Welcome To Aloke (Al) Ghosh’s Blog

Al (Aloke) GhoshWelcomzicklin-school-of-business_416x416e to my weblog, www.alokeghosh.com. Via this personal blog, I am sharing pertinent issues, current topics, and policy matters in the fields of auditing, financial reporting, and corporate finance with relevance for auditors, hedge fund and mutual fund managers, controllers and CFOs of public companies. The targeted audience includes my current and past students, colleagues from academia and practice, and anyone else fascinated by the crossroads of auditing, accounting and finance. Because my academic training and professional experience overlaps these three interconnected business fields, my commentaries/ideas/claims are often a distinctive outcome of a triangular subject-matter lens rather than a specialized subject-matter lens.

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Mardi Gras Float in Trouble: First NBC

mardigrasIn the absence of major national banks in New Orleans, regional banks have floated the NOLA (New Orleans, Louisiana) economy. Through its wholly-owned subsidiary First NBC Bank, First NBC Bank Holding Company provides a wide range of financial services in New Orleans, Florida, and Mississippi Gulf Coast with 39 banking offices.

Following Hurricane Katrina, First NBC invested heavily in New Orleans construction projects that included generous tax credits established by federal and state governments. These investments collectively helped propel First NBC to become the city’s largest bank based on assets under the leadership of CEO Ashton Ryan.

Halloween Scare: Stress Test

The Federal Reserve Bank of Atlanta and the Louisiana Office of Financial Institutions informed First NBC on Oct 11 that the bank is under “troubled condition.”  As troubled bank, it must seek regulatory approval before adding any new directors or senior executives or changing the responsibilities. The bank is also prohibited from increasing its debt, distributing interest on subordinated debt or paying dividends on its stock.

To add to the stress, the Federal Deposit Insurance Corp. (FDIC) recently declared that First NBC is no longer “well capitalized,” restricting its ability to take on certain deposits and pay interest. First NBC was recently downgraded to junk status by Kroll Bond Rating Agency Inc., which specializes in rating smaller lenders. HoldCo Asset Management, which owns the banks’s debt has shorted the bank’s stock and as a way to hedge its risk against a bank default has also publicly questioned the bank’s accounting policies.

Uncle Sam’s Subsidies: Tax Credits

First NBC invested heavily in New Orleans in construction projects following Katrina and thereby benefited from the generous tax credits from federal and state governments. Because the tax credits received by First NBC were more than the taxes being paid, the bank was able to use the unused portion of the tax credits to reduce future tax payments by offsetting future taxes against the unused portion. For instance, if the government gives a $1,000 tax credit to a single parent for raising a child alone, and the parent must pay $800 as federal income taxes based on his/her income, the parent does not pay any taxes for the current period because the tax credit fully offsets the $800 taxes payable for the current year. More importantly, even after the tax offset, the remaining $200 tax credit balance can be used to reduce future taxes.

Accounting rules allow this $200 future tax benefit to be capitalized (i.e., treated as an asset) and booked as a deferred tax benefit. As of the first quarter of 2015, the bank’s deferred tax assets—the benefits from reduction of future taxes—are $247 million, up from $95.8 million a year earlier.

In 2014, the company reported $28.6 million as income before taxes yet it reported a net income of $55.6 million because it had an income tax benefit of $27 million (instead of having an income tax expense which normally reduces net income).

Mardi Gras Float in Trouble: Recanting Previously Issued Statements

First NBC announced in August 2016 that it expects a delay in filing its 2015 Form 10-K (annual report filing with the SEC) because of restatement of previously issued financial results! The prior results included errors because of the following reasons:

  • Use of an inappropriate amortization method in accounting for investments in tax credit (Halloween Hullaballoo)
  • Consolidation of certain investments in Federal Low-Income Housing Tax Credit entities because such entities were determined to be variable interest entities in which the Company was the primary beneficiary (Enron Phantom).
  • The result of the consolidation has adverse effect on the financials (Hurricane)

Following the error corrections, the 2014 net income was now being restated (or reduced) by 20% ($55.6 million being revised to $44.7 million). Similarly, the 2013 net income was being restated (or reduced) by 18% ($40.9 million being reduced to $33.6 million). Accumulated earnings for 2012 and prior periods was being reduced by 16% from $59.8 million to $50.3 million. The company in its 2015 10-K stated “We determined that we had insufficient qualified personnel at both the executive management and staff levels with appropriate knowledge, experience and training on accounting and reporting matters, which contributed to the material weaknesses that resulted in the restatement, as well as the inability to timely file this report.”

To make matters worse, the bank was in violation of NASDAQ listing rules because it had not filed its 2016 quarterly statements. To avoid delisting from NASDAQ, First NBC submitted a plan to regain compliance with Nasdaq’s listing rules.

In a time-span of less than a year, the stock price of First NBC declined from a high of about $40 to around about $5.30, which is a cyclonic decline of around 86%. More than $600 million in shareholder wealth was destroyed because of the accounting related aggression.  

