found here.

From an operational perspective, faster confirmation of trades is an important building block in achieving T+2. It is something we refer to as same day affirmation (SDA) and is defined as “the agreement of all trade details on trade date between a broker/dealer and investment manager.”

The case for SDA is based on the single premise that by agreeing on the details of a trade more quickly, operational risk, costs and efficiencies are significantly reduced. If trade details are locked in sooner rather than later and confirmed on trade date, there is greater opportunity to identify and resolve any potential errors.

Settlement failures are an indicator of trade processing inefficiency and add cost as well as operational risk to the trading activities of buy‐side and sell‐side firms, many of which are already under strain from processing increased volumes due to smaller trade sizes. The speed and accuracy of trade processing in the middle office has a direct impact on the efficiency of the settlement function for these firms and therefore deserves close attention in the policy debate – which in truth has been lacking in comparison to the downstream processes of clearing and settlement.

One of the principle objectives of the middle office is to capture and disseminate accurate trade details as efficiently as possible. It is a vital function that drives efficiencies downstream since it is not possible to minimize operational risk without having an accurate near real‐time picture of what has been traded.

The financial services industry has made important steps toward improving operational efficiencies and this latest consultation process on CSDs and the harmonization of settlement practices launched by the European Commission provides an opportunity for the industry to streamline processes in the middle‐office, thereby reducing operational risk.

Working with policymakers to achieve the proposed T+2 settlement cycle – and ensuring that the operational processes are in place to enable its implementation – should be a significant focus for the securities industry over the next 12 months.

Bernanke and the Fed vs. Buffett, El-Erian, Gross and the Investor

Submitted by Jim Casella on Mon, 03/14/2011 - 12:44.

On March 2nd aiCIO reported in its Daily News, Following PIMCO’s El-Erian, Warren Buffet Discourages QE2, “Echoing statements made by Pacific Investment Management Co.’s Mohamed El-Erian and Bill Gross, Berkshire Hathaway’s Warren Buffett has said the US does not currently need an economic stimulus.

“The sentiments by the financial heavyweights reflect waning public support for the Federal Reserve’s effort to stimulate the economy as well as fears that the US cannot continue with the stimulus.

“In an interview with CNBC, Buffett explained that despite his respect for Federal Reserve chairman Ben Bernanke, he believes the US does need to continue its quantitative easing program, dubbed QE2, as there has been a tremendous amount of government stimulus since the beginning of the financial crisis….Previously, El-Erian has said that the cost of the Federal Reserve’s actions is starting to outweigh the benefits. In an interview with CNBC, El-Erian said the central bank should calculate how it can exit from its multi-trillion dollar quantitative easing program.”

Several days later Bill Gross of PIMCO weighed in, “Speaking of investment tips, no clue or outright signal could have been any clearer than the one given in December 2008, labeled ‘Quantitative Easing.’ While the term was new, the intent was obvious: (1) pump public money into the financial system to replace private credit that was being destroyed in the process of deleveraging; (2) lower interest rates on intermediate and long term-mortgages/Treasury bonds and in the process flush money into risk assets - most visibly the stock market; and (3) forecast publically then hope that higher stock prices would lead to a wealth effect, and in turn generate new private sector lending, job creation and a virtuous circle of economic expansion that would heal the near-fatal wounds of Lehman and its aftermath. If that was the game plan, then so far, so good, I’d say. Interest rates are artificially low, stocks have nearly doubled since QE1’s first announcement in December of 2008, and the U.S. economy will likely expand by 4% this year, although a $1.5 trillion budget deficit must share QE’s Oscar for most stimulative government policy of 2009/2010.

“Many critics, though, including yours truly, would wonder whether Quantitative Easing policies actually heal, as opposed to cover up, symptoms of an unhealthy economy.” (PIMCO, Investment Outlook, Two-Bits, Four-Bits, Six-Bits, a Dollar)

From an investment standpoint, PIMCO has determined that the spread is too low on Treasury notes and answered their own question, “Who will buy Treasuries when the Fed doesn’t?,” by announcing that they had exited U.S. government debt and liquidated their holdings in PIMCO’s heavyweight Total Return Fund.

