Profit Flaunting no More?

Three months ago, I logged a post titled "Profit Flaunting" in which I observed the Western banks peculiar behaviour of flaunting their profit for first quarter than had not yet ended. Perculiar because such disclosures were not required by securities guidelines and regulations. Nevertheless, the market reacted positively and their share prices promptly jumped. Indeed the momentum generated followed through and led the equity markets worldwide into successive months of upward movement.

We are now near the end of the second quarter but we have yet to hear any preliminary announcement from any major banks- flaunting type or otherwise. Are we to infer from the non-announcement or should we just sit tight and await the normal flow of announcement?

090626 Update: Standard Chartered PLC has announced that it has made good profit for the first five months of the year.

The Conundum of High Treasury Yields Amidst a Strong Equity Market

10-year treasury yield has reach multi-month high in recent weeks while equity markets too were reaching year's highest levels. This seem to go against the conventional thinking that interest rates and share prices are inversely related.

I think this is not the normal business cycle that retain normal correlation. The 'Black Swan' we are witnessing is caused by the actions of the Fed. Specifically, the act of printing money, or 'quantitative easy' as a better name, has upset the system.

In a normal cycle, as economy overheats, monetary policy is expected to be tighten and treasury yields go up due to slowing money supply. Equity prices hence go down due to higher cost of funds. As economy slows, perhaps even becomes recessionary, the Fed engages in a expansionary monetary policy and money supply is growing again. All the while, the Fed is only setting a benchmark rate and letting the market decides the actual interest rates.

Presently, with the Fed directly purchasing treasury bonds, the money supply is immediately increased due to expanding monetary base. Hot money created is chasing stocks higher while bond traders are factoring in the possibility of climbing inflation by bidding for treasuries at higher yields.

Meanwhile, aggregate demand and economy's production capacity remain relatively unchanged.

Therefore, I think the debate over whether we are in an inflationary or a deflationary cycle is irrelevant- we are in both. i.e. asset prices are going up (note the price movement of crude oil) while wages and other production costs are stagnant (due to overcapacity).

It seems the Fed has not learned any lesson from the era of stagflation in the 1970s, which is to control the money supply and putting price stability at the highest priority. By control I don't mean keeping it fixed but any easing of monetary policy should be done in moderation and all the while letting the market know that price stability is top priority. Quantitative easing runs in contrary to objective of maintaining long term stability of both price level and economic activities. In addition, the direct purchase of treasury bonds and other commercial papers set a precedent and may impair the Fed's Independence. In future, Fed may be pressured politically into taking such inflationary action.

To prove my point, last week's 10-year treasury yield reached a 2009 high of 4% but subsequently retreated due to intervention from the Fed. It has purchased in total close to US$150 billion of the US$300 billion target, barely two and a half months since the start of the programme. There are already opinion by economic columnist hinting that it should raise the US$300 billion cap.

Once the expectation of inflation is out of the bottle, it is very difficult to contain.

Would the over-extended treasury market collapse and bring about a plunging US Dollar?

That would be a disaster that US government will do its best to avoid. I think that scenario will not happen as USD is still the reserve currency and all the major holders of treasury bonds, namely the central banks around the world, will be serving their own vested interest in supporting the US treasury bond market.

However, with ever-increasing supply, treasuries prices will continue on its downward trend. As yields move in opposite direction as bond prices, long term interest rate will stay high and move higher. Along the way, USD will be under pressure as US budget deficit continue to grow due to higher refinancing costs.

US equity market will be stagnant- on one hand negatively affected by high interest rate while on the other positively impacted by 1. the government spending; 2. hot money arising from expanded money supply; and 3. assured profit due to government guarantees (from TARF to bank deposits to motor vehicle warranties to commercial papers purchased by the Fed, you name it).

Not much restructuring will occurs as companies are largely above water, albeit barely, so there is no incentive to rock the boat.

I am afraid my prognosis shall be that US will be entering its own lost decade a la that of Japan.

It will take another Paul Volcker to bring major changes that will involve some level of pain to shake the economy out of the malaise.

To quote Nassim Taleb: "The Obama administration's attempts to fight the financial crisis with more cash is like treating a bad tooth with Novocain instead of a root canal."

A short story on economics

A theorist, a psychiatrist and an economist are teeing off in a round of golf. The game is rather slow as the flight before them takes a long time to finish each hole. After several holes, they begin to grumble:

The theorist: In the name of the Almighty, may their action be met with just punishment for playing so slowly.

The psychiatrist: I wonder who in the right mind will play out each hole at such unenjoyable pace.

The economist: It is costing us too much time.

