Breaking the Financial Spiral - Part 2

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(for part 1 see here)

This financial disaster requires some extra innovations in stimulus. Stimulus is needed from the governments simply because the massive reduction in demand brought about by job loss, credit freeze and re-balancing of household budgets. Tax cuts versus cash handouts are a red herring. The sheer amount of demand lost cannot be replaced by increasing discretionary income. Most of the consumer demand was credit based that 140 to 160% leverage of households. Trying to replace that with tax cuts or cash handouts is like trying to refill a reservoir with a bucket after the dam as broken. It’s not going to even touch the sides.

Nor can businesses replace the demand. They are inextricably tied to the crisis as businesses have been just as profligate as consumers over leveraging and not building up capital reserves. Few companies have built up cash reserves that they can use to invest during the down turn. Government handouts or tax cuts to businesses aren't going to do much to create the necessary investment in growth. Too many companies need to repair balance sheets (just like households).

The only point is for governments to step with their own demand. The idea isn't to replace all the demand lost (that will never happen) rather to break the cycle of lost demand causing further lost demand. Government stimulus initiatives need to be more direct than perhaps they have been in previous recessions. For the demand replacement to work it can't focus on make work like ditch digging. Stimulus programs need to consist of short, medium and long term that focus on energy, transport, communications and maintenance in order to produce a trajectory that gets us out of the spiral.

Short term initiatives are programmes that can be started in a very short space in time. Short term projects that would work are:

• Insulation or wheatherisation of homes (in particular low income households),
• Rebates, low interest loans or direct funding for households to install renewable energy systems and general energy efficiency for both households, schools, hospitals and government buildings,
• Maintenance of roads, bridges, culverts and buildings will improve infrastructure are usually ready to go and can easily verified.
• Re-opening existing funding programs for example, in Australia there was a solar-rebate program that was shut due to over-subscription. Adding money into this and re-opening would be a quick win as the bureaucracy already exists and nothing new has to be done.

Medium term require more time to get off the ground. The idea is these projects take over creating demand as the demand from the short term projects peters out. Examples of projects are:

• National conduit system for communications (fibre). The idea is that the conduits are all built to the same design and can be undertaken by a multitude of companies across the country at the same time.
• Installing Electrical re-charge stations would overcome the chicken and egg problem of getting plugin cars main stream. They would also reduce bills spent on petrol (gas), while stimulating demand to replace existing cars with plugin’s.
• Replacing old bogies and busses and expanding the fleet will generate demand for manufacturing while improving the energy consumption of the economy. As per unit energy of transport falls productivity rises and frees up resources to be spent elsewhere. London Transport could certainly do with more upgrading the overground trains and increasing the size of the fleet. To say nothing of the underground.

Long term projects are generally large scale infrastructure projects that take time to get off the ground. These take over as the demand from medium term projects peter out. The type of projects I think should be funded are:

• Fund mass transit systems in cities.
• Fund fast rail projects linking up major cities. In Europe this would involve funding cross boarder connections and city bypasses.
• Provide loans for large scale renewable energy projects. The loans provide the initial liquidity that is lacking at the moment and address the need to create green jobs.
• Fund the extension of the power grid from sources to demand. This overcomes the chicken and egg problem that make a lot of large scale renewable energy projects dicey.

Development projects are only one part of the stimulus package. Additionally, help to start new and existing businesses is needed (many of the old businesses need to die as we progress from centralised to edge economy). For small business the hardest part is getting the capital/resources together to get the business to a point of being cashflow positive. Venture funding is not the answer. Most small businesses are not venture businesses but rather businesses that will turn a tidy profit but never exit.

For many (if not most) small businesses labour is the largest cost in the early years. To help new businesses start, governments need to provide income-contingent loans that pay salaries for up to 5 employees for the first year with an option to extend for a 2nd year. The income-contingent loans would be on the employee and not the business (reduces gaming of the system and also means the employees are invested in getting the business to succeed). Large numbers of new small business will go a long way to address demand destruction.
The government also needs to reduce the costs they impose on business through the amount they charge for services and cost of complying with regulation and legislation. This will free resources leading to increased investment and lower prices which benefit the economy overall.