Grateful Dead Sings Aiko Aiko Ande

Ernst & Young (E&Y), a Big 4 auditor with international reputation and stature, has been the independent auditor of First NBC leading up to the 2015 financial statements. First NBC’s restatement is likely to bring considerable negative publicity, media scrutiny and regulatory intervention for E&Y. It will not be surprising to see class action lawsuits initiated by shareholders to recover losses.

In September 2, 2016, Ernst & Young declined to stand for reappointment as the company’s independent auditor for 2016. Is it a case of too little too late? A restatement is considered an audit failure.

Did E&Y fail the shareholders of First NBC? Only courts and the SEC can render a verdict on this matter. Until then, the accounting profession sings “Aiko Aiko Ande” in Cajun style.

 My spy boy saw you spy boy sittin by the bi-yo

My spy boy told your spy boy, Im gonna set you flag on fi-yo.

I said, hey now, hey now, Aiko aiko all day, jockomo feeno na na nay, jockomo feena nay.

My grandma and your grandma were sitting by the fire

Said my grandma to your grandma, gonna get your tail on fire.

Chatham- Helsinki; October 30, 2016

 

 

 

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Drugs and the Land of Lords

fdaIndia has become a dominating player in the production of generic-drugs particularly targeting the large U.S. market. Indian drug manufacturers account for 40% of generic drugs sold in the U.S. While most Indian pharmaceutical companies continue to make their money selling inexpensive generic drugs, there is a visible change in their strategy over the last few years. Indian generic-drug manufacturers have started competing intensely to develop their own products through heavy R&D spending and finding solutions to many illnesses and diseases.  

Motivated by the desire to produce innovative and patented drugs, Indian pharmaceutical companies have started applying for drug approvals with the U.S. Food and Drug Administration (US-FDA) at an unprecedented rate. Approximately, a third of all FDA applications in the last year were submitted India’s multibillion-dollar pharmaceutical industry. A year ago, the growth in application was only 19% which means the growth rate between the two consecutive years has almost doubled.

Why the Change in Strategy?

Generic drug business (production and sales) entails making money through large volume. Margins are low because there is heavy competition from other generic drug producers. Think of grocery stores as an analogy. In contrast, patented drugs generate high returns for the producer because they are the only producer, i.e., volume is high, and margins are high because they act as a monopolist (sole producer). Think of the diamond business and DeBeers as a parallel.

Medical innovation in drugs requires considerably investments in R&D with initial outlays exceeding millions, and sometimes billions, of dollars. However, following the successful development of a drug, a pharmaceutical company must first procure a patent before the drug can become a commercial product.

Patent

The economic idea behind a patent is simple. The government wants the private sector to invest and innovate in the field of medicine and find cure for illnesses. However, because the cost of finding a cure for human ailments can be prohibitively costly, the government offers through a patent a “protection period” for a drug company to sell its drug over a certain period, which is typically 20 years in the U.S.

As a result of the patent, only the pharmaceutical company holding the patent can manufacture the drugs being approved by the FDA. Therefore, in essence the drug manufacturer with a patent is akin to a monopolist, which means it can charge an exorbitant price (think of the recent Mylan case). High prices result in high profits because the cost of production is generally low. The higher profits allow the drug manufacturer to recover the initial investment in R&D and thereafter make a ‘healthy,’ and sometimes super-healthy, return.

Humans benefit, we get to live longer and are able to become more productive, which means that society benefits but all this comes at a step price. Some drugs can cost between $10,000 to $30,000 per dosage (e.g., cure for AIDs or cancer)!

Prominent Manufacturers

India’s largest drugmaker by sales, Sun Pharmaceutical Industries Ltd., received approval for an eye drop to treat swelling and prevent pain in patients undergoing cataract surgery. In 2014 it received approval for a new injection to treat a rare blood disease known as myelodysplastic syndrome. However, to receive these patent approvals, the company had to invest heavily in R&D. The company’s R&D outlay increased from about $50 in 2011 to about $261 million in 2015, which is more than a 400% increase in a span of 4 years or about 100% annual growth.

Dr. Reddy’s Laboratories, India’s second-largest drugmaker by sales, received FDA approval for a spray for treating a skin condition called plaque psoriasis, as well as an injection for migraine headaches. The company similar increased in R&D from $50 in 2011 to $253 million in 2015, which again translates into a 100% annual growth.

Lupin increased its R&D spending by 17% to $168 million in 2015. The company is  developing an injection to treat less common cancers and a nasal spray to better deliver off-patent drugs to treat some types of pulmonary diseases. The company’s U.S.-based laboratories in Florida and New Jersey are also working to improve AllerNaze, according to Wall Street Journal.

Cost versus Benefit

Dr. Reddy’s Lab spent about $25 million in developing its migraine injection and was able to get it from concept to market in less than five years so the gestation period can be long. However, the company predicts that it expects to earn more than $100 million in annual sales from the migraine injection and skin spray.

A 20-year patent period means that the sales over the duration of the patent period would generate about $2 billion sales. The “bottom line,” it pays to invest in R&D for a company and switch from generic production to patented products. But, the company must first succeed in its innovation efforts otherwise all the investment is lost, which is the typical risk associated with R&D investments.

