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The Hutch Report

Is Hammurabi’s Code the key to fixing the banks?

By | Finance, Law

Over the years there have been a chain of events that have led us to where we are now. This is true not only for the US but for the rest of the world. In a previous article we tried to determine when the US was at its strongest, to maybe shed some light on where the US went off track. It seemed clear that when the US middle class was the largest portion of the population domestic production was also at its greatest. Simply put, people were working and had money to spend. More demand created more production and more jobs.

Looking at the non-farm payroll reports you would think that everything is booming yet we see from a number of sources that low unemployment numbers do not tell the whole story. There are a large number of facts and arguments that support that point of view. Things are not well and getting worse but the subject of this article is what to do about it?

We know from the financial crisis of 2007 that very little was done. The New York Times highlighted the differences between the Savings and Loans Crisis of 1983 and the Financial Crisis of 2007 where following the S&L crisis there were 1,100 prosecutions, compared to 2007 where only one banker went to jail.

The population that was affected by the crisis tried to vent their frustration in anyway they could. So the protest movement, Occupy Wall Street was born The main issues raised by Occupy Wall Street were social and economic inequality, greed, corruption and the perceived undue influence of corporations on government—particularly from the financial services sector. The OWS slogan, “We are the 99%,” referred to income inequality and wealth distribution in the US between the wealthiest 1% and the rest of the population. That was 2007 and now it is worst.

How did the financial media cover this?

“SERIOUSLY?” CNN’s Erin Burnett asked mockingly after finding one protester who didn’t know the government made money on the Wall Street bailout.

Fox News largely mocked them as “whackos” and “communists,” and took pains to compare Occupy Wall Street unfavourably to the Tea Party.

At the time, CNBC’s Lawrence Kudlow suggested the protests were unpatriotic (currently President Trump’s chief economic adviser).

Most financial media criticised the protests for not supplying any concrete solutions and to stop playing the “Blame Game,” and here lies one of the main issues. The levels of greed and corruption are through the roof yet fewer and fewer are being punished, in spite of the fact that these so called white collar crimes have had serious repercussions in the greater economy and do affect peoples lives indirectly. Today the motivation behind greed to steal and harm others seems to be stronger than the deterrents from the risks involved. We should therefore be playing the blame game even more and bring people to justice. Here we look to the Code of Hammurabi for some insight.

The Code of Hammurabi is a well preserved Babylonian law code of ancient Mesopotamia, dating back to about 1754 BC. It is one of the oldest deciphered writings of significant length in the world. The sixth Babylonian king, Hammurabi, enacted the code, and partial copies exist on a man sized stone stele and various clay tablets. The Code consists of 282 laws, with scaled punishments, adjusting an eye for an eye, tooth for a tooth as graded depending on social status, or slave versus free man. Nearly one half of the Code deals with matters of contract, establishing, for example the wages to be paid to an ox driver or a surgeon. Other provisions set the terms of a transaction, establishing the liability of a builder for a house that collapses.

If an architect was hired to construct a bridge, he and his family would be forced to sleep under the bridge. If a captain was hired to sail a ship and he was responsible for wrecking it, he would be personally liable for the damages. If a builder built a house for someone and did not build it properly, and the house that he built fell and killed the owner of the house, then the builder would be put to death. These are examples of clear and direct irresponsibility. If the builder purchased crappy materials at a cut rate, he would still be responsible. The principle concept is to hold people responsible for their actions.

If an accuser brought an accusation of a crime but could not prove it, the accuser would be put to death. Or, thieves would have their fingers cut off. We are supposed to be living in a more civilised society and are not advocating such exaggerated drastic measures, although one of the closest allies to the US employs them.

The main idea here is holding those in power accountable for their actions to the point where should their actions harm others, they would be “personally” liable, or as Nassim Taleb advocates having “skin in the game.”

How could the code be applied to today’s incidents? Think about how many investment manager market forecasters would change their tune if what they pushed their clients into was taken out of their personal accounts. You would most likely begin to see the most conservative portfolios you have ever seen. It would probably cut Goldman Sachs business by 60%. How would Jim Cramer react if his “Buy Buy Buy” rants held him personally liable for any losses he may incur?

Wells Fargo used improper accounting techniques to hide losses in order to borrow money from the Federal Reserve at lower interest rates — effectively defrauding the government by hiding the true scope of the bank’s financial problems. According to Hammurabi’s code, if the line of management responsible for such actions were forced to pay damages, not under the guise of an incorporated company, but from their personal net worth it is doubtful that those responsible would have ever authorised such actions. The result of the present judicial system is that the bank continues to replicate such actions and at worst the CEO is dismissed with a massive bonus.

