The Japanese election

The legislature

The Japanese legislature consists of two houses, upper (councillors)and lower (representatives), which function pretty much like the Senate and House of Representatives in the US.

The parties

Although there are many different political parties in Japan, they have formed coalitions around two centers of political thought:

the left-of-center Socialist Party, an urban-based group which grew from the ashes of Hiroshima and Nagasaki on an anti-war, anti-nuclear weapons platform; and

the right-of-center Liberal Democratic Party, formed from a disparate collection of rural interests by, some contend, the CIA as a pro-American counterweight to the Socialists.

The election

Until yesterday, when it was defeated soundly by the intellectual successor to the Socialists, the LDP had held control of the lower house since the mid-Fifties.

Is the third time the charm?

There have been two previous attempts to break the LDP stranglehold on power.

In 1989, the Socialists, renamed Social Democrats, won control of the Tokyo city government and the upper house of the Diet, under the leadership of the charismatic Takako Doi.  Ms. Doi, an advocate of womens’ rights, also tried to break the somewhat odd (to me, anyway) connection between the Socialists and North Korea by refusing to travel to Pyongyang to receive congratulations on her victory (she did eventually go, though).

Unfortunately, the Social Democrats spent most of their time bickering about who should take credit for their electoral victory rather than enacting legislation, and were voted out of power in the next set of elections.

The second try came from within the LDP earlier in this decade, when another charismatic figure, Junichiro Koizumi, became prime minister in 2001.   Mr. Koizumi ended the decade-long banking crisis and began the process of removing a major source of porkbarrel project funding by privatizing the National Postal Service.  He also tried, mostly unsuccessfully, to redirect the LDP away from its traditional rural and agricultural power base to concentrate more on urban constituents and service industries, which he (correctly) regarded as the future of Japan.  Since Mr. Koizumi’s withdrawal from politics in 2006, contol of the LDP has passed to older and more conservative elements, and the party’s popularity has plunged.

What appears to be different in this election is that large numbers of the legislators who opposed the Koizumi reforms have been swept out of office.

What needs to be fixed

The Japanese economy has stagnated over the past twenty years for two main reasons:

1.  demographics:  the working population has begun to shrink, so that productivity gains are necessary just to keep the economy from contracting;

2.  government action:  with the notable exception of exporters like the automakers, electronics firms like Canon and mavericks like Nintendo, the typical Japanese company strikes me as frozen in time, almost hoping that the salad days of the Eighties will return.  Today’s Japanese executives seem to find it culturally very difficult to effect the “creative destruction” that typically characterizes industrial progress, even though the generation of leaders immediately after WWII were relentless practitioners of continuous improvement.

In some cases Japanese entrepreneurs, but mostly foreigners, have tried to take control of grossly inefficient firms in order to improve their operations.  But they have been thwarted at virtually every turn, either by legislation that makes foreign ownership virtually impossible, or by tacit approval of actions by customers or suppliers to “rescue” target firms from the possibility of increased profits and expansion in size.

What is the Democratic Party’s economic platform?

At this point, we don’t know.  There’s a huge investment opportunity if the Democrats will allow change to happen in Japanese industry.  But just as the watchword of previous generation was to sacrifice their economic well-being to make this generation better off, the thrust of the present generation has been to sacrifice their children’s inheritance to preserve the status quo.  It will take time, and a careful watch at legislation, to see if this attitude is likely to change.

Contango and backwardation

What’s wrong with these people?

Every area of specialization has it’s own jargon.  But there’s jargon and there’s jargon.

Securities analysts use jargon.  For example, they like to talk about a company’s earnings before interest, taxation, depreciation and amortization.  They do this to focus on the here-and-now of a company’s profitability from its business activities, without considering its capital structure or how much it has spent in the past on buildings and machines to get the business up and running.    But they say EBIT or EBITDA.  They do this both in the mistaken belief that it sounds cool and because the words “earnings…” are a real mouthful.  Nerdy, but pretty straightforward.

On the other hand, there’s jargon, whose function is not so much to communicate as to make small ideas look big and to embarrass outsiders who don’t know the terms.  The second group is where I put backwardation and contango. But then, I’m an equity guy not a commodities trader.

