OBAMANOMICS

OBAMANOMICS 101: REFRESHER COURSE

2010-08-07T03:32:00.000-07:00

Political change is about shifts in voter opinion of the so-called 'floating voters'. In most of the USA in 2008, the Democrats gained such shifts, but not everywhere. Whether the White House will have a majority on 'the Hill' (both houses: Senate and Congress) after November is on a knife-edge of 'economic recovery' and voter confidence about how recovery is being managed by government.
The shifts that gained the White House for the Democrats looked very considerable, but in troubled stressful times voter opinion may be fickle, and perhaps not helped by 'no holds barred' decision of the Supreme Court over corporate spending on politicians! The outcome of the November election of legislators is probably as dependent on the performance of the domestic economy as at any time in USA history.Three months in the Obama presidency approval rating was high among Republican voters and not just among Democrats on key issues. Obama's rating then fell from over 60% to just over 40% - to some extent due to gathering anxieties about the economy as jobs were lost, also coloured by Main Street protest in an election year (Congress and Senate Mid-terms in November), and in part reflecting unemployment variance state by state, even county by county, as well as by economic class among registered voters.
The stimulus package/s are substantial but their effectiveness is interpreted as short term boost with a long tail work-through effect by which time when the benefits are becoming tangible they will coincide with wind-down of fiscal stimulus and thereby lose some edge. Like debates everywhere the issues concern how long should fiscal efforts to boost recovery continue befoe the private sector takes over?
Electioneering brings out ideological extreme views to sharply distinguish the two major parties. Post-cold war notwithstanding war in Afghanistan, and the continuing anger with banks and Wall Street, politicians inevitably seek to demonise domestic economy issues. It is traditional to fan the flames of anxiety about the national debt, and in so doing ignore its economic benefits and its actual affordability (most of it domestically owned and a third by owned by government and government controlled agencies).
Purchases of bonds issued by government-sponsored enterprises plus Treasuries swelled the Fed’s balance sheet from $900bn two years ago to $2,350bn today. The Fed’s buying of government agency paper has stabilised the market but selling soon might cause a price shock. Paring the amounts by repaying accruing principal and interest to the US Treasury seems more prudent (about $250bn a year). A very brave decision would be to cancel or recycle a lot of the national debt owned in government accounts and to recognise formally the amount of that debt which banks and other financial institutions must hold to invest pensions and insurance funds in and to improve the quality of the finance sector's capital reserves.
The Congressional Budget Office has a long history of ignoring the tax revenue feedback from deficit spending and thereby producing exaggerated forecasts of federal Debt.The USA has been, and will continue mainly to be, a credit-boom economy with a large trade deficit. This is maintained by a high proportion of bank lending to property, especially mortgage lending. Property exposure accounts for about70% of US domestic bank lending. Therefore, stimulating the housing sector has short term importance in restoring home-owner confidence, to lessen home-owner negative equity and mortgage defaults, to help restore banks' collateral and asset values, limit construction sector unemployment, and improve household credit and consumer spending generally. The American Recovery and Reinvestment Act, with a $700bn to $1,000bn gross spend ($500bn-$700bn net spend) has 40% going to small business and personal tax breaks, $77bn for unemployment benefits, and $400bn-$600bn remainder to maintain government consumption spending when tax revenues are down by 6% or more? Much depends on the multiplier feedback benefits of the fiscal boost.One of the criticisms of bank bail-outs is that funds given directly to support banks is into the wrong end of the economic food-chain - the mistake that Japan made following its 1989 asset bubble collapse that left most of its retail banking insolvent and that triggered low growth for most of two decades. The Japan government cut infrastructure spending and inflated the national debt to compensate banks directly for their loan loss provisions. While those loans were repaid government continued with deficits because consumers retrenched being forced to by multi-generational mortgages and low employment growth in domestic services.The above pictures are what the USA wishes to avoid, and China is afraid of similar happening to it in the next decades when its asset bubbles burst.
