Philosophy Bob

Back in May last year I attempted to describe why income levels must match production levels; and where this doesn’t hold at a micro economic level, then one group is acquiring the income that should have flowed to another. A standout example is banking executive salaries in the lead up to the GFC and in many cases through to today. See the May Post.

Nearly eighteen months after writing the piece considerable, credible support for the position can be found in the following Ross Gittins article.

For a while Philosophy Bob has been thinking that there is some positive correlation between grumpiness and higher incomes. That is, to the casual observer, those with the highest annual incomes appear to be the least happy - the most grumpy amongst us. They seem to be living examples of the adage money doesn’t make you happy. But the correlation isn’t quite so straightforward.

A little while back I wrote about the necessity for global Income to be equal to global Production. Local and/or individual variations (inequalities) are examples of one entity’s income drawing unjustly on another’s.

So for some countries, or for some companies, or for some individuals, their income exceeds their production. It is this excess - rather than high incomes per se - which manifests itself in grumpiness.

That is, people (or companies or countries) that know they are overpaid, or paid in excess of their productive capacity, pay the price in lack of happiness.

Happiness then is the force that drives us toward the equilibrium of Income being equal to Production at every point.

So when you see that senior manager, who is sour faced day in and day out, you know that he or she is overpaid, and you also know that he or she knows it.

Today, Cardinal Pell, the head of the Catholic church in Australia, attacks the Greens as “anti-Christian”, and as akin to “poison”. Inflammatory statements indeed.

Also today, in Tony Abbott’s federal election campaign launch, he made a special appeal to those contemplating voting Green, arguing the Greens as less green than the Liberals with respect to action on climate change. (Strange but true).

Co-incidence? Unlikely.

Tony Abbott is entitled to employ any legal political tactic at his disposal, as are his political opponents. But Cardinal Pell has no such mandate.

His overt political action is a breach of trust of the position he holds over the masses of the Faithful. The apparent inability to undersand what is reasonable, and what is abuse of privelige, is a very familiar characteristic of the officers of the church that he leads, and within which he thrives.

The Australian Dollar is about to fall! Reason? None. None offered. And none needed, because a bank employed technical analyst has found a ‘double top’. And well, if you’re just a little au fait with the fantastical world of these gurus, then you’d already know that a double top spells double trouble.

During June PhBob read an article  on the front page of the business section of a reputable Sydney broadsheet. It reported that due to the fact of the double top the Australian Dollar was likely to fall and to keep falling. It noted this shape had been observed previously. The article offered virtually no editorial comment, and thereby promoted the trajectory of the quoted analysts as based in fact, or at least as being seriously newsworthy.

It transpires that the Australian Dollar has, in relative terms, flatlined in the intervening weeks.

Notwithstanding;

If you see a double top at the now point in any asset price graph, then by definition its most recent direction is distinctly down. To report this observation as an insight into the down, or worse as offering a cause for the down, or even worse, as some predictor of the depth of the down, is simply fantasy. It has less credence than graphing lotto balls.
 
Given the gobsmacking naivety of the entire analysis, should we be more concerned about the bankers who pay for this rubbish, or the journalists that report it as respectable and eventful.

The tragedy is that our supposedly reputable banks, our supposedly clever bankers, pay high salaries for this madcap palm reading. In the end of course, it must be the public that pays for the excess – refer the government sponsored GFC bailout – and will do so again in the future, without appropriate pricing or regulation of the sector.

AUD @ time of news story: ~0.85

AUD @ time of blog: ~0.85 

Within a nation, and across the globe, it is reasonably easy to be comfortable with the idea that the sum of all incomes must closely resemble the value of all production. If this were not the case, then available income would not be able to act as a rationing mechanism for available goods and services – the output of productive effort; there would be too much cash with nothing to spend it on, or there would be an abundance of unsold quality goods and services sitting idle amongst an impoverished population.

Income at a national level is broadly the sum of all individual salaries and wages plus the sum of all company, or organisational, profits. Since national income equals national production, then within a nation, an individual company’s profit plus the incomes of its workers should equal that company’s contribution to the national economy. That is, it should closely resemble that company’s contribution to the value of available goods and services in the economy.

Now since an organistaion’s income (workers’ income plus entity profit) equals an organisation’s production  (economic contribution), then within that entity the income levels of the individual workers should be equal to the economic value that they have added through their individual effort.

If this is not the case, then one individual has somehow acquired some of the income that was attributable to someone else. And at the enterprise level, if this is not the case, then one organisation has acquired income or profit that was due to the productive output of another enterprise.

In Australia, at the end of 2009, the average annual salary was around AUD$66,000. Many teachers, medical workers, public servants, and skilled trades people earned around this amount.

In late 2008, in the grip of the GFC, the Australian public propped up its banks by way of government guarantee. Around the world many other governments were forced to take more drastic measures at the expense of the general public.

