naked capitalism

Bloomberg reports that former Harvard Fund Management CEO, now Pimco CEO Mohammed El-Erian does not buy the idea that US is returning to normal any time soon. El-Erian in particular took issue with some of Larry Summers’ sunnier prognostications:

El-Erian likened Summers’s view of the economy to a three- stage rocket attempting to escape Earth’s gravity to reach space, with government spending programs marking the first boost to economic growth, inventory reductions the second, and consumer demand the final booster stage.

Summers “has this concept of ‘escape velocity,’” El-Erian said at a meeting of financial market professionals in Toronto today. “We don’t have enough to achieve escape velocity.”

El-Erian, who co-heads the world’s largest bond fund manager with Bill Gross, has said the U.S. is facing a sustained period of annual growth of about 2 percent where credit and jobs are less plentiful than in the past, a scenario he called the “new normal.”…

El-Erian’s ideas about a “new normal” have been shared by Lawrence Fink, chief executive officer of New York-based asset manager BlackRock Inc. BlackRock will become the world’s largest manager of bond funds when it completes the purchase of Barclays Global Investors this year.

The “new normal” includes a higher level of government intervention in the economy, with new rules requiring higher capital levels for businesses and stricter reporting requirements, El-Erian said. That will drive up business costs, he said.

El-Erian’s take is wildly upbeat compared to the October 5 report from David Rosenberg, former North American economist for Merrill, now safely ensconced in his native Canada at Gluskin Sheff. Rosenberg is admittedly has a dour outlook, but he also reads the data very closely and with a well honed sense of historical patterns. Some snippets (hat tip reader Scott, no online source):

Nonfarm payrolls in the U.S. slid 263,000 in September, but the details were even more sombre. The Household Survey showed a massive 785,000 plunge in September, and employment on this score has now slid by 1.2 million in the past two months….the Household survey leads the cycle and typically bottoms and peaks before the Payroll survey do…. never before has a recession ended with civilian employment declining this much (on average, it goes down around 70,000 or almost negligible the month the recession ends)….

There were absolutely no redeeming features in the data. The private nonfarm diffusion index sank to 31.9 in September from 34.9 in August (the manufacturing diffusion index fell to 22.9 from 28.3 in August) which means that for every company adding to their staff loads, more than two are cutting back. The labour force contracted by 571,000 and has plunged now by 1.1 million since May. That again is a sign of the labour market seizing up, which is very disturbing when you consider all the government efforts to stem the tide last quarter – from housing subsidies, to cash-for-clunkers, to mortgage modifications…

It is so difficult now to find a job that a record 36% of the ranks of those unemployed have been searching with futility now for at least six months. In “normal” recessions since 1950, this ratio peaked at just over 20%…..the chances that we see a 13% peak unemployment rate this cycle is far from a ludicrous proposition at this point; and just in time for the mid-term elections.

Yves here. I have been arguing unemployment would peak at over 11%, simply based on Reinhart/Rogoff’s norms for severe financial crises (some of those countries had better responses than ours, and none were faced with a synchronized global downturn, so relying on precedent here would seem to be optimistic). Back to Rosenberg:

The share of the unemployed who are not on layoff is at record 54.3% as of September. In prior recessions, this ratio would barely pierce the 40% mark. In number terms, we are talking about 8.5 million Americans who have lost their job due to permanent shutdowns, a figure that is double what you typically see at the peak of the recession….I think there is a nontrivial chance we see zero percent real GDP growth in Q4 (consensus is around 3%)….

the employment/population ratio (the “employment rate”) has fallen to a quarter-century low of 58.8%; it peaked at 63.4% in 2007. To get back to a cycle high, we need to create more than 10 million jobs. Before that happens, deflationary pressures are going to trump whatever inflationary risks arise from the Fed, Congress and the White House.

The last time the ratio was this low was back in December 1983. Back then, household debt per capita was $9,900; today it is six times larger at $58,000. At the margin, one has to wonder what is going to be paid for first. The debt-service payments coming out of the paycheck are looking increasingly vulnerable. Default rates are extremely likely to worsen for the foreseeable future; groceries will not be sacrificed; however, credit will.

This is all sobering stuff. Rosenberg issued an equally downbeat piece later in the week that commented on valuations (again via Scott). Key factoids:

On an operating (“scrubbed”) basis, the trailing P/E multiple on the S&P 500 has expanded a massive 10 points from the March lows, to stand at 27.6x.