Some have questioned how long PIMCO, the leading bond fund investor, will stay out of the U.S. bond market. Michael Mackenzie weighed in, “But this move away from Treasuries could prove costly for Pimco…To say no to Treasuries, the most liquid of bonds, means you are dismissing a haven that warrants being part of your portfolio. It is an interesting stance at a time of Middle East turmoil and the unresolved debt woes in the eurozone.” “There is much to be said for not following the herd, but as traders warn, the reward of being first to a new investment opportunity must be weighed against the risk of being eaten by an unforeseen foe,” he concluded. (FT, March 11, 2011, Bond king’s Lear-like Treasuries renunciation)

In the interim, Ben Bernanke has not changed course in response to public calls by Buffett, El-Erian and Gross on behalf of the investor. As the week wound down, we saw how difficult it is to predict when a central bank will make a change in direction. Alen Mattich in The Wall Street Journal wrote, “Yet again, the Bank of England delayed the inevitable, holding interest rates steady at the latest monthly meeting of its Monetary Policy Committee. So far, the MPC has managed to keep the market on its side, despite interest rates at historic lows and still-climbing inflation. But bond investors’ willingness to accept negative real yields is likely to be wearing thin…Europe’s bond markets are broadly divided into three groups. There are the untouchables, like Greece, Portugal and Ireland. There are the high-quality issuers, like Germany, France and the U.K. And there’s an intermediate purgatory, in which Italy and Spain sit, where yields are painfully high but still serviceable. It’s unlikely to take much to push the U.K. into a purgatory of 5% to 6% yields on 10-year debt, Mr. Jeffrey says [Richard Jeffrey, chief investment officer at Cazenove Capital Management]. That may not be much above inflation, but it would be enough to inflict serious pain on an economy as heavily indebted as the U.K.’s. And serious pain for the U.K.’s bond holders as they watch the value of their assets fall.” (WSJ, March 11, 2011, BOE Doves Living on Borrowed Time)

This debate will go on in both countries against the backdrop of rising oil prices caused by the continuing chaos and struggle in Libya and the other Middle East oil-producing nations. We all woke up on Friday to the horror of the massive earthquake and tsunami in Japan, whose shear size and deadly impact rattled the global markets. Humanitarian rescue and support efforts have begun, while the world anxiously watches for potential meltdowns of several nuclear reactors. This island nation and its people have shown before that they are resilient and I trust that they will start to rebuild their lives and their country in the coming months.

Trillion Dollar Rescue Plan and a Changing of the Guard: Part II Ireland

Submitted by Jim Casella on Mon, 02/28/2011 - 15:48.

Last May I wrote, “As we headed to JFK early on Monday morning for our BA flight to London, we learned that over the weekend the Eurozone leaders had fashioned a rescue plan that went well beyond Greece.…The world markets remained concerned that the new austerity measures imposed on the PIIGS (Portugal, Ireland, Italy, Greece & Spain) could lead to another recession in Europe while the world slowly recovers from the Great Recession…This was clearly a historic week on the continent and in the United Kingdom. There is a new determination to deal with the structural issues that have left most of the countries with debt loads that the global bond markets cannot support in the long run, and there is a new resolve by these countries to put themselves on a course that will support sustainable long-term growth.” I closed with, “Mary Claire and I have flown to Dublin for the weekend and will return to New York on Monday evening.” While we had a wonderful three-day weekend in Dublin, which has a special charm and many excellent restaurants, I did not report on the one thing that caused me concern. As we left dinner on Saturday evening and looked for a cab to take us back to our hotel, I saw a line of idle cabs longer than I had ever seen in New York City or London. After we got into a cab, I asked the driver why there were so many cabs available. He responded that the vast majority of the drivers had worked the past several years in the construction trades and the only work they could find now was driving a cab, but there was not enough demand for them to earn a fraction of their previous wages. It struck me then that the recovery of the housing and commercial construction markets around the globe would take a long time and the human cost would be very high.