Before economic activity can be developed to where the middle class becomes stronger once again, putting the greater economy on a stable footing for all, regulations have to be enforced and more crimes need to be punished. Crimes need to be punished accordingly. To do this requires political will, but those politicians need to be also held personally accountable. However, we need to start somewhere so the financial industry seems like a good place to start. As Billy Ray Valentine said in the movie Trading Places, “You know, it occurs to me that the best way you hurt rich people is by turning them into poor people.” The movie Trading Places was essentially an example of an eye for an eye. You may remember that the Winthorp’s bet was for $1, no skin in the game.

Getting 5 years in prison for stealing a few packs of gum compared with ripping off billions from tax payers and getting a slap on the wrist is an economy on the edge of chaos, not stability. As trend forecaster Gerald Celente likes to say, “When people lose everything, they lose it.”

The Hutch Report

Will Turkey be the first domino to fall?

By | Finance

There has been many financial crises over the past century, yet few of those provided much of a warning that they were about to hit.  It only becomes clear after the fact. We then begin to hear speeches on what there was to learn and how to avert any future crisis, until the next crisis arrives in a slightly different form. Philosopher George Santayana, once wrote, “Those who cannot remember the past are condemned to repeat it.” History has proven this to be true. 

We now have a situation brewing in Turkey, yet there are many in the financial media who are already quick to write off the current collapse in the Turkish Lira as contained to Turkey and that the size of Turkey’s GDP makes it less of a threat. Yet, Turkey’s GDP is double the size of what Thailand’s was during the Asian crisis. Therefore, in order to understand the current crisis in Turkey, it is worth looking back at the Asian crisis of 1997.

In 1997, just before the crisis hit, Thailand’s economy was booming. Banks were lending freely. The resulting large quantities of credit that became available generated a highly leveraged economic climate, which led to excessive real estate speculation, and pushed up asset prices to an unsustainable level. An economic expansion, that nobody wanted to end, was in full force. In fact, the Thai central bank kept the currency artificially high, fuelling the speculative bubble. 

I guess you could say that there were signs of a brewing crisis if you choose to focus on them. Banks began lending against the security of the buildings that didn’t have too much of a chance at being filled. Muang Thong Thani was a housing estate built for 700,000 people and became a victim of the coming crash.  At the time of the mid-1990s, Thailand, Indonesia and South Korea had large private current account deficits and the maintenance of fixed exchange rates encouraged external borrowing and led to excessive exposure to foreign exchange risk in both the financial and corporate sectors. Capital controls were being reduced and there was a lack of transparency. 

In 1995 the US dollar began to strengthen. For the Southeast Asian nations which had currencies pegged to the US dollar, the higher US dollar caused their own exports to become more expensive and less competitive in the global markets. Southeast Asia’s export growth slowed dramatically in the spring of 1996, deteriorating their current account position. Once the financial markets sensed that the Thai foreign currency reserves were dwindling, they started shorting the Thai Baht. The asymmetric information in the financial markets led to a “herd mentality” among investors. Their actions helped to magnify the underlying weaknesses and hence, make the first domino fall.

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The economy ground to a halt, salaries were cut and the price of everything began to go up. The IMF stepped in with a loan but that didn’t help so they went to the US for help but they refused. The US was hardly worried that a small country like Thailand could cause any significant damage beyond its own borders. 

Once Thailand began to unravel, speculators and traders began to get worried about other South Asian countries, such as Malaysia, Indonesia and South Korea. Like a classic run on the bank, investors began to dump their positions in those countries, and at the same time speculators were quick to short the currencies, putting more downward pressure on them. Current Prime Minister of Malaysia, and also Prime Minister at the time, Dr. Mahathir bin Mohamed,  stated, “As the currency and the stock market went down, we felt totally helpless.” Once the contagion hit Indonesia, the Government and economy collapsed and from that fallout, the social fabric began to collapse. The IMF had to step in and provide huge loans, but with those loans came conditions. These countries were then subjected to acute economic austerity.

The contagion then spread to South Korea but by the time the IMF got to their central bank the money was all gone. In spite of the fact that the South Koreans had convinced everyone their financial foundation was stable. In order to avoid a default, South Korea received a bailout of $55 billion in new loans and credits. In the end roughly $116 billion flowed out of Southeast Asian Markets.  

