When a Currency Is Working, It Isn't Questioned.

Definitions matter

Economists are fond of defining money by enumerating its uses.  The ECONOMIST Magazine had an article on the topic.  It first reviewed the standard definition:

“Money fulfills three main functions. First, it must be a medium of exchange, easily traded for goods and services. Second, it must be a store of value, so that it can be saved and used for consumption in the future. Third, it must be a unit of account, a useful measuring-stick. Lots of things can do these jobs. Tea, salt and cattle have all been used as money.”

Economists do a substantial disservice to the public's understanding of the role of money by enumerating its potential uses as if they were all equally important.  As is discussed below, there are important caveats to the notion that money is a store of wealth.  If money is not channeled into something that produces in the future, there is no wealth in the future. 

ECONOMIST magazine goes on to describe the function of money as reducing the cost of barter (“On the Origin of Specie,” Aug 18th 2012).  The emphasis on reduced cost of barter has the advantage of automatically explaining the benefit of having a well-functioning currency.  There is tremendous benefit to society from making barter (trade) less costly.  It introduces tremendous efficiencies into the economy.  Reduced costs of exchange allow the same resources to produce more benefits to society.

Considerable controversy about monetary policy and the government's role can arise from placing different emphasis on “store of wealth” verses “media of exchange.” That can be seen immediately from the fact that inflation is inherently an issue "across time."  So, it relates only to the role of money as a store of wealth.  If one places a high value on the role of money as a medium of exchange and a low value on the role as a store of wealth, one’s policy conclusions will be different from those of somebody who inverts those priorities.

The focus on making barter efficient can lend perspective to this often contentious debate.  The role of money as a store of wealth can be viewed as making barter more efficient.  However, in the case of "store of wealth" the barter is across time.  Essentially, the store of wealth function of money relates to only a subset of the broader category of medium of exchange. 

Monetary theorists do not seem to realize that the issue of whether the different roles of money can be separated is more important than the emphasis on specific aspects of the role of money.  Clearly, they can be separated for prolonged periods of time.  Further, there is a distinct possibility that too much emphasis upon the role for money as a store of wealth is counterproductive.  Wealth can never be produced by money.  It is always produced by the effective deployment of resources to produce in the future. 

If a substantial portion of the population does not know how to use current resources to produce in the future, money may have a default role as a store of wealth.  When money fills that default role as a store of wealth, it becomes a mechanism by which society can transfer current productive effort into the future, but for that to happen the money must be entrusted to someone who can effectively use it to produce in the future.  In that respect, the size of the financial service industry, or at least its importance, is inversely related to the portion of the population who know how to productively employ resources.  If few people know what to do with money other than spend it, they need a large financial service sector to channel resources into future production.

Differences in the emphasis placed on the various functions of money are often assumed to relate primarily to one's balance sheet.  Specifically, the role as a store of wealth is far more important to those with wealth.  Those with debt, on the other hand, do not want money to function well as a store of wealth.  They benefit from a depreciating currency. But they will care whether it is an effective means of exchange. 

A strong argument can be made for the position that the wealth is not the cause for the attitude about the importance of money as a store of wealth.  Both the wealth and the belief that money should serve as a store of wealth reflect an individual's preference for income in the future rather than immediate consumption.  The inverse is also true.  Those who think the exchange value of money (i.e., the ability to spend it) is most important probably are those most anxious to spend it now.

It never seems to occur to people that what applies to the individual may also apply to the entire society.  A society that is wealthy and producing wealth may lean toward a stable currency, while a society in decline where wealth and income are falling favors a currency that is declining in value along with their income and wealth.  What is not clear is the direction of causality.  Does a society with growing income and wealth want a stable currency?  Or, does a stable currency produce rising income and wealth within a society?

Basel Negotiators Actually Have Their Heads Screwed On

They are focusing on the right issue

Readers of The Hedged Economist are aware that this blog is hardly a fan of those developing the Basel banking regulations.  Yet, it does appear that they actually understand what the risks to banks are.  On January 7, 2013, the WALL STREET JOURNAL had an interesting article on the status of the Basel negotiations.  It appeared under the title “Rules for Lenders Relaxed: Regulators Agreeto Ease Requirements for Meeting Guideline on Liquidity.”

It is interesting that the reporter discussing the regulations presented the changes as “Global banking regulators watered down a key element of their plan for creating a safer financial system, giving ground to banks…”  Perhaps, the reporter was a former sportscaster and does not understand that financial regulations have financial implications.  This is not a game where one side wins the other side loses.  Either side could win or lose with disastrous results.  The purpose of the regulation is the results they achieve, not the game itself.  The article goes on to explain that the regulators made the changes in response to the fact that banks “argued the rules were unworkable and financially risky [emphasis added].” 