Chatham, Feb. 29, 2016; 11.22P

http://www.wsj.com/articles/indian-drugmakers-target-niche-markets-1461024100

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Van Guarding your Assets: US Market The Best Bet

sp_chartThe annual return for investing in the U.S. stock market over the last 50 years has been around 7-8%. How can one explain this remarkable growth in the U.S. stock market? The Sage from Omaha, Warren Buffett, has a lucid and precise response. The U.S. economy, as measured by gross domestic product (GDP), has been growing, and is expected to grow, at an annual rate of about 3%. The inflation is about 2 to 3% which pushes nominal GDP growth to 5-6 %. Stocks pay about 1-2 % of dividend which increases the growth rate to about 6-8 %.

If you were fortunate enough to have invested during the bull market, i.e., 1982 to 1999, the S&P 500 Index, a common benchmark for U.S. stocks, would have crowned you with returns of about 18 percent per year. You surecannot beat these numbers unless you happen to be the humanitarian George Clooney with the reliable Ocean’s Eleven to back you up!

Risk

So where is the risk if you make 6-8% each year when the period is dull and about 18% during the bull period, which is no bull.

While these numbers are average returns, for some decades you could have easily lost money (e.g., 1970s and 2000s). Sadly, more than half the adult American population gets deprived of the “vintage bourbon” offered by the US equity market. Only 48% of adult Americans have a claim on the returns offered by the US stock market, which is such a travesty. A considerable majority has foregone the benefits of the goldilocks economy.

The Best Bet

The stock market remains the best bet for growing and preserving your financial assets. If you invested in Certificate of Deposits (CDs) with banks, you would earn about 7% in the early 1990s and about 1-2% in the last 5 years. If you invested in government bonds, which is only possible via an authorized stock broker, you would have earned between 2 and 6% in the last 30 years. If you had invested in AAA corporate bonds, you would have earned between 3 and 6% per year.

Clearly, the US stock market offers the best returns in the long run with very little risk when the investment horizon is sufficiently long.

The Van Guard(ing) your Assets

The million-dollar question for your million-dollar investment is what stocks do you pick or what fund/portfolio-manager do you choose?

The relatively safest and least costly method is to pick an index mutual fund. Instead of hiring fund managers to actively select which stocks or bonds the fund will hold, an index fund buys all (or a representative sample) of the securities in a specific index, like the S&P 500 Index. The goal of an index fund is to track the performance of a specific market benchmark as closely as possible, which is why index funds are also referred to as a “passively managed” fund.

The all-time favorite financial company offering index funds happens to be Vanguard Group because they charge very little commission or administrative fee for managing your assets. Vanguard’s 500 Index Fund started business with $11.3 million in assets. Today, the same fund holds more than $252 billion, i.e., the Fund’s assets grew by around 23,000 times.

By investing in the Index Funds like the S&P 500, you must calibrate your expectations. You should not expect staggering returns from investing in a few darling stocks like Tesla or Amazon or Apple. Why? Because those are much riskier bets. You sure make money when the market loves those stocks, but you could also lose your shirt when the market turns its roving eye towards other more attractive beauties. By investing in the Index Fund, you have committed yourself to getting whatever returns the market offers which, in this case, happens to be returns on the S&P 500 index.

Alpha-Males

Some would advise that you seek “alphas” by investing your money in hedge funds or mutual funds choreographed by “superstar” portfolio managers. While this seems like an attractive proposition, chasing these types of funds or portfolio managers can be akin to making a million through lotto tickets. The odds are heavily stacked against you; you might as well give your money to some charity.

There is another caveat. Superstar managers and high profile mutual funds will charge you a bulky administrative fees (> 1%). In addition, you must pay about 20% performance fees, especially to hedge funds.

Possible because of the realization that it is impossible to beat the market consistently over the long run (academics have been saying this for more than 30 years), or for the fear of paying exorbitant fees, index funds have grown in astounding popularity. From their start at $11 million in 1976, index funds grew only to $511 million by 1985, and thereafter expanded more than 100-fold over the next decade to $55 billion in 1995. Their assets hit $868 billion by 2005, and the future still looks very bright so you need wear shades.

Are you ready to invest in the stock market and Index Funds to help grow your financial assets. It sure beats any other form of legitimate financial investment.

Chatham, September 20, 2016; 11A

http://blogs.wsj.com/moneybeat/2016/08/31/birth-of-the-index-mutual-fund-bogles-folly-turns-40/

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Accounting’s Got Talent

accountingtoday-top-100Financial economics, as the title of the discipline suggests, is an embedded field within mainstream economic sciences. Therefore, it should not come as a surprise that quite a few Nobel Laureates in economics are finance professors who have done pioneering work in financial economics.

Closely linked with economics and finance, mainstream accounting research is derived from economics and financial economics. While there are a few strong delineators between finance, economics and accounting, the three fields intermingle and influence one another which is why it is difficult to have a strong grasp of one without at least a basic understanding of the other two.