At the time, US hedge fund LTCM, controlled $100 billion in global assets and $1 trillion indirectly. The Asian financial crisis was not factored into their complex mathematical risk equations and therefore took Long Term Capital Management completely by surprise. Contagion came to America.

Looking back, one important point here is that this contagion was not set off by anything fundamental beyond Thailand. If Thailand had been contained, the other economies may have adjusted and set stricter controls in order to avoid a Thai scenario. It was fear of the unknown and a loss of confidence that forced the financial markets to make the moves they made. The corruption, overbuilding, and foolish loans were just kerosene for the fire once the match was lit. Today’s world financial markets and economies are so interlinked that events impacting one region will have an emotional behavioural impact on another. One domino falling sparks fear in the markets that others are sure to follow. 

So the question is looking at today’s markets, who will be the first domino to fall? Some thought Cyprus but that was contained. Then there was Greece but that was contained. There was talk of Italy being the first. Then last week we had Turkey. If the Turkish situation deteriorates you can bet that the financial markets will, like during the Asian crisis, become nervous regarding areas beyond Turkey bringing considerable risks of financial contagion. We already saw investors dumping stocks such as Italian bank UniCredit last week, for fear that they are over exposed to risks in Turkey. According to the Bank for International Settlements, international banks had outstanding loans of $224 billion to Turkish borrowers, including $83 billion from banks in Spain, $35 billion from banks in France, $18 billion from banks in Italy, $17 billion each from banks in the United States and in the United Kingdom, and $13 billion from banks in Germany. So what happens next is anybody’s guess but to believe that it couldn’t happen again is probably not the most prudent view to take.

The Hutch Report

Market Forecasting is Dead

By | Economics, Finance

The ability to forecast the markets is dead. It can also be argued that it never existed.

Regardless of that oversight, we are entertained by a constant stream of “experts” on financial media who profess to understand why the market has acted on any given day, or how it will act tomorrow. Everyone of them is trying but very few get it right. When they do get it right you can attribute it to pure chance, as their track records for being consistent are far and few between.

Many investors, individual as well as institutional, rely on market experts and forecasters when making investment decisions, regardless of the fact that they keep coming up short. For example, on 3 January 2015 Thomas Lee predicted that the S&P 500 index would be at 2325 one year from his prediction. The S&P 500 ranged between 1867 and 2122 during this period, and closed at 2012 on 4 January 2016, well short of the goal. There have been several previous analyses of forecaster accuracy, both in academic literature and also in the financial press in the past. Although many will correlate with the S&P 500 during years of stability (where you could essentially just apply a variety of statistical methods to extrapolate into the future), they have been seen to be surprisingly unreliable during major shifts in the market. For example, an analysis by Nir Kaissar found that the strategists overestimated the S&P 500’s year-end price by 26.2 percent on average during the three recession years 2000 through 2002, yet they underestimated the index’s level by 10.6 percent for the initial recovery year 2003.

There are a variety of reasons why forecasting the markets is a futile exercise. As Nassim Taleb puts it – “The tragedy is that much of what you think is random is in your control and, what’s worse, the opposite.” Regular savings are in your control, your expectations and behaviour is also in your control, however, stock market moves in an uncertain world are not.

GAAP

Fundamentally, businesses usually go public to raise capital in hopes of expanding. The ownership of the business is then spread among a large group of shareholders. If the company’s earnings are solid and consistent, the share price is valued higher and the shareholders get rewarded for putting their money at risk. These companies issue quarterly and yearly earnings reports in order to provide current and any potential future shareholders a snapshot of the health of the company at that moment. To do so they usually apply what we call, “Generally Accepted Accounting Principles.”

But as the MIT Sloan Management Review recently pointed out,

“Lurking within the financial statements and communications of public companies is a troubling trend. Alternative metrics, once used sparingly, have become increasingly ubiquitous and more detached from reality.”

They went on to provide the following example:

“In 2011, Groupon Inc. announced plans for a highly anticipated initial public offering. But enthusiasm for the offering waned when the U.S. Securities and Exchange Commission (SEC) issued a comment letter questioning Groupon’s use of a profit metric it called “adjusted consolidated segment operating income.” To our knowledge, no company had ever used that metric before; it was intended to measure operating profit without including marketing expenses, stock-based compensation, and acquisition-related costs. Management argued that a $420 million loss from operations reported on its 2010 income statement should really be considered a $60 million gain.”

This is not an isolated example, and the use of these so called, “Accounting tricks” have only become more sophisticated. What was once analysis of a business’s operations and their ability to satisfy customers and grow has become an exercise of forensic accounting analysis in order to spot the manipulators! Try forecasting the next clever income statement adjustment!

