A Fearful Symmetry

Tyger Tyger, burning bright,
In the forests of the night;
What immortal hand or eye,
Could frame thy fearful symmetry

– William Blake, “The Tyger”

Fidelity’s Abigail Johnson is in the FT today talking up fulcrum fees. Apparently Fidelity recently announced they would be launching a number of new mutual fund share classes with a fulcrum fee structure (details TBC). Here is Ms. Johnson:

Asset managers have typically charged a flat fee for active management. Most clients understand that even the best managers suffer some periods of underperformance measured over the long term.

Fulcrum fees would align the asset manager’s interests with those of the asset owner and encourage investors to remain committed to active strategies through the natural fluctuations in short-term performance

But is a flat fee fair, regardless of the value that is being delivered? Too often this model leaves us open to accusations of overcharging for mediocre performance. In a world increasingly dominated by index funds that allow cheap access to markets this is clearly unjustifiable. “Performance fees” are even more egregious. On top of the base fee, they add further charges when the manager does well — heads we win, tails you lose.

We need a fundamental rethink of the way asset managers charge their clients. Fulcrum fees have been used in the US since the 1970s — charges that rise when the fund outperforms, but fall by the same amount when the fund underperforms. Simple.

An important thing to remember is that it is generally not permitted under the Investment Company Act of 1940 for a mutual fund manager to charge a performance fee (e.g. the 2 & 20 structure common to hedge funds and private equity). If it were allowed, everyone would do it. Trust me.

However, the 1940 Act does allow symmetrical performance-based fees. In this structure, if the fund is outperforming its benchmark the manager’s fee is adjusted upward as a reward, while if the fund underperforms its benchmark it will be adjusted downward as a penalty. Later in her editorial Ms. Johnson acknowledges that despite being on the books for decades, this is not a popular compensation structure.

No kidding.

This is a classic issue of incentives. Fulcrum fees are bad juju for a lot of asset management businesses. Some old-but-good Vanguard data will show you why:

Vanguard_underperformance-chart.PNG

So according to this study, in a fulcrum fee arrangement 97% of these funds are going to get whacked with a performance penalty for a minimum of five years over any arbitrarily long time horizon. Meanwhile, if you stick with a flat fee based on assets under management you are guaranteed to collect your full management fee 100% of the time.

So why is one of the world’s largest asset managers now championing the structure?

My $0.02:

  • Investors are probably more cost conscious now than they have ever been. This is partly a function of academic research on the impact of expenses on investment results, but more so because investors have access to a proliferation of cheap investment alternatives (note: cheap does not necessarily equal better, though for the time being it seems most people are treating the two as synonymous).
  • Add to the above the fact that a lot of active funds aren’t as active as you might think.
  • On a totally anecdotal level, I would say investors are more aware of issues around conflicted advice as relates to investment manager compensation than they have been historically. Personally I attribute a lot of that to the internet and the number of professional and personal blogs devoted to personal finance and investing.

Fidelity isn’t run by idiots. In my view they are making the smart play. Better to get out in front and position yourself on the leading edge of investor-friendly compensation structures. It gives you some initiative in dealing with the business impact and will also provide some marketing ammunition, like investor-friendly editorials in the FT. Vanguard has been doing this for decades now and it has paid off in spades. I know this all sounds rather cynical but remember we are talking about trillions of dollars in mutual fund assets that are perpetually up for grabs.

Now over to William Blake for a pithy conclusion:

When the stars threw down their spears
And water’d heaven with their tears:
Did he smile his work to see?
Did he who made the Lamb make thee?

Tyger Tyger burning bright,
In the forests of the night:
What immortal hand or eye,
Dare frame thy fearful symmetry?

Empires & Barbarians

Empires_Barbarians.jpgPeter Heather’s Empires And Barbarians is a book worth reading. Unfortunately it is also a book that is difficult to recommend. It is written for an academic audience. Which is another way of saying it can make for incredibly dry reading. This is a shame in that the scholarship, the ambition and the quality of Heather’s arguments are all impressive.

The central idea is this: in the beginning there is agriculture. Primitive agriculture is hard. It consumes a great deal of time and energy and leaves very little time for anything else. Life is nasty, brutish and very short.

What societies need to develop beyond a relatively miserable subsistence level agriculture is specialization.