Yet, accounting has never been considered part of mainstream economic sciences which is why no accounting researcher has won the Nobel Prize. Not to be outdone, the accounting profession has created a list of 100 most influential individuals, thought leaders, and visionaries who are responsible for shaping the accounting profession.

Requirements For Top 100

Gaining entry into the coveted top 100 Most Influential Person in Accounting is a daunting task. The Accounting Today complied the Top 100 list using the following criteria.

  • Innovator and creator. The individual must have created new ways to market the accounting/auditing professional services.
  • Educator. The individual must have taught the profession something the profession didn’t know already.
  • Regulator. The individual must have been involved in enforcing rules which had a game changing influence on the profession.
  • Elevator. Individuals who help achieve the ideals of the profession, or and those who are actively planning the future of the profession, are deemed the most influential of all.

What is the gender composition? Among the top 100 most influential accounting professionals, 70% are males and the remaining 30% are females.

Top 5

The top 100 most influential accounting professionals then voted to pick the Top 5 thinkers within the profession. The Superstars in Accounting are:

  1. Barry Melancon: President and CEO of AICPA
  2. Tom Hood: CEO and Executive Director of MACPA
  3. Mary Jo White: Chair, SEC
  4. Russell Golden: Chairman of FASB
  5. Ron Baker: Founder of VeraSage Institute

MIA

Surprisingly, no academic made it to the Top 100 list. Although academics meet the threshold requirement as an educator, presumably, Accounting Today does not consider academics to be influential enough to teach something to the profession that the profession didn’t know already. Academics are merely disseminating accounting/auditing knowledge that is already codified by the profession so academics are not deemed as innovators in the field.

We salute the Top 100 Most Influential Accounting Professionals!

Chatham; September 10, 2016

http://pages.marketing.accountingtoday.com/act_unsponsored_75635_sr_lp.html

 

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An Enduring Relationship

Ambassador_AdamsThe enduring Finnish-American diplomatic relations is a tribute to the skilled statesmen from both countries who have served the interests of their nations with distinction.

There is a strategic geo-political explanation for the large U.S Embassy in Finland (US Embassy is the second largest embassy in Finland). Helsinki is about 110 km away from the Russian border. During the Cold War, Finland held a strategic position between two hostile blocks—U.S. and Soviet Russia. Finland was a “buffer zone” and a “military transit route.” Both sides cultivated the potential to use tactical nuclear weapons against targets in the Finnish territory, at least pre-emptively. Both sides engaged themselves in intensive intelligence activities in Finland and in the bordering areas.

Brief History

The United States and Finland have enjoyed almost centennial years of cordial relations. Upon gaining independence from Russia in 1917, Finland sought diplomatic recognition from the United States. However, the Wilson administration, concerned about Finland’s political instability and ties with Germany, refrained from granting Finland diplomatic recognition until 1919.

During the Great Depression of the 1930’s, Finland was the only nation to continue to pay off its World War debts it owed the United States.

Relations between the United States and Finland reached the lowest point during World War II. The United States severed diplomatic relations with Finland in June 1944 but did not declare a war against Finland. However, once Finland signed an armistice with America’s allies in September 1944 and expelled the Germans from its territory, the United States appointed a U.S. representative to Finland. In 1945, the two nations re-established diplomatic relations.

After World War II, U.S.-Finnish ties was marked by renewed stability and increasing cooperation. Finland pursued a strict policy of neutrality. The United States, acutely aware of Finland’s precarious geographical position, supported Finland’s neutrality and promoted policies that would not provoke Soviet retaliation. It also endorsed Finland’s independence and democratic institutions. U.S.-Finnish relations focused on economic assistance and expansion of trade.

 Finland’s Neutrality

Following World War II, Finland embarked upon a foreign policy of neutrality. Their policy sought cooperation with the East and the West. Known as the “Paasikivi-Kekkonen line” after 1945, it was meant to convince the Soviet Union that Finland had no intentions of undertaking foreign policies that were deemed dangerous to Soviet interests to avert possible future Soviet aggression against Finland.

Finland’s cautious and realistic foreign policy was successful. Finland maintained working relationships with the Soviet Union and its communist allies but also cultivated expanded contacts with the West. It carefully steered toward membership in the Nordic Council and admission to the United Nations in 1955.

 Secret History

The U.S. Embassy had a large and efficient Military Attaché department following WWII. Many of their officers spoke Finnish. A secret report of the Finnish general staff counter-intelligence department stated in 1953 that the one of the main tasks of the western Military Attachés was to study Finland as a future combat area.

The narrowest area, the “waist” of Finland, interested Americans and Soviet Russia. The Russians were not interested in the southern part of Finland. They were interested in the area where the distance between NATO and Soviet Union was the shortest, namely, northern Finland. This area was also of great interest to Americans.

NATO had regarded Finland as an area not possible to defend and it worried that Finland as a country was cooperating too closely with the Russians. NATO suspected that Soviet troops could cross northern Finland in about one week. Even if Finns resisted a Soviet Russian attack, they would be forced to retreat toward the south and not the west. The Western line of defense was drawn between Finland and the Scandinavian peninsula.