While we will not belabour the point, when all the write-downs are included, the trailing P/E on “reported” earnings just widened to its highest levels in recorded history of nearly 140x, which is three times the levels prevailing during the height of the tech bubble….

Bullish analysts like to dismiss the actual earnings because they are “depressed” and include too many writeoffs, which, of course, will never occur again.

The consensus is usually overly-optimistic, which is why so many analysts love to do their analysis on “forward” earnings since the market almost always looks “attractively priced” on that basis. The reality is that the forward P/E multiple is now at 16.2x after bottoming at 11.7x at the market lows. The multiple has not been this high since February 2005 when the economic expansion was already nearly four-years old! Today’s stock market, on this basis, is now being priced as if we are late in the cycle — forget this mid-cycle valuation stuff.

Reader Dwight pointed to an outbreak of bearish calls today on CNBC:

Risk of Double Dip, Investor ‘Bloodbath‘ (from Carl Icahn)

Dollar Fall Can ‘Destabilize Markets’ Like 2008 (Art Cashin of UBS)

Dow Will Fall to 6,300 by Year End (John Lekas of Leader Capital)

Of course, one could cynically note that this equal opportunity programming started on a Friday afternoon before a long weekend.

Jesse, generally of the downbeat persuasion based on fundamentals, but not afraid of a tactical long, points out that mutual funds are now heavily invested: Mutual Funds Are at Cash Levels Not Seen Since the 2007 Market Top.
But Barry Ritholtz argues in “The Most Hated Rally in Wall Street History,” that the fact that so many are skeptical means the equity rally has further to go.

Just remember: for mere mortals and pros, market timing is rarely a winning strategy.

When Jim Rogers taught classes at Columbia, he liked to tell students that the US had a proud history of implementing capital controls, and warned them against going on the merry assumption that it would ever and always be easy to make cross-border investments. For instance, taxes on foreign securities transactins are a soft form of control and have been used to facilitate or restrict cross-border capital flows. The US lowered them when it abandoned Bretton Woods in 1971 to aid in adjustment of the price of the greenback.

Despite the hue and cry that we must keep trade and capital flows open, I have long believed that they would be restricted as financial reforms moved forward. The Carmen Reinhart-Kenneth Rogoff work shows convincingly that periods of high international capital mobility are associated with frequent banking crises. They do not assert that the relationship is causal, but I suspect it is. Capital that can move easily across borders is by nature difficult to regulate. It would require a considerable sacrifice of national sovereignity to devise rules and organizations that could do an adequate job of supervision. So a high level of international investment flows means lawless or seriously underregulated financial firms and activities. And we have just seen that this lawlessness eventually exacts unacceptably high costs to the real economy.

Thus, measures to increase stability that will be effective can only take place on a national level, and they further require at least some restriction of cross border flows. But how that would come about remained a mystery to me, hence my silence on this topic. Everyone seems wedded to the prevailing ideology of “fewer international restrictions are better.” Indeed, some have decried how awful it would be if the world were to revert to largely national pools of capital, depicting it as a financial Dark Ages. But would it be a Dark Ages for the economy, or merely for bankers?

Russell Napier in today’s Financial Times, describes how capital restrictions might come about, and his case is entirely plausible. The interest of high finance are increasingly opposed to those of governments. Capital will want to flee to havens which are not suffering from the need to work off enormous bank rescue costs. But those very same governments will find it necessary to keep funds at home to earn a return to work down those very same expenses. Hence capital controls.

From the Financial Times:

One consequence of the financial crisis is that fund managers are increasingly going to come into conflict with governments…

Developed world governments are desperate for finance; they will attempt to constrain private-sector credit growth and are likely to ease the economic pain with inflation and exchange-rate depreciation.

This differs from the environment of the past few decades when investors were happy to save in their own currencies, buy government debt and participate in credit-fuelled domestic asset booms. Will fund manager fiduciaries now be prepared to finance record fiscal deficits? Will they buy domestic assets in an era of sub-par credit growth? And will they buy shares in banks stuffed with government credit and loans aimed at securing employment rather than sound returns?

If they don’t, how much capital will they export? Indeed, might they consider it prudent to short government debt to protect their clients’ wealth? To protect against inflation, might they buy commodities?

This may all look necessary to fiduciaries, but governments will view it as speculating against their currencies and driving up the cost of government financing. Governments will not stand by and watch what they might come to term “capital behaving badly”.

