German stubbornness vs American Forbearance: a case study of Deutsche Bank’s never-ending saga of woes

In 2016 Deutsche Bank (DB) was the 12th largest bank in the world (8th largest non-Chinese bank) with a market valuation of about €67 billion, which operates in 70 countries. However, its balance sheet was contaminated by a large amount of toxic assets, particularly concentrated in its investment banking unit, which constituted much of its earnings before the financial crisis of 2008-09.

The negative interest rate and financial regulations that were introduced in Europe after the financial crisis—and all the way through till today—have fundamentally overturned its traditional business model. The bank as a balance-sheet lender tended to be heavily reliant on net interest income, but its net interest margins have been severely slashed as a result of ECB’s negative interest rate policies, while at the same time the bank has been under pressure to recapitalize in order to build a larger financial buffer.

In a low growth environment with limited investment opportunities the bank, like other European banks, saw its profit margins squeezed to an unprecedented degree.

More specifically, Deutsche Bank’s $1.75 billion 6 per cent Additional Tier 1 bonds (AT1), known as contingent convertible capital instruments or CoCo bonds came under severe downward pressure when were bid at 69.55% of face value the, and when the US Department of Justice asked Deutsche to pay the aforementioned massive fine to settle an investigation into its selling of toxic mortgage-backed securities. This was lower than the February 2016 sell-off low of 70.2%.

The former chief executive of Deutsche Bank, John Cryan, who in an interview with the German tabloid Bild   had stated that a capital increase was “currently not an issue” was forced to issue a statement on September 30th 2016, highlighting the bank’s resilient financial position, emphasizing that it has an “extremely comfortable buffer” when it comes to liquidity. “There are forces now under way in the markets that want to weaken confidence in us,” he wrote. “Our job now is to ensure that this distorted perception does not more strongly influence our day-to-day business,” Cryan added. “At no time in the last two decades has Deutsche Bank been as safe as it is today,” reporting that the bank’s liquidity reserves amounted to more than 215 billion euros. He was putting the blame on hedge fund “speculators” who were shorting Deutsche’s shares and Coco bonds.

The German officials, of course, have denied any attempt on a rescue plan to help Deutsche Bank, as new rules introduced to prevent misguided investments by large financial institutions prohibit taxpayer-financed bailouts. German authorities have been quite vocal in their oppositions to relax   these regulations, spurning a recent rescue proposal by the Italian government, allowing them to inject public funds into the Italian banking system. Germans have been steadfast in criticizing southern Europeans for the euro-zone financial crisis and admonishing them for their lack of fiscal discipline. Thus, after so many non-German European banks collapsed or drifted into insolvency because of unavailability of public funds, it would be politically perilous to relax the rules to rescue their own bank. Call it what you may but we have to admire German consistency.

The CoCo bonds eventually recovered, even trading at a premium of 5% to face value by end Q1 2018. But then came news out of DB’s US subsidiary. Deutsche Bank U.S. operations had missed clearing the Fed’s stress tests in 2015 and 2016, and in 2017 was the subject of Fed enforcement actions for perceived lax controls tied to currency trading, money laundering, and Volcker-rule trading restrictions.

 

But it was when the FDIC had put Deutsche Bank’s US operations on its “Problem Bank List” that we were back to where we had started. The FDIC keeps its “Problem Bank List” secret. It only discloses the number of banks on it and the amount of combined assets of these banks. A week ago, the FDIC reported that in Q1, combined assets on the “Problem Bank List” jumped by $42.5 billion to $56.4 billion. That increase in assets of $42.5 billion on the “Problem Bank List” nearly matches the assets of Deutsche Bank’s principle subsidiary in the US, Deutsche Bank Trust Company Americas (DBTCA).

The price of the CoCos fell from 105 to 91 on face value in two days. And they have continued to fall.

So, here’s my question: which is better? US-style mollycoddling of financial institutions or Teutonic hands-off treatment?

 

 

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“Abnormal” profits aka rent-seeking in the US Healthcare industry

“There is no industrial sector in the US economy that is more deformed than health care, in that it excels in delivering inferior outcomes at an exorbitant price.”

This is what I wrote in my article “Health Care in the US: A Case Study in Oligopolistic Market Power” posted on Medium on November 13, 2017.

