Shareholders

Shareholders. I once called them the suckers of the capital market. I must admit, it's even worse. Shareholders are a nail in a banker's coffin, be they (the bankers) greedy and guilty of the current financial crisis or be they victim of prices 'the market' supposedly sets.

I explain the last remark: Banks need money to lend. After loss write-offs as a result of the real estate crisis, there is so much less money in the bank, but worse, their complete balance sheet is in disorder. The regulators (the bankers' nightmare book keepers) simply state: what do you have as collateral and they use a very important yardstick to measure this collateral, and it is called market value. Once there was a ruling (in FASB-look-up-the rulings-number-yourself) that stated that banks have to report their possessions in terms of market value. So whenever market prices for listed securities drop, it immediately shows in these banks' reports (the same phenomenon -but reversed- shows when market prices rise). This drop is reflected in the amount of (equity and equity-alike) capital that banks' reports show. Simple enough: market price down -> equity down.... And equity (broadly defined) is the lever the bank uses to calculate how much can be lended to outside parties. In short market prices determine how much a bank may lend.

And who decides on market prices... Yes, the shareholder. We take a side step here and look at pension funds. The same FASB rule goes for them: lower market price -> lower coverage for outstanding pension obligations. In the Netherlands this means that a pension fund, suffering from lower market prices sees their surplus of assets above (future) pension obligations sink below certain margins (105% or less) and consequently they may have to sell off part of their (low market value portfolio) in order to make amends or ask sponsor firms to pay larger premiums.

Again, who decides on market prices... Same answer as above: the shareholder (in its combined form well known as 'the market'...).

Back to these suckers. What do they do in times of crisis, which we now experience: They overbid each other, meaning a Dow Jones Industrial Average (or DJIA) has risen the past few months (it has, look it up) or -to stretch our time frame here- they underbid each other resulting in a lower DJIA, meaning lower market prices (they were really low last March).

I say the following: the market is too sophisticated to be left to these suckers aka as shareholders.

What do they know? Practically nothing in times when institutional investors leave the market and only the real suckers determine market prices: the John Does of the market I mean. Panicky as they always are they flee in herd behaviour and -in times of crisis- sell (meaning lower prices afterwards) or they buy in self fullfilling prophecy times (meaning higher prices afterwards). In the mean time the institutional investors did not move an inch. They did not buy or sell but sit on their portfolios and leave the sucker to their market.

BUT, banks are not happy, nor are pension funds. They lose lending potential (banks), they must engage in rescue plans (pension funds)....

It all has to do with Quantity again, yes friends here we go again. In my view a price must not be counted as a set price when only minimalistic parties engage in securities trading. I mean of course the end-of-the-trading-day price. What happens in between is the sucker's (mis)fortune and nobody else's.

Suppose we set the limit at 10%, meaning that prices will only be seen as such when 10% (or more) of a stock's number of shares are traded on a given day. Only in these situations a price is to be regarded as a MARKET's price. I bet you: most securities prices will not change during a full year of trading. Banks and pension funds can breath again and nobody is worse off.

Stiglitz and Size

During my active academic years I often told my students that enlarging the size of a financial enterprise, is not a good idea.

Mergers and take-overs, MBO's and otherwise, upscaling the size of a financial giant ALWAYS (give or take a few percentage points) results in financial disaster. Reasons for the mergers, including acquisitions or take-overs (= M&A's) were newsed as being efficient, profitable or otherwise positive, while two years later management had to confess it did NOT work out as planned. The source of this is Stiglitz (http://jessescrossroadscafe.blogspot.com/2009/09/stiglitz-on-financial-crisis.html)

No surprise.

Normally ANY (M or A) buy-in is NOT profitable. More than 70% of any M&A activity fails to produce what their godfathers predicted it would result into. 70%, yes indeed, a sizeable amount, implying that most M&A's are delivering S H I T for the buying party and deliver G O L D for the selling party.

So why is this M&A thing so popular. The answer is as simple as it is dangerous: It is consultants! Consultants drive managements mad (which demonstrates the incompetence of management).

These (consulting) people stress the need for change on a quantative scale: big(ger) is (more) beautiful... meaning management acquires more prestige, the company gets a higher mark in the Fortune top 500, you get more noticed in the financial (duhhhh) press, and so forth.

SURE...?

In reality the combined lean, mean sex machine of a merged company gets burdened more and more with bureaucratic overhead, shows no more swift and time-related management actions, quadruples its consulting fees and loses money every day of its existence. How nice indeed....