The Obama administration, with its economists led by Larry Summers, recognised that tax cuts for the wealthy and big business (the Bush response to the 2001 recession) resulted in a 'jobless recovery', relatively-speaking. This time the stimulus would be to 'middle America', to 'hard-working families', to 'blue-collar' as well as 'white-collar' and very much to small firms. But banks lend only 10% of customer loans to small firms despite these employing more than a third of all jobs in the whole economy. And, lending to business has shrunk by a third. Small firms are not an economy onto themselves however; they rely on the activity of large firms and on housing, construction, government and consumer spending. Everyone agrees that productive industry needs a lot of stimulus, especially in producing tradable and exportable goods and services, but how to do this, which means changing the size and stock of firms by sector, is not at all clear in a western democratic system that knows it has to trust the markets to make economic sense for the total economy.Tax breaks and other support to small firms (30 million small firms) helps their survival rates (lower firm death rates than otherwise it is hoped). But recession hits new firm birth rates through banks reluctance to lend and low confidence among start-up entrepreneurs, more than death rates caused by loss of trade credit between firms, late payments and, biggest factor of all, banks calling in loans or refusing to recycle loans and shrinking overdraft facilities - what is collectively called 'stricter credit standards'.
How much of that spending is on proven anti-poverty programmes? Setting aside the discussion on infrastructure and job creation, anti-poverty actions are more "benefits in-kind" rather than money i.e. food stamps, housing subsidies, and Medicaid. There is a cultural moralising presumption with a very long history, one that infects most Western aid to poor countries too, which is that the poor should be helped to benefit themselves and not given money directly except when absolutely necessary. 'The Projects' in the USA can be appallingly destitute places as all know, but whether anti-poverty actions will boost the economy short term or significantly in ways that feed through to the rest of the economy is a politically highly-charged set of questions. The data below is pre-credit crunch and pre-recession and must today be substantially worse.One extreme example of moral parsimony is the well-worn idea that all food-stamp, unemployment benefit and housing benefits to the poor living in 'the hoods', the slums, leaks out $ for $ in payments for illegal drugs, the 10% black 'black economy' etc. This is quite untrue, but a popular prejudice, like many among the better-off who need excuses for not being more charitable. The medicaid medicare debate over health insurance reform brought out many of the political issues but they were shunted into financial questions of budget deficits and national debt with the worst case scenarios absurdly produced by the Congressional Budget Office and believed despite caveats to say that the data is hypothetical and not to be relied upon.
The short social-democratic answer associated with European welfare states is to say "if the rich are not taxed to give money to the poor the rich will soon become a lot poorer because they can no longer trade profitably with the poor" but that is all about where money should be recycled into the economy's 'food chain' - at the top for 'trickle downwards' or at the bottom for 'sluicing upward'?
The question of criminal 'entrepreneurship', black market and prison population comes into this. At not far short of 1% of the population costing several times minimum standard of living cost, and the supposition that sounds like $1 trillion of crime and anti-crime; maybe a $1tn black market economy sector, which is equivalent to half the GDP of California or almost half of that of England?
Justice & Policing spend is about $200bn including state budgets. Cost of crime is estimated by academics at something like $800bn, of which half is considered to be white collar crime not counting up to about $500bn in tax evasion, according to some estimates. Total welfare state spending in food stamps ($75bn, with food stamp rolls growing by 5m people in 2009), medicare, unemployment benefit, totalling about $700bn, but with payments going to about one third (100m) of the total population including people with incomes at double the poverty minimum etc. is actually higher relative to the size of the economy in the USA than in many EU countries because poverty is a higher % of the population.
Total US welfare spending is about $1,600bn. More than one third of that returns to Treasury in taxes within a year.
Illicit drug spending is estimated by the UN at $240bn worldwide (other estimates of street value are $320bn-$400bn) with a quarter in the USA ($60bn-100bn). Ten years ago, US estimates were $36bn cocaine, $10bn heroin, $5.4bn methamphetamine, $11bn marijuana, and $2.4bn other substances (total $65bn). Perhaps it is $80bn today, but only 10-20% of that among the welfare-assisted poor?