This can happen in a couple of different ways. One way (the slow way) is that agricultural societies gradually develop technology that makes farming more efficient and less time intensive. This allows certain members of the community to focus on other activities — perhaps the manufacture of consumer goods, or the development of systems of writing (if this process interests you I highly recommend Jared Diamond’s Guns, Germs, and Steel: The Fates of Human Societies). As specialization increases people’s lives tend to get a little less nasty, a little less brutish and a little bit longer.

Another, faster way that development happens is via trade and migration. For example, of early Germanic societies, Heather writes:

In the case of the Germani, Rome may have acted as a source not only of extra economic demand, but also possibly for some of the ideas and technology that made agricultural intensification possible […]

[…] Where and how, exactly, these ideas spread remains to be studied, but both the more efficient ploughs and the better integrated farming regimes were well known in Roman and La Tene Europe, much of which the Empire swallowed up in the first century BC, long before they spread into Germania, and and these areas may have inspired the Germanic agricultural revolution.

Other goods produced in Germania were also in demand in the Roman world. The occasional loan word and literary reference identify some specific products. Goose feathers for stuffing pillows and particular kinds of red hair dye were two such items. Much more important than any of these, though, was the demand certainly for two, and probably three, other raw materials.

Empires And Barbarians is more or less a case study of migration and development in the context of Europe in the first century AD. What I take away from the book is not so much the details, but the timeless nature of the process.

For example, in the fourth and fifth centuries the arrival of the Hunnic Empire in Europe caused enormous political and social dislocations. In essence, displaced barbarians showed up on the Roman Empire’s doorstep. For a whole series of complex reasons, not least of which was the need to bolster Roman Legions with barbarian manpower, the Romans were sometimes forced to grant concessions.

In a general sense, this is not so much different from what we see in Europe today with the mass influx of refugees from the Middle East, North Africa and South Asia. Or in the United States with refugees and migrants from Central and South America.

Again, Heather:

[I]t is important to factor in the general patterns of economic development operating in and around the Roman world. The Goths and other Germanic migrants of the third century had moved into the Black Sea region because it was part of a more developed inner periphery around the Roman Empire, with many economic attractions. And while these migrants were benefiting from that greater wealth, the Roman Empire was operating at a still higher level of development, with still greater economic surpluses. This wealth was immediately visible to outsiders in the Empires frontier zones in the form of towns, fortifications, armies, even villas, all of which, as we have seen, regularly attracted cross-border raiders. Ammianus’ account of Gothic motives, — that Roman wealth had entered their calculations — makes perfect sense, therefore, and also recalls modern case studies, where it is rare for economic motivations to be absent from immigrants’ calculations, even when their thinking has a strong element of the political and involuntary about it.

What I think is often missed in the debate surrounding immigration and refugee policy is this “zoomed-out” perspective of trade, migration and development. This is not some series of isolated incidents that can simply be prevented or outlasted. It is a cyclical process underpinning the evolution of human civilization. You don’t “beat” these kinds of cycles any more than you “beat” waves in the ocean.

So why does this get missed?

The news cycle plays out in hours. Election cycles play out in months and years. Economic cycles play out over decades. These cycles of migration and development play out over multi-decade, multi-generational time horizons. They create winners and losers.

People do not like to spend even half a lifetime losing. They will do seemingly crazy things to stop losing — to have a shot at winning. They will vote dictators into power. They will support ill-advised wars of aggression. They will wander thousands of miles on foot and pay thousands of dollars to criminals to ferry them across oceans in what are more or less bathtubs.

The value of a history like Empires And Barbarians, dry as it may read at times, is that it can afford to take the very, very long view. A luxury we cannot often afford.

Gazprom vs. Sanctions

Gazprom_Balloon.jpg
Source: Gazprom

In the interest of full disclosure, I am long Gazprom ADRs. This post is written for entertainment purposes only and is not a recommendation to buy or sell any Gazprom-related security. Readers should consult a financial advisor before buying or selling any security. An advisor will be able to make a recommendation while taking the investor’s unique circumstances into consideratiom. Now, on to the show…

Hear that frenetic popping sound? Kind of like a firing squad executing a an opposition politician? Actually it is the sound of the Russian oligarchy uncorking champagne. Gazprom, Russia’s state-owned gas company, was recently ranked #1 in the 2017 S&P Global Platts Top 250 Global Energy Company Rankings, dethroning reigning champion Exxon Mobil.

