The American Banking System: America's Hope

General Motors,IBM,Google,Microsoft,Apple,Caterpillar and countless other great American companies that at some point (some currently) were the symbol of America's power, envy and prestige.

A Subway franchise, a local hardware store, a gas station with a convenience store, a neighborhood Laundromat, a medical practice, a medium size business etc... together they provide most of the private jobs in America.

This combination of status and economic power is the result of ingenuity, hard work and ability to innovate in a free society with a stable political system and minimal government interference where capital is most efficiently allocated by those willing to take a risk.

There was a time when America did not have to worry much about competition from abroad. Of course that is not to say that foreign companies did not exist. But American technology and know how were sought after the world over. Today a Japanese company can produce the same quality product for less, a Korean manufacturer can out innovate an American company, even Airbus can cast shadow over a great American icon such as Boeing. It seems that America may have lost its technological and manufacturing edge in a world of globalization. This could not be more evident than in the surge of Chinese exports (and others). There is still one area in which the United States,even after all that has happened over the last three years, still holds a big advantage. That is America is still the financial Mecca of the world. However this advantage may not be with us much longer if the current policies of attacking, regulating and blaming the banking industry continues. Let's get one thing straight here. I am not suggesting that American banks are financially sound nor am I defending some of the practices of wall street but I am defending and arguing for the need for wall street to innovate. This can only happen in an open and free environment where business decisions are left to the private sector and regulatory uncertainties are kept to a minimum. Otherwise we risk losing a very defining edge of the American way.

No question some on wall street have committed social injustices if you will. Some may have even committed punishable crimes; but it takes two to tango as they say. Banks could not have lend all that money to buy houses if they didn't have willing clients, and Americans would not have borrowed as much if money was not readily and cheaply available. Greed goes both ways. But here is why I place more blame on the consumer in this case. First, it does not take a genius to figure out that if you make $50,000 a year you probably can't afford an $800,000 house (common sense people please!!!). Second, a doctor, a businessman and perhaps even a banker cannot claim he/she were mislead by an aggressive banker. The point being, if you look at the statistics and the market segments affected you will see that highly educated people are in the same boat as those claiming (some justifiably so) ignorance and having been mislead. The comfort of a safe and stable business environment comes from the dependence on and the knowledge that an agreed upon set of laws apply to a certain situation. In other words people will not invest in an uncertain political or judicial environment. Hence New York is the financial capital of the world, not Shanghai or even Tokyo; not even London (even though we saw some pretty aggressive moves by the administration especially with the auto industry). So let's use the laws on the books now to prosecute those who have broken the law. If the argument is that the laws are outdated than let us update them but let us not make the mistake of applying collective punishment for that achieves nothing but short term political gains at the expense of future viability of the banking system.

For those who know me know that I have argued, contrary to popular belief that our banking system is now healed, that there are more pains for this industry ahead. The most obvious to me are all those toxic assets that suddenly everybody stopped talking about when the regulators did away with the mark-to-market rule. They may have done away with the rule but not the toxic assets which are still sitting on banks' balance sheets. By not having to set aside reserves (or as much reserves) against these toxic assets banks have been showing what I call fake profit. A quick glance at the major banks reports show that most of the money they have made over the past year or so came from trading activities and not from traditional commercial banking transactions (the exception beingtwo or three investment banks). This is unsustainable. The slowdown in world's economic activities will put further pressure on banks' profit. In addition all the talk about increased fees and taxes on banks and banking/investment related activities does not lend itself to a nurturing and predictable environment needed for capital investment. Capital should and will go to where it is less restricted and most needed. Does anyone believe that a bank will lend money out when it is told by the government who to lend to, how much to lend and how much to charge? It is unrealistic to expect anyone with excess capital to turn over the decision of risk management to the government.

It will be a long time before American banks are back in shape for it will take years to work off (charge off) all these toxic assets in a slow economic environment yielding minimum profits at best. Otherwise their only quick and painless solution would be a sudden V-shape recovery of the housing market, something I believe even the most optimistic forecasters don't see happening for many many years to come.

I believe a vibrant and innovative banking system free from government shackles is what will ultimately lift us from this economic malaise for it is the best way to allocate capital where it is most needed based on free market principles. In this day and age a technological edge is not necessarily the sole determinant of a society's dominance. In fact I would argue that a free banking system is a better indicator of a country's future. No matter how great ideas are most would remain just that if not for the ability of a financial system to take on risk of its choosing and allocate private capital where it thinks would be most productive. Apple and Google,to take just two most recent examples, would not be where they are today without the help of our free banking system and specifically investment banking.