Many executive bankers earn circa AUD$7 million+ per annum; both pre and post GFC. Since Income = Production, this level of income states that this banker is over 100 times more productive than the average worker. Or that he or she is able to produce in two and a bit days what the average worker toils over for a year.

Or, that in just a few months, this individual’s banking superpowers enables him or her to produce, for the national economy, more value than the entire lifetime’s work of an average full time employee; more value than the entire lifetime’s work of a teacher or a nurse, in just one season of one year.

These guys and gals must be just fabulous - indeed superstars worthy of ongong community adulation and awe. But hang on, what happened just a couple of years ago?

There is a mystique that surrounds many financial derivatives – their purpose and valuation [pricing] little understood in wider society. Perhaps the most mysterious are the so-called exotic options. The term applies broadly to any option with extra features.

Banks compete to invent and sell exotic options – usually to some party with a natural interest in the underlying physical asset of any given option, say a gold miner, or soy bean wholesaler, but they might equally sell to any punter who was attracted to the features [and price] on offer.

Banks employ armies of business development staff, quantitative analysts, marketers and sales staff - at huge expense - to invent and flog these exotic options. Why? Because its money for jam.

Why? Because the exotic option is just the sum or net result of its components – usually some combination or collection of vanilla call and/or put options, and perhaps some forward price agreements – that have been bolted together in a particular manner and given an exotic name – say, a double barrier flexi quanto – then the option premium is massively marked up and the salesmen [traders] work their contact lists to try to flog the inflated goods.

When the bank sells the exotic option it offsets the risk by entering into opposite positions for the component parts – mostly vanilla options – at fair prices in say the interbank market, and in the process books a risk free profit, being the difference in the inflated premium received for the exotic, less the sum of the premiums paid for the hedges. The difference can be significant, often six figures, and sometimes seven, for a single exotic deal.

Banks make billions and billions of dollars from this activity – which boils down to financial gadgetry and heavily resourced marketing and sales.

Sometimes of course the banks can outsmart themselves, inventing, pricing and selling products they don’t really understand. The CDO’s contribution to the GFC being the most graphic example where banks along with their customers were hoodwinked by the magic maths and their own industry’s sales pitch.

One thing is certain. If you buy an over the counter, exotic, financial derivative product from a bank you are handing them a neat profit. The protection, payoff profile, or asset flows, inherent in any deal could have been secured more cheaply from a collection of more vanilla, more broadly traded, and more fairly priced products.

The global financial crisis of 2008 was primarily caused by the actions of the first world’s banks. There were a number of other significant players, notably the credit ratings agencies and the government structures responsible for financial system oversight, but it was the banks’ rapacious addiction to skimming and structuring for higher short term profits, with no addition to productive output, which led the world headlong into the crisis.

The banks required many billions of dollars of public assistance to remain solvent. Yet it is the same firms which now seem to be the first to recover to pre-crisis profitability. Perhaps not surprisingly little or nothing has changed in the conduct of their business.

In this light I thought it worth reproducing a short GFC essentials which I wrote in October 2008 in response to a number of requests for some kind of explanation of the severe downturn.

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(October 2008)
The crisis has been primarily caused by two separate banking practices. The two are related, but could have occurred independently.
· credit was mispriced
· securitisation alchemy

Mispriced Credit
A bank can borrow at say 5%, and cover costs by lending at say 7%. Assume all borrowers have the same credit worthiness. The bank knows that statistically 1 in a 100 of its borrowers will fail, so it needs to add a credit spread on top of the 7% - so the bit of extra profit it earns on the 99 good loans covers the loss of the bad loan – so it lends at say 9%.

Assume this is a fair number. We would say the credit spread is 200 points.

In good economic times, with banks competing to make more loans, there is a temptation to cut the credit spread – reducing your headline loan rate. If you ignore or understate the credit risk (provisioning) in your consolidated accounts you can fool yourself into believing the loan book is still profitable even at very reduced credit spreads.

But the losses must be realised. Statistics don’t lie. Over time a percentage of the loans will fail. Many of the good/profitable (management bonus paying) loan books were in fact bad/loss making loan books.

The Austrian Economists wrote about it in the late nineteenth century – …if credit is priced too cheaply, leading to an increase in economic activity, it will eventually be realised in credit losses and reduced economic activity…; i.e. a recession.

So, credit pricing is now going through a massive (over)correction phase.

Securitisation Alchemy
In the old days the bank borrowed money – say from depositors, say $10mill. This is a Liability on the bank balance sheet – it owes the punters the money.

It then lends the money, as say, 20 x $500k mortgages, to a different set of punters. These loans are an Asset on the bank balance sheet.

To make more loans it needs to raise more deposits, or borrow more money. One way to borrow more money is to issue a bond. Governments, banks, other corporates do this all the time.

