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Bernard Madoff’s last minute honesty will not be the last disclosure to be prompted by the harsh realities of the current financial climate. Clients need reassuring and that means providing greater transparency so that they know bad news is flowing with the good. Madoff’s funds were being executed and cleared by his own business so there was no independent custodial or prime broker reporting of the value of the funds. Regulators and the market will put pressure on this kind of arrangement but funds providing their own execution and clearing or with multiple brokers are left with a lot of integration work which it is difficult for them to manage internally and they are often reluctant to resort to hearsay reporting of positions to a prime broker.

Leveraged funds will to some extent be driven to disclose fuller details to their lending brokers because without a true prime broker arrangement there is not visibility of the full fund and trust is no longer sufficient to allow lending to the level of leverage that the funds had enjoyed. A lesson that was taught by the Long Term Capital experience where multiple lenders were unaware of the extend of borrowing and exposure from other brokers.

The greater significance of transparency gives added leverage to Prime Brokers and Custodians to offer reporting services and increase the premiums people are willing to pay for more regular or better integrated reporting. The challenges of integrating derivative workflows in order to provide greater confidence in the valuation and reporting process will also continue to be differentiators.

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Finance derivatives, funds, reporting, risk

There has been much discussion of U.S. competitiveness lately. Michael Porter of Harvard has had the front cover of BusinessWeek and the New York technical community is a buzz with how it needs to save the economy. This comes after the demotion of media, advertising and financial services which are all undergoing structural change that has shaken their institutions and hasn’t stopped shaking them. The Hi-Tech industry in New York is smaller than that of Boston and has had difficulty achieving economic scale, particularly when it is compared with California, Tokyo, Taiwan, Israel, Bangalore or the UK. The strongest remaining business in New York is Health Care and that is not something on which the economy can be based. The surrounding area does have significant Pharma businesses and it is noticeable how many service businesses are trying to re-orientate themselves to serve the Government and Pharma businesses. You just can’t export the Health Care services and to the extent that you can their price would not be competitive.

The call for government strategy is partly in denial of the fact that the economy makes more decisions than politicians do, but there are things over which politicians do have influence. For example there is a need to better understand the impact of the split between federal and state government. The federal and state split in the US starves the funding of education and social services, as compared to defense, due purely to which side of the government tax structure they fall under. We have competition between states which drives down our education and social programs to the extent that many children have so many issues in their homes that they can not focus in the classes that are available to them. The problem is further exacerbated by the provision of so much educational funding at the township level so that wealthier towns pay only for the education of their children and not those of the adjacent poorer town.

The strategy of a strong military to control the resources that we need, rather than a skilled workforce to provide economic strength, is a strategic decision which we would do well to re-examine. Imperialism is part of our past, as with many countries, but it isn’t acceptable as part of a modern, communicating, flat Earth.

America has enormous strengths due to scale and having the world’s reserve currency. Both of these advantages, for our industry and our government, put the US economy head and shoulders above any other. Our companies can be more specialized and more efficient in their chosen market purely due to the scale of our economy and this higher level of specialized experience puts them at a huge advantage to competitors in smaller economies. Europe, as the closest competitor in scale, is in reality a series of markets fragmented by language, media, culture and law. Europe and China are however becoming better integrated and catching up.

The use of the USD as the global reserve currency allows the US government to borrow in its own currency without devaluing it. Other countries have a limited ability to borrow without weakening their currency and having resulting difficulty in repaying loans in foreign currency. This single factor will allow America to spend its way out of a recession more cheaply and to a greater extent than any other Country can safely achieve. One strategy that US governments have consistently followed is to maintain the U.S. Dollar as the global reserve currency. It has driven policy over many spheres, from the creation of the IMF, to the support of oil rich governments. While the vast majority of global trade is valued in U.S. dollars less than 18% of it is with the U.S. itself. The largest single chunk of that global trade is due to the pricing of oil in US dollars. Much world trade is also in oil derived materials, energy and transportation which inevitably track the price of oil.

Michael Porter’s article over plays the strength of the US economy having been based on our brilliance in technology, finance and the brilliance of our institutions while it ignores the advantages of sheer scale. Even issues such as U.S. companies being able to sell almost all of their product in their own currency and not having to cope with foreign exchange risks to the same extent that other nations’ businesses do, have a significant benefit across economic cycles.

The claim that America lags so heavily in access to University education is dubious. When we compare university education in different countries and across different decades we are not comparing apples with apples. America has very broad access to university education with much better access to funding than in any other region of the world. One has to note that Michael Porter is a Harvard academic.  I would suggest that U.S. university education is probably more constrained by the educational standards of those entering university than by financial constraints. Michael Porter appears to agree with this assessment of public education. The problem with this and social investment by governments, as a strategy, is that it takes fifteen years for us to start receiving the benefits and we have been soft peddling for far too long.

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Finance education, government, strategy

After any serious hurt there is a call for immediate action in the political sphere. People look to politicians to protect them, and politicians are happy to encourage the notion. This rush to action overlooks the fact that even the management of the investment banks hadn’t understood the situation in time to avert their own losses. They are all very capable, highly functioning individuals but were unable to play out the head game of managing the risks effectively. There is little reason to think that regulators are better able to understand the issues and we have seen that the regulators both in the US at the SEC and in the UK with Northern Rock have failed to understand the pending emergency or to act. This does not prove incompetence but primarily points to the misplaced expectation that they would be able to.