As will be explained below, on key issues the article is wrong about the rules being watered down.  The article discusses Basel regulators decisions on the most important issue: liquidity.  Unfortunately, the article treats, liquidity, as if it were posted to a scoreboard.  What is overlooked is that the very definition of liquidity is what was being negotiated.  Viewed from that perspective, the changes may represent a strengthening of regulations.

As was discussed in “It's a Wonderful Life’ OnRegulatory Policy: The Real Risk,” the maturity mismatch characteristic of banking is unavoidable.  Their liabilities are short run while their assets are long run.  The classic example is that deposits can be pulled without advanced notice, but the banks’ loans cannot be called immediately.  Consequently, the greatest risk to banks is that they will not have the liquidity to meet withdrawals.

Where the article goes astray is in its assessment of what produces liquidity.  For example, it reports that “The liquidity rule requires banks to be holding enough liquid assets—originally limited mostly to cash and government bonds—to be able to withstand an intense 30-day liquidity crisis similar to what occurred in fall 2008.”  Under mark-to-market accounting, the value of government bonds can drop as much or more than many other assets.  US investors only have to remember what happened to government bondholders during the 70s and early 80s when government bond holders got crushes.  Europeans, on the other hand, have a more recent example in Greek bonds.

Liquidity is not just being able to sell an asset: it also involves not taking a bath or losing one’s shirt when the asset is sold.  An asset is only liquid if one can get a decent price for it.  To ensure that they would have some assets that were retaining their value, banks lobbied for the inclusion of a large number of “high quality liquid assets.”  Their contention was that it should include a diverse array of assets: “everything from blue-chip stocks to mortgage-backed bonds to stashes of gold.”  It took the European debt crisis, which has seen some governments' bonds become junk-rated and illiquid, to convince the Basel Committee that a diversified portfolio provided liquidity better than a portfolio concentrated on a single set of investments.

It is easy to understand why it took the European financial crisis to impress upon the Basel Committee the simple fact that a diversified portfolio is liquid.  One only has to look at how this rather commonsense change in their focus is being reported to realize that they suffer from broad media and public lack of appreciation of investment fundamentals.  Keep in mind this article was taken from the financial press.  One would hope the financial reporters would have a better understanding of investment fundamentals. Still, one has to wonder why the Basel Committee did not immediately recognize the legitimacy of the banks’ arguments. 

More than once The Hedged Economist has commented on the excessive dependence on theoretical models of portfolio performance characteristic of the Basel regulations.  Perhaps, the Basel Committee has problems applying their quantitative rigor to more than one asset at a time.  But clearly, a diversified portfolio will, under most circumstances, including a financial crisis, provide more liquidity than a concentrated portfolio. 

Interestingly, what is totally missing from the discussion of liquidity is hedging.  As discussed in a previous posting (“It's a Wonderful Life’ On Regulatory Policy:Focus”), hedging is an important way banks address the maturity mismatch inherent in their business.  What is curious about the absence of reference to hedging is that the OCC is well aware of the role of hedging.  As was pointed out in the previous posting, the former Chief Counsel for the OCC identified the “whale trade” as a likely hedge and a routine aspect of banking.

Given that the Basel III regulations rely heavily on quantitative measurement of risk associated with various investments, one is surprised that they would not extend that analysis to include hedging strategies.  Those familiar with The Hedged Economist probably noted a high degree of skepticism about the quantitative measurement of risk and hedges.  But, the techniques are necessary at bank, and they are extremely effective when applied with the appropriate level of skepticism about the quantitative measurements.

The thought of the Basel Committee looking at hedging strategies is a little bit scary.  The problems with the quantitative methods they use include that they assume a determinant variability of asset prices, and what is even scarier is that they often assume constant variability of asset prices.  The models assume that there is always a market.  Therefore, when addressing liquidity, the assumption of constant variability implies something close to constant liquidity.  Thus, there is a risk that their quantitative methods will assume away the problem regulators should be addressing.  They have not developed models that predict market discontinuities (i.e., interruptions in liquidity).

The article goes on to report other changes that were made.  While the folly of how the article addresses the source of liquidity is apparent, the balance of the coverage does address serious questions about the extent of liquidity banks should be required to hold.  But note that it is the extent of liquidity that is now the focus not the source of liquidity.  No change in the intended amount of liquidity would have any significance if the definition of what is liquid was wrong.  Consequently, while “watered down” may seem more justifiable with respect to the amount of liquidity, it's a quite hollow description without first defining liquidity.