What do the terms mean?   They describe the relationship between the spot price of a commodity, the cost of purchasing the commodity to have it today, and the price of the same commodity at some time in the future.  The commodity is said to be in contango if the actual future price is higher than the expected future price (more on this in a minute).  It’s in backwardation if the actual future price is lower than the expected future price.

How does one figure out the expected future price?  The simplest case is one where either there are no seasonal trends or other trends in the in the commodity, or where the future time we’re looking at is too short for the trends to make much difference (Note:  in all this, I’m going to ignore the difference between futures and forwards.)

Anyway, in this simple case, if I need the commodity in three months, I have two choices.  I can either buy it in the physical market today and store it until I need it in three months, or I can enter into an agreement to buy the commodity at a set price three months from now.  In theory at least, if the price in the future differs very much from the spot price plus the cost of finance and storage, arbitrageurs will enter the market and move the future price toward spot + finance + storage.  In this case, spot + finance + storage is the expected future price.  If the actual future price is higher, the commodity is in contango.  If it’s lower, the commodity is in backwardation.

Not every case is so simple.  Some commodities, like gasoline or heating oil, have distinct seasonal patterns.  So the expected future price has to be adjusted for seasonal patterns of supply and demand, as well as for the cost of finance + storage to determine whether there’s backwardation or contango.

How can backwardation or contango exist?

Why don’t future prices simply adjust?

For physical commodities anyway, there can easily be temporary disruptions to supply or demand.  A strike may have closed a mine for now and raised prices as a result.  But the market knows that no work action in the industry concerned has ever lasted more than a week.  So traders are unwilling to project today’s higher prices into the future.  Similarly, surprisingly strong current demand may have pushed spot prices up, but the market knows the supply chain will adjust in a month or so, thus again is unwilling to believe that today’s higher prices will last.

Generally speaking, backwardation occurs when the market judges that today’s prices are too high and can easily see what path prices will likely take downward.  Similarly, contango occurs when traders see a temporary anomoly in the expected future price.

Brokers: where are the customers’ yachts? Goldman’s trading “huddles”

I happened to see an article in the WSJ the other day that both disappointed me and conveyed in a few words how brokers and clients can have diverging interests.  Here’s the link.

Goldman’s weekly trading “huddles”

The article describes the Goldman practice of having short weekly meetings between its research staff and the firm’s proprietary traders–the ones who operate with Goldman’s own money.  I assume the article is factually accurate.  I haven’t seen a correction or retraction, and the WSJ has subsequently reported that several regulators have begun investigations of the meetings, called “huddles.”

In the “huddles” the analysts and traders discuss stock ideas, including their opinions about near-term prospects for names under Goldman coverage.  The Goldman traders obviously have the conclusions the meetings generate, because they take part.  From the article, it sounds like the institutional salespeople assigned to Goldman’s most profitable fifty or so accounts relay this information over the phone later the same day.

But nothing is published and most clients don’t even know the meetings exist.

Apparently, Goldman written reports all say someplace on them that “salespeople, traders and other professionals” may act against the firm’s recommendations.  I must have read thousands of Goldman reports over the years and never noticed this warning, though.

…are not a big surprise

It shouldn’t come as much of a surprise that Goldman, or any other broker, gives more service to itself and to its best clients.

Nor should it be a shock that the firm isn’t at pains to point this fact of life out.  After all, it’s part of a good salesman’s job to try to turn a commercial relationship into an emotional one, where the client ends up paying more than he should.

[An aside:  Years ago a friend of mine told me about a portfolio management colleague who fancied himself an expert billiards (actually, snooker) player.  He frequently met the brokers he dealt with after work for drinks and a few friendly games of snooker.  He routinely trounced his institutional salesmen, until…he left his portfolio management job and became a broker himself.  As of the time my friend told me about this, the colleague had yet to win another match.]

…but it’s disappointing

Some things I find disconcerting in the article’s description of the meetings, however.  They are:

1.  The meetings were attended by compliance people, the in-house experts on adherence to securities laws.  There’s no mention that the compliance people were any more than passive witnesses, but the mere fact that they were there indicates to me that Goldman knew it was treading in a delicate area.  Notes could easily have been disclosed by posting them on the GS website, but that wasn’t done, either.