Why energy, communications, transport and maintenance? Energy has two effects it addresses the simmering problem of peak oil and energy security (that hasn't gone away only been pushed to the background and will come roaring back soon). Additionally, by increasing energy efficiency cash is freed up (households, business and government) that can be used elsewhere whether repairing balance sheets faster or for consumption. Communications and transport projects also go to increasing energy security but primary reason is that improved communications and transport increase the productivity of the economy. Maintenance improves the performance of assets while also extending their life.

Moral hazard will be raised along with the supposed unfairness to people who where sensible. This is a concern but one that shouldn't, mustn't, hold up initiatives to break the spiral. The market can only work if there is a market and we are all part of a system. Just like destruction of one part of an ecosystem flows on to destroy other parts, so too will the spiral flow on to effect even the sensible. Within the three pronged approach you can put in place methods to address moral hazard and poor behaviour. For example, with the mortgage principal reduction the government can take a majority of any future realised capital gains. People who have the mortgage reset can also face additional credit restrictions in the future.

All of this is further complicated by the need for Western countries (particular the Anglo-Celtic countries) to coordinate the implementation of such a sweeping initiative. If the countries go it alone they will only make the whole job harder.

These are unusual times and call for unusual measures. The aim here is to reduce the crushing debt and cushion the economy from the plunge in demand by making it easier for new businesses to start and creating demand to replace some of what was lost. Make no mistake; the world will not return to levels of demand seen previously and the point of stimulus packages is to make the shift in the economy orderly rather than chaotic. Now is not the time for ideological battles or programs. The world needs pragmatism and the leadership to break the spiral and begin the path to recovery.

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Breaking the Financial Spiral

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Many have talked about how to solve the current crisis. I have my own view. I’ve written this as two comments so far; on Tom Evslin’s blog and Fred Wilson’s blog. At Fred’s suggestion and prompted by Neil Ferguson’s recent article in the Australian about similar proposal I’m turning this into a blog post.

The continual drip feed of rescues and bailouts is like keeping someone who has been bitten by a snake on life-support without removing the poison from the body and wondering why you have to keep treating heart attacks and seizures. Until the poison is removed from the body nothing is going to change. The economy is poisoned and the rescues and bailouts are doing nothing to remove the poison.

The poison is fear. Fear of investors who don’t know where the risk is and how risk exists. Fear of households who don’t know whether they will be able to keep food on the table or a roof over their heads. Fear breads fear. It feeds off it and becomes self perpetuating. To begin recovery, initiatives need to short circuit the fear.

The poison entered the system via inflated asset prices and loans. The principal on loans is simply too large. Now the loans are sucking up increasing amounts of income to pay off reducing consumption and increasing default rates, both feeding into the broader economy to reduce demand and in an on-going spiral leading to a recession, job losses and further defaults. As job losses mount consumers reduce their expenditure as they fear losing their own jobs and not being able to put food onto the table and a roof over their heads.

Investors injected fear as they suddenly found themselves in the unknown. Their safe investment s weren’t and now they had no idea where the risk is or how much, leaving them to stop investing and lending causing liquidity to dry up. The liquidity loss caused further increase in risk and default feeding further problems. It is all a spiral and until the spiral is broken it keeps going.

So far initiatives have halted the convulsions and resuscitated from heart attacks, but it is now time to draw the poison from the system.

Drawing the poison starts with loans. Until loans reflect the actual value of the assets, foreclosure rate will be high, subsidised payments and modifications notwithstanding. It simply doesn't make sense to continue to pay a mortgage, even at subsidised rates, when the value of the underlying asset is 20% or more less than the mortgage. In the end the mortgage principal needs to be reset to be within shouting distance of the underlying value of the asset.

Governments need to look at wholesale reduction in principal, something along the lines of financial institutions writing down the principal by 15 to 30%, the government purchasing 30% of the principal from the institutions. Depending on the location the Government can either write-off their purchase principal, suspend interest on their part of the principal or do nothing. The mortgage principal in effect is reduced by between 30 to 60%. The price of housing gets a massive reset to something resembling reason and underlying value. The principal reset has the effect of creating massive re-balancing of household balancesheets and freeing up income for discretionary spending.