Gazprom is a fascinating entity for any number of reasons. Chief among them is that it is majority controlled by the Russian state, is a behemoth of an integrated oil and gas company and is therefore an instrument of Russian geopolitical strategy. Here are some fast facts from the 2016 Annual Report:

Gazprom_Fast_Facts.PNG

There is common misconception in the United States that sanctions on Russia somehow really matter. And sure, they matter at the margins. Certainly if you are a Russian oligarch they may impede your ability to make extravagant purchases. Sanctions make it harder and more expensive for Russian companies to do certain things. Project finance wrangling in particular can be a pain.

But remember – Russia via Gazprom controls nearly 20% of global gas reserves and maintains a relatively low cost position. This is something of an economic moat and if you are Russia/Gazprom it gives you options. For example, running export pipelines into China, and developing a liquefied natural gas (LNG) export hub in proximity to Southeast Asia.

Gazprom_China.PNG

Gazprom_SE_Asia_LNG.PNG

It is hardly a coincidence that in 2016 Gazprom closed a EUR 2 billion credit facility with the Bank of China (the 2016 Annual Report trumpets this as “The largest deal in the Company’s history in terms of the amount of financing attracted directly from one financial institution”). The company also held investor day events in both Singapore and Hong Kong earlier in 2017. Why? Per a Gazprom press release:

The region is of strategic importance for Gazprom’s development. The Company aims to foster an increased cooperation with its Asian partners and strives to diversify its investor pool and financing sources, with a primary focus on Asia-Pacific’s potential. Specifically, 52 per cent of the Company’s loans in 2016 were provided by Asian banks, which shows that they have a high level of confidence in Gazprom.

Translation: “Ready access to Asian capital markets allows us to reduce our dependence on US and European companies and institutions for financing, just in case we lose access to western capital.”

So here is a lesson in incentives: trade restrictions like sanctions will only bite insofar as no one of means has a strong incentive to violate them. Otherwise someone or some entity is going to come in and arbitrage those restrictions. Critically, ideological incentives do not count. History is replete with examples of people and entities abandoning entrenched ideological positions when it will benefit them economically. In many cases, simple greed will do the trick.

This old Bronte Capital post provides an elegant historical example:

A typical Marc Rich & Co trade involved Iran (under the Shah), Israel, Communist Albania and Fascist Spain. The Shah needed a path to export oil probably produced in excess of OPEC quotas and one which was unaudited and hence could be skimmed to support the Shah’s personal fortune. Israel – a pariah state in the Middle East – wanted oil.  Spain had rising oil demand and limited foreign currency but was happy to buy oil (slightly) on the cheap. Spain however did not recognise Israel and hence would not buy oil from Israel – so it needed to be washed through a third country. Albania openly traded with both Israel and Spain. Oh, and there is an old oil pipeline which goes from Iran through Israel to the sea.

So what is the deal? The Shah sells his non-quota oil down the pipeline through Israel and skims his take of the proceeds. Israel skim their take of the oil. Someone doing lading and unlading in Albania gets their take and hence make it – from the Spanish perspective – Albanian, not Israeli oil. The Spanish ask few questions. The margins are mouth-watering – and they all come from giving people what they really want rather than what they say they want. We know what the Shah wanted (folding stuff).  We know what Israel wanted (oil). We know what Spain wanted (cheap oil). Who cares that Spain was publicly spouting anti-Israel rhetoric. [Similar trades allowed South Africa to break the anti-Apartheid trade embargoes.]

[…]And when the Shah fell?  Oh well – Pincus Green – an American Jewish businessman – gets on the plane to Iran and does a similar deal with the Mullahs – who – despite their rhetoric will sell oil down a pipeline through Israel – and will allow Israel to skim their take. Trading through the American embargo – well that is just another instance of getting around restrictions and profiting (very) handsomely.

The Gazprom-China relationship isn’t nearly as complex as these Marc Rich & Co. transactions. China has not agreed to the sanctions regime imposed on Russia by western countries. China and the rest of developing Asia simply need cheap and abundant supplies of natural gas. Gazprom is able to meet that need, and will be happy to have the Chinese as a source of project finance.