2.  Someone (the compliance people?) coached (“guided” is what the article says) analysts to use euphemisms to avoid uttering the words “buy” or “sell” in the meetings.  Apparently, an analyst who had issued a written opinion of “buy” on a stock would say to a trader it was “overbought” or could “go down,” to suggest the trader should sell it.  Although hard to believe, the WSJ makes it sound like Goldman figured that this word trick would get around the necessity of disclosing to ordinary clients the analyst’s most current thoughts.  Coincidentally, but luckily for Goldman, these uninformed investors might well end up being the other side of the trader’s sell order.

More worrying, one might easily think that the idea behind the doublespeak is to ensure that the letter of the law was being upheld, although the spirit might well be being broken.  Or Goldman might have been thinking that the ambiguity of the language used would make it harder for any third party to figure out what Goldman really intended to do.

3.  How did the WSJ find out about the meetings?  My guess is that one of the participants, unable to decide how legal/ethical they might actually be, spilled the beans.


1.  The regulators will figure out if Goldman has broken any laws.  It could easily be that the answer is none.  For an investor, the bigger issue is the apparent breach of trust.  A client placing a buy order with Goldman for a stock on the recommended list now has to consider that the analyst who wrote the “buy” report may be telling the trading desk the opposite story.  Goldman’s rejoinder to a client protest?–read the fine print in the research report.

In a technical sense, that’s right–caveat emptor. I would have anticipated this kind of treatment in a used car lot.  But I thought better of Goldman.  Small and mid-sized clients probably also thought they had a relationship of reciprocity and fairness with the firm–the “invisible handshake” that Arthur Okun talked about, the idea of “let’s grow rich together.”.  Now they may conclude otherwise.  Even clients in the inner circle may question what information they are not privy to, or whether they will be able to retain their privileged status for any length of time.

2.  The “huddles” also make the Goldman business strategy clear:  concentrate on proprietary trading, hedge funds, a few big clients. GS won’t usher everyone else to the door, but they’ll have to be satisfied with the crumbs that fall from the table.

Does Goldman think it may someday need these other clients?  –say, as distribution capability in case the IPO market revives?  If the WSJ article is accurate, apparently not.

Does it need a retail presence?  other than its bank, no.

Will this strategy work?  It remains to be seen.  It will be easier to judge if the regulators’ probes shed more light on Goldman’s actual conduct and as client reaction is heard.  I think that the biggest risk in an aggressive strategy to find the line between behavior clients will accept and what they won’t is that in the search a firm steps over the line without knowing–and damages its business reputation severely as a result.

Soft dollars–what they are and how their demise will affect professional equity managers

What they are

Soft dollars, sometimes also called research commissions, are commission or bid-asked spread payments (for over the counter securities) made at a higher than normal rate by investment managers to brokers as compensation for research services the broker provides.

Although investment managers are required to obtain the lowest cost and the best execution in their trading for their clients, the SEC created a safe harbor years ago that allows soft dollar commissions to be paid, providing that:

–services are genuinely for research, and

–clients understand this is going on.

The SEC has publicized the soft dollar issue a number of times and has given illustrations of types of services that are (like the broker’s own research, Bloomberg terminals, third-party research) that are allowable, as well as services (like transportation costs, furniture, rent) that are not.

Why is this an issue?

Two related reasons:

in paying commissions, the manager is using the client’s money, so he has an obligation to spend it wisely; also,

by using soft dollars, the manager is using client money for expenses that would otherwise come out of his management fee.

Who understands this practice?

Institutional investors understand the use of soft dollars very well.  In fact, some require their managers to direct a certain amount of commission business to brokers that the client designates, to satisfy soft dollar arrangements the client has entered into.  Retail investors?–not so much, I think.  For example, do you know what policies your mutual funds follow?  or how much of your investment money goes to buy services your manager uses?

Sizing soft dollars: a percentage of commission payments

Consider an investment management company that has $10 billion in equity assets under management.  If the stocks are all US (commissions are typically higher abroad) and the average price of a share of stock in the fund group’s portfolios is $40, then the group holds 250 million shares of stock.

Let’s say that the group turns over 80% of the portfolio yearly and that it pays the following commissions (including imputed commissions for NASDAQ trades):

electronic crossing networks        20% of volume                   $.015/share

soft dollar trades                               20% of volume                   $.08/share

“regular” brokerage trades             60% of volume                   $.04/share.

If we figure this out in dollars, the amounts are:

crossing networks               $600,000         11% of total commission expense

“regular” trades                 $1,600,000         30%

soft dollar trades               $3,200,000      59%.