With all its past present and future problems or inequities our banking system remains the best engine to power future growth in the US as well as globally. If you are a believer in the China story or the emerging market story or whether you subscribe to Africa as the last investment frontier or space travel as our future then you also have to believe in a strong, free and capitalist banking system capable of innovating without worrying of having rules changed haphazardly and unexpectedly. Yes life is not fair but as to why it is not fair no one on this earth can convincingly say. A banking system of the kind I support may and will have some injustices but it is still a far better system for society as a whole than a centrally planned politically charged allocation system the kind of which we have witnessed disintegrate with the fall of the Soviet Union. Society cannot exist where everybody is a doctor or a banker or a Judge or a cashier etc...society is only sustained by the variety of functions necessary to complete the economic circle of life.

As sick as the banking system is (or perceived to be) it still is the heart that supplies blood (credit) to the body. A feeble heart is not capable of delivering the necessary amount of blood to keep the body going. The patient gets sicker and eventually dies. The creativity of IBM, the innovation of GM (in the past of course), the vision of Apple and Google and the ability of a Subway franchise to create jobs would not have been possible without the ability of our free banking system to take those ideas to the next level of actual execution. So please let's keep those arteries open and unobstructed by any hick ups or regulatory buildup. The way to do this is not by proping up some banks or exempting some from the upcoming regulations (think Fannie Mae), rather you achive this by letting the free market weed out the weak (let them fail). Than and only than would the heart regain its strength and ability to sustain a growing body.

Don't bank on our banks as an investment in the short run but do bank on them to pull us out of this mess eventually and keep America's edge going forward.

Looking For A Black Swan

There is real fear the US economy may see a double dip soon. A quick glance at the housing market following the expiration of the government credit and the heap of banking regulations coming soon seem to confirm the inability of the economy to generate necessary credit to sustain the recent growth. Why would banks want to lend to a consumer who is unable to repay when the government is dictating to them how much loans they can make and how much fees (and who knows what else) they can charge. Better yet, why would they lend when they can have their cash parked with the Treasury earning a guaranteed return. The US economy is facing deflationary pressure just like the EU is. The growth we have seen over the last year or so comes from cost cutting and not from increased revenues for companies have no pricing power. It seems department stores, and others, have daily sales going on. Combine this with heavy cost cutting and you have the unsustainable growth we all celebrated. Unlike China our stimulus money is still kept,for the most part, within the banking system (that is between the Fed and the Treasury) and therefore has not had the multiplier effect that usually accompanies such stimulus spending (ironic, because that is the exact reason for a stimulus). The challenges facing the US economy in the coming months are many and serious. Unemployment is stubbornly high and likely to remain so for few years. Difficult times await the Dollar as well as Treasuries. Our deficit is simply too large and will prove costly to finance going forward when either interest rates inch higher or when buyers shy away from Treasuries. The most serious problem facing the economy is the future of our banking system and its ability to innovate and be competitive (more on that in a future blog).

Europe and China are facing their own economic problems. In the case of China too much growth that has created a bubble or two. Nonetheless the end result is the same, but perhaps to a varying degree. In the age of globalization it is difficult to see how the world's main economies can grow when they are dependent on each other at a time they all seem to be heading in the same wrong direction. So how do we get back on track to growth? there is only one sure and quick solution; and that is a pretty heavy shock to the system. By that I mean stop all government interventions and let the chips fall where they may. This is a harsh but necessary treatment. The risks are high but less so than following a path of slow economic self-destruction. It is all about duration. It makes more sense to suffer the same consequences over a shorter period of time; then we can get on with the recovery. The crisis we have experienced is not your garden variety one and therefore normal government intervention is not effective.

Geopolitical events may yet give another boost to slowing world recovery. The west, lead by the US, is moving forward with plans to impose sanctions against Iran despite its agreement with Turkey and Brazil regarding its enriched uranium. North Korea is threatening war against South Korea; and a potential war between Israel and Hizballah threatens to go regional.

In his book Nassim Taleb defined a black swan as a rare event with an extreme impact and retrospective predictability. Are we about to witness a black swan so close to the recent one (the financial crisis of 2007-2009)? If so in what form or medium? Is the collapse of the US dollar the next black swan? Could an Israel attack on Iran transform oil into a black swan event? or would the heavy burden of the US deficit turn Treasuries into swans? Perhaps the ultimate black swan will turn out to be golden because of the lack of confidence in the world's major currencies. No matter what the answer is there is a way to profit from it, assuming one is right of course. In that case I want my reward to be a black swan one indeed.