However you look at this, it would be absurd to imagine that what welfare spends on helping poor people is matched or exceeded by spending on drugs, or in supporting crime? Officially about 1.5% (5m) of the total US population are in abject poverty, and 15% (40m) living on or below the poverty line.
In most countries the poor are the 'bottom' 20%, for a wide range of reasons. 10% (30m) are handicapped of which only half (15m) or less have jobs. Nationwide, 37m people, including 13m children, live below the official poverty line of $9,643 for one person and $19,311 for a family of four. Nearly one in five U.S. children is poor (meaning that they are a member of a poor family or no family?) .
One of the problems with anti-poverty policy is that the bulk of it is administered by the states, meaning the states set their own criteria and spend within balanced budget requirements, and most are currently 'under-water' financially. This leads to cuts to social programmes and the disparities between generous states like NY and punitive states like Louisiana.
In respect of unemployment benefits and "aid to states" figures, it seems $80bn-$100bn of the Obama stimulus will go to states for Medicaid coverage, not enough to compensate for cuts in most places, but it softens the blow for low-income households relying on state-healthcare. Food stamp use is at record high, yet there's no formal line item for food stamp provision in the stimulus plan. The presumption is that state aid covers food stamp programmes, in addition to job training programmes and infrastructure investments.
There is no evidence of Federal distribution being party-politically biased. Another important issue is states' rental assistance to households, for low-income, unemployed, and those at risk of foreclosure. Many progressives outlets and non-profit anti-poverty advocates want more spending on food stamps, rental assistance, and Medicaid coverage. The reality is that the number of Americans living in severe poverty - on less than $5,000 per annum for individuals or less than $10,000 for families rose 24% under Bush and must have remained high or even crept up in 2009 with rising jobless. It is doubted whether Congress will manage to push through an extension of benefits to part-time (underpaid) workers.
In the UK a counter-intuitive argument is developing within government that unemployment benefits need to rise (pensions and other welfare provision too) to force up wages and thereby improve the impetus to find a job rather than the previously prevailing view that sub-minimum benefits will force the jobless to seek employment, which seems to have failed as an intuitive concept.
The UK policy is often led by US examples where by international OECD standards welfare is minimal. It remains to be seen if such a gear-change is remotely possible in the USA?
Much depends on how the economy is boosted in relation to income distribution, which is not the same as wealth distribution, but the latter is sufficiently stark to make the point. Funding social programs beyond unemployment insurance is critical. The economic returns to food stamps compared to unemployment insurance and tax breaks need examination. The economy is not a homogeneous sponge, but it is highly interconnected in all directions including external trade and money flows. The logical argument is to say that as money flows inevitably towards the richest segments then the maximum multiplier effects, the widest benefits, are achieved by boosting the income and spending power of the poorest in the economy.
Robert Reich, Professor of Labor at Berkeley, defines the deficit hawks (cut sooner not later) as Herbert Hoover's disciples. The 2001 recession was responded to by the Bush administration with tax cuts for the richest.
President Obama, in a speech to the A.F.L.-C.I.O. executive committee, alluded to the issue in reviewing his administration’s efforts to emerge from what he called “the hole” Republicans dug in the Bush years. Advisers said he would engage more fully when Congress turns to the issue.
Now, Tim Geithner, Treasury Sec. has told New York Times all the Bush tax cuts will expire as scheduled. His reason: the nation's looming deficit requires it. "Permanently extending the tax cuts for the top 2% would require us to borrow $700bn more in the next decade, adding significantly to an already unsustainable level of debt,” Mr. Geithner said in remarks at an event jointly hosted by the Center for American Progress, a Democratic-leaning research and advocacy organization, and the American Action Forum, a Republican-oriented group.
Mr. Geithner described the Obama fiscal policies as seeking to balance short-term stimulus measures with moves toward long-term deficit reduction, calling this “pro-growth” — which used to be the Republicans’ favorite adjective for tax-cutting!
Former Treasury Secretary Robert Rubin, Reich's colleague for a time in the Clinton administration, appearing on CNN, says any further effort to stimulate the economy is "counter productive," and that policy makers instead should craft a deficit-reduction plan.