Let me take you back a bit... (theory wise)

Perfect competion, as we were told while we were students, is theory's bliss. If every company would have an insignificant contribution to total 'production' of goods and/or services they ALL benefit. If parties collude or cartellize this benefit is jeopardized. Meaning: no good.

So, all parties within any industry would be better off on their own. Simple message, simple answer, simple solution. So what did companies decide?:

GROWTH

especially external growth (= M&A's ).

Illogical, of course, but all the more any day's reality.

Theory against practice. Theory says: stay as you are, grow INTERNALLY where you can and where your strengths show. Practice (apparently) says: grow where you can EXTERNALLY , eliminating competition where you can in order to be the 'big player' in the field you entered....

Empirical evidence shows that M&A activities lead to losses and bad results.

ANYWHERE.

So, also in the financial community (as in the rural, production and any other form of activity oriented business).....

D O N O T M E R G E,

I beg you.

EXTERNAL growth is inferior to INTERNAL growth...

R E M E M B ER TH A T...

My love

2B continued

The door

You all know about dimensions. 3 to 4 is the limit of our thinking....

Suppose you live in a 2-dimensional world and you had brainy people like a 2-dimensional Newton, a 2 dimensional Einstein and so forth. Would THEY be capable of transgressing their reality by assuming there are more than 2 dimensions, suppose 3? (Stupid of course because 2-dimensional thinking implies 3 dim. things, because 'ad infinitum' the third dimension of 2-dim. thinking involves a 3rd dimension, cause 2 dim. pictures have a depth of at least 1 atom, which makes them 3-dim people.... although they may think of themselves as 2-dim. people...)

(re-read the last sentence and STOP when the () appear.....). Sure they can, but they do NOT experience 3 but only 2 dimensions. Then came the theorists. They imagined more than 2, even more than 3, they imagined N (N > 3) dimensions. They had computers, they had IT specialists, they even had math wizards that projected N dimensions (where N > 3).

Now what.

There come the neurologists.

They had their own ideas. They said: we treat patients that experience 6 dimensions (although we have a hard time finding out what it is that they think the 4th, the 5th and the 6th dimensions are all about.....)....

Suppose, we -in our three-to-four (including time)- dimensional neuroframe thought about entering the 4th/5th/6th dimension.....

Could we cope?

Are we ready to comprehend?

Is our mind sane?

I think it has to do with doors..

Our mind is accustomed to a certain number of dimensions. To introduce a 5th dimension (never mind the record), we have to invent dreams.... A 5th dimension will only come into existance in dreams... and in dreams..... everythig is possible...

OK, we dream......

Even in our dreams we think in (a maximum of) 3 dimensions...

But ....

Our minds are not fully explored or exploited...

We have a lot to learn about our own functionality....

Suddenly, we find ourselves bumping against the limits of our own (3dim.) understanding,

and,

THERE IS A DOOR.

Which we do not know about,

But it is there....

Let us -all together- try to open that door.

It may be the one we're looking for....

CU

New Panic Signals?

There is a sort of down spiralling, 'we are not there yet', doom scenario spirit going on in the periphery of the financial world that has bothered me a lot lately. For example: Precious metals hoarding is supposed to be skyrocketing, where today (090909) I only see precious metals (or to be more correct: the value of precious metals measured in US Dollars!!!) depreciate in value. What I DO see is nothing more than could be expected, i.e. a slow but steady downfall of the US Dollar (1.45 US$ = 1 € as measured today. A week ago this was 1.41 US$ = 1€, so the US$ is losing ground).

A year ago (about) I predicted a US$ fall to 3 US$ = 1€. Ridiculous right? Well, we're nearly halfway there, but do not despair and keep remembering 'I told you so'.

As the US$ depreciates, the price of gold will rise, as will the price of oil and all other -traditionally- $-denominated commodities. To then conclude that 'everybody' flees into (precious) metals or into other simply marketable commodities is -IMHO- a too hasty conclusion. There is not enough gold to hide in anyway and investors will be the wiser to remember that while 'fleeing'.

I do not claim to be the world's foremost predictor, I only try to reason out my thoughts:

• fact is that the US$ is overvalued given its nearly immeasurable debt,
• fact is that China is more and more hesitant in financing US debt,
• fact is that US mass production industry is nearly bankrupt,
• fact is that older US citizens need to be employed. There pensions have evaporated,
• fact is that the US financial system is still very unstable,
• fact is that US debt is (still) steadily rising and wars are still fought,
• fact is that not one of the items above applies to Asia and/or for Europe.