Another way to raise more cash is to sell Assets. The bank has Loans as its Assets. It decides to sell them, to take the cash now, and to use that cash to make more loans. That is, it effectively packages the loans as a type of bond or ‘security’ and sells it into the market place. The returns on the loans no longer directly affect the bank, who now merely administer the loans, and pass on the proceeds (mortgage repayments) to the bond holders.

The bank continues to recycle loans in this fashion.

Then non-banks got in on the action, borrow from a bank, make some loans, package them up as a security, sell it into the market – perhaps to another bank – and go around again.

But how much cash do we get when we sell these mortgage backed securities? The market has some sense of comparative value, so it discounts the bond by the perceived credit worthiness of the underlying mortgage holders. Is there any way we could get a higher price?

Lets say, for a given mortgage backed security we rate all the mortgagees as a ‘B’, and lets say, statistically, 5 in 100 B’s will fail (default). How can we get more cash for these B rated mortgages? Magic – turn most of them into A’s! Enter the Collateralised Debt Obligation (CDO) or tranched debt instrument.

We know 5 out of 100 will fail, so it follows 95 of the B’s will succeed. Those B’s will effectively perform as well as the A’s. So, lets split our “100 mortgages asset” into one group (tranche) of 90, and one group of 10 (the bottom tranche). The rules of our fancy CDO bond say that any defaults hit the bottom tranche first. So, statistically, the top tranche is protected from any defaults. Viola! we have some ‘A’ rated paper. And the Ratings Agencies – S&P etc – bought the argument. So, the bank can sell 90% of its B rated loans for a much higher (A style) price, more than compensating for the much lower (C style) price it has to accept for the risky (but high yielding) bottom tranche.

So, while credit was getting cheaper, and there were more loans, and more upward pressure on asset (house) prices, there was also a flood of mispriced mortgage securities being bought, and often pledged as collateral on more low credit spread loans, and so on.

All Comes Unstuck
Part of the argument the banks could use for lending on such low credit spreads, was that it didn’t really matter if someone defaulted. You could sell their house to get your money back.

But as the number of defaults began to increase, so did the downward pressure on house prices. Banks suddenly got a little nervous and began tightening (increasing) their credit spreads. This starts to dry up the amount of available loans to potential house buyers putting further downward pressure on prices. Banks panic and bring forward foreclosures exacerbating the problem.

The supposedly safe ‘A’ part of the dodgy bonds start to get hit. There are trillions of dollars of these things held all around the world from local councils to pension funds to banks themselves. As their value is marked sharply down, the holders of the bonds also see their credit spreads jump sharply up. Even if they can find someone willing to lend to them, they probably can’t afford the repayments.

Without short term liquidity, the system starts to freeze up. Organisations with high debt levels and/or dodgy asset valuations begin to go under (e.g. Lehman’s), further compounding the problem.

The conscious decision to misprice credit – both directly and via the CDO smokescreen - is directly responsible for the current drama.

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Postscript (March 2010)
Bank management paid themselves billions of dollars in ever increasing cash bonuses in the decade leading up to the GFC. This was supposedly due to out performance, a reward for great efficiency and superb use of Bank capital.

The GFC proved it to be a croc. The profits were not real. The return on capital was not real. The profits were based on flawed valuation methodologies. The cash bonuses were not earned and have now been effectively funded by public subsidy.

Just two years since the GFC was getting into full swing and we seem to be returning to exactly the same scenario – the subsidised financial corporations are again ready to pay themselves large bonuses.

The lack of direct government action, while regrettable, is somewhat predictable given the relatively short timeframe, and the domiciles of the major culprits. But the force of public outrage should be such that it can shame these institutions to behave in a socially responsible and equitable manner.

Act now.

All of us rely on a set of beliefs, or truths, or principles, or rules, or everwhat [sic] they might be called in any individual’s life, to guide our behaviour and decisions.

But our brother, our colleague, our minister, our mate, all may have conflicting views, or dogma, on the right course in any given situation.

How then can we decide which rule or truth or principle takes precedence? Philosophy Bob advises a simple, nearly poetic, tenet :

Fact - Family - Faith - Fairytale

In that order.

If the hard Facts of any situation dictate a certain course, then the values and opinions of others should bear no influence. ‘

Where there are a number of possible reasonable responses or reactions to the facts, one’s family values or family conventions should take precedence over other codes of behaviour. Here, Family is primarily meant as the kinfolk living together sharing one home. In doing so they likely to establish some strong codes of behaviour. But the Family term can be redefined in other contexts.

One’s Faith can provide guidance where Fact and Family are unclear or indifferent. But Faith should not be used to overrule the Family code or the Facts.

Finally, where neither Facts, nor Family, nor Faith has an interest, Fairytale characters, or indeed any other real or imaginary adviser, can be used as a mentor or guiding light.

So, we have a simple credence to help us navigate the river of life:

Fact - Family - Faith - Fairytale