Reich is caustic about Rubin's view. He says the Bush tax cuts should expire for the top 2% (those earning over $250,000) because they save more than they spend, "and we need all the spending we can get. The cuts should be extended for everyone else because they'll spend them". The top 2% own a quarter of total national income i.e. the middle classes alone do not have sufficient purchasing power to lift the economy. Reich says "The best way to give them even more purchasing power would be to give the middle class a larger tax cut -- say, a payroll tax holiday on the first $20,000 of income." and that "Rubin is entirely wrong... the gap between total private spending (consumers plus business plus net exports), on the one side, and the nation's capacity to produce goods and services at or near full employment, on the other, is still a chasm. So government needs to do more spending now, in the short term, in order to get people back to work and the economy back on track."
In 1999, both Greenspan and Rubin, who were at the time said to be joined at the hip, urged Congress to repeal the Glass-Steagall Act that had separated commercial from investment banking since 1933. In 2000, they argued against allowing the Commodity Futures Trading Corporation to regulate derivatives. Until recently, Rubin ran the executive committee at Citigroup, where it was clear he had n problem with excessive risk taking and encouraged it. In 2001, Greenspan supported the Bush tax cuts that blew a gigantic hole in the federal deficit to mostly benefit the wealthiest. In 2002, Greenspan lowered interest rates to near zero but refused to oversee how banks were using their almost-free borrowings.
Reich says both Greenspan and Rubin are deficit hawks, like Herbert Hoover, and Hoover's Treasury Secretary Andrew Mellon. And look what Hoover and Mellon caused. Reich says "when we least need him, Hoover is being exhumed".

Citigroup Disposals and Regulation lessons: A question of Time.

2010-08-06T03:16:00.000-07:00

You will remember that in December 2007, Vikram Pandit became the new CEO of Citigroup, replacing interim-CEO Sir Winfried Bischoff, who became chairman of the board as well as remaining CEO of Citigroup Europe before becoming Chairman of Lloyds Banking Group. Pandit succeeded Charles 'Chuck' Prince who resigned in November 2007 due to that year's poor performance due to CDO- and MBS-related writedown losses. By 2007, it was not totally clear that Citicorp's performance was unsurprising. It had suffered and survived other shocks.Prince was named by Fortune magazine as one of eight economic leaders "who didn't [see] the crisis coming", noting his overly optimistic statements in July 2007. Other journalists identified him as one of twenty five people who were at the heart of the financial meltdown. Before Prince left he started some retrenchment. It was Citicorp than by making margin calls on Bear Stearns that propelled Bear into crisis. In early 2007 Citi began eliminating about 5% of its quarter million global workforce, to cut costs (a year later more job losses and a year after that as much as a quarter of jobs would be in plan to go). Prince resigned in November 2007. When the bank warned it may write off $11bn of subprime mortgage loss (out of $55bn exposure) on top of a $6.5bn write-down the preceding quarter.
The factors that led to the housing mortgage and price boom and the 20% or so of 'sub-prime' mortgage lending were various. It was the job of banks to see through the 'smoke 'n mirrors' and assess the fundamental realities. The delegation of a lengthening food chain that supplied mortgages and the risk packaging that appeared to disperse the risks blinded almost everyone as much by their 'I'm only a cog in the bigger machine' type thinking.There has been blame heaped on regulations, regulators and central banks. But it is not their job to order decisions that the boards of banks only had responsibility and authority to do on behalf of shareholders. Authorities can only be blamed if they withheld big picture information from the banks that if revealed would have triggered better decisions earlier. The balance of argument should be that the information was made public; it was out there for those with the eyes to see it. Bankers are mortal and like salesmen anywhere they can be chumps for their own sales patter and that of others.
If the property price fall and mortgage default linked to a follow-on recession was the only problem, then no problem; banks are experienced, and capital equipped to take that in their stride over the medium term. What made the crisis worse was the scale of structured products and derivatives that had built on top of this fast-growing mortgage business that had crowded-out other bank lending to industry and which postponed the onset of recession making it worse than would have happened if securitised loanbooks had not played such a large role in financing the USA's external trade deficit.