Where it that simple of course. Unfortunately, underwater equity is only a small (although extremely toxic) part of the problem. The abject fear of not being able to keep food on the table and roof over their head is causing consumers to save. That fear undermines all stimulator policies. While new jobs may be created they are not going to be created fast enough to replace the jobs lost. Job loss happens far faster than job creation. The fear is creating a spiral to disaster that needs to be short-circuited. A short circuit would be to guarantee 75% to 90% of previous salary for a period of 12 to 24 months (the time length depends on time lag between job loss and job creation). This would remove the fear of not being able to buy food or keep a roof over their heads.

Existing unemployment benefits don't work in this situation as people can't downsize their life nor do you want people to down size their life quickly as that only exacerbates the asset and consumption problem. Broadly, the economy needs a short circuit and breathing room to allow stimulus and automatic re-adjustment to gain traction. The current disaster spiral overwhelms normal automatic adjustment in the economy.

Reducing principal and supporting salaries will draw the poison for the system and provide breathing space to begin recovery. But just like a patient, the economy needs physical therapy to return to full health. This is where the stimulus comes in.

Part 2: Stimulus and more

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Reinventing the Wheel of Finance

Image via WikipediaOne of the ideas batted around every so often during the financial crisis is whether it would simply be easier and cheaper to create new banks and leave the old ones to die. On and off I’ve been thinking what this would mean. Which lead to the question of “are the current financial institutions the best way to manage capital?”

Banks have three primary roles: 1) store money 2) transfer money and 3) lending dormant money. Storing money is to the consumer the main view of banks. They store your money for you until you need it to pay bills and purchase stuff. Transfer money is what allows you to get your money from storage to where you needed it e.g. an ATM or to pay a bill online. Banks aggregate deposits and then lend this out of businesses and individuals to buy assets. It is this process that keeps money circulating and supports wealth creation.

There is no reason why these various roles need to be contained in one institution. We could in the future have one type of institution that stores money, another focused on transferring money and another on lending. What would happen if we separated these roles? For a majority of day-to-day banking tasks not much would outwardly change. The institution that stores your money would outwardly look like an existing bank with branches, debit cards and bank accounts. The transfer role is already there to an extent through various interbank agreements. Broadly, you won’t notice much.

Separate roles with be very noticeable in lending. Banks aggregate deposits and lend this out to individuals and businesses to buy assets (property, machinery etc.) Banks keep a percentage of deposits for people to use to pay bills and buy stuff. This works with the assumption that all the depositors are not going to need their money all at the same time. This process gives banks access to very cheap money which they can then lend out.

By separating the roles banks wouldn’t do the aggregation and lending. Instead those that lend would need to develop various ways to aggregate deposits from companies that store money in order to fund lending.
It is fair to ask whether this system would be more effective for society. I don’t know but it is worth exploring the idea. The advantages that I can see are:

• Reduce conflict of interest between storing money and lending
• Competition among deposit aggregators will produce a sustained increase the interest paid to depositors
• It opens up the financial utility system for horizontal innovation and competition leading to better delivery of financial services

The existing banks and financial institutions will cry bloody murder as it attacks the status quo and potentially their profitability. However, they really haven’t demonstrated keen management of one of society’s key utilities. A potential more important issue is that individuals will be personally confronted with the idea that not all of their money is in their account. The existing illusion of your bank account actually having all your money ready to go will be stripped away as individuals have to decide how much of their account to lend to the aggregators. The removal of the illusion is very likely to create problems as people adjust to reality.

Separating the roles isn’t something that needs to be forced on existing players. Instead the various regulatory bodies should reform regulations to allow companies to step up and fulfil each role. Unleashing innovation in the delivery of financial utility (rather than in financial instruments) to society will do much to resolve the financial crisis.

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Transparency and ending the Financial Crisis

Mike Masnick has interesting post on the requirement for transparency in order to do trade. The basic premise is that lack of transparency therefore information is at the root of the crisis as people simply don't know what the value of anything is any more.

This is along the lines of my own thoughts. The subprime crisis was the trigger where people realised they had no idea what everything was worth and it spiralled from there.

As information or lack thereof is at the heart of this crisis, I believe that the continual injections of cash and purchase of assets is only prolonging the issue. The system is relatively stable now so the key is radical transparency. The banks, financial institutions, hedge funds etc. need to open their books to 3rd parties (trusted 3rd parties) in order for the information to be found.