Against the backdrop of street revolutions sweeping through the Middle East and eastern Africa and with the world focused this week on the bloodshed in the streets of Tripoli, where Colonel Qadhafi appears unwilling to leave and clings to power, vowing to fight unto his death, Ireland went to the polls this week. The Irish delivered a Democratic revolution, dealing a resounding defeat to the Fianna Fail party, which has ruled Ireland for most of the past 85 years and has been in power for the past 13 years during the rise and collapse of the Celtic Tiger. (WSJ 2/26/2011)

Fine Gael, a center right party, will most likely form a coalition government with the left-of-center Labour Party, based on all the early polling results. Fine Gael’s leader, Enda Kenny, appears likely to be the next Prime Minister. (FT 2/26/2011) He will inherit a country where the voters are clearly unhappy with the burden they have been left with after the near collapse of their banking system and the bailout that was agreed to with the European Union and Central Bank. I trust that there will be much talk of renegotiation, but this will be an unlikely outcome and the austerity programs will remain a way of life for many years.

Last week Guy Chazan reported in the Wall Street Journal, “The people of Ireland go to the polls Friday to deliver what’s expected to be a knockout blow to the governing party. But many are choosing to vote in a traditional Irish fashion: with their feet. Tens of thousands are joining in a new wave of emigration, turning their backs on a country mired in economic malaise….Forced emigration was long Ireland’s curse. A million fled in the decade after the great potato famine of the mid-19th century, which killed some 800,000 people. There was a huge exodus a hundred years later, with thousands lured away by a building boom in the U.K. Another mass migration followed in the 1980s.” (“Irish Remedy for Hard Times: Leaving,” WSJ 2/24/2011) Many are emigrating to the U.K., Australia, New Zealand and Canada, as well as other European Union countries. Once again, we are seeing that jobs will be the defining issue of global elections for the democratic governments trying to recover from the Great Recession. Against this backdrop, we will hear arguments regarding deficit reduction and austerity programs versus Keynesian economics. The right balance will define those who gain power and try to advance the recovery versus those who are thrown out by the voters. I expect the recovery to continue, but the unemployment rates will remain stubbornly high in the U.S., the U.K. and on the Continent until housing and commercial construction recover.

Fee Billing in 2011: Out with the Old; In With the New

Submitted by Shaun McGee on Fri, 02/25/2011 - 16:14.

Of course global and sub-custodians want to provide the very best in service to their institutional clients across a range of services - safekeeping, settlement, registrar and transfer agency services etc. The sticking point is coping with today's complexity and having processes that can both genuinely cope and are trustworthy in their clients' eyes. The days of Excel and Access are over.

The nature of a competitive market leads to negotiated price points on value and service, which when combined with different methodologies or models, increases complexity in the fee schedules.

Manual calculations taking place on a monthly or quarterly basis are no longer considered acceptable due to the associated costs and revenue risks. To avoid errors and late billing, custodians need a more concrete way of being able to deal with fees rather than working off of spreadsheets. Not to mention the lack of audit trails. Clients want accurate, timely and flexible billing despite the ever-increasing volumes and complexity of fee arrangements.

One of the main challenges faced by the operational departments is in data management. All the data required for billing of custody and fund accounting is often available within a multitude of systems, however, proper extraction of data in a timely fashion which is compatible with the billing function, is rarely repeatable with manual processes.

Inefficient billing impacts revenue and leaves clients wondering if they can trust the charges they're being asked to pay. The business case for automation is real and delivers a platform to provide innovative products and services at the right price against the changing custodian landscape.

Breaking up is hard to do

Submitted by Dominic Hobson on Fri, 02/25/2011 - 11:09.