Until 2008, capital colluded in maintaining the myth of prosperity, by providing the credit for excessive consumption. Capital supported the illusion of savings by pumping up equity valuations to ridiculous levels; and it supported the need to speculate, most notably in the housing market, by manufacturing savings that could not be earned. This support ended with a bang, and governments stepped in to prevent the deflation that would have brought poverty all too quickly.

The first emergency step was to partially nationalise commercial banks, but government interference with capital allocation will not end there. The need to bail out the banking system accelerated the public debt crisis that was coming anyway, due to the baby-boomers’ failure to save for their retirement. Once known as the ‘Grateful Dead’ generation, their demand for pensions and healthcare will mean they will increasingly be seen as the ungrateful undead. The political necessity of supporting their claims will drive government further into the capital allocation business.

Governments still need the support of capital to ensure that the myth of prosperity dies slowly. If that support is not provided willingly, history shows that governments can conscript capital to the cause. So what sort of “national service” can we expect ?

A transaction tax on financial instruments is very likely… A suitably high transaction tax would force investors to hold shares for much longer periods and to engage management to control risk. This would reduce the need for governments to police risk-taking in corporations. What could be more laudable than a tax that turned everybody into Warren Buffett?

Capital controls are also more likely than investors believe….There is an inherent conflict between western governments’ need for finance to sustain living standards and capital’s need to seek out the greater growth opportunities in emerging markets. Whatever the long-term benefits in boosting returns on savings, the short-term political necessity of public financing is likely to necessitate slowing capital outflows.

Capital controls seem impossible to many, but when a choice has to be made between economic principle and government bankruptcy, they are a likely political response

Japan is a case study in the cost of losing control of capital flows. The government made it easy for retail investors to buy foreign currency investment, with the logic being that yen-based returns were so low, savers needed to be allowed the opportunity to earn higher yields overseas. Unfortunately, a cadre of retail FX traders, every bit as manic as US day traders and holding even more funds in aggregate, now dominates yen trading. The government now has more impediments than it otherwise would have in influencing the level of the yen thanks to this self-inflicted wound (not that currencies are easy to manage even in the best of circumstances, but this policy has made a difficult task even more fraught).

It isn’t uncommon for a theme or a trend to dominate how investors and analysts view a particular sector. For instance, when barriers to interstate banking were lowered, then dropped, bank consolidation was all anyone seemed able to think about, even though there were other important developments in the industry. During that era, at McKinsey, a slide show made fun of typical presentations to banking clients. One had a cartoon of an a school of little fish fleeing an enormous fish with a wide open mouth and sharp teeth. Caption: “Citibank is about to enter your market.”

But while some banks were gobbled up by bigger ones, it was often because it served the executives to do so, rather than because it was a business imperative. Well-run small banks can do well; in fact, beyond a not-very-high threshold, banks do not show economies of scale (it may be that the diseconomies of scope outweigh the scale advantages within particular activities).

Similarly, in the dot com era, even stodgy industrial companies would feel compelled to show that they were somehow taking part of this (the seemingly) earth shaking change.

The rising influence of China is another sea change that investors and companies can nevertheless overdo. This tidbit comes from Andrew Kaplan, a hedge fund manager who focuses on the technology and alternative energy sectors:

From American Superconductor’s June quarterly earnings call, 7/30/09:

In 2008, China grew its installed base of wind turbines to about 12 gigawatts of power and early this year declared that it intended to add another 10 gigawatts or more in 2009…more recent reports state that China may exceed 150 gigawatts by 2020. To put all those numbers in perspective, one gigawatt is enough electricity to power…about 3,000,000 Chinese homes. It’s quite clear that the opportunity in China is tremendous and we are definitely taking advantage of the situation.

The 150 gw number by 2020, while it seems large, would be largely achieved if China kept its pace of wind installations flat with its 2009 number (10 gw).

China’s population is 1.3 billion. At current growth rate, population will be 1.4 billion in 2020.

Average household size in China (blended avg of urban + rural) is 4.0.

So in 2020 there will be 350 million Chinese households.

Given that 1 gw of wind can power 3,000,000 Chinese homes, 150 gw of wind will be able to power 450 million Chinese homes.

So in 2020 wind will account for 129% of Chinese household electricity use.

That’s all. You may now return to regularly scheduled programming. (and, yes, I know that households are not the only consumers of electricity. But, believe it or not, wind is not the only source of electricity in China).

We’ve note during the well-warranted furor over the dreadful performance of rating agencies in assigning credit grades to structured credits, a business that was handsomely profitable to them, that it was difficult to limit their impact. Ratings are enshrined in all sorts of regulations, from the Fed’s haircuts on its discount window to its alphabet soup of facilities, to Basel II rules on bank capital, to pension fund standards through insurance industry regulations.