The political kerfuffle surrounding Gazprom’s Nord Stream 2 pipeline in Europe revolves around similar dynamics. Eastern European states such as Poland, Latvia, Lithuania and Estonia rightly fear dependence on Russian gas as it gives Russia powerful leverage over their economies and therefore their political independence. German industry, meanwhile, would much prefer cheap Russian pipeline gas to more expensive LNG imports.

While today’s headlines herald booming US LNG exports, independent research implies US exports will eventually need to price significantly higher to cover producers’ full marginal costs (including capex, liquefaction & shipping — after all it is not cheap to send tankers full of LNG halfway around the world):LNG_Transportation_Costs (1).PNG

Gas_Price_Breakevens.PNG

Gas_LT_Marginal_Costs.PNG

So again economic incentives outweigh any warm and fuzzy notion of European solidarity. The result is a running trade case that has been winding its way through the EU bureaucracy for years.

And meanwhile the Nord Stream pipeline project grinds on…

Fear and loathing in asset management, cont’d

Yesterday I addressed the topic of whether index investing is truly the road to serfdom. This is one of the sillier marketing ploys the financial services industry has trotted out lately, so it’s something I find worth harping on.

David Merkel from The Aleph Blog highlights another issue with this posturing:

There’s been a lot of words thrown around lately saying that indexing has been leading to overvaluation of the US stock market. I’m here to tell you that is wrong. I have two reasons for that:

1) Active managers have been pseudo-indexing for a long time. The moment they get benchmarked to an index they do one of two things:

a) accept it, gain funds for mandates that are like the index, and then they constrain their investing so that they are never too different from the index, and hopefully not in the fourth quartile of performance, so they don’t lose assets. This is the action of the majority.

b) Ignore it, get less fund flows, and don’t let the index affect your investment decisions. The assets should be stickier over time if you explain to clients what you are doing, and why. Only a minority do this.

This has been my opinion since my days of writing for RealMoney. All of the active managers out there add up to something close to a passive benchmark, less fees. It can’t be otherwise.

The one exception of any size would be stocks excluded from indexes because they don’t have enough free float available for non-insiders to own/trade. Even that is not very big — it might be 5% of the total stock market, though this is just a wild guess.

2) If you want to talk about valuation issues, you really want to talk about the trade-off between stocks and bonds, or stocks and cash. Stock valuations are never absolute — it is always a question of the other assets you are measuring the stocks against, and how you desirable those other assets will be in the future, and how sustainable the profitability of stocks will be over time.

There is a straightforward reason that pseudo-indexing (also known as “closet indexing”) is good for business. That reason is that most clients do not really want extraordinary returns.

That is to say, clients think they want extraordinary returns, but are not actually psychologically prepared to do what it takes to earn extraordinary returns. I use the word “earn” very deliberately here. Generating extraordinary returns is hard work, and it usually requires swimming upstream against consensus. Whenever you find a client who understands this (for they do exist) you should treasure that client.

Regardless of what they say, all clients really want is to achieve their financial goals. Inasmuch as portfolio returns are concerned, they are generally loss averse. That is, they dislike losses more than they value gains. This leads to an asymmetrical payoff for the investment manager. As an advisor or portfolio manager, you typically stand to lose much more by losing money when the market is up or flat than you stand to gain from outperforming the market when it is up.

So from a business perspective it is safer to put up middle of the road numbers than look too different from the indices or your competitors. The bottom quartile thing David mentions is a big deal. I have sat in the meetings where these issues are debated. Woe betide you if you find yourself in the bottom quartile of your peer group a couple of years in a row. Fire your sales team and wait for the numbers to turn.

Anyway, here is how you build a portfolio as a closet indexer. You pick something like 75 to 150 stocks, which keeps your largest positions to maybe 3% or 4% of the portfolio (if that). So even if one of those stocks goes to zero (unlikely) you are facing at maximum 3% to 4% of performance detraction from an individual name. This will be offset by some stuff you own that goes up, and it all kind of averages out in the end. Indeed, that is whole point. I cannot help but remark that this looks a hell of a lot like what the index investor is trying to achieve. (Mutual Fund Complex Marketing Person: “Ours goes to 11!”)

Likewise, you keep your sector weights within a couple percent of the benchmark weights, and the same with the individual stock holdings. You won’t own every security in the index. That’s okay. A lot of the securities in the index are crap — too much debt, negative cash flow and earnings, whatever. And anyway omitting some stuff will make you look better on certain measures that institutional research groups use, like active share.