In 1959 the Canadian sociologist Erving Goffman published "The Presentation of Self in Everyday Life". He shocked polite opinion with his claim that a man can be "sincerely convinced that the impression of reality which he stages is the real reality." That human beings deceive themselves in order to deceive others better is now a staple of evolutionary psychology, but the study of deception among animals has only stamped with the imprimatur of science what was obvious to Robert Burns as long ago as 1786. More than two centuries later, there is still no power that has given us the gift to see ourselves as others see us. Lloyd Blankfein ("Doing God's work"), Bob Diamond ("That period is over"), Barney Frank ("People really hate you") and Poul Nyrup Rasmussen ("When I listen to you it's like you're living in another world") are only vivid editions of the universal fact that it is only by convincing ourselves that we are right and good that we can convince others of our moral and logical rectitude. The result is a collective dishonesty about the origins of the financial crisis, and the remedies for it. Even now there are plenty of people in business and journalism, as well as in politics and banking and central banking, who have convinced themselves that the creation of credit is the source of the generation of wealth.

The truth is that in the long run credit adds nothing to the stock of wealth. It is a zero-sum game, which redistributes wealth from those who get their timing right to those who get their timing wrong. Its persistence owes little to its contribution to material progress, and everything to the fact that bankers and politicians use central banks to manufacture money and credit to their mutual advantage. Over the last three decades they have orchestrated one of the longest credit cycles in history. Between 1978 and 2007, the volume of borrowing in the United States to finance purely financial transactions rose four times as fast as borrowing by individuals to buy houses or cars or by companies to build factories or buy goods. That calculation does not even include the leverage added by OTC derivatives, which grew from next-to-nothing in 1978 to a gross market value of $35.3 trillion at the end of 2008. Derivatives feasted on securitizations, especially of commercial and residential mortgages. These became increasingly complex transactions, in which multiple tiers of credit, or "tranches," were created out of the liabilities of a single issuer. They gave rise to structured credit instruments (such as CDOs and CLOs) and credit derivatives (such as the notorious CDSs). By the final stages of the boom, there were synthetic CDOs and even CDO Squareds. Because they ate no regulatory capital, derivatives added yet more leverage to the financial system. By the eve of the financial crisis in 2007, investment banks were creating complicated credit instruments not as a way to earn underwriting fees, but as a liquidity management tool.

That is why so much of the MBS and ABS and structured credit ended up not in the hands of end-investors, but on the balance sheets of investment banks and hedge funds, and sometimes off the balance sheet in SIVs and conduits too. Banks and hedge funds were in effect manufacturing their own collateral, to raise the funds to expand their balance sheets. It was not so much a case of "originate to distribute" as "securitize to finance." And financed they were, by short-term borrowing, chiefly in the repo markets. For years, investment banks and others collected an apparently risk-free spread between the cost of borrowing in the repo market and the yield on structured portfolios of bonds that they pledged as collateral. Some called it matched book trading. Others insisted it was nothing of the kind. What matters is that by 2007 the survival of the leading investment banks depended on cash-rich banks continuing to take as collateral pretty much whatever credit instruments they chose to hold. One of those banks was Bear Stearns. By 2007, its balance sheet was leveraged 33 times to 1. In other words, a movement of just over 3% in the value of its assets was enough to obliterate the capital of the firm. It was using the repo market to finance a portfolio of around $150 billion of illiquid credit instruments, including MBS, ABS, corporate bonds and CDOs. In effect, the Bear Stearns repo desk was using short-term funding as longer-term financing through repeated rollovers with the same counterparties, using the same collateral. Its ability to continue to finance the firm depended entirely on the assumption that the collateral would remain liquid, and financeable.