Ironically, insurers, which are state-level regulators, would appear least likely to act in a concerted fashion. But their fragmentation means that they are not well targeted by the agencies, who tend to lobby regulators rather than politicians. And the state insurance regulators are considering this idea jointly. Even though they will act on a state-by-state basis, the fact that these regulators are collaborating increases the odds of a coordinated response, that of many states putting similar measures in place.

From the Wall Street Journal:

Insurance regulators are considering whether to substitute analysis from other financial firms with expertise in valuing the securities, officials say. The effects of such a change could trickle throughout the world of bond investing, given insurers’ outsize role in the bond markets.

“We just need to take stock of this reliance on a system that allows that kind of shock,” in the form of swift and severe downgrades, “and frankly evaluate if there are other alternatives,” said New York Insurance Department Deputy Superintendent Hampton Finer in an interview. Amid criticism of ratings agencies, he added, “we’re under quite a bit of pressure to respond.”…

The National Association of Insurance Commissioners is scheduled to hold hearings on the matter next week in National Harbor, Md…

Just this month, the ratings agencies suffered a setback in one part of a civil lawsuit, in which a U.S. District Court rejected some raters’ argument that ratings were protected from lawsuits by the First Amendment…

Insurers have a lot riding on the outcome of the debate. Life insurers are big owners of mortgage-backed securities, which represent about 8.5% of insurers’ portfolios, according to A.M. Best Co. U.S. life insurers had to ante up a total of $2 billion in capital in 2008 to back up residential mortgage-backed securities to satisfy regulators seeking assurance companies have enough money to pay claims, the American Council of Life Insurers said. As of June 30, the insurers were facing a year-end bill of $11 billion to back up such securities, the trade group said.

Under the current capital guidelines insurers use nationally, the lower the ratings on bonds owned by insurers, the more capital they generally have to set aside to satisfy regulators….

Regulators say they have no plans now to move away from the leading agencies for corporate and other bonds considered less-difficult to rate…

Regulators say they don’t have a specific vision of an alternative, but one possibility would be to use the services of firms such as BlackRock Inc., the asset manager, or RiskMetrics Group, the research firm, regulators say.

BlackRock has developed an expertise in valuing bonds through its BlackRock Solutions unit, which has done work managing portfolios for the Federal Reserve Bank of New York during the credit crisis. BlackRock declined to comment and a spokeswoman for RiskMetrics had no comment.

Still, it isn’t clear whether other firms would have the interest or capability to deliver the kind of analytical services regulators would require for the variety of mortgage-backed securities held across hundreds of insurance companies.

Also unclear is how any service would be paid for. Currently, bond issuers — in the case of mortgage securities, typically banks — pay the ratings firms for ratings, which are then publicly available.

In a new scenario, one option might be the National Association of Insurance Commissioners paying for the additional analysis, a cost the NAIC could pass on to insurers in the form of fees. Or the issuers could pay for the extra analysis.

Conspiracy theorists will have to wait until the article described in Inside Science is published to determine whether it delivers on its claims. It claims to analyze stock holding across 48 countries and alleges they are held in very few hands. But the work was done by physicists, which means they may not have understood the limits of the data they were working with.

I suspect this will wind up resembling a paper a friend studied in his graduate level statistical methods course over two decades ago (he has since gone on to a successful career in academia). Everyone in the seminar was assigned a single paper and told to analyze the techniques used and to present their findings to the class. This was the sole basis for the grade.

The paper my buddy got had already created a bit of a stir, although it had not yet been published. The author had looked at the prices at which the Fed did its daily operations (then the famed “noon buying rate”) and compared it to the results of Treasury auctions. The paper concluded the Treasury was doing a terrible job, as demonstrated in all sorts of analyses.

When my friend’s day to present came, he stood up and said, “I have only one comment to make. The Fed conducts its daily operations in transaction sizes ranging in the millions. Treasury auctions are in the billions. The Fed data is irrelevant to the Treasury analysis,” and sat down.

He received an A.

In this case, an obvious fly in ointment is many (most?) stocks are held in street name, meaning in the name of the brokerage firm or fund, not the ultimate owner. I presume it is impossible to segregate accounts where the broker has discretion to trade versus those where the clients simply trades through the securities firm.

But even if the analysis is flawed, it might stir up some interesting discussion.