Inventory Recovery

This evening I had the privilege to listen to Bob Doll, BlackRock Vice Chairman and Chief Equity Strategist, speak in Phoenix about events driving today's global markets. The presentation was very enlightening and interesting. Mr. Doll sounded a definite long-term bull, especially on US equities. He pointed to the very healthy earning season and improving job market yet still acknowledging the head winds facing the US and global economies. Mr. Doll seems to be a believer in the inventory buildup cycle and the comeback of the US consumer. He attributed the tame inflation to the lack of the multiplier effect of the huge stimulus plan. Far be it from me to disagree with an established and highly regarded money manager and Vice Chairman of a company with well over $1.3 trillion under management. However, it seems to me that a lack of a multiplier effect is inconsistent with a spending consumer and growing economic activities. Hence, I would argue that unless the inventory buildup cycle, which I believe is mostly business-to-business, reaches the end consumer, the US economy runs a real risk of double dip.

China Not The Savior Some Thought

The economic rise of China over the past twenty years has been nothing less than spectacular, or at least it would seem so on the face of it. Many economists, analysts and political observers alike have been predicting the end of American economic and political dominance in the world in favor of a Chinese rise to power based on China's economic growth. Many others are pining hope on the so called mighty Chinese economy to rescue the world from its financial and economic doldrums. Is there truth to the thinking that a thriving capitalist economy in a communist political system will come to the rescue of the free world? Not so fast. Remember that China is still a communist country ruled by a one party system that when threatened, or perceived to be threatened, will not hesitate to pull the plug to ensure its existence. Example of this are plentiful, the latest being the squabble with Google. It is ironic to think that the very reason Chinese officials embraced economic reforms- that is survivability- may be the same reason that one day will cause the political elites in China to reverse course or at least take away many of the economic freedoms that lead to such phenomenal growth over the last two decades. There are already powerful voices in China calling for the abandonment of the new found system. The term "paper tiger economy" (no pun intended) may be an appropriate description of the Chinese economy for the following reasons:

While it may be true that the Chinese economy has been firing on all cylinders according to Chinese government figures it is also a fact that China is home to the largest poor population among the countries of the world. The gap between the very few rich and the very many poor is only growing wider and is bound to create social unrest in a country where economists predict the economy needs to grow at 8-10% year just to absorb the 20 million or so new job seekers. It is fairly easy to grow at double digits over a period when credit creation and availability was abundant and cheap; and when the start point was almost zero. That is the same period that the American consumer, by far the biggest spender, had access to unprecedented credit (not anymore, at least for now.) It is not realistic to pin hopes of rescue on a consumer that makes a fraction of what the American consumer makes. It is unrealistic to look up to a "Chinese middle class" (that does not exist) to put growth back into the world economy when the average car price is three times the average annual salary (think credit bubble given the number of cars sold in China over the last 3-5 years) and when the real estate price ratio is even worse. China's enormous currency reserves, which would otherwise give it prominence and power on the global stage, would have to, at least partially, be diverted internally to help create a middle class and to help stem the social tensions and problems created by the widening gap between the haves and the have not in the coming years. Some of this reserve may be converted into gold (see previous post "Does Gold Glitter?"). Even if you believe the Chinese government figures the reality is those figures point to an export lead economy and not an internal consumption driven growth.

The western economies, by far the most consumption oriented,(see previous post "Is There A V-Shaped recovery Of The Consumer Psyche?") are in an economic slowdown and face real deflationary pressure. The EU is the largest trading partner of China. How realistic is it to expect meaningful growth in an export dependent economy at a time when its largest trading partners are forecasting feeble growth at best. While it may be easier for America to go it alone (to decouple somewhat-which I don't think is possible) it is not the case for China because its economy is export driven and because it lacks a meaningful middle class. This is the age of globalization and the world economies are intertwined like it or not. Otherwise how can one explain the phenomena of China acting as America's banker by using American financial innovations (raising and efficiently allocating capital) to sell Chinese goods to American consumers in exchange for their dollars which in turn China uses to extend credit to the same consumer so he/she can go on buying Chinese goods or otherwise finance the American deficit.