In that earlier post I mention the dominance of two vertically-integrated medical services companies in the Pittsburgh metropolitan area—a structure that is repeated in most health care “markets” across the country—which are responsible for the rising share of expenditure on health out of the household budget. The least one can expect from increasing concentration is that the centralization of information should enhance cost efficiency, some of which could be passed on to the consumer. Instead we get rising costs.

Meanwhile, corporate profits in the health care industry continue to rise. The reason for this rising share of spending on health care appears to be what economists call rent-seeking by these firms. Health care providers are extracting and enjoying “abnormal” profits not just relative to what they were making in the recent past but also using more absolute financial metrics. They are making “excess” profits when measured against capital deployed and risk taken. This is a complicated subject and needs unpacking.

We begin by laying out the scope of the exercise. We tackle three definitional (“what”) questions and one (“how”) analytical question:

  • What precisely constitutes the health care sector?
  • What methodology do we use to calculate abnormal profits?
  • What are the figures we finally arrive at for abnormal profits?
  • How and where are these abnormal profits generated?

The health care sector is multilayered. Broadly, there are the payers, the insurers, the manufacturers and the providers. Underneath this, there are still other layers: payers could be employers, government or individuals or sometimes a combination of all three; manufacturers are the pharmaceutical companies who make the drugs and medical device companies who make the equipment; providers are doctors, pharmacies hospitals, lab services and emergency services, often connected to each other via referrals. Only insurers stand alone. But this has not stopped an extraordinary number of mergers, acquisitions and buyouts at the level of each layer and between layers leading to horizontal and vertical consolidation and concentration across the industry.

Second, the methodology. We begin with publicly available numbers first. Health care analysts working at three credit rating agencies—Moody’s, S&P and Fitch—estimate earnings before taxes, depreciation and amortization (EBITDA) for all publicly listed companies in this sector across all three of the layers discussed above. We then scale up the aggregate figure to include estimates for privately-owned companies. We then compute profits after taxes using an average tax rate for companies in the sector, not making a distinction between public and private companies. The numbers are necessarily approximate.

The calculation of what would constitute abnormal or excessive profits is more controversial. But we know from historical data bases used by the ratings agencies, often spanning a century or more, that a 10% return on capital is the norm for most competitive industries in the American economy. By these estimates abnormal profits in the health care sector alone were close to $70 billion in 2017–and on track to rise to $80 billion in 2018 because of the recent changes to the tax code. The magnitude of abnormal profits is eight times that of the airline industry and three times that of the similarly convoluted media and telecoms industry.

Yet a more careful examination of the flow of revenue shows where the real rent-collection—or gouging—is taking place. It is in a group of companies that hide in the interstices of these layers. These are the preferred provider organizers (PPOs) or benefits managers. They are little more than administrators who join the different layers. They manage the information flow and capture as much as 40% of total abnormal profits. How do they do that? As with most coordinators they are capital light, hire very cheap labor and so can generate huge returns on capital. These are companies like Trinet, Paychex, and ADP but others are springing up like mushrooms after a wet spring.

What’s more troubling is that the layers have started to merge. Insurers and PPOs are coming together. Cigna has merged with Express Scripts, and Aetna and CVS are on the way. The argument is that this will foster “internal efficiencies”. Yet according to analyst reports just these two mergers will increase combined profits by $2 billion.

The problem here, as with so many other industries, is that antitrust is asleep at the wheel…or perhaps it has been put to sleep.

 

“Every revolution is impossible until it is inevitable.”

I heard the outstanding Chilean political scientist, Cristobal Rovira Kaltwasser, at the American Social Sciences Association meeting in Philadelphia earlier this month. Regrettably, his participation in the panel discussion on Populism was not recorded but we are fortunate that he was at the IMF later and gave this sparkling interview to a Fund representative. It is well worth listening to.

Hearing Prof. Kaltwasser speak got me thinking. As I followed my thoughts I asked myself whether the political trends we are seeing in this country and in many of the advanced countries of Europe could take a turn towards the violent. Is revolution out of the question. Somehow, I don’t think so.

Political leaders have long agonised over the causes of political instability, not least because it threatens their hold on power. But in recent years they have had plenty of good company. Sociologists and political thinkers too have found themselves stumped, as much by sudden outbreaks of political upheaval as by its failure to occur where it is most expected.