From Inside Science (hat tip reader John D):

A recent analysis of the 2007 financial markets of 48 countries has revealed that the world’s finances are in the hands of just a few mutual funds, banks, and corporations. This is the first clear picture of the global concentration of financial power, and point out the worldwide financial system’s vulnerability as it stood on the brink of the current economic crisis.

A pair of physicists at the Swiss Federal Institute of Technology in Zurich did a physics-based analysis of the world economy as it looked in early 2007. Stefano Battiston and James Glattfelder extracted the information from the tangled yarn that links 24,877 stocks and 106,141 shareholding entities in 48 countries, revealing what they called the “backbone” of each country’s financial market. These backbones represented the owners of 80 percent of a country’s market capital, yet consisted of remarkably few shareholders.

“You start off with these huge national networks that are really big, quite dense,” Glattfelder said. “From that you’re able to … unveil the important structure in this original big network. You then realize most of the network isn’t at all important.”

The most pared-down backbones exist in Anglo-Saxon countries, including the U.S., Australia, and the U.K. Paradoxically; these same countries are considered by economists to have the most widely-held stocks in the world, with ownership of companies tending to be spread out among many investors. But while each American company may link to many owners, Glattfelder and Battiston’s analysis found that the owners varied little from stock to stock, meaning that comparatively few hands are holding the reins of the entire market.

“If you would look at this locally, it’s always distributed,” Glattfelder said. “If you then look at who is at the end of these links, you find that it’s the same guys, [which] is not something you’d expect from the local view.”

Matthew Jackson, an economist from Stanford University in Calif. who studies social and economic networks, said that Glattfelder and Battiston’s approach could be used to answer more pointed questions about corporate control and how companies interact….

Based on their analysis, Glattfelder and Battiston identified the ten investment entities who are “big fish” in the most countries. The biggest fish was the Capital Group Companies, with major stakes in 36 of the 48 countries studied. In identifying these major players, the physicists accounted for secondary ownership — owning stock in companies who then owned stock in another company — in an attempt to quantify the potential control a given agent might have in a market….

Glattfelder added that the internationalism of these powerful companies makes it difficult to gauge their economic influence. “[With] new company structures which are so big and spanning the globe, it’s hard to see what they’re up to and what they’re doing,” he said. Large, sparse networks dominated by a few major companies could also be more vulnerable, he said. “In network speak, if those nodes fail, that has a big effect on the network.”

The results will be published in an upcoming issue of the journal Physical Review E.

This was too good to pass up. The key section of an offering at The Reformed Broker (hat tip reader Gonzalo):

The Five Stages of Panic Buying!

1. Denial (Late March/ Early April)

“Ha, another Bear Market rally…wait til the foreclosure/ new home sales/ confidence data comes in! Right back to 6500, maybe lower…bagholders”

“Dude, the stress tests are coming out next month. B of A may be done-ski. Sell the May 10 calls, you’ll never have to cover.”

2. Anger (Mid-April)

“What the f@&% do you mean the goddamn banks are cheap based on normalized earnings? They will never ever earn anything again, ever! Idiot!”

“You gotta be kidding me with these retailers running now. RETAILERS? Are you nuts? They’re FINISHED!”

“If one more consumer discretionary name rallies on a less-than-expected loss, I’m gonna kick this Bloomberg down a flight of stairs.”

3. Bargaining (May-June)

“Okay, I can stomach picking up some large cap tech and I’ll nibble – NIBBLE! – at discount retailers, but I will absolutely NOT buy Goldman Sachs at 130.”

If China would just pull back 5 to 7% I’d get in, but I can’t chase it here…except Sohu, and I guess a little Baidu and I’ll just take a quarter position in China Mobile just in case. But I’m not chasing here.”

“(whispered) Dear market god, please stop the tape. Just give me one crack at the Nazz and some banks and I will never doubt the solvency of the US balance sheet or the wisdom of the Troubled Asset Relief Program ever again.”

4. Depression (July)

“I can’t believe I missed it. Those D-bags next to me are high-fiving after every earnings report. Hate those f@&%ing guys.”

“How could Las Vegas Sands do this to me? I’ve been watching this stock go up for 900% now. Couldn’t just give me one chance to get in. I suck.”

5. Acceptance (Early August)

“That’s it! I don’t give a damn anymore, GET ME IN NOW! Forget the big ones, they’re already up too much, are there any $5 stocks left that haven’t done anything yet?

“I gotta blow out this stupid GLD, it does nothing, sick of it and sick of hearing about inflation. Even Paulson blew it out. Get me some $2 biotechs and some midwest regional bank stocks, I gotta get poppin’ over here! We’re going to 10,000 baby!”