That assumption was proved false on Aug. 9, 2007. That day BNP Paribas suspended redemptions in three structured credit funds because, as the bank explained at the time, of a "complete evaporation of liquidity." Repo rates soared. The value of structured credit as collateral collapsed. Margin calls increased. Haircuts, even on AAA-rated ABS, rose from 3% or 4% to 50% to 60%. This was not what was meant to happen. Secured forms of lending, like repos, were expected to remain liquid while unsecured lenders withdrew. Yet the European repo market shrank from €6.8 trillion in June 2007 to €4.6 trillion in December 2008. The US Treasury repo market shrank from $1.3 trillion in December 2007 to $659 billion in December 2008. The US tri-party market shrank from $2.8 trillion in early 2008 to $1.7 trillion at the beginning of last year. This was more than deleveraging. As a recent report by the BIS Committee on Payment and Settlement Systems notes: "During the recent financial crisis, some repo markets proved to be a less reliable source of funding liquidity than expected." Far from the repo markets taking the place of unsecured financing, central banks ended up using the reserves of banks that would not lend to other banks to lend to banks. It was on Aug. 9, 2007, that the European Central Bank and the Federal Reserve made the first of their many interventions in the money markets. By March 2008, the Federal Reserve was lending directly to US broker-dealers for the first time in its history.

There could scarcely be a more dramatic illustration of the loss of confidence, not in counterparties, but in collateral. The banking crisis of 2007-09, like the milder banking crisis of 1998, proved collateral was not the solution, but the problem. In retrospect, the reliance of investment banks on collateralized funding in the wholesale money markets was just one part of a seismic shift within the banking industry as a whole, from long-term and stable sources of finance (such as retail deposits) to short-term and unstable sources of finance (such as repo). The AAA-rated tranches and structured credit instruments being financed in the repo market, like conduits and SIVs and the mania for money market funds, were all symptomatic of that shift. The real vulnerability in the banking systems of the world by 2007 was their reliance on a naturally unstable source of short-term funding: the wholesale money markets. The lenders are well informed, the sums are large, the transaction costs are significant and the terms are shorter and less predictable than a monthly salary deposited in a bank account. They are far from certain to be rolled over.

Yet, as the crisis broke in 2007, around half of the $6 trillion US repo market was being refinanced every night. In Europe, 40% of the repo market was being financed on a daily basis, 40% at maturities no greater than a week, and 60% at maturities no greater than a month. There was of course a powerful macroeconomic impetus behind this absurdly risky process. The wholesale money markets are a much more efficient way of recycling global imbalances. They are one of the principal means by which money is recycled from countries that save (such as China, Germany and Norway) to countries that spend and borrow (such as the United States, the United Kingdom, Spain and Greece). The credit-driven world is not one in which rich Americans save the wealth of a mature economy to invest in the lavish opportunities of emerging markets. It is a world in which impoverished Chinese workers earn dollars to recycle to American banks so that they can lend money to rich American consumers to buy Chinese goods.

This is where the repo market meets the politico-cultural addiction of Western civilization to credit. In most Western economies, democracy has come to mean the right to refinance a house at a lower rate of interest, pay for everything with a credit card and vote for whoever will give you the most of someone else's money. For decades, Britons and Americans in particular have preferred importing and consuming to producing and exporting. There is nothing intrinsically wrong with that. After all, the purpose of production is consumption. But it is a matter of arithmetic that people cannot continue indefinitely to spend more than they earn, even if they can do it for a surprisingly long time. As P.J. O'Rourke put it in The Wealth of Nations, "imports are Christmas morning; exports are January's MasterCard bill." That bill may be surprisingly large, and not just in financial terms. History suggests that large current account imbalances are not resolved gradually but instead in a series of wrenching political and economic crises - of which what is happening in the euro area today is almost certainly just the first of many.

Yet the travails of the euro are merely one malignancy among the many spawned by the nexus between bankers, central bankers and politicians, which makes it impossible to halt the credit cycle. A previous generation would see the current attempts to rescue the euro as a "bankers' ramp." It is not only that, but also a successful attempt by politicians to escape the constraints imposed on credit and money creation by currency competition, and especially by the sound money policy of the Bundesbank. The consequences are now unfolding. The euro has turned out to be a powerful engine for the transfer of wealth to countries that inflate their supplies of money and bank credit faster than others. The sight of the ECB accepting as collateral against loans to European banks Greek government bonds reduced to junk status is an illustration of how the credit cycle aligns perfectly the interests of politicians and bankers. Investment bankers were content to rely on overnight forms of finance secured on illiquid and even synthetic collateral because they knew the risks they took were underwritten in the first place by the central banks, and in the second place by the taxpayers.

