The joys of "stuff"

Last post, I was riffing on the story of how commercial banking got replaced by investment banking. I implied that it was bad that this happened, and the great crash of the last few years has largely confirmed this model. Unfortunately, I wasn't clear on the real ontological problem: "stuff" and money have become disconnected in the financial world.

Consider bank capital. What is it? Sophisticated investors, regulators and scholars fundamentally disagree about what should be counted and how to count it. So the fundamental building block of bank, and thus finance, regulation is something that bankers try to inflate, regulators cannot measure and investors just have to hope is real.

Meanwhile, equity markets have fallen from their "assured 11% growth" that was promised to your piemaker by a man in a sharp suit in 2004. I was told that day that betting against the NYSE was "betting against America!" Turns out I would actually have been betting against algorithms playing arbitrage games with exchange order books and Congressmen with insider information (h/t to Dan Carlin). To this day I'm not sure if the man in the suit was foolish or disingenuous, but his passion and intensity convinced me that he did not work in a rational market.

Normally, when money and "stuff" go their separate ways, there's hyperinflation. Indeed, the price of gold (~$1200/ounce as of this writing) would seem to bolster this claim. Unfortunately for large debt holders, the rest of the economy is extremely deflationary. Housing prices are such that homes financed after 2005 (give or take a couple years depending on the market) cannot even be rented at a high enough rate to cover the mortgage. Those same houses are now unaffordable to the people who would buy them until three years ago, and people with highly mobile careers (essentially the whole upper-middle class) have been taught the hard way that equity can be an anchor instead of an asset.

Meanwhile, globalization's march to ever cheaper labor helps ensure that there will not be too many dollars chasing too few goods. Quite the opposite, as imports continue to hold steady or rise slightly and the effective monetary destruction of housing debt defaults and write-downs (Planet Money's "pet" Toxie tells this story well). So instead, too few dollars wind up concentrated in the hands of relatively few people and companies with declining incentives to invest in the face of uncertain regulation and government action.

Clearly something has to give. The question is are we Turning Japanese, or going medieval? I'm not sure how the world's reserve currency can hyperinflate when the second largest economy intentionally devalues itself, and the other major currencies face similar (or worse) economic pictures.

Is there a brighter future? Quite possibly. The loss-making rentals I mentioned aren't so bad when the Mortgage Interest Tax Credit is taken into account. There is simply not enough oil that can be extracted at $70/barrel to keep up with demand for the next several years, and so there will be innovations in transportation and infrastructure. Where and how that happens depends on the policies of various countries, but we have the cash and expertise to take the lead in the US. Support your favorite climate legislation and encourage investment in "stuff."

Hitting the limits

Disclosure: The author has intentionally, and continues to, hold only assets that are either liquid or utilitarian. He does not own stocks or property and considers the mobility required to use his education to be of greater importance than financial investment.

I've had a lot of time to reflect on property management and economics over the past week, and the exercise has not been uplifting. It has produced, however, an interesting narrative that you readers might enjoy.

In my youth, I spent a great deal of time with bankers. As a result, the old small bank "rules of thumb" for income/loan ratios, price/earning ratios and some of the mechanics of commercial finance were drilled into me from the beginning. My reaction to events of the last twenty years is heavily influenced by that experience. The most interesting story, I think, has been the transition of commercial banking into investment banking.

The commercial bank model assumed that a borrower would provide a stream of revenue. The banker's job was to find new customers, arrange lines of credit, and then help those customers continue paying by arranging new credit terms or special deals with other bank customers. For instance, a bank with a large construction business as a client would be more likely to lend to a hardware store, since their original customer could use the goods in the new customer's warehouse if something went wrong. Thus, banks tended to be tied to a given industry, and rose and fell with one sector of the economy. Today, this is still done, but it's called "private equity." (there's a great story about a firm buying a fashion magazine and using it to promote "thin belts" as the new fashion item, boosting sales from another company of theirs)

The Investing Banking model assumes that any stream of revenue should be sold to investors. In the short run, this is enormously more profitable because instead giving out a bunch of capital and waiting for loan payments to trickle in, the banker "originates" the loan and sells it to an external investor as a Structured Investment Vehicle (SIV) or Collateralized Debt Obligation (CDO). Thus, issuing loans doesn't affect the capital base of the bank, unless they do something like insure the value of the security, but that's an off-balance sheet transaction and so doesn't count. As a result, the amount of credit available, and thus money creation, is limited only by the amount investors can buy.

This approach also move innovation up the value chain. Instead of employing tens of thousands of commercial bankers to find relatively simple innovations (the builder helping out the struggling hardware store), now the world needs thousands of very smart "quants" to find statical arbitrage. Since banks don't need to keep industry experts on staff, and they have more money to lend, interest rates go down. If something goes wrong, instead of an "offer you can't refuse" to receive help from another bank customer, it's much easier to get an extra bridge loan. As long as there's someone to buy that next security, life is good.

But what happens when the market for iffy debt saturates? Well, either everyone goes bankrupt together or we go find another sucker. With TARP, the US government promised to be the Sucker of Last Resort, and now the EU's large Eurozone economies have promised to do the same thing for sovereign debt. Is this "find another buyer" model sustainable? I'm starting to doubt it.

Equity markets, social security and Chinese purchases of US Treasury bonds all represent wealth transfer mechanisms that count on relatively young people giving money to their elders. Middle managers at the Chinese central bank and treasury are typically fans of Currency Wars, a book that makes very a clear case that the Politburo's export-subsidizing policies are effectively a huge tax on them. The loudest advocates against any changes to Social Security in the US come from people who also demand no new government revenues, and so the SSA will turn to statical tricks to keep payments reasonable. Stagnating real wages and rising unemployment, especially among people under 30, chokes off the flow of money into 401ks, and so depletes the order books on the NYSE and other exchanges.

I'm thinking that this is actually very good news, net. Moving innovation away from the "real" economy and into finance has encouraged manufacturing and physical R&D to leave the United States. If the most profitable move for a pension fund is to build a wind farm or factory instead of buying the bad mortgages, that has to be good for the country as a whole. The next few years will be rough, but I think we'll emerge with a better world for it.

Improved Applesauce Pie

Week Of Pies, Day 3

Roll out a Whole Wheat Pie Crust and get it into a deep-dish pie pan, preheat the oven to 400F.

In a medium mixing bowl, combine:

3 eggs at room temp
1/3 Cup brown sugar
1/4 Cup granulated sugar

Mix until combined. Then add:

2.5 Cups homemade applesauce (much better this way)
1/4 butter, melted
pinch of allspice
~1T lime juice

Pour the mixture into the crust, place on an upper rack and bake for ~50min. Let cool and serve.

Simple Carmel-Apple Pie

Day 1 of the Week of Pies.

I have a bunch of Fuji apples, which are delicious in pies, pancakes and plain. I also had about a cup of caramel sauce left over from a party. The solution:

Simple Carmel-Apple Pie

Ingredients:

1 Whole Wheat Crust

~6C peeled, cored and finely sliced Fuji apples

~1C caramel sauce, heated for easy pouring

Proceedure:

(1) Roll out crust to 13", place into a deep dish pie plate. Trim and reserve the overhanging crust

(2) Place sliced apple into the crust, cover with caramel.

(3) Arrange the reserved crust in two concentric rings on top of the fruit.

(4) Bake at 400deg for 45min or until bubbling. The bubbling is key.

(5) LET COOL COMPLETELY! There's no cornstarch here, so the fiber in the fruit has to set up to hold this thing together.

The coming Week of Pies!