Enduring Relationship

Washington became positively disposed towards Finnish armed forces by the 1970s for several reasons. The Americans were impressed by the Finns’ fighting will and ability. The military officers in Finland were western-minded. More importantly, ordinary Finns were patriotic and anti-Communist. The educated guess was that, in the event of a war, the Finns would fight with the west against the Soviets. According to U.S. military experts, there would be no resistance worth mentioning from the Finnish side if American troops entered Finland.

2017 will mark the centennial celebrations between United States and Finland. United States is considered the leading protagonist in higher education, while Finland is considered the world leader in rendering top quality basic/elementary education for its youngsters. There are synergy benefits to be realized from close co-operation in education between the two countries.

Helsinki, August 29, 2016

http://finland.usembassy.gov/root/pdfs/015_040tt8393.pdf

http://www.economist.com/blogs/easternapproaches/2011/12/finland-and-american-intelligence

 

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The Joy of Being Wise

joyconnolyJoy Connolly,1 a Professor of Classics and the Dean for Humanities at New York University, has been appointed as the Provost of the Graduate Center of the City University of New York. As the Dean for the Humanities at New York University, Professor Connolly was responsible for about 400 faculty in 30 departments, programs, centers, and institutes. Her primary research interests include Roman republicanism, rhetoric, civic discourse, classical reception, and the role that aesthetic experience plays in the formation of political judgments.

With immense pride and excitement, we welcome Professor Joy Connolly to Graduate Center and to the City University of New York.

The City University of New York (CUNY)

The City University of New York, or CUNY as it is popularly known, is the largest urban university in the United States. CUNY is an integrated system of senior and community colleges, graduate and professional schools, research centers, institutes and consortia. The City University of New York receives funding from New York State and the City of New York. Presently, the CUNY network of colleges and schools provides high-quality, accessible education for more than 274,357 degree seeking students at 24 campuses across New York City.

CUNY faculty includes recipients of the Nobel Prize, the Pulitzer Prize, the National Humanities Medal, the National Medal of Science, the National Endowment for the Humanities, the Rockefeller Fellowship, the Schock Prize, the Bancroft Prize, the Wolf Prize, Grammy Awards, the George Jean Nathan Award for Dramatic Criticism, Guggenheim Fellowships, the New York City Mayor’s Award for Excellence in Science and Technology, the Presidential Early Career Awards for Scientists and Engineers, and memberships in the American Academy of Arts and Sciences and the National Academy of Sciences. For example, Paul Krugman, the Nobel Laureate in Economics, is a Distinguished Professor of Economics at the Graduate Center of CUNY. Professor Krugman was awarded the Nobel Memorial Prize in Economic Sciences for his contributions to New Trade Theory and New Economic Geography.

CUNY alumni includes an awe-inspiring list of individuals. Some prominent examples include Colin Powell (Former Secretary of State), Barbara Boxer (U.S. Senator from California), Max Kupferberg (Manhattan Project physicist), Ray Romano (TV actor and comedian), Joy Behar (comedian and writer), and Matthew Goldstein (Former Chancellor of CUNY). Refer to the website below for a comprehensive list of CUNY alumni.

http://www2.cuny.edu/alumni/fields-of-excellence/education/

Graduate Center, the City University of New York

Residing within the City University of New York (CUNY), the Graduate Center (GC) is an advanced teaching and research center. With over 35 doctoral and master’s programs of the highest caliber, and 20 research centers, institutes, and initiatives, the GC benefits from highly ambitious and diverse students and alumni. Through its public programs, the GC enhances New York City’s intellectual and cultural life. A distinct advantage for the Graduate Center is that it can draw upon its more than 1,700 faculty from across the CUNY college-campuses and scientific institutions dispersed throughout New York City.

Devoted exclusively to graduate education, the Graduate Center provides rigorous academic training in the humanities, sciences, and social sciences. GC remains the principal doctoral-granting institution of the CUNY system. As of June 2013, the CUNY PhD in Business is offered jointly by the Graduate Center and Baruch College.

Baruch College, the City University of New York

If you want a business degree, graduate or undergraduate, you must walk about 10 blocks south and head for the CUNY’s crown jewel, or its Kohinoor, Baruch College. Baruch College has about 18,000 students with around 80% majoring in business, which makes Baruch College the largest business school in the U.S.

With a legislatively mandated mission, the CUNY education system acts “as a vehicle for the upward mobility of the disadvantaged in the City of New York … ensuring equal access and opportunity.. to students, faculty and staff  from all ethnic and racial groups.” 

In spirit, the CUNY education-system embodies the much revered Finnish education system!

 Helsinki, August 17, 2016.

 1Irish meaning of the name Connolly is wise or brave.

 

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A Sach of Gold for the Common Man

gs_logoArguably the best financial company in the world, for almost 150 years, Goldman Sachs has served the financial needs of wealthy individuals, corporations and rich sovereign nations. Their business activities include investment banking, serving the financial needs of institutional clients, investing and lending, and wealth management. Because of their ability to attract top talent and pay handsome compensation, their payroll includes the best and the brightest talents that money can buy.

