Section One, Part two

MONEY FOR NOTHING - Investment Banks There was a very bad movie starring Kris Kristofferson, called " Rollover " , where the premise/denouement was that a non-reinvestment of a large amount of petro-dollars would cause the collapse of the US financial system.. While this played to the broader thematic of the US dislike for other/aliens from the Middle East ( in this case caused by the build up of financial balances arising from the high price of petrol in the 1970's ), the real distemper in this movie was that the non-rollover of a deposit was somehow malicious, and designed to cause hurt. Oh, that this theme wasn't highlighted during 2007 and 2008, as the possibly viable cause of the start of the problems. Let's do a very brief stocktake of a couple of instances from the period. As an example, assume I am in charge of an investment portfolio, whose main clients are a few wealthy individuals; some savings balances of key executives in my operation, and some wholesale/professional investors introduced by my prime broker. I will also assume that I will not have to define all of these terms, but suffice to say the prime broker relationship is one in which some other investment bank acts as the account keeper/market broker for the purchase of securities/administrator of the account/and financier when I need to borrow to fund my purchasers. I have set it up like this because it keeps both internal and external scrutiny to a minimum. Now, the purpose of my investment portfolio is to make money. I can get financing at , say 4%. I can invest in securities that my models tell me will pay 7%. My prime broker will allow me to borrow over $ 1 billion, even though my clients have only put in , say $ 50 million. This fund is very leveraged at twenty times, but this is, strangely, not excessive for the time. Since I get paid to simply make money, nobody objects to my fund structure, because on the face of it, it is like " shooting fish in a barrel" , I get a three percent carry for every dollar I have invested.....and because I get three percent on an extremely large amount of money, I can pay myself really outrageous amounts of money, and still " deliver" a good return to my clients. I will even be conservative, by assuming that I am earning this carry on a simple basis every month that goes by. My prime broker is not going to stop me: not yet anyway. Remember the prime's role is multiple: they get paid to service my account, they also probably find/package together the securities that I have bought( for which they would have earned a fee ) , they also introduce some of their clients to my portfolio ( for which they get a capital introduction fee) , they also arrange my finance, for which they will also probably earn some fee......they probably borrow at 3.85%, and so giving it to me at 4%, means they also get some slice of an interest carry. And as a capital market competitor to me, they will buy and sell very similar securities to me, because they assume/know that I will be buying and selling in the markets, and therefore have fore-knowledge of the likely demand/supply for my type of securities. It is only the latter ( the ability to illegally front run my purchases and sales ) which is perceived as against the law. There are any number of ways that this can play out badly, but let's assume that it plays as follows: my prime broker suddenly develops a dis-like for me ( maybe I was arrogantly offensive at a social baseball game, by being abusive in front of some women and children.......no sexism here - the industry is largely male ). The prime, who values my securities and reports my Net Asset Value ( NAV ) of my portfolio to me on the 14th of the month, decides that some of my securities are only worth 85c, not $1. They know that this will probably force me to sell some, and they have probably short sold some securities ahead of giving me the NAV. I have got some really big problems now.....I have been telling my clients that their investments have been performing well, and now I will have to make a significant re-statement of the value of my portfolio. Not only that, the prime, who asks me to lodge a percent of my total portfolio with them, will probably ask me to increase that percent if I have some notional loss position that I will need to cover, or failing that, to significantly shrink my portfolio. That would cause me to sell at the artificially lowly set price, turning notional losses into " real " ones. Of course, the easy way out for the prime is simply to do a " rollover " and say that they will not let me have borrowings of $950 million any more, saying that if they only lend me $850 million now, I need to reduce my portfolio by $100 million all of a sudden. [ a number of mainstream banks did these facility reductions for a whole range of high quality companies in 2008 , so the concept of egregious facility reductions was not an unknown behaviour ]. My business is now in a death spiral, and my clients, who did not expect to lose money, or for that matter did not understand what I was really doing in the first place, now require all similar activities to either restate their NAV's or to reduce their loan amounts/demand higher margins. Now the industry is in a death spiral, because banks will reduce what they lend to investment banks, who will reduce what they lend to their clients, including all prime broker relationships. As an aside, I, as an investment bank, is staring at my own business mortality , unless of course I get re-classified as a bank ( I.e. get my banking license approved ) or have access to an internally managed cash management trust which I can coerce into buying my head company loan securities as a way of tiding over any shortfall I have from Main Street banks. Both of these " solutions " were invoked by a few organisations in 2008 and 2009. The speedy banking license, and therefore access to central bank " support/protection " was probably the most offensive, in the implied taxpayer underwriting that is then generated by the acquisition of the license. I shouldn't need to point out where is the " money for nothing " theme here. What might surprise is that, for over-the-counter securities, the nature of market value is so arbitrary, and so contingent. And that the consequences are so profound. It is interesting that there are now a number of re-imaginings that says that the GFC was essentially an investment banking problem. The solutions adopted by the central banks are therefore flawed, and the impacts felt on the real economy have therefore been unwarranted. Arbitrariness has again interfered with normal relations between the populace, and trust further undermined.