Arguably, however, that was a great boon to emerging markets of long term benefit to the world economy. When the property market turned south in mid-2005 and banks took little action before the end of 2006, it was already too late to avoid the Credit Crunch. It was especially too late as banks had responded to underlying business weakness and the last gasps of competitive market-share grabbing by upping their funding gap financing and making themselves vulnerable to a large chunk of the liabilities side of their balance sheets suddenly unsticking and not returning. When prince resigned the length and depth of the crisis was becoming apparent only over the previous 4 months as ratings agencies downgraded more and more collateralized mortgages. What market players forgot however is that the liquidity and collateral supporting credit risks is not what ratings agencies rate; they only rate the gross credit risk in the underlying loans, and not market prices of the bonds. The structuring of these bonds made them vulnerable to threshold triggers and insurers and standby liquidity providers took fright, panicked. Investors could not see who was liable to whom, the whole had become hopelessly tangled spaghetti, and certainly far beyond the central banks to unravel, not least because these were over-the-counter deals without a secondary market or an exchange or clearing house. The only Cassandras were a bunch of economists using the Levy Economics Institute Model that at that time no one else paid any attention to.What anyone could also have seen, however, was the unsustainable share of corporate profits in the USA taken by the finance sector, growing to an unsustainable 45% of the total. Bankers even today do not appreciate how untenable and absurd that was, and how their bonus levels established in those years can never be returned to, at least not for nearly as many 'rainmakers' as before, at best only for very few. Similarly, fees and margins on lending have to narrow. Banks should not return to the rich seams of earnings relative to the 'real economy' as before the crisis. But that is a question like weaning addicts off heroin or methadone in a rehab.When Prince saw the game was up for him, former U.S. Treasury Secretary, Robert Rubin, no stranger to the bonus culture, who had chaired Citigroup's executive committee, but who had also had a role in pushing structured product investments that were the bank's downfall, was named chairman, while Sir Win Bischoff, head of Citigroup's European operations, was named acting chief executive. Prince's memo to staff said, "I am responsible for the conduct of our businesses. The size of these charges makes stepping down the only honorable course for me to take as chief executive officer. This is what I advised the board." Getting out was honourable and his package reflected that, but the speedy exit was probably not unconnected to CEO Stan O'Neal's ousting 5 days earlier at Merrill Lynch & Co following a $8.4bn write-down that was more than 50% higher than forecast. It was a long haul ahead before the bank could sight dry land. At the time, it was thought capital levels needed supplementing and that could be achieved by June 2008, partly by a 54c lower dividend. All banks were losing credibility. They were incapable of getting together collectively to help each other and the only safe harbour was government support. By Nov.'08, the crisis hit Citigroup hard again despite TARP bailout money and Citi made further cuts. Its worst stock value hit was in March '09 the month that many claim was the final nadir of the Credit Crunch. Its stock market value dropped far below book value to $6bn down from $244bn in '06! It is now back up to $119bn and "hair-shirt" Pandit is safe, a story that Eric Daniels at LBG (also with Bischoff's oversight) is emulating in many respects (except the hair-shirt).
Whoever is in charge of our banks has to navigate through choppy waters around a lot of rocky outcrops and submerged reefs. What happened to Citi - its timeline lessons?
Early in '08, Citigroup was on the floor for the count, winded by subprime mortgage financing. Since mid-'07 to mid-'08, Citi lost $17.4bn from over $58bn write-downs apart from increased funding costs hitting net interest income. Citi's credit derivatives was its Damocles Sword, a $3.6tn portfolio, 2nd-biggest CDO player.
From Aug.'08, it revamped its capital markets within the investment banking division. It raised $2.92bn by selling three-year samurai bonds in Japanese market in Sept.'08, which as a sum was not confidence-building, but the opposite. To enhance liquidity, a group of ten US banks unveiled a $70bn collateralized borrowing facility just as Lehman Brothers Holdings Inc. filed for bankruptcy protection and Merrill Lynch offered itself to be acquired by Bank of America followed by Citi failing to buy Wachovia cheap for $2.1bn in stock (+ $53bn in Wachovia debt, facilitated by FDIC, the Fed, Treasury and The White House) just as too Congress was debating and voting the TARP $700bn rescue plan to buy retail mortgage securities and with $250bn to buy stock in major banks.