While the steps the Chinese government has taken recently to help slowdown the runaway growth may or may not work they point to the problem the Chinese economy is facing in the coming years. Faced with a slowing world economy China pumped huge sums of money to keep its economic engine humming. But because it lacked a consuming middle class China had to direct most of the stimulus money to state owned companies that went on a commodities buying binge and built unneeded factories or entire cities that remain empty to this day. Herein lies the future headache of overcapacity at a time when the rest of the world is being thrifty. The other problem the Chinese will be facing soon is in their banking system. All that crazy lending over the last few years, mostly to state owned companies, is creating a situation not unlike the one we faced in the US, perhaps not in complexity but certainly in terms of simple loans gone bad. China has a bitter experience with such loans, dating back to 1999, which are still on the books of the so called AMCs (Asset Management Companies), otherwise known as "Bad Banks" in the west. A burst of a credit bubble or a real estate bubble will certainly trigger the need to recapitalise Chinese banks unless of course the old communist regime reverts back to its old ways.

Perhaps the most telling of the state of the Chinese economy is the fall in the premium between the A shares of Chinese companies traded on the Shanghai stock exchange and the H shares of the same companies traded in Hong Kong. That premium reached a high of 40% in favor of the A shares over the last three years. This is telling because the A shares are not available to foreigners (for the most part), meaning it is a true reflection of how the average Chinese feels about the economy.


Whether we believe the Chinese government figures or not a simple application of the test of logic should be enough to realize that China will not be the shoulder upon which the rest of the world's burden will come to rest. Rather, the Chinese economy is a paper tiger one waiting to crumble in the short term. Longer term, and after the excesses have been dealt with and as the US and the EU start to emerge out of their slumber, China will have its appropriate role to play on the world economic stage but not one that will upstage the US.

Does Gold Glitter?

In 1946 the Bretton Woods System established a fixed exchange rate of $35 per once of Gold. That is when the dollar and the U.S. economy were the envy of the world. In 1971 President Nixon ended the fixed rate peg and the dollar (and other currencies) was allowed to float supported only by the strong U.S. economy, low debt and the full creditworthiness of the U.S. government. Smelling blood and lead by Russia in 2009 we saw the BRIC bloc declare their support for an alternate world reserve currency to the U.S. dollar. What will the form of this alternate currency be and what will support it? Neither of the BRIC currencies is strong enough to carry this burden and privilege. Nor can the BRIC bloc be unified enough to form the backbone of support for they are (geographically), politically, economically and culturally far apart. I don't think for a moment the BRIC thought they can actually replace the dollar as a reserve currency with another currency, not even an SDR. They also did not create a road map for the replacement. However, recent events may be turning their desire into reality no thanks to them.

The U.S. dollar is weighed down by too much debt and an uncertain regulatory terrain of the financial system to retain the title of "reserve currency". Don't be fooled by the recent tactical retreat to the safety of the dollar following the horrible but expected events in the EU. Simply put the dollar is the lesser of the evils out there at the moment.

With the announcement of the massive bailout the Euro just started down the path of the dollar. Tapping into future earnings to pay for past spending is a sure way to tame growth for years to come. This massive bailout is more of an attempt to preserve Europe's ability to face an aggressive Russia at its doorstep more then anything else; for economic unity, no matter how feeble, brings political determination.

At times of great uncertainties countries must and will do what they see is in the best of their interest. China's massive dollar reserves can be a blessing or a burden. China is facing its own economic problems stemming from fast growth. Recently the Chinese government has taken a series of steps to curb the runaway growth of its economy and what many consider a huge bubble in its housing market. Faced with a declining dollar and weak prospects of its largest trading partner, the EU, China may well decide to rid itself of some reserves- who wants to hang on to a declining asset- and preserve its wealth in gold. For over five thousand years people have been turning to gold to preserve their wealth at times of distress.

For the last couple years we saw some central banks around the world increase their gold holdings (India among them) while others declared their intention of doing so (China). Given the unprecedented amount of debt issued over the last decade and the additional debt burden assumed (think potential inflation) lately in a failing attempt to rescue the system and faced with a real slowdown both in Europe and in America (think uncertainty) signs of a perfect storm are beginning to form giving rise to all things golden and a De facto undeclared new world reserve currency.

At a time when no one currency is strong enough to be dominant the country (or countries) holding more gold has more say in the shape and composition of a future reserve currency. The competition is on.

I say gold does glitter.

Death of Capitalism Times (X) 2

Enough with the congratulatory comments and kudos for the latest EU bailout. How can this be a good thing when you take a trillion dollars of future earnings to pay for past spending. Where is the growth going to come from with the deflationary pressure this move will cause. There is only one solution, which had it been used in the US we would probably be out of this mess by now, and that is to let the market correct the problem. Yes let Greece fail (restructure its debt), yes let the big European (and American) banks fail. Stop interfering with the natural process of dealing with failed entities. This is not the end of the crisis. It is now beyond a geographically contained area. This is a loosing attempt at saving the integrity of the Euro and delay the day of reckoning. Let market forces shake off the rotten fruits.