Reader John O passed along this Bloomberg chart du jour (click to enlarge) which effectively argues that the consumer has gone down so far she has nowhere to go but up:

The related article argues:

….these so-called discretionary goods and services accounted for a smaller percentage of consumer outlays last quarter than at any other time since 1959. The proportion dropped about 0.3 percentage point, the sixth decline in seven quarters, to 15.6 percent.

The chart is similar to one created by Steven Wieting, Citigroup’s managing director of economic and market analysis, that Levkovich cited yesterday in a report. Both were based on spending figures compiled by the Commerce Department.

Consumer behavior is likely to revert to “the ‘Old’ Normal” — spending more closely tied to income, rather than borrowing — that prevailed during the 1950s through the 1970s, Levkovich wrote. “Some reasonable bounce is to be expected” in discretionary spending as that occurs, the report said.

“The frivolous consumer will not turn into the frugal,” he wrote, adding that pent-up demand will lead to production and employment gains.

Houses, cars and other durable goods, or items made to last more than three years, are the biggest category of discretionary spending as defined by Citigroup. The firm also included outlays on games, sports supplies, flowers, newspapers and magazines, hotel rooms, recreation and non-U.S. travel.

The “old normal” reference contrasts with the “new normal” that Pacific Investment Management Co., or Pimco, foresees. The firm expects relatively slow economic growth for the next three to five years as households and businesses retrench.

If one wanted to be a devil’s advocate, it isn’t hard. Comparing this downturn to past post war busts seems questionable. Those recessions, save our current bust, were the result of imbalances in the real economy. Inventory swings explain more than 100% of the change in GDP. By contrast, this one is the result of a 20 year debt party in the US, with the manic phase starting in 1999. This is a different sort of beast, and expecting old patterns to reassert themselves quickly is a bit of a stretch.

Ooh, so there is gambling in Casablanca! I’m shocked, shocked!

An excellent bit of sleuthing comes at the Wall Street Journal, on how Goldman has for the last two years has had “trading huddles” that lead to ideas being presented to clients before analysts changed their grades on a stock. Proprietary traders also attend the meetings.

Now the funny bit about this is that this is an ongoing not so keen practice that Goldman that Goldman has pushed pretty far, in typical Goldman propensity to exploit any ambiguity in the regs.

One of the differences between big accounts and everyone else is access to the analyst. The idea that this article fails to highlight is that the written research report is much less meaningful than believed, except in the cases when an analyst does a big revision of earnings forecasts. Goldman seems to have played those changes to its key accounts, and maybe its own advantage.

But a second bit is that within a seemingly static rating, an account can get tremendous insight from talking to an analyst that a mere low level client who gets only the written product and participation in conference calls misses.

In other words, the two-tier system (or even three, since top accounts can get to analysts any time, but other institutional accounts will not get the same priority) has long been in effect. But Goldman appears to have pushed the boundaries yet again. Putting the prop traders with the top accounts onto hot trading ideas (by implication, everyone knows GS intends to pile in, hence it is safe for the big accounts to throw their weight int) smells like tan organized ramp of a stock.
From the Journal:

Every week, Goldman analysts offer stock tips at a gathering the firm calls a “trading huddle.” But few of the thousands of clients who receive Goldman’s written research reports ever hear about the recommendations.

At the meetings, Goldman analysts identify stocks they think are likely to rise or fall due to earnings announcements, the direction of the overall market or other short-term developments. Some of their recommendations differ from ratings printed in Goldman’s widely circulated research reports. Some Goldman traders who make bets with the firm’s own money attend the meetings.

Critics complain that Goldman’s distribution of the trading ideas only to its own traders and key clients hurts other customers who aren’t given the opportunity to trade on the information….

Since the trading huddles began about two years ago, Goldman has supplied “trading ideas” on hundreds of stocks to the traders and top clients, according to internal documents reviewed by The Wall Street Journal.

Yves here. Goldman defends this practice as merely giving “market color” and contends this practice is simply to cater to accounts with a short-term trading focus, versus long-term investors. Please, is anyone an investor any more? Average holding time for NYSE stocks is well under a year. Back to the story:

Goldman was looking for a leg up on rivals when it started the trading huddles in 2007. That year, Goldman ranked ninth in Institutional Investor magazine’s annual list of the best equity analysts, as determined by a survey of big institutional investors. Goldman was rated eighth in last year’s competition.