Goldman’s clients include high-net-worth individuals, families, foundations and endowments. What is the Gold standard for a high-net-worth client? Let us start with any positive number followed by a minimum of 7 or 8 zeros. Six zeros may be too modest an amount to get the attention of the Wall Street luminary. What remains indisputable is that Goldman’s business interests do not hinge around a “commoner” with modest income.

Low and behold, the company has decided to rebrand its uppity image. The financial behemoth is now in the online savings-banking business and eager to attract savings deposits as meager as $1. A cataclysmic metamorphosis.

Avant-Garde Acquisition

Recently, Goldman Sachs acquired GE’s internet-banking subsidiary with a total of $16 billion in retail deposits to get a foothold into the online banking business. The company’s online banking business called ‘GS Bank’ is keen to attract even more deposits by offering generous interest rates regardless of the amount deposited.

Online versus Traditional Banking

Traditional banks require an average of above $4,000 in average daily balance for not charging any monthly maintenance fee. Also, a checking or savings account typically pays between 0 and 0.1% in annual interest rate. The benefit is that the deposits are insured up to $250,000 by FDIC regardless of the financial health of the bank, which is intended to avoid a bank run. However, depositors pay a steep price for the benefits of a traditional bank. Customers are slapped with all types of fees/charges and the interest rates on the deposits are measly.

The online banking has changed the thrifty culture of the traditional banks. Normally, online banks do not require a minimum deposit (e.g., CapitalOne 360, Discover bank). Some online banks offer free checking facilities. More importantly, as any traditional bank, the online deposits are also insured up to $250,000 assuming that the online bank is registered with the FDIC (the online page will indicate whether it is the case). Because online banks do not operate physical locations, they do not incur the high costs of managing a network of branches. Consequently, online banks can pass on some of their cost savings to depositors in the form of higher rates.

GS Bank is offering annual interest of 1.05% for all deposits without any minimum balance and time restrictions. CDs are paying around 1.20% for one year term deposits. Compared with borrowing on the bond market, however, it is cheap.

Benefits to Goldman from Online Banking

To finance its investments, Goldman Sachs must borrow from the bond market. The interest rates in the bond market are much higher (between 3% and 4%). Therefore, assuming a constant rate of return on their investments, there is a 2%-3% spread from acquiring funds at a cheaper rate.

Based on its 2015 annual reports (FORM 10-K), Goldman has $97.519 billion in deposits. Additionally, it has 42.787 billion in short term borrowings. If Goldman can replace all of its short term loans with online banking deposits, an extreme case scenario, the annual interest cost savings generated would be around $1.3 billion. Assuming that the savings are in perpetuity, the present value of the cost savings using modest discount rates is around $13 billion. Because presently there are 426.4 million shares outstanding, the potential cost savings alone could generate a pop in the stock price by $30.

As a common Man, are you ready to invest in a Sach of Gold?

Helsinki, Finland, August 5, 2016.

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Academics and Central Banks

raghuram_rajan--621x414A central bank is a public institution charged with managing a country’s monetary policy and regulating member banks. The main objective of a central bank is price stability. By statute, many countries also require their central banks to support full employment. Governments often appoint influential academics as the Chair/Governor of the Central Bank. Ben Bernanke, Professor at Princeton University, served as the Chair of the Federal Reserve, the Central Bank in the U.S., from 2006 to 2014. Stanley Fisher, a prominent macro-economist from MIT, served as the Governor of the Bank of Israel from 2005 to 2013. An academic staff at Trinity College Dublin, Philip Lane was appointed the Governor of the Central Bank of Ireland in 2015.

In 2013, India’s then Prime Minister, Dr. Manmohan Singh, invited Raghuram Rajan, a high profile financial economist and a Professor at the Chicago Booth School of Business, to become the Governor of the Reserve Bank of India for a three-year term. When Dr. Rajan took over the reins of India’s monetary policy, India was grappling with high consumer price inflation, industrial slowdown, a free falling rupee, and a widening current account deficit.

Key achievements

During his short tenure span of three-years, Dr. Rajan is credited to have

  • Strengthened the Indian currency.
  • Boosted investor sentiments.
  • Contained the current account deficit from around 5% to around 1.9% by levying added import duty on gold.
  • Reduced inflation to 8% from 11%.
  • Established the “Joint Lenders Forum” to foster greater coordination among bankers and discuss every loan decision above Rs. 5 Crore in forum so that bad loans can be prevented.
  • Forced the recognition of non-performing loans (bad loans).

Non-Performing Loans

Mr. Rajan’s priority was to purge the banking system of bad loans by forcing banks to remove non-performing loans from their balance sheet. The de-recognition of bad loads forebodes bad news for banks because they would need to recapitalize the balance sheet if their equity cushion fell below the mandated levels. Moreover, banks would be forced to call out the bad players.

In country that wants to open up the economy, India has 27 government-controlled banks which account for 70% of the country’s banking assets. Much of the bad bank loans are confined to India’s state-owned banks. According to the Economist, nearly 17% of all loans need to be written off. Therefore, the problems of bad loans are quire severe.