There are more modest and specific areas which can be codified such restricting the scale of bond insurance / credit default swaps (CDS) for a given level of reserve. This would in reality restrict this market to a fraction of its prior scale but would make bond insurance a realistic private business. CDS contracts are not independent events and market slumps inevitably result in failures of those over selling insurance via CDS contracts. The staggering number and value of these contracts, given the level of reserves of the companies writing them, mean they are not enforceable as written and do not really have the value described without recourse to government bail outs.

The scapegoat of short trading is a cosmetic political issue similar to restricting profit taking on building supplies during a Florida storm. Its main purpose is to avoid news stories and resentment and its main effect is to reduce the motivation to assist in running an effectively priced market. People don’t like to hear that anybody has profited from a downturn but this can’t be confused with addressing the causes of the bad news.

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Finance, Securities Lending financing, regulation

With Lehman and Merrill Lynch joining Bear as past proud names of Wall Street, and contracting their businesses, it is apparent that there is a significant contracting of US institutional finance. The government financed support of Fannie Mae and Freddie Mac resulted in the government financing of over half of the US mortgage business. The next two largest players in the mortgage market were Lehman and Merrill Lynch. For scale it is worth noting that the amount of debt held by just Fannie Mae and Freddie Mac was greater than the total value of the UK economy.

There are now only two remaining independent US investment banks. Goldman Sachs and Morgan Stanley. This will hurt the US economy significantly because when investment banking services operate within a retail banking group they are subject to severely constrained risk limitations.

The remaining global investment banking players are: Goldman Sachs, Morgan Stanley, Citibank, Deutsche Bank, UBS, Bank of America (With Merrill), Credit Suisse and Nomura.

Unfortunately there will inevitably be a contraction for those who provide services to Merrill Lynch,  Lehman and Bear Stearns as the consolidation of everything from custodial services to data contracts will result in greater bulk pricing and fewer relationships. This is likely to further effect the custodian banks though with less dramatic exposures as it is a pure service model and not an investment exposure.

There will also inevitably be a knock on effect to portfolios as there has now been a significant loss of market value for the US financial sector.

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Finance contraction, economy, lehman, merrill lynch

The Senate permanent subcommittee on investigations has published a press release about a report which appears not to be available online.

This relates to the common practice of trying to lawfully minimize ones taxes by investing in ways which are subject to lower tax rates. A normal business practice. Unfortunately the committee is representing this as tax dodging and maligning the industry.

Many countries offer lower dividend tax rates to one type of entity than another. In some countries to encourage inward investment and in some situations to benefit local investors. In some cases the benefit is just that the tax is not withheld from the dividend and instead becomes a tax liability which is assessed in the normal taxation cycle. In many cases, particularly with cross border investment somebody holds stock via a preferred entity in order to more efficiently manage their taxes. For example via a locally registered entity or an offshore entity or via an insurance company. It has also been common practice for at least the last fifteen years to arrange swaps or loans of securities which occur only during the dividend season in order to have better control of the securities settlement during the rest of the year and still have the dividend benefits. In such cases the fee for the transaction accounts for the fact that there will be a dividend benefit.

In many cases the tax benefit is the primary reason for such transactions but to try to prevent the securities from flowing to lower tax entities is an attempt to stop water flowing down hill. To some extent these noises from polititions are a signalling arrangement where the industry becomes more or less cautious about the type of transactions it performs. For the financial services industry, both brokers and clients, there is a significant risk of suddenly receiving a tax liability that had not been factored into the original transaction. In practice the IRS can not be in the middle of every transaction and relies upon such signalling. We can have rules about what structures are permitted but they need to be clear. Most tax advice is after all aimed at minimizing tax liability. Still there does need to be caution not to start carelessly prosecuting those who have allowed water to flow down hill on their land.

A better solution than those suggested is to have clear and more even tax rules regardless of entity so that there is less reason to add the overhead of administering these transactions. That requires harmonization both internally and internationally given the diverse listings of securities in the modern world. That of course in turn requires hard work for politicians, co-operating across borders and doesn’t allow for drama of the more visceral press releases.

According to the press release, in the report, the Subcommittee Majority staff recommends the following:

1. End Offshore Dividend Tax Abuse. Congress should end offshore dividend tax abuse by enacting legislation to make it clear that non-U.S. persons cannot avoid U.S. dividend taxes by using a swap or stock loan to disguise dividend payments. This legislation should end the abuse by eliminating the different tax rules for U.S. stock dividends, dividend equivalent payments, and dividend substitute payments, and making them all equally taxable as dividends.
2. Take Enforcement Action. The IRS should complete its review of dividend-related transactions and take civil enforcement action against taxpayers and U.S. financial institutions that knowingly participated in abusive transactions aimed at dodging U.S. taxes on stock dividends.
3. Strengthen Regulation on Equity Swaps. To stop misuse of equity swap transactions to dodge U.S. dividend taxes, the IRS should issue a new regulation to make dividend equivalent payments under equity swap transactions taxable to the same extent as U.S. stock dividends.
4. Strengthen Stock Loan Regulation. To stop misuse of stock loan transactions to dodge U.S. dividend taxes, the IRS should immediately meet its 1997 commitment to issue a new regulation on the tax treatment of substitute dividend payments between foreign parties to make clear that inserting an offshore entity into a stock loan transaction does not eliminate U.S. tax withholding obligations.

There are reports of the press release in the New York Times and the FT with little reaction.

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Finance, Securities Lending irs, lending, Securities Lending, swaps, withholding