The Federal Reserve

What were once pretty much free markets have become markets that have become pretty much dependent on the next Central Bank intervention. QE1 took place in November 2008 when the Fed spent $600 billion on purchase of Mortgage-backed Securities (MBS) in order to “save” the financial system from ruin (which could be argued that they facilitated in the first place). But they didn’t stop there. They continued with QE2, Operation Twist, Operation Twist Extended and QE3. It didn’t stop with the Fed, as they do work closely with their central bank colleagues, such as the ECB and BOJ.

Total Assets of Major Central Banks

Was there an impact on the financial markets? Of course there was. They drove interest rates pretty much to zero for an extended period. As Quicken Loans pointed out, there will be a time when the Fed has to get out of their positions and when that happens:

“A new buyer, or more likely several of them, would have to pick up the slack and buy lots of MBS in order to keep mortgage rates where they are right now. No one has a crystal ball as to when the Fed will start to get out of the MBS market, either.”

So without a crystal ball or being privy to what the Federal Reserve has planned regarding future manipulations of the market, trying to forecast them is a futile exercise that serves no purpose.

High-Frequency Trading, Spoofing, and other Shenanigans

In addition to accounting trickery and central bank intervention, here are a few more choice headlines and examples as to why forecasting the markets is dead.

“Six banks fined $5.6bn over rigging of foreign exchange markets”

“HSBC faces fresh suit alleging forex manipulation”

“BNP Paribas pleads guilty to forex manipulation”

“Wells Fargo Accused Of Manipulating Business Banking Data”

Since 2007 we have seen a new player in town, high frequency traders. High-frequency trading is an automated trading platform used by large investment banks, hedge funds and institutional investors that utilizes powerful computers to transact a large number of orders at extremely high speeds. This has completely changed the dynamics of the markets. As JP Morgan pointed out in their own report of June 13, 2017:

“While fundamental narratives explaining the price action abound, the majority of equity investors today don’t buy or sell stocks based on stock specific fundamentals,” Marko Kolanovic, global head of quantitative and derivatives research at JPMorgan, said in a Tuesday note to clients.

Kolanovic estimates “fundamental discretionary traders” account for only about 10 percent of trading volume in stocks. Passive and quantitative investing accounts for about 60 percent, more than double the share a decade ago, he said.

Which introduced another brilliant market manipulation called “spoofing,” and another choice headline to present:

“Gold, Silver Manipulation: CFTC Fines Deutsche, USB, HSBC For Spoofing Markets”

The CFTC announced earlier this year that Deutsche Bank, UBS and HSBC faced fines totaling $46.6 million. Deutsche Bank was the hardest hit as it was fined $30 million. UBS was ordered to pay $15 million and HSBC was fined $1.6 million.

How about naked short selling? Naked short selling, or naked shorting, is the practice of short-selling a tradable asset of any kind without first borrowing the security or ensuring that the security can be borrowed, as is conventionally done in a short sale.

Paul Craig Roberts described this process as it is used in the gold markets:

“This manipulation by the Fed involves the short-selling of uncovered Comex gold futures. “Uncovered” means that these are contracts that are sold without any underlying physical gold to deliver if the buyer on the other side decides to ask for delivery. This is also known as “naked short selling.” The execution of the manipulative trading is conducted through one of the major gold futures trading banks, such as JPMorgan Chase, HSBC, and Bank of Nova Scotia. These banks do the actual selling on behalf of the Fed.”

To see proof of this, one just has to check the latest Comex Reports to see that the current ratio of paper gold to physical gold is 176:1.

Conclusion

The next time you are watching your favorite financial media program providing explanations as to what the market is doing now and what the market will do,  remember the previous points. Remember to ask yourself two questions, “Does this person really have the ability to forecast the markets,” and “should I have confidence in any of their conclusions?” Because, in reality, market forecasting is dead!

The Hutch Report

Your Bank Account – Who really owns the money (hint: it’s not you)

By | Finance

Although few depositors realize it, legally the bank owns the depositor’s funds as soon as they are put in the bank. Our money becomes the bank’s, and we become unsecured creditors holding IOUs or promises to pay.

In general, unsecured creditors, such as depositors of a bank, will have very little redress to cover their debts if a company is put into liquidation. The courts will not deal with the question of which class of creditor should have priority over other classes in such circumstances. 