The article uses as an example of the amount of liquidity required.  It states: “the original rule stated that banks needed to assume that, in a theoretical 30-day crisis, they would see 5% of their retail deposits vanish. The banking industry argued that was unrealistically harsh. Sunday's [January 5^th] rule lowers the level to 3%. And instead of assuming that corporate clients would draw down their credit lines by 100% in a crisis, the figure has been changed to 30%, a shift that significantly lowers the amount of liquid assets banks need to have on hand.”  One can draw his or her own conclusions about which scenarios are more realistic for a financial crisis in the 21st century, but, clearly “watered down” is an accurate reflection of the changes in the amount of liquidity.

One has to congratulate the Basel Committee for addressing the right issue.

“It's a Wonderful Life” On Regulatory Policy: Crimes Verses Mistakes

Ignoring theft

The third deficiency of the current regulatory focus presents less of a systemic risk to the financial system, but clearly creates a substantial risk of the different type.  One can hardly consider regulations just if they overlook stealing. 

Perhaps the policy wonks should come up with the simple regulation that overrides all their other regulation and states simply “no other regulation implies a right to take other people's money.”  It is when until uncle Billy loses a deposit, in other words until money disappears, that regulators and law-enforcement become involved.  In “It's a Wonderful Life” misappropriation of the depositors’ funds is among the most serious charges Potter levels at George when Potter really wants to be nasty. How refreshing!

The media, bank regulators, the judicial system, and policy wonks all seem to be totally unable to distinguish between out-and-out theft and perfectly honest activities.  For example, on Christmas eve day, the same day the WALL STREET JOURNAL reported the investigation into Regions Financial, the paper had an article entitled “MF Global Trustees Cut 'Gordian Knot.”  This second article reported on the current status of efforts of the courts in relation to MF Global”s bankruptcy. It was an amazing juxtaposition of a complete failure of our legal system and the waste of our regulatory system.

Recall that the banks are not being accused of taking depositors’ money: what has been in question is how they were investing it for the depositors.  Regulators are focusing on issues such as: Whether investments were prudent, were reserves adequate for the types of investments being made, and did banks adequately disclose their investment activity?  Those are important issues but pale compared to ensuring that no one is just stealing the money.

The situation at MF Global is totally different from that of the regulatory focus.  As the article reports: “In the months after the bankruptcy, trustees estimated that about $1.6 billion in customer money had been moved from its proper place in MF Global's final days.”  It's incredible that no one explicitly states the money was stolen from customers’ accounts.  These were not funds deposited with MF Global for use by other than the owners.

One should note this is very different from the example of Prime Reserve, a mutual fund that broke the buck.  In that case, the funds were at all times invested within the mutual fund for the benefit of mutual fund owners.  In the case of MF Global, funds from depositors were pledged, (i.e., loaned), and the proceeds used for the benefit not of the depositors but of MF Global.  In short, they took the depositors money and used it for their own benefit.  It is the possibility that a similar event occurred at Bailey Building and Loan that brings the law into play in “It's a Wonderful Life.”

MF Globel involves a violation of depositors’ intent as well as a phenomenal demonstration of dishonesty on the part of MF Global’s management.  It is a regulatory disgrace that this could be done.  So, one would suspect that given the emphasis on reforming our financial system there would be severe penalties for those involved and a serious effort to ensure that such regulatory loopholes are eliminated.  Instead, as reported in the WALL STREET JOURNAL article, the result is an agreement that “signaled a new détente over how money from the eighth-largest U.S. bankruptcy should be distributed and whether creditors or former customers of the company's brokerage operations should take precedence.”

“Regulators and plaintiffs' lawyers also are looking into MF Global's bankruptcy. Plaintiffs' lawyers have sued Mr. Corzine and other former executives of the firm, hoping they could win funds to compensate MF Global customers.”  One is forced to ask:  Why in the world is it necessary for customers to sue in order to get their money?  Common sense would suggest that one of the primary purposes of financial regulation should be to ensure that people do not steal other people's money.  Instead our regulators set up a framework that allows them to pursue trivial issues while ignoring what was clearly intended as a misappropriation of funds.

It isn't any wonder that there is active opposition to regulation?  Regulators have no one but themselves to blame for it.  They are not focusing on institutions that represent the greatest risk.  In addition, they seem to be more interested in pursuing witch-hunts, then protecting individuals from dishonest behavior.  The Hedged Economist considers this nonsensical behavior on the part of regulators extremely unfortunate.  A healthy regulatory environment would go a long way toward producing a more stable financial system and one that the public could trust.

“It's a Wonderful Life” On Regulatory Policy: The Real Risk

Not addressing systemic risk

Focusing on the wrong institutions may lead regulators and policy analysts to ignore the greatest risk to banks.  This second failing of regulatory and policy focus has serious implications beyond just the resources they are wasting.  Bank runs represent the source of the greatest risk that arises from the maturity mismatch.  They are far more serious systemically than any bank’s trades.  It is, after all, a bank run that threatens Bailey Building and Loan.  George tries to explain that to customers of Bailey Building and Loan.