The deal collapsed when Wells Fargo bought Wachovia for $15.1bn in a stock-for-stock deal. Citigroup shares lost $2.99 and traded at $19.51 and it resorted to litigation. These issues would have informed the echoing deal in the UK where Lloyds TSB bought HBoS. In consultation with Federal Reserve, agreed for a litigation standstill after which Citigroup decided not to continue its legal challenge and the stock was further battered down to $11.67 (market cap. now below $70bn).
Citi soon reported another bleak quarterly performance (3Q '08 net loss of $2.82bn or $0.60 per share, compared to $2.21bn profit or $0.44 per share in the same quarter a year earlier). By early Nov.'08, the stock was at its lowest level since May '96 at $9.64. In Oct.'08, Citigroup decided to exit its wholesale mortgage business and shrink its network of external mortgage brokers to 1,000 from 9,500.
Rumours emerged of Citigroup looking to sell parts of the company or outright sales. Citigroup's shares plunged below $5 (back to 1993 values pre-buying Salomon Smith Barney and Traveller's). Investors were doom-laden about further credit losses and write-downs in '09. That Vikram Pandit survived all this is remarkable. It helped that Saudi Prince Alwaleed bin Talal bin Abdulaziz Al Saud increased his holding back up to 5% and expressed support for management, but Citi shares did not respond positively. The share price continued down as hedge funds were forced to unload holdings to meet requirements of not holding shares trading below $5. The bank announced plans to cut 52,000 jobs and reduce expenses by 20% below peak.
Investors remained gloomy even after the U.S. Treasury's infusion of $25bn from TARP. The bank had posted four consecutive quarterly losses totaling over $20bn (write-downs of bad debts) while rivals JPMorgan Chase & Co. and Bank of America Corp. turned in profits.
It was a blessing for Citigroup that Vikram is so much better looking than 'Chuckie' who had the same Hollywood Casting's bad guy looks as Dick 'Fooled' Fuld. Chuck 'the share' Price did not oversee such a loss of shareholder value as Vikram Pandit, but he looked like he could care less:The bank in its Q1 '09 reported using $45bn of TARP to infuse $36.5bn to boost customer lending. In February, Fitch, whose model must have been oblivious to government support, downgraded Citigroup's individual and preferred ratings to junk, predicting Citigroup would face huge credit losses in a deteriorating economy. One has to severely question the ratings agencies models for ideological bias! The February '09 balance sheet with idea of good bank/ bad bank split: In Feb. '09 Fed Chairman Ben Bernanke said there is no plan to nationalise Citigroup. This followed FDIC advice concerning legal obstacles. Stocks temporarily rebounded. The bank and government made a deal to increase the government's stake. The Treasury's Tim Geithner said big banks that are found to require capital would have 6 months to raise private capital or resort to government funds under TARP, which had onerous conditions that banks were very loathe to accede to such as bonus caps.
Federal supervisors conducted stress-test assessments to evaluate the capital needs of major U.S. banking institutions under a more challenging economic environment for the period to the end of the current budget (Sept.30). Citicorp was severely examined and its shares fell marginally to $2.46.At the end of Feb. before the stress tests, Citi agreed a deal to let the government to exchange up to $25bn fee money from asset swaps for a bigger stake (36% of Citi's outstanding common stock) leaving others 26%. In Q2 '08, Citigroup reported net loss of $2.50bn or $0.54 per share compared to net income of $6.23bn or $1.24 per share in the same quarter of '08. The sock fell further until in March it (alongside other troubled banks on both sides of the Atlantic) bottomed at $1.02.