A soft commission dollar doesn’t buy a hard dollar’s worth of goods or services.  A typical ratio is that 1.7 soft dollars equals one hard dollar.  Using this relationship, our firm’s $3.2 million soft dollars buys $1.9 million hard dollars worth of research services.. a boost to the manager’s profits

Let’s relate this to our hypothetical firm’s profits.  If we assume that the firm charges an average fee of 50 basis points on its $10 billion in assets and has a relatively constant 50% operating margin (I’m not saying this is the best way to analyze any company, but it is fast…and gives a reasonable ballpark number), then the company has operating income of $25 million.  Using soft dollar power supplied by client commissions raises the company’s operating earnings by about 9%.

The CEO of our investment company might comment that this $2 million adds up to only .002% of the assets under management, so that this practice really doesn’t affect investment performance by any noticeable amount.  (This would be sort of like saying that taking money is ok if you don’t get caught–not exactly a confidence builder in the speaker’s attitude toward fiduciary responsibility.)

On the surface at least, soft dollar trades appear to be no more or less profitable than “regular’ trades.  If processing costs are about $.015/trade, a $.04 trade yields a profit of $.025.  An $.08 soft dollar trade has $.047 in costs to provide services (figured at the retail price the investment manager would otherwise pay) + $.015 in processing costs,  so it yields a profit of $.018.  But brokers are in a position to bargain with suppliers for quantity discounts.  The SEC investigated the discount question about ten years ago and found that most brokers supplied the services at their cost, but that some charged a distribution fee.  Bernie Madoff has subsequently unveiled the limits of the SEC’s investigative skills, so it’s a safe bet that a short conversation with service providers would reveal that brokers universally take a substantial markup.

Why managers don’t highlight this practice Continue reading

US dollar as the world’s reserve currency: (III) China’s strategy

When China took its decisive turn toward capitalism in the later Seventies, it chose the time-honored development path of linking its currency to the dollar and concentrating on export-oriented industries aimed at the US market.  Like its predecessors down this road, it has chosen to keep its profits in dollars, to prevent an otherwise steady stream of sales of the US currency from altering the favorable exchange rate on which at least some of its overseas commence is based.

China’s industrial success has resulted in its becoming the largest foreign holder of Treasury securities, with a value of about three-quarters of a trillion dollars.

Recently, China has been complaining publicly that excessive government spending in the US can potentially pose a threat to the worth of China’s Treasury holdings, either through currency depreciation or higher interest rates.   Of course, the last thing China wants is a sudden outbreak of fiscal responsibility in the US, either by the government (fat chance!) or the population at large.  That would translate into sharply reduced demand for Chinese goods and by doing so would realize Beijing’s greatest fear–social unrest triggered by job losses and rising unemployment (the Financial Times cites recent problems among state-owned steel companies, even in good times).

How are we to interpret these remarks, then?  I think Premier Wen gave a hint a week or so ago when he made the first formal statement that, as part of China’s “going out” policy, the country wants to use its some of its dollar holdings to buy foreign physical assets.  In itself, this isn’t a startling statement.  If you’re worried about inflation. the last thing you want to hold is conventional bonds, which afford no protection.   You want to be a borrower (at fixed rates) or hold stocks or physical assets instead.  To the degree that China might buy ownership interests in producers of industrial raw materials, it strengthens its supply chain at the same time.

An entity (government, corporation or individual) living beyond its income can either reduce spending or finance current consumption by borrowing or selling assets.  In particular, it would make sense for the US to allow/encourage China to buy US assets to reduce its Treasury bond holdings.  These might be government-owned things, like roads, or buildings or transport facilities (what about Amtrak?).  Even if they’re not, such sales would help remove an unhappy holder from the Treasury roster.  And history suggests that foreigners tend to pay ludicrously high prices for US assets (think:  Japan in the late Eighties), benefiting US sellers–to say nothing of the capital gains taxes transactions generate.

Nevertheless, despite the fact that an American getting a crazy-high price for an asset he owns is a good thing, and the fact that you’d think a holder of US bonds should be able to use them for something, Washington has generally blocked asset sales to China for what appear not to be valid economic or national security reasons.

I think this is the issue Premier Wen is trying to put back on the table–a potentially serious threat to the Treasury market will go away if Washington allows China to make acquisitions in the US.