Perhaps both policy discussions and regulatory initiatives should focus on the maturity mismatch.  Put simply, it is the greatest risk in banking and is far more likely to result in a financial crisis than any particular bank’s investment.  US policy wonks and regulators seem to have outsourced the entire issue to those negotiating the Basel III rules. 

Regulators and policy analysts should be trying to figure out how to assist banks in hedging the maturity mismatch.  US regulators seem to be doing exactly the opposite.  Remember, ultimately, it is only the ability to produce cash that saves Bailey Building and Loan.

Once one focuses on the real issue of the liquidity squeezes that create financial crises, TARP is neither the only nor the most important government program implemented during the financial crisis.  The government's Transaction Account Guarantee (TAG) as the name implies involved guaranteeing deposits.   As anyone at all familiar with American banking regulation knows, the FDIC guarantee of deposits was a primary response to bank runs during the depression.  What was different about the Transaction Account Guarantee program was it guaranteed all deposits rather than those below a limit.

A WALL STREET JOURNAL article published the day after Christmas discussed deposit guarantees. It focused on one of the issues deposit guarantees implemented during the financial crisis created.  As the article's title, “Small Banks to Depositors: Trust Us: Dec.31 Expiration of FDIC's Unlimited Guarantee Drives a Scramble to AllayCustomers' Concerns,” implies, runs remain a problem for small banks.  In fact, the primary argument that small banks make for continuing the guarantees is that they cannot compete for deposits without the guarantees.  They fear that if the guarantees are ended, they will experience runs as depositors shift their money to larger banks.

The article clearly demonstrated that maturity mismatches characteristic of banks are still the major systemic risk.  That risk is most immediate and threatening not at large banks but among small banks.  Instead of addressing that risk directly, regulators are off tilting at windmills.  Hedging and even proprietary trading do not create maturity mismatches.  In fact, when done appropriately they mitigate the risk introduced by maturity mismatches.

Probably nothing illustrates the confusion better than how one of the small banks is trying to encourage depositors not to withdraw their deposits.  The article quotes Keith Costello, chief executive of Broward Bank of Commerce. "We are telling our customers that we have a loan portfolio that has no nonperforming loans, which is a very clear statement that our bank is very solvent, very safe and very secure."  

Under mark-to-market accounting, what matters is not whether the loan is performing or not.  Market value and liquidity are what determines the solvency of an organization.  Performing loans do not necessarily meet the liquidity requirements that can be created by a run.  When a run occurs, performing loans may have to be sold at distressed prices in order to meet emergency liquidity requirements.

The systemic risk that this creates was highlighted in a WALL STREET JOURNAL article on December 30, 2012 (“Gauging the Guidance That ModelsGive the Fed”).  The article describes how the Fed uses various models of the economy and the financial system to predict the future course of the economy.  Those predictions are then used to determine what the appropriate Fed policy is.

It goes on to note the limitations of the model with the following quote: “But here is the problem: The models are deeply flawed. They failed to foresee the financial crisis in 2008 and have tended to overestimate the strength of the economy for several years.”  The article is not being at all alarmist.  As it notes, “Of course, no model or human can perfectly predict the future.” 

The problem is not that the models are less than perfect.  From the perspective of regulatory policy, the problem arises from the sources of the gaps in how they read and project the economy.   “One of the biggest is that they have ignored the nuances of the financial system—one of the primary channels through which Fed policy works.”  This is a pretty explicit statement that their models are not a useful tool in directing regulatory policy, and that their models do not reflect the risks that can arise from misguided regulation.

It goes on to make those risks rather explicit.  “The models have formulas that predict how many pennies an investor will spend for every $1 increase in his stock-market portfolio or how much less banks might lend if interest rates go up half a percentage point. But they haven't predicted the vulnerability of banks to a financial panic or how that vulnerability affects the broader economy [emphasis added].”  In short, a principal Fed policy tool provides the Fed with information that has a big blind spot.  That blind spot relates to the greatest source of systemic risk arising from the financial system.  One can call that risk bank runs, liquidity squeezes, financial markets freezes or financial panics.  They should be the primary focus of regulation.

“It's a Wonderful Life” On Regulatory Policy: Focus

Focusing on the wrong organizations

Let's start with the waste inherent in focusing on the wrong institutions.  The WALL STREET JOURNAL had an article entitled “Probe of Big Bank Widens: SEC, Others ExaminingWhether Regions Financial Improperly Classified Bad Loans” As it reports, “Federal agencies are examining allegations that Regions Financial Corp. (RF) improperly classified loans that went bad during the financial crisis, according to depositions filed as part of a civil lawsuit against the large southeastern U.S. bank.”