The US can not decouple from Europe. Not when the EU, the largest trading partner of China, is going into a prolonged period of uncertainty and economic malaise at a time that China, our banker, is facing very possibly the same fate. The same wheel goes round and round.

Is There A V-Shape Recovery Of The Consumer Psyche

For the last year or so Larry Kudlow, whose ideas and views I agree with almost always, has been promoting and rightly so the idea of a V-shaped recovery of our economy. There is no question that such a V-shape recovery has been underway as supported by numerous economic data. But the questions remain "is this recovery sustainable?" And "what is fueling it?". The answer to the first question in my opinion is NO because any sustained recovery is contingent upon the ability and willingness of the [end]consumer to spend. After all, all goods and services are produced for the end user - the consumer. In this blog I will attempt to explain why the consumer will remain weak for many years. I'll leave the answer to the second question to a later blog.

The shock that the U.S. economy, indeed the world economy, suffered over the last three years or so is far more damaging that many would accept beyond the quantitatively captured harm. It was not a normal and a necessary healthy recession that every free economy needs every now and than to rid of excesses. This recession shook the very foundation upon which a free capitalist system is based- and that is the concept of credit availability to fuel demand, and by extension the manageability of debt, both on the individual and government levels.

It is not the intention of this piece to argue the causes and responsibilities of this enormous shock, but to explore the consequences it left behind. To understand this one has to understand that consumer behavior is like many other human behaviors based on confidence. Once this confidence is broken one has to go through a series of steps, processes and time to gain it back. The deeper the crack the longer the build up process. This notion applies to the entire chain of economic activities. Meaning that each entity in the system (a government, a manufacturer, a doctor, a bank, a lending officer, a purchasing manager, a teacher, a cab driver etc,....) at some point is a consumer in his/her business entity capacity and has to make decisions just like the end consumer does. It is hard to see how a bank or a bank officer can lend money to a confidence shaken business or decision maker just as it is hard to see how the end consumer, who for years used an artificially inflated asset price (his/her house)to fuel an unprecedented level of demand for all goods and services produced, can embark on a shopping spree the kind of which we experienced over the last decade or so. Yet that is exactly what wee need to sustain the V-shape recovery. Remember not only has that end consumer seen the value of his/her largest asset and piggy bank plummet in value but he/she has also watched his/her retirement fund plummet as well. So now the piggybank is gone and any future earnings has to go to replenish the retirement fund and for many who were hoping to retire soon now have to extend their working years. Not to mention the pile of individual (and public)debt accumulated during the boom years. I ask you does this bring confidence back to a broken psyche? Therefore, there is neither the ability (credit availability) nor the willingness (consumer behavior)for this recovery to sustain itself at the pace it has for the last year. Given the global economic conditions and the amount of sovereign debts the world has to deal with the U.S. economy will grow at a very tepid pace in the years ahead.

It is also worth mentioning that business entities are made of individuals whose personal experiences heavily influence their decisions- bad memories tend to linger for a while.

Some may say that the same economic figures that point to a V-shape recovery also point to an engaging consumer. That may be true to a certain extent. Still one has to ask what is fueling this limited consumer participation. Many are the answers embedded in the same economic figures. Others have offered countering answers that, if true, spell a pretty disturbing picture (such as people who are upside down on their mortgages intentionally skipping payments-thanks, in part, to all the government bailouts- and spending that money elsewhere). However, these figures reflect a bounce from a very steep drop and the unemployment rate is still near 10%. My answer to those who say that the other 90% are still employed is twofold. First, remember that many have to work harder and longer and save more in order to replenish some of what was lost in this crisis. Many had counted on their home price appreciation as the retirement fund. Second, we need that other 10% working to fuel the extra end demand needed to sustain a V-shape recovery.

This is not a gloom and doom view. It is merely a realty check. The sooner and the more embracing we are of the facts the faster the recovery is and the more reasonable expectations are. This is not a consumer lead recovery. This is a liquidity driven short term bounce.

In short there is no V-shape recovery of the consumer psyche. It is time to tighten the belt one more notch and acknowledge that a lower standard of living await us all.



Coming soon:

Does Gold Glitter?

China Not The Savior Some Thought

Sovereign Debt: Can More Debt At Higher Cost Bring Debt Relief?