Colliding Politics and Personalities

The Modi government, which came to power with a huge mandate in 2014, has had major disagreements with Dr. Rajan’s economic policies. The current government is more ‘dovish’ and prefers a low interest rate environment to spur domestic investments while electing to ignore the risk of higher inflation from pursing an aggressive monetary policy. In contrast, Mr. Rajan was more ‘hawkish’ on inflation and, as a result, he was more focused on controlling inflation by keeping the interest rates high even at the cost of choking potential investments. Also, the Central Bank’s aggressive policy to recognize bad loans may have contributed to the disagreement between the government and the governor of central bank.

The current BJP party is led by a charismatic leader who is predisposed to governing with an iron hand. The top gun of India’s Central Bank was also a high-powered intellectual, a renowned economist, and a man with strong economic convictions. Fireworks are inevitable!

The Outcome

After some modest ideological confrontations with the BJP party, Dr. Rajan abruptly decided to step down as the Governor of the Reserve Bank of India and not seek a second term. CNBC deems Mr. Rajan as the world’s best central banker because of his commitment to structural reforms and because of his ability to stabilize prices and exchange rate during his short term. Did he deliver? The market believes so!

Unfortunately, India is the big loser in this Bollywood-style drama. The country is deprived of the services of a financial superstar who could have guarded financial markets and helped the Indian government pursue pro-market reforms.

Helsinki, July 25, 3.36P

http://www.economist.com/news/leaders/21699911-proposed-reforms-indias-financial-system-are-welcome-insufficient-banks-and-bureaucrats

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Tryst with Transylvania

transylvaniaSituated in central Romania and surrounded by the Carpathian mountain chain, Transylvania or the “land beyond the forest” is easily one of Europe’s best-preserved medieval towns. Bram Stoker’s 1897 vampire novel was inspired by Vlad Dracula, a 15th-century Wallachian nobleman who lived in a castle close to Brasov (a town south-east of Transylvania). According to some estimates, Transylvania has about 100 castles and fortresses and about 70 fortified churches.

Some travelers describe Transylvania as ‘the last truly medieval landscape in Europe,’ which seems quite accurate. Hergé, the creator of Tintin, might have had Transylvania in mind when he wrote ‘King Ottokar’s Sceptre’! Some of the more prominent Saxon regions in Transylvania including Sighișoara, Biertan, and Viscri are deemed as Unesco World Heritage Sites.

Brief History

Because of Transylvania’s colossal natural beauty, the region was coveted and acquired many times over by various empires and kingdoms. The region was an integral part of the Kingdom of Hungary between 950-1526. Subsequently, it became an independent Principality (1526-1690) before being reabsorbed by the Habsburg Empire. It was united with Wallachia and Moldovia to form what we know as Romania today after the Austro-Hungarian Empire was dissolved in the Treaty of Triannon. After World War I, Transylvania became part of Greater Romania.

The region was dominated by Wallachians, Moldovans, Hungarians, Germans, Romas, Jews, and Armenians. Because of the diversity in racial composition, Transylvania’s history is marked by turbulent periods. The cultural differences within Transylvania are stark. According to experts, the South is dominated by a Saxon culture, the East and North East characterized by a Hungarian culture, the North is more Slavic.

Traditional Cuisine

Transylvania’s cuisine is heavily influenced by German, Greek, and Turkish cultures. The key condiments include thyme, red pepper, tarragon and some regions specific wonders like leuștean and cimbru. The staple ingredient is built around lamb, beef, chicken or pork.

All meals traditionally begin with a soup or ciorbă which has many variations including beef, egg yolk, flour dumplings, homemade pasta, or regional vegetables. One national treasure is ciorbă de burtă or a soup made of a cow’s stomach. Soups are traditionally served with a red or green pepper on the side to spice up the palate. As a leading producer of cabbage (varza), it is not surprising to find variations of cabbage cooked in slow heat with various types of animal protein. The most popular side dish is mămăligă – polenta served with a dollop of fresh smântână (sour cream).

Some of the popular main courses include sarmale (cabbage rolls stuffed with spiced pork and rice), Tochitură (pork and beef stew cooked in spicy tomato or wine sauce) served with fried egg yolk. The most popular grill food is a distinctive form of sausage called mici (grilled rolls of minced pork, beef and lamb). What distinguishes a mici from other types of sausages is the absence of any sheath around the meat.

The dessert menu includes strudels and cakes, clătite, (crepes filled with chocolate or fresh fruit) and the simply divine papanaşi or a fried dough sweetened with cream cheese or jam (a sweet beignet). Food is typically served with wine, which is less than mediocre (the natives beg to disagree), beer, which is of high quality, or ţuică (plum-based snap liqueur sure to give you a hangover).

Beware, the culinary experience in Transylvania is expected to increase the chances of a heart attack. But then who cares about the efficacy of arteries pumping blood into the heart when one has a date with ‘Ambrosia’ and divine food.

Noroc (cheers)!

Brasov, July 11, 2016, 1.45P

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Can Migration Explain Britain’s Decision to Exit EU?