If you are good you will maybe generate 1-3% of annualized outperformance over time, net of fees. If you are really good you might do even better. Unfortunately most closet indexers are not that good. There is plenty of data to support this (see below).

The two main statistics we use to measure the differentiation of an investment manager’s portfolio from a benchmark index (like the S&P 500) are active share and tracking error. Active share specifically looks at the overlap in holdings, while tracking error measures the volatility of the return differential over time (for quanty nerds this is the standard deviation of excess returns).

If you are a stock picker running a concentrated portfolio of your best ideas, you will score high on both measures. If you are a closest indexer, you will score low on both measures. There was a robust, if somewhat dated, exploration of this topic by Antti Petajisto in the Financial Analysts Journal in 2013. If you are interested in this subject you should definitely read the whole paper.

In the meantime, here are the relevant results from his cross-sectional analysis of US equity mutual funds:

Closet_Indexing_Stats.PNG
Source: Financial Analysts Journal, Vol. 69, No. 4
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Financial Analysts Journal, Vol. 69, No. 4
According to Petajisto’s data and criteria, about 64% of US equity mutual funds were either moderately active or closet indexers. However, the average assets under management for closet indexers was $2 billion, versus $1 billion for the entire data set.

So like I said, mediocrity sells. So much for efficient capital allocation.

Fear and loathing in asset management

Today I listened to a presentation that was one part screed against passive investing and one part shameless plug for sexy, paradigm-changing growth stocks. I will not mention the name of the presenting firm because it is irrelevant for the purposes of this blog. I am more concerned with the substance of the presenter’s arguments.

Assertion #1: Index investing distorts capital markets by inefficiently allocating capital

Rebuttal: This one is easy. Index funds buy shares on the secondary market. Companies raise capital in the primary market, in which index funds do not participate. While trading activity by index funds certainly impacts share prices, the contention that index funds distort activity in the primary market doesn’t hold much water. Index funds may influence financing decisions at the margins (should we raise debt or equity to finance a new factory?), however the impact of index funds on this decision pales in comparison to prevailing interest rates and tax policy. If capital allocation is going to keep investors up at night, they should be far more concerned with distortions and malinvestment driven by central bank policy actions, such as negative interest rates in Europe and Japan.

This is not the first time this argument has been trotted out and it certainly will not be the last. In August 2016 Bernstein published a research note titled: “The Silent Road to Serfdom: Why Passive Investing is Worse Than Marxism” (you couldn’t make this stuff up). It featured the below paragraph, which reads like something issued from the deepest bowels of The Ministry of Asset Management Propaganda:

We show later in this report that active investing, by seeking to understand ex ante what the ‘fair value’ price of an asset, or an equilibrium price level for an industry is, and allocating capital accordingly, helps the process of price discovery to occur much faster than would otherwise be the case. This has clear social and economic benefits compared with a passive regime where capital flows at best do not help, and indeed can hinder, the price discovery process. We would argue that, by virtue of being forward looking, a process of planning of capital allocation in a Marxist society could by similar logic be superior to a largely passive regime where the capital allocation is done by a marginal participant based on past performance and without any regard to industry dynamics or deviations from fair value. Whether or not any planning process can ‘beat’ fully functioning capital markets with a meaningful share of AUM run actively, we can envisage such a process being more effective than largely passive capital markets at allocating capital- and so a Marxist regime being superior to a capitalist system with little or no active management.

This is possibly the most extraordinary straw man I have seen in my career.

Assertion #2: Index investors are buying a backward-looking view of markets. Therefore index investors will miss out on the impending technologically induced disruption of our entire society

Rebuttal: This argument resonates more with me, although I take issue with the “backward-looking” characterization of index investing. The index investor seeks to piggyback on the work of active traders at low cost. The theoretical underpinning of index investing is that markets are efficient and thus price assets perfectly. Market prices therefore should reflect all available information about a stock, including expectations for future growth and profitability. If markets did not attempt to price future growth, you would not see certain stocks trade on triple digit earnings multiples.

There are certainly conditions under which indexing might impede price discovery and market liquidity, but it’s not like we are seeing some huge blowout in bid-offer spreads for S&P 500 stocks. And even if we are facing a less efficient market as a result of the trend toward passive investing, that should be a thrilling development for skilled investment managers. It should create more opportunities for stock picking.