A Tunisian fruit seller’s self-immolation setting off a conflagration across the Middle East that eight years later has yet to be extinguished—in the bargain wrecking Western foreign policy towards the region—is no less mystifying than the phenomenon of long-term unemployment in Greece and Italy where a quarter of the workforce has been jobless for half a decade or more, yet has failed to produce mass protests or sustained violence that would menace the stability of the political system.

Social scientists ought to dust off their copies of a half-century old book, Why Men Rebel, written by an American political theorist, Robert Gurr, now an emeritus professor at the University of Maryland, trying to make sense of these events. Written in the late 1960s at a time of widespread public disorder in American inner cities and savage internecine violence in the newly decolonised states of Africa, the book enjoyed short-lived fame as a guide to the causes and timing of political upheaval.

Gurr identified a handful of characteristics that predispose societies to violence. Of these the most important was the idea of relative deprivation. He made individual psychology, collectively organised, the centrepiece of his theory. In a uniquely American fashion he made psychology lie at the root of extreme politics. He argued that grievances are interpreted by people through their economic and social position relative to others who were once like them. He contrasted his notion of a deprived group with the more static idea of an economic class where individuals were expected to broadly identify with those who came from a similar background and performed similar work to themselves, paying no heed to each individual’s relative success. Class solidarity in the pre-Gurr world was never fine-grained. It merrily glossed over differences in individual outcomes.

Gurr’s deprived group on the other hand was made up of people who felt the sting of being outsiders, deeply aggrieved towards those who had now become insiders. If this makes the deprived seem little more than a collection of sore losers one wouldn’t be entirely wrong. But one would miss the theory’s many subtleties if one had to stop there.

Gurr asserts that his emphasis on relative deprivation is the only way to understand how mass mobilisation occurs. The success of one deprived group in propagating its grievance inflames other groups with their own grievances, whether they arise from economic inequality or from religious or other cultural identity differences. These groups do not coalesce around a common core because such a core does not exist, but rather are carried forward by the momentum of the swelling movement. The convulsions in the Arab Spring countries would appear to validate Gurr’s hypothesis, though the political theorist could not have imagined the scale and speed with which the upheaval spread due to the existence of social networks on the internet.

Gurr does not make the light of the capacity of states to repress and coerce the population of protesters, often even using insiders to fight the army of outsiders. He believed however that pluralistic democracies have a kind of soft power (though he does not use that term anachronistically, since it came into vogue many years later) that gives them higher state legitimacy and so less need to use repression since its deprived groups have other outlets to express their grievances.

This conclusion is surely too simple. Gurr’s work, fresh and scintillating though it is in re-discovery, needs to be updated. The pleasingly paradoxical result that democratic states lack the apparatus of repression because possessing it makes them more vulnerable, ignores lots of other evidence that a hidden repression, exercised for instance through a corporate media that transmits messages of passivity and conformism, may be a fuller explanation behind the apparent stability of our distressed Western societies. And now with return of a darker kind of democratic populism—one that has strains of nativism and a strong assertion of sovereignty—I would be tempted to go further. Perhaps Trotsky’s aphorism with which I began this post will apply to our societies after all. What’s worse, we may well be in the midst of it without even knowing it.

 

 

 

 

 

 

 

Will welfare systems survive? Should they survive?

The word “welfare” is the conjoining of two words—fare and well—and thus related in an oblique way to our familiar valedictory wishes. But the notion of welfare in an institutional sense, specifically involving the state, is modern, dating back only to the late 19th century. In this intervening period of time it has also come to mean very different things in different societies.

It is the role of the state that has made welfare controversial, even though the term “welfare state” is hardly ever used these days. In the United States it is defined narrowly to include income transfers for specific needs and the provision of services to support a minimum standard of living. It has an expressly and modestly redistributive effect. In Europe it is defined broadly to cover not just redistribution but also spending to pool collective risks and as an investment in the human capital of its citizens. The United States has some of the former in its retirement systems but none of the latter. Canada, Australia and Japan would fall somewhere between the two extremes of the US and Europe.