BrexitNearly 52% of British citizens (17.4 million) voted in the ‘referendum’ on Thursday to exit the European Union. The outcome is startling because, from all accounts, the economic cost to Britain in the short- and long-term is expected to be staggeringly high. In less than 3 days, the global financial markets lost more than $3 trillion. During this period, the FTSE lost more than 100 billion pounds. The British pound, which was trading at an exchange rate of around $1.7 about a year ago is trading today at around $1.35.

The worst may not be over. Many sophisticated analysts believe that the pound could fall to as low as $1.10 within a year and it is projected that the U.K economy might hit a recession with a precipitous decline in property prices.

Why did the majority of the voting electorate elect to exit the EU and embrace large economic costs? One common explanation is linked to the sustained inflow of migrants from other EU countries.

Migration Statistics

Statistics disproves this theory. In 2015, the inflow of foreign nationals into Great Britain was 630,000. The increase in foreign population in 2015 as a percentage of Britain’s population, which is around 65 million, is less than 0.01%. Most economists would consider such an increase as a rounding error.

Between 1990 and 2015, Britain’s population grew from 57 million to 65 million, which translates into a modest increase of less than 1% per annum. Again, this small magnitude of the inflow of foreign nationals into Britain is unlikely to drum up mass hysteria among British citizens. Granted, the politicians have exploited the foreign migration issue to harness their individual political careers. However, the migration numbers from the census bureau do not support the casual observation that migration is a key factor driving the British anger.

If the scale of ‘legal’ migration fails to provide a compelling narrative why the majority of British nationals, principally the English, chose to exit the EU, there must be other persuasive economic explanations why 17 million rational British individuals didn’t hesitate to marry into an economic uncertainty.

Factor Price Equalization Theory

The Nobel Laureate in economics, Paul Samuelson, wrote his theory of “factory price equalization” in 1948. His theory might provide deeper insights into Britain’s current dilemma.

The Theory: According to factor price equalization theory, the prices of identical factors of production (typically labor and capital) will be equalized across countries as a result of international trade in commodities. Thus, when two countries have a free trade agreement, even without free mobility of labor, any differential in wage rate (price of labor) and rent of capital (interest rate) between two trading countries is expected to slowly dissipate. With the advent of free mobility of labor, as in the case of EU-Shengen countries, the factor price equalization process converges rapidly.  

Wage Disparity

Anecdotal evidence suggests that much of the migration of EU nationals into the U.K. has been mostly from Eastern Europe, which is typically identified as having depressed wages. For instance, according to World Bank statistics, the average monthly wage rate of Poland is €430, for the Baltic States (Lithuania, Latvia and Estonia) it is €380, for Hungary it is €358, for Romania it is €279, and for Bulgaria it is €215. For some Western European countries like Spain and Portugal the wage rates are also quite low (around €600).

In sharp contrast, the average monthly wage rate of Great Britain is around €1,550. Thus, the average wage rate of U.K is about 3 to 5 times larger than the wages of the migrant countries.

Economic Outcomes

  • Negative outcomes
  1. Wages in the host country are expected to decline as new migrants from lower wage-rate countries provide their services at a lower price in the U.K. The influx of competition injects considerable downward pressure on the wage rate of the host country. Unfortunately, U.K. workers must bear the brunt of this cost. In the absence of any barriers to entry in the labor market, i.e., specialized degrees or technical skills, wages of the host country will decline. Typically, “blue collar” workers who do not have a comparative advantage are most affected by migration. In contrast, “white collar” workers remain unaffected because migration does not affect competition in this sector.  
  2. Depending on sector specific labor migration, the abundance of labor force will also lead to some loss of jobs. Again, the job loss is expected to be confined to the blue collar working class because of fierce competition and limited growth opportunities in this sector.

The combination of job losses and a decline in wages gives rise to public discontent, anger, and resentment. This resentment is likely to be confined to working class. This is a strategic reason why the voting pattern in the referendum can be explained by the level, or lack, of education. The more affluent people or the more educated people would vote against an exit while those with lower levels of education or having less financial security would vote in favor or an exit.

  • Positive outcomes

Economists often underscore the gigantic economic benefits of migration. Yes, wages/rates decline with migration but it spurs investment, which in turn leads to more jobs. Consumers always benefit from migration and trade because of lower prices.

The Politics of Winner and Losers

A fundamental human natural law is that there are winners and losers in any society. An optimal and emancipated society aspires to minimize the number of losers while maximizing the number of winners. Judging from the referendum, a disproportionally small segment of the U.K population appropriated much of the gains from being part of the European Union, while a large segment of the population lost because of the union.

The U.K experience is a reminder that gains from trade, or common markets, must accrue to all strata of society. Otherwise, there will be social unrest or perverse outcomes that are to the detriment of the country’s long term economic welfare.

Migration issue is a sensitive topic in the U.S. as well where the discussion centers around illegal immigration. Whether the benefits of migration accrue to the majority of the citizens of the host country will decide whether ultimately host countries become more welcoming towards migration (illegal or legal).

At the end of the day, we are all migrants. Some migrated recently, while others migrated a while back.

Helsinki, July 1, 2016; 9.59P

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