Once that is done, investors will regain confidence in their ability to value companies and assets. At the moment they can't and so won't risk their money.

This will probably require Government legislation to force the opening but it has to happen. The more public the information is made the fast this whole crisis will be solved and then everyone can move onto fixing the damange being done to the real economy (you know the part that creates real wealth and improved living standards?).

Chaos, Finance and Non-linear Behaviour

With all the noise around cause and remedies for the financial woes we are currently experience something has been niggling at the back of my mind. It was only after watching the BBC documentary "High Anxieties: The Mathematics of Chaos" on Chaos math and reading some posts on nodes that it twigged.

The idea that the financial system is fundamentally chaotic (in mathematical terms) has been around for a while so that isn’t new. A system being chaotic is not a problem in itself, it just is. The problem lies in the transition from linear to non-linear response in chaotic system. Here we had a situation that seemed to be out of portion to reasonable rules of thumb for the system response. The size of the sub-prime looses shouldn’t have been enough to trigger the meltdown.

Unless of course the system was optimised and being highly driven. The past 20 to 30 years has seen the financial system optimised for making money. Without getting into the whys, wherefores and who did it, the optimisation process pushed the financial system to the edge of instability. Optimisation moves a system closer and closer to instability, which is how you get “optimised performance.” This works fine when a system is steady-state without unexpected shocks. The downside is it takes very little amount of non-steady state change to force the system into instability.

In chaotic system instability creates non-linear response that is unpredictable. That is what we are facing. A relatively small shock has sent the system into non-linear response. The system was pushed to the edge of non-linearity by two forces: growth in connections between nodes and the hard driving of the system.
The interconnection of nodes grew exponentially via the creation of various 2nd and higher order derivatives. The intent was to “spread risk”. Instead it amplified the risk across the system which would in turn amplify driving forces. The second part was the cheap credit. This acted to effectively increase the energy sloshing around the system, driving it hard.

To stop future financial crises, we need to de-optimise the system. We need to make the system robust. Regulatory changes such as tying capital ratio to the incentive system of executives, whether a good idea or not, will do little in an optimised chaotic system as even a small shock can have massive consequences. Instead we need regulations that look at limiting interconnectedness of the various nodes in the system and work to dampen movement of a shock through the system.

Put another way, we want to shift the system into an area that has the broadest linear response to shocks as possible. Some possible ideas are banning all 2nd and higher order derivatives or counter cyclical capital ratios. There will be great resistance to making the financial system fundamentally robust as it will limit the money making ability of financial institutions.

Pulling out of recession

Most of the developed economies are facing a slow down if not a recession. Mark Cuban has described his method for pulling an economy out of recession. I broadly agree with his idea but I think that with an addition it address the biggest issues facing startups.

Startups (and small business as well) face two major hurdles or barriers to entry. The first is regulatory and the second is capital. Mark Cuban's plan address the regulatory barrier to entry and some of the capital issues (not paying taxes improves a companies cashflow). But it only goes so far. Not paying taxes is moot point if you don't have any revenue to support yourself.

To address the capital barrier, governments should implement a HELP-style business loan scheme. In this case the government would provide an initial loan that covers a single person's wage for a year. The loan could be renewed for a 1 year extension. The idea is that the load allows a small company to meet salary for initial employees during the launch phase when little to no revenue is available and other sources of funding are not useful.

The loan is then paid back through the tax system. The scheme would have several limits such as being limited to the average yearly wage and a company would only be allowed to ever have 5 employees use the scheme. Individuals would also need to be limited in the number of these loans that could be taken out within a time period (say once in a 5 year period).

The scheme is designed to allow people to take the plunge and spend that all important first year to get of the ground. It is very similar in intent to Ycombinator fund.

With Mark Cuban's plan addressing the regulatory burden faced by startups and small business the loan scheme addressing the initial capital requirements, people will find it easier to start a business and get it through that all important first year.

Economy, Mark Cuban, Finance, Policy

The Best Regulation is Information

With the recent upheavals in the world financial markets there has already been calls to regulate. Arguably these calls are not wrong. The question, rather than should we regulate, is how and what do we regulate?

