Tuesday began the holiday-shortened week with a bang. Oil (NYSEARCA:USO) had a rather incredible day. Brent crude, in particular, was all over the place, rising to as high as $35.50 on rumors of a deal to cut oil production.
But as the rumors gave way to uncertainty, prices plunged 10%, back to $32. RBOB gasoline (NYSEARCA:UGA) futures contracts dove intra-day from their early morning peak of $1.08 down to 97 cents. If you're long refining stocks, you better hope the company's hedging desk/inventory management department is doing a good job.
The US stock market opened sharply higher, but put in a decent mid-day wobble as oil sold off. However, contrary to past behavior, the market stabilized and regained its momentum, closing the day on the highs.
The S&P 500 (NYSEARCA:SPY) was up 1.7%, or 31 points, while the Nasdaq (NASDAQ:QQQ) jumped more than 2%. Long-suffering sectors such as biotech (NYSEARCA:XBI) finally put in big bounces. This feels like a real risk back on rally with interested buyers, rather than just an oversold short-covering/reflexive pop.
Everything I said in yesterday's Briefing holds. The bulls have the ball in their court. Let's see if they can get the job done here.
Banks As Public Utilities?
Neel Kashkari, the new Fed president hailing from Minneapolis, gave a rather interesting speech regarding banking regulation. I'm going to quote from it and analyze. This is my first take on the subject, and I look forward to seeing other authors and economists' views of his comments.
He started off suggesting that more regulation is needed:
While significant progress has been made to strengthen our financial system, I believe the [Dodd-Frank] Act did not go far enough. I believe the biggest banks are still too big to fail and continue to pose a significant, ongoing risk to our economy.
Kashkari then mentions that the Fed bank in Minneapolis is making a plan it will offer to Congress that will end too-big-too-fail (TBTF) once and for all. He suggests this is necessary because past banking crises, such as the 1980s savings and loans bust, didn't systemically threaten the economy, whereas the 2008 mess had much broader ramifications. That's a fair point.
After discussing the implications of TBTF, Kashkari makes an interesting concession to the lack of the Fed's omniscience:
Thus, although the size of a financial institution, its connections to other institutions and its importance to the plumbing of the financial system are all relevant in determining whether it is TBTF, there is no simple formula that defines what is systemic. I wish there were. It requires judgment from policymakers to assess conditions at the time. I know this is unsatisfactory to many people, but it is the truth today.
By admitting that it is unclear which institutions are systemically important, he sets the stage for the radical proposal that all large institutions should be greatly reduced in size.
I believe we must begin this work now and give serious consideration to a range of options, including the following:
- Breaking up large banks into smaller, less connected, less important entities.
- Turning large banks into public utilities by forcing them to hold so much capital that they virtually can't fail (with regulation akin to that of a nuclear power plant).
- Taxing leverage throughout the financial system to reduce systemic risks wherever they lie.
The first proposal is somewhat funny. Remember that a major impact of the Dodd-Frank Act has been to force bank consolidations, since the compliance costs from the greatly increased paperwork have made it painful for small banks to remain independent. There's some perverse irony in the idea of forcing banks toward mergers and then telling them to split up.
That said, the idea has some merit and should be considered. In a way, it can be viewed as a throwback to the pre-Clinton days, when investment banks and commercial banks were legally separate entities. If an investment bank wanted to blow itself up with crazy leverage, the impact on Main Street would be manageable.
The second idea, oddly enough, is by another means, an approach that many libertarians and fiat currency-skeptical folks like. Some people, particularly gold partisans, claim that any fractional reserve system is inherent fraud. The creation of capital out of thin air is viewed as a purely negative act.
By forcing banks to hold so much capital that they'd be incapable of failing - as Kashkari proposes - it'd more or less be a return, by another name, to the gold standard days. Banks would be prevented from blowing up simply by constraining their operating capacity so greatly that they'd be incapable of lending their way to ruin. The amount of leverage in the economy would collapse, eliminating much, if not most, of the GDP gains the economy has seen over the past few decades.
