04/03/2009 - 22:00

System’s fatal flaws need to be addressed

04/03/2009 - 22:00

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OVER the past 20 years or so, there has clearly been a growing, but until now unrecognised, systemic failure of the modern capitalist system, culminating in the US's sup-prime mortgage crash of 2007.

System’s fatal flaws need to be addressed

OVER the past 20 years or so, there has clearly been a growing, but until now unrecognised, systemic failure of the modern capitalist system, culminating in the US's sup-prime mortgage crash of 2007.

Much of the blame for this deterioration can be aimed fairly and squarely at an ever-expanding array of financial derivatives, or what legendary US investor Warren Buffett has called 'weapons of financial mass destruction'.

An exponential expansion in the use of derivatives over recent years has lifted financial leverage to the point that global markets are now inherently unstable. Money is almost irrelevant as a means of conducting or even measuring commerce, since credit and a vast array of financial instruments now dominate daily commerce. Briefcase hopes that President Obama and chairman Rudd have advisers who understand that pumping a few dollars into their respective economies holds little chance of any lasting benefit.

Briefcase sees three main issues underlying this failure. The first, as I have previously outlined, is loss of control of the strategy and ethics of corporate management by a company's equity holders. In effect, the animals (management) have taken over the farm (the company) while the farmer (shareholder) has been locked in his barn and only gets a look out once a year at the annual general meeting.

Many non-executive directors have been compromised by accepting remuneration conditions that align their interests with those of management and not the shareholders that they are appointed to protect. When directors receive bonus payments, while management destroys shareholder value by issuing toxic debt, then the system is broken and needs to be reconstituted.

Boards should be totally independent and funded separately by the shareholders. Larger shareholders need to stand up and take an interest in their investments over and above banking a dividend cheque every six months. Today's internet communications open up an avenue for more active shareholder communication and more effective monitoring of management by a board.

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The second issue is a breakdown in corporate governance and market regulation. We now know that the US corporate regulator, the SEC, which is its version of our ASIC, had clear and concise warnings of the $US50 billion Madoff swindle, at least four years before Mr Madoff's sons blew the whistle on him. The SEC chose to do nothing about it, for fear perhaps of causing a market rout and perhaps jeopardising a juicy job the SEC wallahs hoped to be offered at some investment bank, if they did not rock the boat.

Here in Australia, we have a market regulated by a listed company, ASX Limited. It is in the interests of ASX to expand the number of companies that trade and to expand the turnover of stock on the market, since it receives listing fees and fees for each transaction. The ASX clearly has a conflict of interest in both monitoring market trade and taking fees for those transactions. The guys at the top are more interested in their multi-million dollar pay packets than the proper working of the market they control.

This leads me on to the third issue, which has led to this point of market collapse. For those uninitiated, short selling is the practice of selling a share that you don't own, in the hope that it will fall in price and then you can buy it back more cheaply to repay the loan. This practice does not build or grow any wealth, except for the short seller, who may incidentally destroy a business built by others.

Short selling does not create jobs or long-term wealth, it only knock down what others are trying to achieve. It destroys businesses and Briefcase cannot see, despite all the arguments about liquidity, that this activity represents a business model which adds value to an economy over time.

The way to add value over time is not by trading stocks for a quick turn, but for investors to assess business risks and subscribe capital only if they are aware of the chances of normal business failure. People who short sell are simply gambling and would be better placed to go to the Burswood Casino to continue their particular form of pleasure.

Short selling is counterproductive. Advocates, mostly the shiny pants who sit at computers all day trying to sell stocks they don't own, say it is a mechanism for price discovery and that it assists the market by providing liquidity. All this sounds good to the men and women at the ASX, since it increases their bonus payments. But in a tough market, short sellers can push a company's shares to nothing and as we have seen, there may still be no buyer for shares, because the market is spooked and buyers have gone on strike.

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If we return to basics here, we need to consider what a stock market is all about and why we have a stock market in the first place. A stock market is a place where savers can invest part of their wealth in the hope of receiving better returns than they can achieve by lending it to a bank (and that is another story) or buying a property. On the other side, businesses list on the market so that they can gain access to capital to support and expand their operations. Shareholders can participate in a company's growth, where returns on equity might range from 5 per cent to 15 per cent a year, compared with lower returns elsewhere. Investors, acquainted with the risks of business are prepared to apply their savings in this way.

But short sellers add an extra level of risk, which renders equity investment unattractive. In addition, it's a system which is open to abuse and market manipulation. Witness the coordinated attack on Macquarie Bank last week. I certainly don't want to defend Macquarie, which is capable of giving as good as it takes, and it is interesting to see the jackals now turning to devour each other. But in this case, short sellers took their positions and then issued rumours about capital raisings and other such negative reports in the hope that shares would fall and they would profit from the pain of ordinary shareholders. How can this be a good thing for a market and how will it encourage savers to subscribe their hard earned funds into companies that can be likewise attacked?

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The most important question readers should ask at this point is where are the regulators? What is ASIC doing to protect investors and how can the chairman of the ASX preside over this casino, pretending to be a stock exchange? Briefcase would like to see a few heads roll and shiny bottoms removed from their exalted status.

There is no doubt in Briefcase's mind of that the capitalist system, as it has evolved, is broken. The system of independent boards, tasked with protecting the interests of equity holders, is fatally flawed and needs to be replaced, while short selling is killing the higher-risk end of the market, which is essential to maintain an overall healthy range of risk and reward opportunities for investors. The underlying premise of many high-risk investments relies on a degree of patients and trust, which are two characteristics absent from hedge funds. They would sell their grandmothers for a penny.

On analysis, it can be seen that banking is the ultimate high-risk investment for both depositors and shareholders. Essentially, banking relies on trust. No bank can operate if its depositors (funders) all decide that they want their money back at once. There has to be trust that the business model will be prosecuted efficiently by a team of skilled managers that accurately assesses lending risks. If this business model is allowed to proceed, everyone makes a return on their investments, but the whole operation is very tenuous. Banks are always borrowing short and lending long, which is a good way to go broke, unless you are a bank.

Briefcase believes that there should be a nursery ground where higher risk capital, often with longer-term objectives and appropriate reward horizons, is given protection from destructive short selling. It is hard enough to build a business without having to worry that your equity will be squashed by some unrelated person wanting to turn a quick buck. In the face of short sellers, it is unlikely that companies such as iiNet, Google, Yahoo!, Microsoft or Cochlear could have grown and prospered in a tight market, because hedge funds would have seen that these companies relied on high risk patient capital, leaving them and their bankers defenceless against short sellers.

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n Peter Strachan is the author of subscription-based analyst brief StockAnalysis, further information can be found at Stockanalysis.com.au

 

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