The financial crisis is one of market failure due to the lack of accurate and timely information about risk. The regulation needs to focus on correcting the issue of the markets providing accurate and timely information about risk.

The regulation needs to ensure that everyone involved in the market has knowledge of the real risk that various instruments and securities have. This will require the regulation of the ratings agencies as they failed to properly provide information on the risk involved in various securities. Or the rating of securities is handled by an independent body charged only with ensuring the risk of a security is accurately measured and information provided to the market.

The second bit of information is where the risk is. Here the accounting rules need to be change to ensure that risk cannot be shifted off-balance sheet so the risk "disappears". Essentially, if there is control and/or liability those risks need to show up on the balance sheet.

Web2 Finance, Mobiles and Two Factor Authentication

A friend has just had problems with fraud and it got me thinking about two factor authentication and how web2 finance sites such as Mint.com and Wesabe can play a role in making online fraud harder.

The Web2 Financial sites could Email and sms the individual whenever a payment or transaction is done to confirm the transaction before it is committed. Essentially the mobile phone (or email) becomes the second factor of authentication. No need to carry around a separate dongle or bit of hardware in order to make a transaction.

Implementation of this would require the companies to partner with the banks or online payment processors to get the realtime-ness need for the second means of authentication to be effective.

Banks and the payment processors could also do this as well and probably should. I would like to be able to receive an SMS to authorise ATM transactions or when paying by card at a shop prior to being the money being handed over. Not the ultimate solution to card cloning and pin card issues but it would certainly put a crimp in that type of fraud.

Web2 financial services have an advantage over the banks, credit cards and payment processors for the following reasons:

• Online banking sites suck - badly
• People often have many bank accounts, credit cards and setting them all up is likely to miss something. As the financial sites already aggregate this information they can act as single point for passing transactions through to authenticate
• Many online payment processors are merchant focused and never have a relationship with user so can't really send an SMS or email
• The financial sites are focused on the user while banks, credit cards and payment processors lack this focus
  

In the end the more services that offer this type of two factor authentication the better for reducing fraud. It isn't going to make it go away (phone and wallet stolen etc) but it can be reduced without having to roll out great numbers of bits of hardware.

Tags: Mint.com, Wesabe, Two Factor Authentication, Mobile, Fraud, Online Payments, Web2

Transparency and Morality in Business

Ross Gittins has an interesting article about the importance or requirement for moral values for a market to function properly. What struck me as interesting was the idea that markets function better when participants are able to judge the actions of other participants against social standards. This jives with what Umair Haque has written about numerous times around the DNA of businesses and the edge economy.

In previous posts, I've talked about the use of transparency of businesses to improve the DNA or the behaviour of businesses. The concept of being able to judge participants against social standards for honesty, trustworthiness etc. provide a strong foundation for judging what information participants need to provide about themselves.

By focusing on the information that allows judgments to be made about a company's behaviour meeting moral standards, we can avoid being inundated with information that is irrelevant and frankly unhelpful in creating better businesses and markets. Businesses are only as amoral as we allow them to be and there is no reason why a business has to amoral.

Tags: Transparency, Finance, Ross Gittins, Policy

Fighting Inflation in Australia using Super

Australia is one of the few nations in the world where the interest rates are rising and rising hard. Commodities boom, over indulgent consumption and 35 year lows in employment have pushed the economy to the limits of capacity.

The debate in Australia is about how to fight the inflation and the recurrent need for the RBA to raise interest rates to combat inflation now outside its 2-3% band. The Rudd Government has brought back fiscal policy to try and help fight inflation by aiming for a surplus of 1.5 to 2% and avoid the RBA rasing interest rates further (unlikely). Although given that for the past 5 years or so the budget surplus has always come in higher that the forecasted 1% its hard to see how a measly 1.5 to 2% is going to make much of difference. It probably needs to be 2.5 to 3%.

The otherside of the debate is how raising interest rates is a blunt policy instrument for fighting inflation, only effects third of households etc. What is missing from the debate is discussion on what other levers that could be provided to the RBA to manage the economy. In many economies there probably aren't many other levers that central banks could use. But Australia has compulsory super for a majority of employed people. The issue is to remove spending from the economy or put another way to increase savings and reducing consumption. Giving the RBA the ability to manage the percentage of income that is paid into super would give the RBA another lever to pull.