One shouldn't misinterpret the focus of these comments.  As pointed out in the last posting (“It's a Wonderful Life’ is truly a gift that doesn't stop giving”), the accounting practices of financial institutions present a serious problem to investors.  As the WALL STREET JOURNAL article puts it, “transparency of accounting decisions at major banks became a major concern for investors...”  There is nothing wrong with that statement.  Also, this posting does not imply any judgment about Region’s accounting practices.  The issue is whether the resources could be used in other ways that would provide greater benefit. One does not need to judge Region’s accounting to see some policy folly. 

What is curious and shows a short sightedness of much of our policy is the timeframe the article seeks to establish for the need for transparency.  They go on to say that the concern arises as “questions on the subject continue to bubble as financial firms' crisis-related cases wind their way through the courts,” and the article treats the issue of transparency as if it only relates to practices that occurred “during the financial crisis.”  As any investor knows, that is pure hogwash.

The problem is that it is not just the reporter who gets this wrong.  Consider the reported origins of the investigation.  The article reports “The Regions depositions emerged as part of a lawsuit brought in 2010 by two pension funds that own Regions stock. The funds allege that Regions hid problems by moving loans out of nonaccrual status, which means interest payments were overdue and collection of the principal unlikely. Rising nonaccruals typically force banks to increase reserves for loan losses, a move that eats into profits. A lawyer for the funds declined to comment.”

Is it any wonder that “a lawyer for the funds declined to comment?”  Pensions have a fiduciary responsibility, and one has to wonder where was the pension manager’s due diligence if they only noticed accounting irregularities during the financial crisis.  If accounting irregularities were there, they didn't start with the financial crisis.  Further, it seems to me that an objective analysis of the practices used to establish reserves would not flag pensions as particularly good judges.  For the lawyer to have commented might have presented a real case of the pot calling the kettle black. 

As the article reports, the investigation reflects a “widening U.S. scrutiny of the lender as regulators and federal investigators step up their surveillance of the methods banks use to classify loans or reserve for losses.”  What policy wonk or bureaucrat came up with the notion that bank reserves at large regional banks are the highest priority for scrutiny?  Although not the purview of bank regulators, from a policy perspective, it would make more sense to focus on pension funds, especially public sector pension funds.  Many pensions, especially those in the public sector, have been deceiving pensioners regarding reserves for years.  It would have been nice if the article had reported whether there was any evidence that pensions’ lawsuit reflects an effort by the pensions to compensate for previous failures in the pension funds’ reserve policies.

Focusing just on banks, large regional banks hardly seem to be highest priority.  One should recall from previous postings that TARP repayments would indicate that it was smaller banks, not large regionals, that proved to be insolvent during the financial crisis.  So, based upon the TARP experience, when the issue is solvency, the bank regulators may be focusing on the wrong banks.

The folly of the regulatory practice was illustrated again in another article on December 27, 2012 in a WALL STREET JOURNAL article entitled “Whale' Capsized Banks' Rule Effort."  It focused on the J.P. Morgan Chase (JPM) trade that resulted in extensive press coverage.  The first thing to note is that the J.P. Morgan Chase trade involved significantly less money than the article on TARP indicates that smaller banks have cost the federal government.  Second, it should be noted that the J.P. Morgan Chase trade cost the bank profitability, but cost the federal government nothing.  That outcome appears, at least to this analyst, to be totally appropriate.

The more important point that many of those framing policy do not seem to understand was highlighted by Julie Williams, The Chief Counsel for the OCC at the time.  As she put it, “such trades were likely part of the bank's regular course of business….  They were likely hedges….”  If that is true, then much of a critique of the trade, and citing it as justification for the Volcker-rule is totally misguided. 

It is unfortunate that many people reach the conclusion that the fact that traders lost money “demonstrated the risks posed by proprietary trading at large banks.”  Quite to the contrary, the conclusion that people are reaching demonstrates, not risk to the bank, but naivety on the part of the person reaching the conclusion.  Put simply, not every trade is designed to make money.  The people who think they have to make money on every trade are incredibly naïve.  They seem to totally lack any understanding of the purpose of a hedge or the reality of investing.  Unfortunately such nonsense seems to be guiding many of the people formulating policy.

As the article points out, portfolio hedging is often designed to protect against losses across an entire portfolio.  J.P. Morgan Chase’s loss on the “whale trade” may have allowed it to hold other investments that resulted in a much greater profit.  The first obligation of anybody who wants to reach a policy conclusion from the “whale trade” is to show that it was not intended to hedge other portfolio risks.  That is far more difficult than just determining J.P. Morgan Chase’s aggregate profitability or loss during the quarter.  There is no reason to assume that J.P. Morgan Chase was not hedging other investments that will yield a return in another period.   Maturity mismatches are extremely common in banking.