In the case of banking, it indicates the limited responsiblity of a bank towards depositors once the bank has the money put into its account. The principle illustrates that the relationship between the depositor and the bank is not one of principal and agent, where the bank as an agent acts on behalf of the principal and their interests. The money deposited in an account is no longer deemed as belonging to the principal but rather to the bank.

The money paid into the banker’s is money known by the principal to be placed there for the purpose of being under the control of the banker; it is then the banker’s money; he is known to deal with it as his own; he makes what profit of it he can, which profit he retains to himself. (Banking Regulation of UK and US Financial Markets – By Dr Dalvinder Singh)

In banking, the verbs “deposit” and “withdrawal” mean a customer paying money into, and taking money out of, an account. From a legal and financial accounting standpoint, the noun “deposit” is used by the banking industry in financial statements to describe the liability owed by the bank to its depositor, and not the funds that the bank holds as a result of the deposit, which are shown as assets of the bank.

There are still, however, people who choose to doubt this and claim that depositors are not creditors. All we have to do is to look at the “Depositor Preference Rule.” A depositor preference rule requires that in the insolvency of a bank, the claims of depositor’s enjoy a privileged status. A majority of G-20 countries have some form of depositor preference rule, including Australia, Switzerland and the United States. An increasing number of European countries which have undergone, or are undergoing, EU/IMF programmes, including Greece, Portugal, Hungary, Latvia and Romania, have introduced depositor preference regimes. In the U.S., among unsecured creditors, the claims of the insolvency administrator rank first, and the depositors rank ahead of tax and employee compensation claims. Otherwise said, this states that the depositors do have to stand in line to get back money that the bank owes them (not the money that they think is theirs in a bank account!).

Previously the bank was obligated to pay the depositor’s money back on demand in the form of cash. According to the 15-page FDIC-BOE document called “Resolving Globally Active, Systemically Important, Financial Institutions”, IOUs will be converted into “bank equity.” The bank will get the money and the depositor will get stock in the bank. With any luck the depositor may be able to sell the stock to someone else, but when and at what price?

Why does it matter? Because if the bank’s IOUs are converted to bank stock, they will no longer be subject to insurance protection by the FDIC, but will be “at risk” and vulnerable to being wiped out, just as the Lehman Brothers shareholders were in 2008.

The FED – Are We Being FED Bullshit?

By | Finance, Markets

Did the market reaction after last week’s 25bps rate hike announced by Janet Yellen and the FOMC (Federal Open Market Committee) leave you scratching your head? The dollar went down, Wall Street rallied with the S&P spiking near all-time highs, commodities including gold rallied … was this what you were expecting? Well, if not and if you are scratching your head, be comforted that you are not alone. Many others are also scratching their heads, from amateur investors to seasoned industry veterans.

As typical with post game couch side review, explanations are being created to match with what happened. One of the explanations that is being repeated is that this was a dovish event on the part of the Fed. A bit surprising because in the recent past, this would most likely have been considered a hawkish move from the Fed, as with most rate hikes, along with the maintained position on a forecast of three hikes this year. Apparently for this latest FOMC meeting to have been considered hawkish the Fed would have had to announce an increase in the anticipated number of rate hikes and there would have had to have been a change to the notorious dot plot of Fed member positions.

If you do not buy the explanation that the announcement was dovish, another plausible explanation is that this is the kind of behavior just driven by ongoing euphoria of the late stage bull market. Jan Hatzius, chief economist of Goldman is quoted as saying that this market reaction does not really make sense and was more akin to what you would expect if it was a 25bps move in the other direction – in other words how the market would have reacted if the Fed had announced a rate cut.

Another dynamic at play here is the bullish rhetoric of Trump, decreasing corporate taxes and regulation, infrastructure spending, US dollar repatriation which would lead to a stronger dollar but also more difficulty for the US economy versus the Fed who want to be sure they have enough powder to keep inflation in check. Another elephant in the room is all of the outstanding US debt which would become impossible to service if rates get too high.

Nothing is ever in isolation and another event with a side-effect impact to the dollar was that the Dutch elections were on the same day as the Fed announcement and there was a boost to the Euro exchange rate due to the non-populist outcome of the Dutch elections. Next month will see additional events outside the US that will have side effects towards the US dollar. Sentiment towards the Euro will surely be impacted as the French elections start heading towards a climax over the next two months as well as the UK’s self-imposed deadlines for Brexit talks next week. In addition, both the ECB and BOJ will be convening towards the end of April and these sessions will surely add to the exciting things to watch out for next month. The next FOMC session is not scheduled until June 13-14 and that session will also be associated with a Summary of Economic Projections and a press conference by the Chair.