The advantages I see in using super contributions this way are;

• It increases the savings rate across a very large majority of households
• It does not directly effect the price of business investment the way interest rates do
• It is spread more evenly across the economy rather than concetrated in the 1/3 of households with morgages
• Individuals don't lose the money, it is simply redistribute to return in the future

The biggest problem I see is the mechanics of actually performing the changes. However, this is a solvable problem as it could rolled into financial packages that most if not all businesses use.

Another possible lever is to allow the RBA to change tax percentages about a median point. But I see that being an even tougher operation and also more politically hazardous. It could be a rather useful tool to have in the back pocket though.

Tags: Superannuation, Inflation, Australia

Incentives cause the [financial] rot

Umair has a new post about the financial meltdown and in particular how the very people at the centre of the meltdown are walking away with massive payments. I think there is a lot about how the very incentive system used by financial institutions are at the very core of the problem.

The incentive systems are probably the single biggest cause of the problems. These systems are designed to maximise profit - which is not the same as wealth creation. The assumption that serves as the foundation of incentive systems is that the "agents" interests need to be aligned with the "owners". An assumption that I now believe is totally invalid.

The incentive systems need to promote wealth creation and not alignment of the interests. Otherwise why will an executive take a risk that has a long term payoff but will hit short-term profitability?

So how do you fix something so broken. The first is to ditch the assumption of aligning the "agents" interest with the "owners" interest. The second is to ditch the idea that a single person at the level of CEO has much effect on the overall profitability of a company. Suddenly it gets hard to justify paying ANYONE 100m salary. Indeed, CEOs make a mockery of their own job - if the share price goes down its due to the market, but if it goes up its due to the skill of the CEO. Spot the paradox?

Can the market sort this out itself? Probably not. Too much self-interest. This leads to the requirement of regulation. The key is to regulate well but lightly. Some regulation will require the out-right banning of current practices, while others are about increasing transparancy and market efficiency.

Golden parachutes need to be banned. Why a CEO should receive money to leave a job is beyond me. The sub-prime crisis has shown this for the rort it is. Which does lead to the second requirement of having all senior management and possibly contracts above a certain value requiring the agreement of a quorum of shareholders. The current negogiation world is far to cosy.

In terms of increasing transparancy, the renumeration and contracts of senior management should be published. This works fine but it helps to have this put in perspective of the how well the company is paying its employees. So companies should be required to publish the various renumeration bands, the requirements for bonuses at these bands and the number of employees per band.

But perhaps the biggest change is to remove incentive schemes that promote short-term profit over long-term wealth creation. Most of the current methods can and are easily gamed. Whether it is EPS, dividends, profit, revenue or share price increase. Most of these items are reflective of things beyond the senior managements control. So the first step is to only use measures that are effected by senior management actions. More important is only use actions that promote wealth creation (as opposed to profit).

So what measures could be used?

• Employee productivity per unit cost
• Throughput per unit cost
• Employee statisfaction
• Revenue growth per unit of productivty
• Productivity growth per employee

And there are more. Most of these measures are harder to game but they are all measuring changes that change the long term wealth creation of the company. Funnily enough, most of these would reduce the awards of financial executives.

Incentive systems and the spiralling cost of financial executives is something that needs to be addressed. Otherwise you run the risk of societal unrest. Perhaps more importantly these spiralling costs are also a distortion of the market causing the mis-allocation of resources and dragging down GDP growth.

Risk modeling in Financial Markets

Bloomberg has an interesting article exploring how the banks are changing their risk models. Roger Ehrenberg adds some insight to the article. To me the most fundamental question that needs to be asked isn't what is the best model, but can risk even been modelled?

In all the discussion about risk and its modelling, there is always the underlying assumption that the risk can be modelled. I'm not so sure you can really model the risk. Time and again in financial markets past performance has been shown to not be a predictor of future performance (all the managed funds have that explicit on their brochures) and yet the assumption is that past risk can be used to model future risk. See the incongruence?

The market looks to be an indeterminate, chaotic system. Which to me makes the assumption of normal distribution of risk a little suspect. Being an indeterminate system, it may very well be impossible to model risk using the standard statistical methods.

Tags: Risk, Finance, Credit Crisis