It is possible that the loss represented a miscalculation of the extent or timing of the hedge.  It is important to keep in mind that when a bank’s investments are not hedged, also involves a maturity mismatch.  So, a miscalculation on timing, or even on the extent of the hedge, may have been less damaging to the bank than if it had left its investments unhedged. 

Regulators seem to be chasing headlines in stead of trying to facilitate a functioning financial system.

“It's a Wonderful Life” On Regulatory Policy: Introduction

’Twas the night before Christmas

Sorting out the good, bad and the ugly is important to investing.  A well-designed public policy would do the same. “It's a Wonderful Life” makes the identity of the good guys very apparent.  The bad guy is equally apparent.   It's the ugly where the movie gets most interesting and is most relevant to regulators. 

Unfortunately, in the real world, good, bad and ugly overlap and trade places.  Even in “It's a Wonderful Life” that overlap exists.  For example, both the Baileys and Potter are bankers.  Is that a good, bad, or ugly?  If you are one of the Bailey’s customers who has a home and wouldn't have otherwise, it's good.

If you are dealing with Potter and he offers you $.50 on the dollar for your assets or conceals the fact that he is holding your deposit, it's bad.

For ugly, all you need to do is to remember that bank runs threatened both the bank and Bailey Building and Loan.

Unfortunately, many of those formulating and implementing public policy seem unable or unwilling to deal with the complexity.  One ends up wondering whether they could even deal with Bedford Falls.  They seem bent on telling people how to pursue perfectly legal activities, often focusing on the wrong people.  They seem to be bent upon ignoring the most severe risks associated with banking.  At the same time, they're unwilling to face the fact that there are people committing criminal activities.

It's worth looking at some of the shortcomings of these policy wonks and bureaucrats.  Their mistakes create opportunities and warnings for investors.  Perhaps as a Christmas present to The Hedged Economist who likes to include examples in postings, the news on Christmas Eve day was full of examples of failures to distinguish good from bad.  As follow-up, perhaps as presents that arrived late, the days after Christmas provided other examples. 

Taking advantage of the opportunities created by regulatory mistakes, or fiddling their folly, as it's sometimes called, can be entertaining and profitable.  Regulatory shortcomings have far more serious implications than the short-run investment opportunities they create.  Frequently, our policies and regulatory focus are not addressing the most important issues.  Three shortcomings stand out: 1) obviously, focusing on the wrong institutions involves significant waste of resources, 2) not focusing on the appropriate phenomena means that policy and regulation is not addressing things that could have a significant impact on the economy, and 3) considerable injustice results from the failure to properly prioritize issues.

Over the next three days each of those shortcomings will be addressed in a separate posting.

“It's a Wonderful Life” is truly a gift that doesn't stop giving.

It says something about the issue of investment selection. 

The posting entitled “Wall Street doesn’t run the world” used a Goldman Sachs (GS) “sell” recommendation for Kimberly Clark (KMB) to illustrate how Wall Street chatter creates opportunities for investors.  Kimberly-Clark was trading in the low 60’s at the time.  It's now trading in the mid 80’s, and it has paid a consistent and growing dividend.  Lest that comment be misinterpreted, the point of posting on Wall Street was that the advice for Wall Street was right for Wall Street.  By contrast, because it was right for Wall Street, it was wrong for many individual investors.  Investors could view the chatter from Wall Street as providing them with an excellent opportunity.  Washington chatter does the same thing.

A major plot line in “It's a Wonderful Life” is the conflict between Potter and two generations of Baileys.  

Potter wants to eliminate the competition that Bailey Building and Loan creates.  Eventually he ends up in concealing the fact that he has the Bailey’s deposit.  George Bailey, on the other hand, displays nothing but honesty even in the face of substantial adversity. 

In the end, one doesn't need to wonder who experiences the wonderful life.  Clearly, the movie’s theme is that leading an honest and trustworthy life yields results.  In the end, money comes pouring in from friends and associates to salvage George Bailey's organization and his reputation.  So, it isn't just nonmonetary rewards that George enjoys.  Sure, security, friends, family, and personal integrity are presented as more important than financial rewards; but, clearly, the movie implies a relationship between financial and nonfinancial rewards.

Trust is an important component in good investment decisions.  As will be explained, it is particularly important when it comes to investing in banks.  In that regard, the sort of Washington chatter that grabs my eye is illustrated by the excerpt from a WALL STREET JOURNAL Opinion piece quoted below:

“A persistent media-liberal lament—make that a cliché—is that too few financiers have been prosecuted for the financial crisis. But maybe that's because when the Obama Administration tries to prosecute a specific individual for a specific crime, it turns out there was no crime.