The huddles began in earnest around the time Goldman’s research department got a new boss, Mr. Strongin. He came to the firm in 1994 from the Federal Reserve Bank of Chicago, where he had been director of monetary-policy research. At Goldman, he had run the commodities-research operation, then was co-chief operating officer of the whole research unit, before being asked to run it in April 2007….

Compliance officers sit in on almost all the meetings, Goldman says. Research analysts say they have been guided on what language to use in the huddles. Words like “buy” and “sell” are to be avoided, while “run up,” “give back” and “oversold” are encouraged. Internal documents reviewed by the Journal initially tracked the trading-huddle tips as “buy” or “sell,” but now refer to them as “up” or “down.”

Yves here. You know when compliance sits in the practice is pushing the margin. And everyone on the calls understands the coded message. Complete form over substance.

Some other firms are more conservative:

At least one competitor discloses such trading tips much more broadly. Morgan Stanley’s research department sends blast emails with short-term views on various stocks to thousands of clients, and posts the information on its Web site. It doesn’t call customers to convey the tips, because Morgan Stanley officials decided that could expose the firm to questions about selective disclosure, according to people familiar with the matter.

Ratings agency Standard & Poors has managed a stunt which to my knowledge has no precedent in the history of the dark art of ratings. It downgraded some not all that highly structured commercial mortgage bonds last week to an eyepopping degree, from AAA to BBB-, just this side of being junk.

Then they restored them to AAA this week. And the reason was not some semi-defensible “the dog ate my homework”, like someone external had given them erroneous information that got plugged into their methodology. No, they had implemented a new model, it gave garbage results, and somehow no one inside the firm noticed the massive downgrades that resulted and bothered to check to see if there might be an error in the model. No, they published and then got customer howls. Now this only involved three bonds, but this happening at all is quite an impressive feat.

From Blooomberg:
Standard & Poor’s backtracked on ratings cuts issued last week and raised the ranking on commercial mortgage-backed debt f

rom three bonds sold in 2007.

The securities, restored to top-ranked status, had been downgraded as recently as last week, making them ineligible for the Federal Reserve’s Term Asset-Backed Securities Loan Facility to jumpstart lending.

S&P lowered the ratings on a class of a commercial mortgage-backed bond offering from AAA to BBB-, the lowest investment-grade ranking, on July 14. The New York-based rating company reversed the cut today, S&P said in a statement. In a related report, S&P said it adjusted assumptions on the timing of projected losses on the mortgages.

“It is a stunning reversal and certainly raises questions concerning the robustness of their revised model,” said Christopher Sullivan, chief investment officer at United Nations Federal Credit Union in New York. “It may engender further uncertainty with respect to ratings outlooks.”

Reader Entirely Random adds a vignette to this comedy of errors:

I finally got someone from S&P on the phone… tried to explain to them that capital markets simply won’t work if bonds go from AAA to BBB and back to AAA in the space of a week, that a number of people had been forced to sell the bonds last week when they had been downgraded and had lost quite a bit of money for the experience, and that any sort of credibility S&P had hoped to re-establish would likely be destroyed as a result of what they’d done. Of course the 25 year-old analyst at S&P didn’t have anything on his script to deal with those concerns and could do nothing but refer me back to their press release. I got so frustrated I suggested they completely disregard any pretense of “official methodology” and go straight to the South Park method — i.e., cut the head off a chicken and see where it lands on the rating board. I don’t think he found it nearly as funny or cathartic as I did.

The very fact an op-ed piece (more accurately, comment, as they call them in the Financial Times) by Paul Boyle against airbrushed accounting needed to be written at all is troubling.

A move is afoot that appears further advanced than I realized is to fool with financial firm statements so as to reduce the procyclical impacts, ahem, namely that asset prices rise in boom periods and fall in busts.

This is the ultimate contradiction of “free markets” thinking. One of its tenets is that you don’t need regualtion because ever-wise “the market” will quickly figure out fraudsters. No joke, folks like Frank Eastabrook (a leading light of the law and economics crowd) argues that the fact that people buy stocks means “the market” does an adequate job of policing. Um, that “the market” just happens to have strict requirements re disclosure, accounting, and bans against insider trading and market manipulation like front running.

But we went a fair way down the “free market” path, the banks and the public went on a leverage spree, and now we have a really big costly mess.