The narrow American version of welfare stems from the more restricted definition of “individual liberty”, closer to the libertarian ideal of the individual possessing a freedom to choose unobstructed by others. The expansive European interpretation of welfare derives from the older–in fact, Roman republican—idea of liberty where the individual is furnished with some of the means to achieve what he or she chooses. They both appeal to self-realization, but the American ideal emphasizes the absence of impediments while the European ideal stresses the presence of resources.

History and hard-headed calculation have played a role too in influencing the shape of these welfare systems. Comprehensive and effective welfare state provisions, which included an ambitious offering of social rights and guarantees, were established in post-war Western Europe which hoped to cement citizen loyalty to democratic systems and market capitalism, holding off the temptations of political extremism that the continent had recently experienced.

With the end of the Cold War the more generous social-democratic welfare systems championed by Western European nations have begun a shift—but only glacially— towards what can be called a liberal welfare model. France and the Scandinavian countries have so far resisted the move but Britain, Germany, the Netherlands, Austria and Belgium have all started to stress consumer choice and the scope for beneficiaries to at least partly opt out and make their own private provisions.

But the even more salient factor was the arrival of economic liberalization that swept across the western democracies, transferring the power of states over to international markets but even more significantly giving markets the power over states. And as the tax status of corporations has become even more fluid and mobile it has undermined the fiscal base for traditional forms of welfare.

Surprisingly, this is as true of the US with its more austere system of welfare provision and relatively good demographic profile as it is of the European nations with their generous provisions and bad demographics for the simple reason that the US economy’s fiscal debt picture is subject to many more centrifugal forces than other mature economies. The public sector debt level—i.e. not just that resulting from the structural deficit—is deteriorating also because of the “protected” status of its large and growing defense budget as well as the inefficiency of its intricate rules-based tax system. The haste with which the recent US tax legislation was formulated and enacted should give us no reason for confidence that we are at a watershed.

Despite the differences between the advanced economies of the world we recognize some common challenges facing our welfare systems: aging trends that are worsening dependency ratios, international competitive pressures that are eroding the corporate tax base, and social risks (such as the rise of the gig economy) that are fragmenting the workforce and leading to widespread economic insecurity. These have all converged to create a crisis of affordability.

We see at once the profound conflicts embedded in the aforementioned themes. Just when we need—and expect—a stronger safety net for our fellow citizens we realize that we can no longer afford one. This will be the defining economic policy question of our lifetime.

 

 

 

 

 

Bond Conundrum Redux: Risk, Rents, or Robots?

On February 16 2005, Alan Greenspan, Chairman of the US Federal Reserve Board, testifying before a US Senate committee, posed a question that had been vexing him and his team of economists: why had 150 bps—a full percentage point and a half—of monetary policy tightening not had any effect on long-term US Treasury bond yields?

It was exceptional because previous episodes of interest-rate tightening had always begun with sharp selloffs across the length of the yield curve. But it was more than just a break with past patterns; there was also no rationalization for it. The Fed had no evidence of a jump in the savings rate due to demographic or other factors, nor of a rise in risk avoidance that would have justified a flight to the safety of the benchmark 10-year government bond. He concluded by calling it a conundrum.

More than a decade later the financial markets find themselves in a similar place. The US Fed, now led by Janet Yellen, has been raising its policy rate slowly but steadily since December 2015, when it moved for the first time after a seven-year  period of inactivity. And once again we see a capped 10-year Treasury yield. Market commentators have revived talk of a conundrum. Some of them remind us that the earlier conundrum was followed by a financial panic three years later and they speculate whether this time too the bond market is signaling something catastrophic.

That may well be the case. But there is an equally interesting and related puzzle to ponder these days.  It has less to do with the low level of yield on a risk-free asset (which is what a 10-year Treasury bond is) than the difference between that yield and the yield on invested private capital in the US economy. (Think of the latter as the average rate of return on all private investment in the economy.)

This difference, often referred to as the risk premium, has widened to an exceptional degree—by some estimates as much as seven percent—and it has left economists scratching their heads. If low Treasury yields are a sign of fragility in the economy could the unusually high returns on private investment also be telling us the same thing—since investors require high returns to compensate them for the additional risk?