The government's latest embarrassments came this month, as one high-profile case collapsed and another was downsized by a federal judge. On November 16, the Securities and Exchange Commission dropped a civil lawsuit against Edward Steffelin. As an employee at GSC Capital, he helped create a synthetic collateralized debt obligation called Squared CDO 2007-1 that was offered by J.P. Morgan Chase (JPM).  It was synthetic because although it allowed investors to bet on the subprime housing market, it involved very little ownership of actual mortgages. Anyone investing in this deal knew he was simply gambling on a continued housing boom.

The government accused Mr. Steffelin of not informing Squared purchasers that another investor in the deal, a hedge fund called Magnetar, had helped select the mortgage pools to be wagered upon while it was simultaneously shorting some of them. Mr. Steffelin argued that Magnetar did not control which assets were in the deal. He also said he had done his job by accurately describing these assets to J.P. Morgan, which as far as he knew had accurately described them to investors. These would be sophisticated institutional investors who were eager to profit from the housing mania but are now cast as victims by prosecutors.

Since the Steffelin prosecution wasn't a criminal case but a civil suit, it presented a much lower bar for prosecutors to clear. But apparently not low enough. Last year U.S. District Judge Miriam Goldman Cedarbaum threw out the SEC's fraud charges, saying that it was a "big stretch" to say that Mr. Steffelin had a fiduciary duty to investors. That left only the accusation of negligence, and Judge Cedarbaum has now allowed the SEC to dismiss its case entirely.

It's true that J.P. Morgan Chase paid $153.6 million of its shareholders' money to settle a related SEC suit for its role in this transaction. But the bank admitted no wrongdoing and sees great value in avoiding adverse publicity. The problem for the government occurs whenever it has to prove that an actual human being has done something wrong.”

The interesting thing about this little excerpt is that the author completely misses the point of the government's accusations.  Often the government isn't interested in winning the cases.  They don't even care whether the accusations have a shred of truth.  They're interested in shaking down the employers for large amounts of money.  In this case, they were totally successful.  They got over $153 million out of J.P. Morgan Chase (JPM) despite the fact that nothing was ever proven. 

What isn't being reported in the general press is that the government's cases are often being disproven.  That would require the reporter do a little work and analyze the actual proceedings.  Besides, like the song says, “we like dirty laundry.”  So, the press has concluded that covering facts wouldn't help circulation, which one suspects is the real reason for not reporting factual information.

There is a nice thing about the press’s abandonment of any story when it starts to deviate from the planned storyline.  It creates wonderful investment opportunities.  For example, the article laments that the money J.P. Morgan Chase paid was “shareholders' money.”   But, the payment of that extortion with shareholder money is far from the most important aspect of the story. 

Investing is about character and trustworthiness. Not every charge results in a government failure to provide accurate evidence.  Thus, when individuals or organizations prove their honesty, it's a significant event.  Disproving charges that are supported by the tremendous resources of the government isn’t easy. 

When the scandal-hunting press loses interest, the opportunities abound.  The loss of interest doesn't eliminate the need for due diligence, but when one is not dealing with corporate representatives face-to-face, the government's failure to prove guilt provides a viable substitute for first-hand familiarity with the organization.  It's especially valuable when the defendant demonstrates honesty in their disclosures. That seems to be exactly what the article is reporting.  If anything, it should be taken as positive information by anyone considering investing in J.P. Morgan Chase or J.P. Morgan Chase offerings.  It makes due diligence somewhat easier when the nonsense coming out of Washington indicates that information J.P. Morgan Chase provides is probably reliable.

That all sounds nice in theory, but what does it imply?  When the government decides to embark on a shakedown effort, the first step is a “Wells notification.”  Unfortunately, Wells notifications are also the first step in a serious investigation.  So, the thing to look for is when the follow-up to a Wells notification is an announcement of a decision not to file charges.  Basically, that's an admission on the government's part that they couldn't even find enough damaging material to pull off a decent shakedown.  For example, the government recently announced that one of their investigations of Wells Fargo (WFC) was not going to result in charges. 

Now, admittedly, the government's approach to pursuing shakedowns is to undertake a raft of investigations in order to intimidate their opposition.  Nevertheless, when they admit that they could not find any damaging information on one investigation, it often has implications regarding what they will find on other witch hunts.  

Wells notifications usually have a negative effect on a stock’s value.  When an organization like Wells Fargo or J.P. Morgan Chase have previously shown that the government is wasting money on many of its witch hunts, the resulting dip in the stock’s value often represents an opportunity to buy.  It's also worth noting the recovery in the stock of the company when a case is dropped or disproven, or when a Wells notification results in no charges.  The recovery is often slower and initially smaller than the drop in the stock that occurred when the investigation or charges were announced or the Wells notification was filed.  There is time to take advantage of the end of the witch hunt. 