At the ninth hole, their patience runs out and they approach the sole caddy of the slow flight and request for moving ahead. The caddy duly complies and explains that the two golfers are former firemen and their eyesight was severely damaged during a mission and hence the slow pace.

The theorist: May the Almighty forgive me for I should not have lay curse on them.

THe psychiatrist: Shame on me. As a trained psychiatrist, I should have better controlled my emotion and be more understanding.

The economist: They should have played at night.

Translated from a passage in a Chinese book: "Stories from Economist"

Predictably Irrationality and Corporate Governance

In the video presentation, Dan Ariely, author of "Predictably Irrational", attempted to provide some insight to what is now called behavioural economics. Using findings in social experiments he conducted (these findings are better detailed and explained in his book), he explained, in very rational way, why human behaviours are sometimes irrational- and predictably so.

He went on to apply the findings in explaining the possible reasons why Enron, and by extention other corporate failures, collapsed.

Perhaps some lessons here for instituting good corporate governance?

The Paradox of Re-defining Marked-to-Market accounting

In February 2009, U.S. Treasury Secretary Timothy Geithner announced the setting up of a Public-Private Investment Fund (PPIF) (in which both government and private entities contribute capital) to provide financing in buying up toxic assets from the banks. With these assets off the their' balance sheet, it was envisaged, banks can then proceed with the path of rebuilding its profitability and regaining the public confidence.

Also, with a well-capitalised entity holding these distress assets (mostly securitised papers back by mortgages or other loans), it can unwind these securities in a orderly fashion thereby averting a volatile downward vicious cycle in the values of these assets.

It was reported today that he will soon provide more details on the plan.

It was also reported in the past week that Federal Reserve Chairman Ben Bernanke had suggested that the 'Marked-to-Market' accounting policy should be revised, but not repealed, as "current rules did not lead to accurate valuations in times like these."

Subsequently, FASB (Financial Accounting Standards Board) announced that it will soon publish new guidelines to the application of 'Marked-to-Market' accounting.

I wonder if the soon-to-be-refined accounting standard will interfer with the Treasury's effort in cleaning up banks' balance sheet.

Let's assume that, following the implementation of the new accounting guidelines, banks need not write-down the toxic assets to their market values, what then is the bank managements' incentive to unload these assets to PPIF? Assuming that PPIF will only pay market prices for them, the banks will incur losses if they were to offload them to PPIF.

Indeed, even if banks are able to sell at or above the assets' carrying values, it will serve their interest to adopt a wait-and-see approach rather than rushing out and unload the distress assets. By doing so, they are hoping that PPIF's effort in buying up the toxic assets (from other banks) will be successful in stanbalising the credit market. With the return of order, they have a good chance in then unloading their own assets at even higher prices. In any case, even if PPIF fails to clear the clog and market prices remain depressed, no downside risk is perceived now that 'Marked-to-Market' need not strictly be adopted.

As a result, banks may continue to hold onto the toxic assets until they deem it to serve their serlf-interest to sell them- at a profit (!!!) and not necessarily to PPIF. What then is the point in setting up PPIF in the first place?

Hence, paradoxically, the redefining of Marked-to-Market accounting, which is supposed to help stabilise the financial market, may post a barrier in the receovery path to a sound financial system.

Updates on 30 March:

Bloomberg reports on the pending revision by FASB.

Profit Flaunting

Following Citigroup's statement in an internal memorandum (it was obtained by the media) that it was profitable in January and February 2009, the U.S. market rallied. And a day later, JPMorgan Chase's CEO also made a similar statement.

It is not normal practice that U.S. listed companies provide updates on profitability on a monthly basis. One wonders if the unusual acts were meant to provide confidence to the nervous investors holding on to their shares.

More importantly, now that two of the big banks had flaunted their interim profitability, who is next? Or more pointedly, for companies that see their share prices under pressure, who can afford NOT to provide the market with updates that they too are profitable, lest investors think otherwise?

Updates:

17 March: Standard Chartered Had 'Strong ' First Two Months

16 March: Barclays Says ‘Strong Start’ to 2009

12 March: Bank Of America Joins Parade, Says Sees Profit This Quarter

Alpha Male vs Beta Female

"Would the world be in this financial mess if it had been Lehman Sisters?"

The question was raised at the WEF in Davos and reported in an article titled "Where would we be if women ran Wall Street?" that appears in 2 Feb 2009 edition of International Herald Tribune.

Indeed, if all those alpha-seekers were more wary of the levels of risk undertaken, the state of the finanical system might not have been as bad as it is. So, as we usher in the year of the ox, it is perhaps time to leave behind alpha which, ironically, refers to the bovine species in ancient Greek and embrace its sister, Beta.