One such economist, Pierre-Olivier Gourinchas at the University of California at Berkeley, who has examined this carefully does not think the answer is to be found in risk. He says if it were true we would be seeing spikes in the VIX, the cost of protection against volatility in the S&P 500. That has not happened. More likely then the answer is to be found in the bounty of corporate profits—oligopolistic rents–that characterizes American business. Or perhaps we are seeing a surge in unmeasured productivity of capital—robots, in his words—that has given American industry a boost even as the Fed moves with extreme caution and so keeps US government bond yields low.

One may think that I am sympathetic to one of those views, expressing concern about the extent to which US industries have become concentrated. Weak antitrust efforts and political capture of regulation engender unwarranted profits. It is the most troubling of the explanations.

 

 

 

 

 

 

 

 

Health Care in the US: A Case Study in Oligopolistic Market Power

Ever since I wrote the two blogposts on short vs long-term thinking–In Defense of Short-termism and  Why so much short-term anxiety disorder?–back in late summer and early autumn of this year I have been dilating on the conclusion I reached at the end of the second of those two posts.

To summarize that conclusion: Long-term thinking (and the huge equity-valuation benefits that are conferred on those businesses that are able to lay out a predictable picture of what their earnings would look like many years into the future) is only possible when there is concentrated market power. We see it most vividly in the US tech industry–whether consumer hardware or social media or the search engine segments of the industry–which is dominated by a handful of Leviathans. If it was not for competition rules enforcement in the EU, or China’s desire to build its own national (and eventually international) “champions”, American companies like Apple, Facebook, Amazon, Microsoft  and Alphabet would bestride the world  like behemoths in their respective segments.

Global finance is another industry where the market is dominated by a small handful of American firms. All these companies–whether they be in technology or finance–have the luxury of talking about what the world would like in the faraway future, and their indispensable role in it, precisely because their are so few threats to their dominance, let alone their survival.

Where fierce competition exists, as in industrial and agricultural machinery, or automobiles, or consumer goods, innovation is quicker, profit margins are far tighter and companies more nimble. Price-to-earning multiples are also much lower.

But today I want to get away from the rewards doled out by financial markets–the ultimate judge of a business’s worth, or so it would appear–for concentrated market structure and look at the effects that market power has on the well-being of the people the business serves. And, for a change, by “people” let’s talk about its customers and not its investors. There is no industrial sector in the US economy that is more deformed than health care, in that it excels in delivering inferior outcomes at an exorbitant price.

Health care is a service business par excellence. The supply of, and demand for, health care is wholly domestic. Unlike finance, the other prominent service industry, there is less room for outsourcing and offshoring; certainly much less so than in manufacturing. We hear of X-rays and CT Scans and other diagnostic tools being sourced from across borders (though they rarely do) and generic drugs that can be imported cheaply from abroad (though we rarely see them).

But it does have something in common with finance. This sector is characterized not by natural oligopoly forces, such as economies of scale and network effects (which we find in social media and other tech businesses) but by those constructed artificially by protective government regulation. They have many of the privileges of regulated utilities–think of the old Bell group of local phone companies which were granted monopoly market positions–with none of their disadvantages, viz., capped pricing. Every segment of the US health care industry, whether insurers or health providers, i.e. doctors and hospitals, or pharmaceutical companies have settled into a hard oligopolistic core. Only medical-equipment manufacturers–like manufacturers of every shape and stripe–compete in a free-for-all marketplace of domestic and international firms.

This thought came to me when Trump made his infamous comment earlier in the year when pulling out of the 2015 Paris climate agreement that his decision was based on the understanding that he represented the people of Pittsburgh, not those of Paris. He was met with a storm of opprobrium–which I don’t object to since the scale of our ecological challenges and the complexity of climate change negotiations are so vast and intractable that an international approach is the only sensible one. But it was the response of many Pittsburgh residents and ex-residents (Indira Lakshmanan, formerly of Bloomberg News, comes to mind) who pointed out that Pittsburgh is not the city of Trump’s imagination anymore, a working-class town built on the back of its “dirty” steel industry. Rather Pittsburgh is the country’s leading center of medical services. It is, in other words, a clean, efficient health-care industry town.

The University of Pittsburgh Medical Center (UPMC) and the Allegheny Health Network dominate the western Pennsylvania heath care market providing a vertically-integrated infrastructure product from insurance to primary care doctors to specialists to hospital and outpatient and ambulatory care as well as a range of pharmacies. Pittsburgh mirrors every region in every other state in the United States, both in industry structure and the rising cost of health care (in actual dollar terms as well as relative to other goods and services).