So, one could do worse than starting 2013 owning Wells Fargo or J.P. Morgan Chase stock.  A series of witch hunts have probably depressed their stock.  The dropping of charges, notification that no charges will result from an investigation, and findings of not guilty would indicate that Washington has been barking up the wrong tree.

Both Wells Fargo and J.P. Morgan Chase are often viewed as best in class.  Their profiles are different, but as investments, both are subject to some of the same risks.  One common risk is implied by this whole discussion.  Specifically, filing charges against banks has become a very profitable endeavor for Washington.  Thus, both Wells Fargo and J.P. Morgan Chase are subject to considerable headline risk.  That headline risk could create more advantageous times to purchase either stock.  So, investors with some experience might consider selling cash covered puts on Wells Fargo or J.P. Morgan Chase.

The Hedged Economist already owns Wells Fargo stock acquired at a much lower basis during the financial crisis.  However, selling cash covered puts on banks is a strategy that seems particularly appropriate currently.  If one wants to take advantage of the witch hunts while they are still in progress, there is another name to consider.  There are ongoing investigations of The Bank of New York Mellon Corporation (BK).  Selling cash covered puts on Mellon would be a way to directly take on exposure to the headline risk. 

For those investors who like to avoid headline risk and recognize the destructive behavior that often emanates from Washington, The Hedged Economist would also recommend looking at financial institutions outside of the US.  Canadian banks represent a totally viable substitute for investors who want exposure to major financial institutions.

It's also worth keeping in mind that it is Potter, not George Bailey, who gets a phone call from the Senator.   Perhaps, the implication of “It's a Wonderful Life” is that investors are best served by avoiding organizations with high profile Washington ties regardless of whether those ties are currently considered positive or negative. 

Given that comment, one might logically ask: why consider any of the large banks in the US?  There are actually three components to the answer. 

First, consider this comment from the WALL STREET JOURNAL published on December 18, 2012.  The article is entitled “U.S. to Sell Bulk of TARP Banks.” It reports that:

“The Treasury in 2013 hopes to clear out its portfolio of banks that took bailout funds during the financial crisis, including scores of institutions that have missed dividend payments owed to the government.

Four years after TARP's launch, the government still owns stakes in 218 banks. Most are smaller institutions, and some are struggling financially—more than half have missed payments they agreed to make when they took bailout funds. Collectively, they owe taxpayers about $7.5 billion.

The Treasury invested more than $245 billion in 707 institutions under TARP's banking programs, most to companies like Bank of America Corp., Citigroup and others with assets of at least $10 billion. Overall, the government has recovered about $268 billion through repayments, dividends, interest and other income.

While big banks quickly exited, smaller ones have been slower to repay.”

What should be obvious from the quote is that large banks, for all their problems, have a risk profile that is markedly different from smaller banks.

Second, consider an article (“FICC or Treat for BankProfits?”) in the Heard on the Street section published the same day.  It notes “Big banks aren't just black boxes. They are black boxes within black boxes….That has always been the challenge for investors—exactly what their assets are worth isn't always clear, and just how they make their money is sometimes hard to discern.”

That is true of all banks and most financial service firms.  Investing in a bank is turning over the decision on the specific investments that will be made to someone else.  Anyone who has been following this blog is undoubtedly aware that The Hedged Economist is extremely reluctant to turn over investment decisions to a third-party.  It does not matter whether the third-party is a bank, a mutual fund, the investment committee of an insurance company, or a pension fund manager.  One could do worse than manage one's own money.

Third, the posting on January 9, 2011 entitled “Investing PART 9: One version of the ‘Unfinished symphony” introduced the concept of the widows’ and orphans’ stock portfolio.  It included large-cap names.  The rationale for the selections and why they were all large-cap stocks was explained in the introduction to the actual portfolio.  It noted that such a portfolio would be remiss in industry coverage and stock market coverage if it did not include a large-cap financial services company. 

So, to summarize the three reasons, 1) any large-cap bank is opaque, but no more opaque than other financial services firms, 2) large-cap financial services firms have a unique risk profile based upon their basic business activity, and 3) that risk profile is a desirable feature of a long run, minimal management portfolio. 

Consequently, one should seek out institutions where there is some basis for believing the company is trustworthy.  That's true of all investments, but particularly true of financial services firms.  Thus, when a financial services firm demonstrates integrity under the close scrutiny of a government’s effort to find an excuse to extort fines, it is important information and justifies considering them for investment.  In fact, the very opacity of the financial service industry makes it even more important to have an independent determination that the organization is trustworthy.