Since it is costly to clean up the wreckage, we are going to have phony accounting to make banks look better to induce people to invest. The whole point of this exercise is to lower the cost of capital. Just like housing prices in the US are the result of misunderstanding and irrational pessimism, so to is leeriness to invest in large capital markets firms that are increasingly hedge funds in banks’ clothes also clearly the result of faulty thinking, So in addition to having the Fed buy tons of mortgage paper to keep financing rates down to boost home prices, the proposal is on the table to massage bank financials so as to correct investor misunderstandings about them.

The entire logic behind the “free markets” school of thought was that they were ever and always virtuous, that markets could always price the risks of firms correctly, and the best approach was to impose regulatory capital requirements that would mimic what “the markets” would require. I am not making this up; Greenspan said precisely that in a speech in Tokyo in 1996.

Now that that movie did not end as happily as everyone expected, the powers that be are trying to manipulate perceptions that admit the construct failed.

From the Financial Times:

The financial crisis has generated a philosophical debate about the role of accounting, notably the extent to which it is pro-cyclical, exacerbating booms and busts….

Yves here. Boyle largely dispatches this idea, but he somehow fails to assault the core problem. Any collateralized lending is pro-cyclical, period. As asset prices rise, banks think their loans are better secured and that their customers are richer, since they have stronger balance sheets. Even if they do not loosen lending standards, the mere fact of rising asset prices means they will lend more against the same collateral. This process tends to continue until debt servicing becomes a problem (unless asset prices are well behaved and do not rise faster than GDP or incomes) and asset prices start to fall because strained borrowers don’t want to take on more debt. Fewer buyers for the same assets means prices start to fall, and the leverage leads to a stronger downswing just as it fed the rise. This has nothing to do with accounting, it is a function of how collateralized lending can easily feed an asset bubble. Back to the article:

However, it is not clear that accounting has the potential to be a public policy tool to reduce pro-cyclicality, nor that it would be appropriate to use it in this way.

An equally, or perhaps even more, dangerous argument now gaining currency is that accounting should be given an explicit role in promoting financial stability, rather than its traditional role of providing information useful to investors in their decision-making. The implication of this view is that accounting measures that show volatility should be adjusted to create an impression of stability.

Accounting is a measurement system that presents the financial performance and position of a company in as neutral a way as possible. It is not surprising that banks report substantial profits when the economy is doing well and reduced profits, or even losses, when the economy is doing badly. This is accounting reflecting the economic cycle, which is a good characteristic of a financial measurement system.

Can this reflection of the economic cycle become too much of a good thing, and pro-cyclical?

To answer this, it is worth considering the dangers of altering other measurement systems to make them less pro-cyclical. It could be argued, for example, that unemployment statistics have damaging pro-cyclical effects. Low unemployment numbers make consumers feel confident, thus encouraging them to borrow and spend at levels which might prove unsustainable. High unemployment numbers make consumers worried, causing them to reduce their spending and pay off debts, with the undesirable consequence of even greater unemployment.

Yet no-one seriously argues that it would be in the public interest for the unemployment statistics to be adjusted in the interests of financial stability.

One could also argue that house price statistics are pro-cyclical; reports of rising prices encourage consumers to make more purchases at higher values, thereby driving up prices further. Reports of falling prices have the opposite effect. I have not heard pleas that the national statistics agencies should intervene to prevent these seditious numbers being disclosed to a public who cannot be trusted to react in a way consistent with financial stability.

If there were to be an intervention to adjust the reported economic numbers then the monetary authorities, and perhaps a small number of other people in influential positions who could be trusted to respond appropriately, would have to be permitted to see the true figures.

Most people would regard this as a deeply unattractive prospect with Orwellian implications. It is for this reason that calls to adjust accounting measures to make them less pro-cyclical should be treated with suspicion.

The way in which consumers or investors will react to statistical or accounting information is not easy to determine in advance, as it will be influenced by a large number of variables. It is, therefore, not reasonable to expect that national statistics agencies or accounting standard-setters should be asked to predict those reactions, far less take a view as to whether those reactions are “good”, in making their measurement choices.

Those who argue that accounting should be amended to make it less pro-cyclical must believe investors are not to be trusted to react appropriately to unadjusted numbers. Once again, however, there would be certain people, including prudential regulators, who would have to be trusted to see the raw figures.

It would, though, be hard, perhaps impossible, to persuade investors to fund financial institutions without showing them the true, unadjusted numbers…

It may well be appropriate to attempt to reduce the volatility of economic cycles, but there are more appropriate tools than accounting to achieve this.

A related comment, “Investors have to be sure statistics do not lie” by Bernie McSherry, is also worth reading.