The only permanent way of breaking this nexus is to put out of commission the tails-I-win-heads-you-lose money creation machine, fueled by central banks under pressure from politicians to maintain a permanent boom, and operated by private banks under pressure from shareholders to increase revenues and profits by growing the balance sheet. To believe that it can be tamed by slightly higher levels of capitalization (as proposed under Basel III) and slightly improved systems of regulation (as proposed by everything else) is Goffmanism of the purest kind. Yet there is enough at stake for politicians and central bankers to deceive themselves into thinking that it is possible not only to grasp the behavior of financial markets, but to regulate it. The modish device of choice is the CCP. It is being applied, or applied more widely, in markets as various as equities, OTC derivatives, repo and reverse repo. The fact CCPs are being embraced so enthusiastically by banks ought to worry more people than it does. Banks have spent the last 30 years inventing ways to take on more risk for less capital, and capital relief for CCP-intermediated trades offers them a new tool for doing exactly that. Investment banks broking centrally cleared OTC derivatives are already advertising to hedge fund clients that CCPs will reduce the collateral they are obliged to post.

But whatever their merits and demerits, CCPs do not address directly the central issue raised by the financial crisis of 2007-09: Collateral liquidity risk is less stable than counterparty credit risk. After all, not many of the MBS and ABS and structured credit from which the market fled in 2007 and 2008 proved delinquent. Much has already redeemed at par. Yet investment banks continue to maintain modest trading limits, not because they distrust counterparties, but because they are not confident they can liquidate collateral in difficult market conditions. Far from solving that problem - and despite repeated claims they have proved they can liquidate collateral in an orderly fashion - CCPs might actually make the problem worse, by appropriating liquid collateral, and concentrating some risks while excluding others. With or without a CCP, collateralized lending is vulnerable to the fear of illiquid collateral prompting destabilizing margin calls and haircut increases and rollover withdrawals, in which markdowns of illiquid collateral drive further margin calls, haircut increases and rollover withdrawals. That is exactly what happened in 2007-09.

Central bank intervention never broke that damaging positive feedback mechanism, because it could not. Central banking was, and is, part of the system, not separate from it. Even now, nearly 2 years on from the nadir of the crisis in March 2009, and despite the expiry of many of the special measures taken at the height of the crisis, central banks are still densely involved in financing the private banking industry through auctions against eligible collateral. Higher liquidity requirements are likely to ensure at least part of this inflation of central bank balance sheets becomes permanent. Weaning the banking industry off central bank money and returning banks to financing themselves in private markets, like reversing the effects of quantitative easing, will be far from easy. Indeed, the continuing reliance on central bank funding is the most obvious measure of how the financial crisis has tightened the nexus that binds politicians, bankers and central bankers. It is not excessive to say that the crisis has exposed the true nature of the relationship between commercial banks, central banks and high spending governments. Deficits are funded in large part by the sale of government bonds to the banking system. Banks are happy to buy them because they are eligible collateral at the central bank. The decision of the ECB to buy Greek government bonds, despite their junk status, is the reductio ad absurdum of this ugly coincidence of interests.

The consolidation prompted by the crisis is another perverse consequence, because it has concentrated power in the banking industry to an extent that makes a major bank failure unthinkable. In the US tri-party repo market, for example, the top ten broker-dealers account for 85% of the securities being financed, and the top ten cash providers for 65% of the money advanced. The largest individual cash providers are putting $100 billion a day into tri-party, as a matter of routine. The 52 banks that took part in the latest ERC survey account for EUR6.9 trillion in outstandings or, without adjusting for double counting, EUR134 billion per bank. "Moral hazard" is no longer a theoretical possibility, but a fact of daily working life in the banking industry. A choice between letting the entire financial, economic and commercial system collapse, and funding banks when the wholesale money markets will not, is not a choice at all.