You can argue that there might be some merit to this - debt-fueled consumer consumption is arguably less beneficial to an economy than long-term investment - but the pain that the economy would face during the transition would be immense. If people were forced to again save for goods before buying them, rather than buying today and paying later, the American economy would be fundamentally altered and millions of consumer-focused service jobs would disappear.
I'd also note the hazard of running banks as a "public utility". Fannie Mae and Freddie Mac weren't the worst offenders of the housing bubble - arguably, that'd be subprime lenders like Washington Mutual and Countrywide - but they were thoroughly bad actors. The public/private partnership with implicit government-backing approach worked very poorly in 2008. I'm not sure it's a model we really want to base the financial system around.
I share Kashkari's concerns about TBTF. I wouldn't invest in Citigroup (NYSE:C) or Bank of America (NYSE:BAC) at just about any price. They're time bombs that are more likely than not to explode during any sustained financial crisis.
That said, his suggestions seem to be overkill. Can't we tighten capital requirements incrementally more and force the off-balance sheet entities back onto the balance sheet?
Simply forcing complex derivatives to be traded on futures exchanges rather than being marked to model (fantasy) would clear up much of the trouble. The markets function much better when there is more transparency.
Among the scariest parts of 2008 was when the ABS market was totally frozen and people had no idea what things were worth. Losses are manageable. But losses that can't be quantified and accounted for are what really inspire panic.
I applaud Kashkari for unconventional thinking on the very real problem of TBTF. However, the solutions are likely to be found in gradual changes, not completely pitching the current banking system and replacing it with something that offers far less robust financial depth to the economy.
Many emerging market banks, such as the Colombian ones I favor, are largely safe from blowing up due to being unsophisticated. They take deposits and lend them to businesses and a very limited subset of high wealth consumers. They have recourse on their loans, and it would take a huge storm to sink them. They barely felt a tremor during 2008.
That's great for investors - they're solid firms with little black swan risk. But by suggesting that the US give up financial advances and go back to primitive banking, you're likely suggesting that you favor ratcheting back GDP/capita toward emerging market levels - something most folks probably wouldn't appreciate.
Buffett And Kinder Morgan
It'd be fair to say I'm not the world's biggest fan of Kinder Morgan (NYSE:KMI). So with surprise and disappointment, I read that Buffett has taken a stake in the controversial pipeline company. As a recent new shareholder in Berkshire (NYSE:BRK.B), I must admit I find some of his recent moves in the public stock portfolio baffling.
With energy, in particular, I'm not sure what the master plan is. In some cases, he's taken positions, only to sell them off shortly thereafter. Berkshire has a big stake in Phillips 66 (NYSE:PSX), which is very overpriced compared to other refiners like Valero (NYSE:VLO) or Tesoro (TSO).
To be clear, I own Berkshire because it is cheap when you consider it on a book value basis, particularly when you mark up long-held assets that are currently marked at the price paid. I'm distinctly not a Berkshire owner because Buffett's recent investments have impressed me.
As far as Kinder Morgan goes, why'd he buy this pipeline for us and not one with a higher credit rating and more conservative management? I get Buffett as the savior of troubled businesses, but usually he cuts a good deal for Berkshire shareholders in return for stepping in during difficult situations. What'd we get here?
What I fear is that Buffett is buying things like Phillips 66 and Kinder Morgan because they're big, rather than presenting any special opportunity. If you were looking at the refining space as a market cap agnostic, you'd never pick Phillips rather than Valero, Tesoro, or Western (NYSE:WNR) at current prices.
Similarly, I struggle to see the bull case for Kinder Morgan at current price levels compared to the rest of the pipeline industry, other than KMI has a bigger market cap, so he can buy it more easily.
Disclosure: I am/we are long BRK.B, IBM.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.