Inasmuch as the new market paradigm is concerned, you would think from the tone of the presentation that the firm assembled a portfolio of niche ideas you couldn’t possibly own in passive form. And yet, what are The Companies Of The Future? Amazon, Activision Blizzard, Nvidia. The list goes on.

Can you guess the overlap with those names and the Russell 1000 Growth Index? Hint: it is high. Can you guess the level of sell-side research coverage for those stocks? Hint: it is not low.

On the basis of this presentation you would also think this was the first time in history markets had been on the cusp of transformative change, and that index funds were totally untested in periods of market and industry dislocation. You would never suspect that VFINX has been around since 1976. You would certainly be surprised to learn that index funds had weathered multiple financial crises, boom-bust cycles in commodities and credit, the rise of the internet – need I go on?

Reading this you might think I am some passive investing fanatic. I am not. I do not believe markets are perfectly efficient. Valuations matter. In my view the ETF world has clearly gone overboard with faddy, thematic products – not to mention solutions in desperate search of a problem. What individual or institutional portfolio needs 3x levered exposure to gold miners? Or 2x levered exposure to China A Shares? That’s just gambling packaged in a “passive” wrapper.

Yet despite all this, investment managers do themselves no favors trotting out tired, straw man arguments to combat what is clearly an existential threat to their business models. It reeks of desperation, and you can pick up the stench from a distance.

Morningstar columnist John Rekenthaler attacked this issue from a bit of a different angle in a recent article, concluding:

There will always be arguments against indexing. If passive funds never existed, traditional fund managers would be collecting an additional $40 billion in annual fees (roughly speaking, $5 trillion held by index mutual funds and exchange-traded funds times 0.80% for actively managed funds’ expense ratios). When $40 billion are put into play, people fight.

***

This post was written for entertainment purposes only and does not represent a recommendation to buy or sell securities, or to pursue any particular investment strategy. Prior to buying or selling securities, readers should consult with a financial advisor who can advise them based on their unique individual circumstances.

Predatory Finance & Community Development

I believe in capitalism because it offers an incredibly powerful incentive system that is essentially self-perpetuating. Broadly speaking, the most significant issue with socialism as an economic system is that it requires either central planning or a high degree of willing cooperation among market participants to allocate resources. The latter is not compatible with human nature. The former does not have an especially strong record — Venezuela is just the most recent example of a centrally planned economy imploding in spectacular fashion.

However, capitalism requires a robust and healthy financial system to flourish. Poor communities in the United States do not have ready access to healthy financial systems. In fact, they are targeted by predatory financial businesses.

Retail Banking

Retail banking products are not designed for the poor. Since the poor by definition spend most of what they earn, what they really need from a retail bank is a simple account they can use to cash paychecks and maybe accumulate some cash savings.

The problem for the banks, and therefore the banks’ low income customers, is that these types of banking relationships are not profitable (if they are profitable at all). The average “free” checking account costs a bank anywhere from $200 to $500. Now this is not so bad if you can offset those costs with interest income from loans and credit cards. In more affluent areas these accounts are simply loss leaders that give the banks a shot at the customers’ mortgages, credit cards and auto loans.

However, for obvious reasons the poor do not make for very good credits (more on that below). So there is not much incentive for retail banks to serve these markets. Even companies that have launched products specifically designed for this demographic have struggled to execute. Finally, since the poor spend most of what they earn they do not contribute much to deposit growth that can fuel asset growth elsewhere.

In the absence of traditional retail banks, poor communities are often forced to rely on check cashing services. These are sometimes offered through other retail stores and other times through financial service companies such as payday loan stores. Check cashing services are extraordinarily expensive. Transaction fees can run 10% or more. That is a significant economic drag on individuals, families and entire communities.

Lending

Much of the predatory financial activity that takes place in poor communities is related to lending. Payday loans, car title loans, subprime mortgage and auto loans, property rental (a.k.a rent-to-own) businesses. The specific mechanics of these businesses are different but the underlying principles are the same. It is more or less legalized usury. Effective interest rates can exceed 100% annually.

Subprime lending is a brutal, rip-your-face-off business. The customers are poor credits. That is not a moral judgement but simply reality. Thus the only way to sustain a subprime lending operation is to charge exorbitant interest rates and aggressively repossess collateral (to the extent loans are collateralized at all). This is death spiral financing for individuals.

