Good News is the New Bad News

Last week looked pretty good if you happened to own shares or hold an upper-management position in one of America's largest financial institutions, so presumably that broader economic recovery we've all been waiting for is just around the corner. Here's a Washington Post article that talks all about it:

The huge profits reported this week by some of the nation's largest banks showed that the government is succeeding in its rescue of the financial industry...

Well, that's good enough for me. I guess I'll just end the post here. Congratulations America! The days of the plenty are back in a big way. Now let me see if the Post still carries a comics section. And if by chance my eyes should stray, skimming the rest of the above paragraph, I am certain that its contents will only confirm my earnest belief in the fairness of American capitalism.

...but the details of those earnings reports made it clear that the broader economy is not seeing the benefits.

If you're as shocked as me or Lucille Ball in the chronic disparity between the welfare of Main Street and excess and seemingly unjustifiable wealth of Wall Street, take comfort in the fact that these profits, much like those of the last five years, are almost entirely unsustainable, illusory or made-up. What a relief.

Citigroup, a banking giant scrambling to survive the financial crisis, reported a $4.3 billion second-quarter profit thanks to gains on its Smith Barney deal, though its primary banking businesses continue to suffer from rising credit losses. (NYT)

And according to a report by M. Ramsey Securities, the same story can be told of Bank of America's recent profit report. That bank sold a major chunk of itself (that's the technical term I'm using in lieu of specifics) to a Chinese investment bank. In other words, both Citi and BofA were able to turn profits by selling their organs. I wouldn't say that these were necessarily distress sales--after all, they were able to turn profits--but they were one-off deals. And at least for Citi, the "primary banking businesses"--that is, all that stuff that they claim to do when they aren't being bailed out by the government--is still stuck in the doldrums with the rest of us.

But then again, I don't think anyone expects more from Citi or BofA at this point. Goldman Sachs and J.P. Morgan, on the other hand, are different financial animals altogether. Specifically, vampire squids, if your following Matt Taibbi. Both banks have already paid back their TARP funds (and shed off any pesky regulatory strings that may have come attached). And both banks are back to making serious money in a seriously predictable way. According to the King Report:

Speculation via levered trading, inside info and electronic advantage, as well as mark-to-model/fantasy accounting allows a select few banks to greatly profit at the expense of the rest of the country.

On the issue of "fantasy accounting," this is in reference to the change in the "mark-to-market" regulation. Before January 2009, a bank (or any other similarly classified financial entity) was required to value the assets on its balance books according to how much those assets could fetch in the market at that given point in time. How are these asset valued if not by the market? Good question, though I would guess quite profitably. However, I don't think this the main source of the bloat in these bloated profits. Assuming all the pre-mark-to-market-suspension assets were already "revalued" at the time of the regulation change, new significant profit would only come from assets acquired since January. Which could be a lot. But probably not this much.

The other issue that the report brings up is the so-called "electronic advantage," which is a reference to high-frequency trading programs employed by these major banks. These programs, very sophisticated and very quick pieces of software, conduct a disproportionate amount of the trading activity for these banks (and therefore, in the world). According the blog Zero Hedge, which I believe gathered this information from a State Street report, "recent data indicates high frequency trading now accounts for over 70% of US volume"(ZH). This issue has recieved some attention lately, after a former Goldman employ (a Russian no less!) was arrested for stealing the codes to one of that banks' trading programs.

Unlike the issue of accounting tricks, the profits generated by these algorithmic trading programs are not fake. But they are potentially destablizing. Where so much of the daily trading activity is being conducted by a select few computers in a select few banks, a) prices aren't necessarily trustworthy since one party can exert undue influence by placing a series of massive buy or sell order and b) the so-called "liquidity" that these traders to contribute to the market is, as some people are calling it, a mirage. Right now, it might look like there is plenty of trading occuring on the NYSE and so, if prices were to suddenly turn around, one might expect that those who wish to sell off would be able to do so without too much trouble. But that is probably not the case. When a market is dominated by a few very fickle actors (fickle, that is, speculative, by design given that these computers are designed to take positions for micro-seconds at a time) a down turn in the market could lead a few of these programs to stop trading or all start trading one way and any unlucky human trying to sell of his position will have a very hard time finding a buyer. And until he or she does, the price will keep falling. That's volatility.

And in the meantime, I've read reports that suggest Goldman is once again leveraging the hell out of itself to get their numbers up while JP Morgan has returned to the credit derivative market with a vengence. And given the continued fragility of the credit markets, those are very precarioius places to be. But don't worry, our government is on it.