But if the funding of banks in the wholesale money markets is now on such a scale that only the full faith and credit of taxpayers can underwrite it, because only governments can commandeer taxes and confiscate property of commensurate value, it is time to ask not whether the risk should be concentrated at CCPs but whether it should be concentrated at all. As even Alan Greenspan has now conceded, if banks "are too big to fail, they are too big." Yet the basic premise of current policy, whether by accident or design, is that a smaller number of large but systemically important banks is easier to regulate successfully. It is not surprising that the big banks themselves have endorsed this view, since it raises the barriers to entry, and gives them a distinct funding advantage over their competitors. The head of the investment banking arm of one of the largest banks explained recently that his clients needed his bank to be "this big." In fact, they need the opposite. After all, the American economy rose to greatness in the 19th Century with a completely fragmented and decentralized banking system, characterized by a high rate of failure. It did not even have a lender of last resort until 1913. Though it is customary to argue that the creation of the Federal Reserve marked the coming of age of American finance, it is was really an early instance of the state being placed at the service of the banks. They gained a backstop that could bail them out with public funds, and which they could direct because they occupied two-thirds of the seats on the board. The Fed was still there, and the bankers were still on the board, on Aug. 9, 2007.

As a result of that and subsequent episodes - indeed, because and not in spite of the failure of Lehman Brothers - the threat that a central bank will ever allow a mismanaged bank to fail now lacks all credibility. It is time to go back to an industry that does not loom so large that the failure of even one institution is a catastrophe for every other institution. Failure is a normal part of business. It ought to be a normal part of the banking business too. But that degree of normality is impossible without a more fragmented, more decentralized and more specialized system of finance, in which the role of the authorities is reduced to the maintenance of competition. It would not be failsafe, but safe enough to fail. This is not a fantastical proposal. The Volcker Rule is actually a step toward it, because its shifts proprietary trading and hedge fund activities out of the major investment banks, and into a marketplace where the risks can still be taken, but are much less concentrated.

Big Banks play the role in economies that Big Men play in societies. They crowd out alternative sources of power, and reduce the level of experimentation. Ask any broker-dealer how easy it is to compete with a major investment bank. Ask a hedge fund manager what scope he has to negotiate his margin terms with a prime broker, or a domestic custodian how easy it is to keep abreast of the global custodians. Ask sub-custodians what luck they have had in resisting the squeeze on prices from network managers. Look at how the incumbent depositories and clearing houses have used prices and processes to hobble their competitors. Everywhere, oligopolists are slowing down the natural evolution of the banking industry, and perverting its course. Evolution is a system of trial and error, which progresses by doing more of what works, and less of what does not. In a system where error cannot be penalized, progress is impossible.

It is a paradox - restoring faith in commercial bank money by withdrawing the central bank safety net - but, where the courage to go all the way and return to a system of 100% reserving is demonstrably lacking, the only way to take excessive levels of risk out of the system is to increase the cost of taking it on. There are those who say that this will reduce the rate of innovation. There are those who welcome that prospect, because they never welcomed CDS and CDO Squareds in the first place. Both are wrong. A more fragmented, more diverse, less frightening (and less frightened) banking industry will actually be more innovative, not less. In the market for banking services, as in any market, it is not the market participants that are the source of innovation. It is the market itself. In a properly functioning market, everything belongs to someone, and ownership confers responsibility. In a system where bankers own the profits, but taxpayers own the losses, nobody has responsibility. Where nobody has responsibility, we cannot have a market. Only by breaking up the oligopolies can the nexus be severed, the amplitude of the credit cycle be suppressed, and the market, in all of its fullness and variety, disclose its infinite possibilities.