So,

The US$ depreciates and I honestly think the IMF has to raise its voice and has to restrict the US economic policies as they did for all other countries that got entangled in similar positions.

Obama will not like this, not with all his reforms to be introduced this fall season. He will need a lot of persuasion capabilities, nationally as well as inter- and supra-nationally.

Sheer Size

My most favourite
subject is SIZE.

In economics
better known as:

QUANTITY or Q.

In most microeconomic 'models' we encounter 'quantity' in relation to 'price'. We -historically- came to understand these models to represent 'supply and demand' models. The intersection between 'supply' and 'demand' came to be known as the equilibrium state, where supply meets demand at a given price and a given quantity.

In financial economics, especially the 'Eugene Fama-Efficient Markets Hypothesis/Theory'-variant aka the EMH, 'price' against 'risk' (however defined), has become (until recently) the only dinner financial economists have learned to eat and get used to.

Within this EMH-world, prices have been set by the all encompassing market, given the measure of (financial) risk, through a process of arbitrage. The market for any security which is traded, so the new-born legend tells us, has come to rest (=equilibrium) given a certain price and an accompanying (measure of) risk, given a specific set of 'known' or market-wide information. Noone in his right mind (so the legend continues) would pay more or less for that given security than this 'equilibrium' price (given the risk).

The current financial crisis has everything to do with the above!

During the nineties and the first decade of the 21st century, real estate (mortgages) and every financial product related to it, has become (and in many cases still IS) the primary security traders within the financial community have favoured. The origin of this 'faith' has always been the historical 'proof' that real estate was a hedge against inflation and a safe way to invest in.

Banks are the primary sellers of mortgages. House owners and owners of commercial real estate have turned to banks for mortgages on their property. In turn banks were very willing to underwrite these loans, because of the 'real' value of real estate (the bricks-have-value religion).

Because of regulatory restrictions banks could only sell so-many mortgages. But they found a trick to circumvent this restriction: they sold their portfolios of real estate mortgages to the market and insured the risk of this portfolio defaulting. In short they sold against cash and could start selling mortgages with this received cash (flow). This procedure -which is called 'securitization' went on numerous times with the same money being invested dozens of times and (re-)insured dozens of times. All went went well for decades.

Remember one thing: although banks (re-)insured their securitized mortgages every time they sold mortgages to the market, the risk for the bank remained. That is: in case the (re-)insurer defaulted, security owners could claim the value of their securities (=shares) at the securitizing bank. This proved to be very important, so take good notice of this!

Given the size of real estate (mortgage) portfolios within the, or any, bank, the resulting situation dramatically tilted the bank towards a very substantial default risk. As more and more money within securitized portfolios was (re-)insured the portfolios of the (re-)insurer also got tilted towards real estate risk.

And then real estate prices did not rise anymore....or even declined..

The home and office owners could not pay their debts (interest and amortization payments) anymore. In short the (re-)insurers went broke, which in turn made the originating banks the owners of these risks (which of course they could not bear), in short the banks also defaulted or at least had to write-off many defaulted loans and or related securities. To their relief, governments stepped in and bailed them out (with different bail out plans per country involved).

The CDO's, the CDS's and all the other financial products related to this real estate drama suddenly had no price anymore. The market, the Heaven of traders, exploded into nothingness. Simply because nobody was interested in them anymore, in fear of defaulting themselves if they would be the responsible party....

I have arrived at the point I wanted to make with this story: Whenever specific securities are dominating the financial community, as was the case with the internet bubble at the turn of the millenium, the market gets out of its 'equilibrium state'. The 'buy-buy-buy' interest that parties show whenever a specific (financial) industry is promising good returns is extremely dangerous. The reason is that the whole market gets focused on this specific industry, by selling securities that do not bear any resemblance to e.g. 'internet' and buying securities that DO! A so-called 'tilting' or 'quantity' effect overwhelmes the market. Everybody wants 'in' and prices rise as a consequence of this. We've seen this numerous times. From the dutch 'tulipmania' via the 'itc-mania' to the 'real estate-mania'. It is all the same.

Finance theory should finally recognize that this lemming behaviour of market parties is an immanent factor they MUST give weight to in their models. If there is anything that can be learned from the current financial crisis, it is the FACT that financial models since Fama, do not pay ANY attention to sheer size, or quantity.

In my view the finance Nobel Prize winners should return their prizes, enter monasteries, never to be heard form again, beginning with Eugene Fama,

for their utter stupidity of forgetting the simplest of economic laws:

prices relate to quantities.

Hope to meet you again tomorrow.