Early in my career I worked in retail banking. I met many individuals trapped in the subprime debt cycle. They typically came to me hoping they could refinance their 10% car loan or mortgage at a lower interest rate. I was able to help a grand total of zero of these individuals. Most of them were doomed to personal bankruptcy. However, I would try to help educate them if there was an opportunity to do so. This itself was difficult because the level of financial sophistication in the subprime demographic is very low (the financial sophistication of the general public being mediocre at best).

One man had taken out a subprime mortgage. He came to me believing he had been cheated by the lender because he had paid vastly more interest than his loan note estimated. In reality what had happened was that he had taken the company up on a “skip-a-payment” offer on several occasions. These offers are common. They allow the customer to literally skip a payment on his loan, with no adverse effect on his credit score. These offers are often released around the holidays under the guise of giving customers a break during a difficult time of year. However, the loan continues to accrue interest in the meantime. This is disclosed in the fine print but financially unsophisticated customers tend not to read the fine print.

You see why the subprime lenders love these deals. The interest compounds on interest over time. In the above case the lender did not appear to have done anything overtly illegal. However, the customer was almost certainly a victim of mis-selling. He was ignorant of the most basic mechanics of loan finance.

Conclusion

Subprime finance is a dangerous business.

One of the main reasons it is dangerous that does not seem to get much air time is that victimizing large swaths of communities erodes collective trust in the financial system and indeed even capitalism itself over time. In this way predatory financial businesses impede the development of healthier, more productive financial infrastructure in poor communities.

Why Do The Chinese Love BitCoin?

This is a quick follow-on from my longer valuing BitCoin post.

The volume of BitCoin transactions originating in China is simply enormous. A New York Times article referenced in my prior post contains the following infographic (this is a little dated):

BTC_FLOWS.PNG
Source: New York Times via Chainalysis

Note the vast difference in volumes between China, the US and Europe. Why do the Chinese love BitCoin so much?

I want to link this to an older macroeconomic analysis from John Hempton. In a post from several years ago, Hempton asserted that China is a kleptocracy made possible by state-owned enterprises’ ability to fund themselves at negative real interest rates. In a follow-on post Hempton theorized that this means there should also be significant retail investor demand for gold in China.

He wrote:

In my kleptocracy post I described how the range of investments available to the median Chinese family is limited. They can’t take their money offshore (unless they are rich enough to afford casino junkets). The local stock market is rigged. There is no worthwhile mutual fund market. They can own see-through apartments. But their main saving mechanism is bank accounts and life insurance contracts (life insurance being a bank account proxy).

Rates are regulated – low. Inflation is high and ex-ante the return to Chinese savers is negative.

Despite negative real returns Chinese save in huge quantity. This may be because of the “four grandparent policy” as described in the kleptocracy post or because of gender imbalance (as described in the follow up post).

Whatever: in China we have huge quantities of savings at ex-ante negative real returns in some sense compelled by local social and political structures.

This pool of savings (part of what Ben Bernanke once described as the “excess of global savings”) has global implications – and these will be explored in a forthcoming posts.

But here I state the obvious.

If you were forced to save huge amounts of money at negative real rates of return wouldn’t gold look attractive?

And, I would add, wouldn’t BitCoins now look even more attractive than gold? If you are an average Chinese household hoarding gold, that strikes me as a tremendous undertaking. You would have to find a way to store the gold, secure the gold — on top of that it is not particularly easy to transact in gold.

BitCoin presents a convenient solution to these issues. Who cares if the Chinese government officially bans cryptocurrency exchanges? For BitCoin at least the whole point is to own an asset that is independent of conventional monetary policy (and, one might add, conventional capital controls). The storage costs strike me as much, much lower. In Cuba people circulated banned American media on flash drives. In China, hoarding BitCoins would be similarly straightforward.

Recall that when Jamie Dimon let loose with his tirade against BitCoin, he also said the following:

The only good argument I’ve ever heard … is that if you were in Venezuela or Ecuador or North Korea.. or if you were a drug dealer, a murderer, stuff like that, you are better off dealing in bitcoin than in US dollars, you are better off bypassing the system of your country even if what I just said is true. There may be a market for that but it’s a limited market.

My question: should China also be on that list?