The structure of the US health care industry with its pronounced market concentration, aided by regulatory forbearance, is of pivotal importance in our public discussions about the design of any future health-care system for the US. Let me explain: in early September 2017 a number of Democrats–including several planning to run for the nomination of their party in the 2020 presidential election-called for a move to a single-payer system for all Americans and permanent residents. This will be our Medicare system writ large. At its best it would resemble something like the Canadian health-care system, with provincial (states in the case of the US government, though some combination of federal and state participation would seem to be more likely) governments providing health insurance at a minimal cost to residents. The expenditure on this publicly-provided service would be recouped through progressive state and federal income taxes. In effect, we replace the fragmented and noncompetitive health insurance industry with a single insurer, a public one.

Yet this is a risky proposition if the underlying costs of the different services that constitute the health marketplace are not addressed. Doctors, hospitals and drug manufacturers can rest easy in this arrangement despite all the talk of the public insurer bringing “monopsonistic” i.e. dominant buyer, power to the market, forcing providers and suppliers to restrict prices on pain of being cut off from the market. Yet, the lessons we learn from Canada have not been wholly encouraging. Prices have been rising–though nothing like the inflation for health care in the US economy– and providers of services do manage to collude to improve their bargaining position.  This is most likely to happen in the US.

And we even have another example right under our noses: the Department of Defense, which is a single buyer and single-payer of all defense equipment and services facing off against a small number of private-sector arms manufacturers and contractors. The DoD is an exemplary  case-study on the failure of managing expenses well and achieving good outcomes.

There are two ways out of this impasse. For a single-payer health-care system to have maximum efficacy we need use antitrust and competition policy aggressively–I would say “Brussels style”–to break up concentrations and realize a competitive marketplace. This is a precondition. But a more effective system would be a nationalized heath system, along the lines of Britain’s old NHS before it began the process of crypto-privatization and sub-contracting to the private sector, where the state owns and controls all health-care. Though there is some rationing involved it still delivers the best outcomes per dollar (or pound) of expenditure. The same goes for that thin slice of the health US health-care that is fully nationalized–the health-care provided through our Veterans Administration. Despite the recent bad press the VA has received recently it remains a model of efficiency and equity.

The question boils down to politics eventually. Can we fathom such changes in our current political environment?

 

Structure of the US economy has changed–possibly irreversibly

Much has been said and written about the depressed conditions in–and the depressed inhabitants of–the American red states. But it wasn’t till I saw these charts presented at the Annual Meeting of the International Institute of Finance last month that I noticed the difference in employment trends in the “old” and “new” parts of the US economy.

One used to think of the Western states -and especially the California and Pacific Northwest–as being paradigmatically new, and bits of newness scattered around the country, and the rest old. But while that mental picture might have been true at the turn of the last millennium it is no longer the case.

Now the “old” economy is the traditional manufacturing and retail industries–and my instinct is telling me that there is some deep connection between manufacturing and traditional retail, i.e. malls and shopping-strip retail, that is worthy of exploration but I will not explore it here–in pockets of the Northeast and the Midwest, the so-called Rust Belt. They are the Left Behind parts of the country. Politically, they are the purple states–unpredictably swinging from blue to red and back again–Ohio the most, and then states like Wisconsin, Michigan, and Pennsylvania that have been threatening to go “red” for a while and finally did in 2016–and they are having a hard time becoming new.

And this time they swung in favor of Trump.

Please note this is not to argue that Trump support is not broad and deep and found all over the country, as argued in last post but one, except that these swing states–really, swing counties if one had to zoom into these states–have flipped because of economic structure. Of course, none of this is a new finding. People have been talking about it since the election on this day last year. But it is the graphical description that is noteworthy.

So I wouldn’t fall for the tales of hopelessness from opioid use (more the consequence than the cause of hopelessness) that did it for Trump. It was the slow death of the old industries and the failure of the market to provide employment in the new ones in some parts of the country that has blighted these regions.

The different rates of obsolescence of the traditional economy in the red and blue is most revealing.

 

Red Vs Blue States