Chuck Prince had to go as all leaders of major troubled banks have had to go, especially the ugly-looking ones (sorry to emphasise such cosmetic aspects) - CEOs only serve the equivalent of political terms anyway. But Vikram Pandit survived worse news over the coming two years. Could Prince have had the foresight earlier to recognise publicly how much value the bank had at its disposal? Could Pandit have steered a better course and made more positive news in his first 18 months? The fact is that the rubic cube problem of re-aligning a hugely complex bank was beyond anyone's skill in such a short period. The lesson is that big complex financial institutions are businesses that need all of a medium term (1-5 years) to turn around and restructure. Just designing and implementing a new computer system takes 2-3 years!
Legacy assets are long-held or even sleeping assets - including businesses - that have been accumulated by the group over time, but are now considered non-core.
As part of Pandit's plan, Citi intended to return to annual net revenue growth of 10% from core operations, including credit cards, consumer banking, securities, corporate, investment banking, and wealth management. It announced job cuts at start of '08 of 13,200 to be made during 2008.
In May, Pandit, in his biggest positive news, said Citi will sell $400bn of assets (out of $500bn it could sell) within 2-3 years to return to profit. This was not received with all the confidence-building it deserved - why, because the market was deluged with short term profit-takers and stock-shorters - it amazed many who could only see an insolvent bank that should be broken up and sold off to others, or taken into state ownership. More than two years on these $400bn sales are almost complete, and at $118bn the share capital value is back to half of what it was at its peak, which is probably not far below where it should be in normal conditions (my guess: $150bn) and when it gets back to safe & solid normal return banking, Pandit no doubt can take all his forsworn back-pay and feel justified!
Back in the winter of '08/'09 FDIC cautioned The Fed and Treasury that a break-up faced legal obstacles across many foreign jurisdictions (operating in 140 countries, but 40 of materially legal significance) and so that option died. It was this problem more than the example of Lehmans or Fortis that inspired the 'living will' idea that is now core to new global regulations for all large complex financial institutions. New regulations also emphasise liquidity reserves and making it easier to break up and sell off or close down big banks. But the real lessons may be that the complexity of banking is such that time is the necessary healer and this is what most government interventions essentially have done, which is to save banks by buying them time to unravel their book - many banks have been doing what Citi announced earlier than others; selling off non-core operating units and investment assets.
A time-winning formula should probably have been consciously applied to Fortis and Dexia that were broken up by three governments acting in concert, perhaps to HBoS too, and is exactly that which has been applied to RBS and LBG, the Irish banks, and to AIG, Fannie Mae and Freddy Mac?
But, in the Autumn of 2008, in the wake of Lehman Bros. left with no option but to declare bankruptcy, the high drama of 15th Sept.'08 and its immediate aftermath that included AIG's implosion, concentrated authorities on instant decisions (even if some disaster-planning had already been worked on). The dark clouds were worst-case disaster scenarios and therefore decisions necessarily, so it seemed, had to not shirk dramatic solutions; "hard choices", "resolute action to save our financial system" etc., what politicians actually enjoy, being Churchillian, the 'Dunkirk Spirit', followed by the 'Battle of Britain', though arguably in the Credit Crunch the line might be "never in the field of human finance has so much been owed by so few to so many".
But, the reality of the crisis moment caused by Lehmans' collapse, the Credit Crunch's Dunkirk, was that politicians, Treasury, Fed, SEC, and FDIC could not bring themselves to 'save' a bank headed by the ugly visage and arrogant demeanour of Dick Fuld of Lehmans (an investment bank with a turbulent history) should have counselled the idea that perhaps there was too large a dollop of subjective politics involved. Nearly three years on the resolution of Lehmans may be turning a profit.
Citigroup was hit by Sept.'08 but not in direct line of fire and further government help was not hugely embarrassing politically. Government in Nov.'08 took a 36% stake by converting $25bn of fees charged to Citi into common stock. This % holding fell to 27% when Citi subsequently sold $21bn common stock (largest share sale in US history, surpassing Bank of America's $19bn in Oct.'08).Stepping hopefully clear of the Autumn wreckage that included failure to buy Wachovia cheap, in Jan.'09, Citi announced its plan to reshape itself as two operating units: Citicorp for retail & investment banking business, and Citi Holdings for brokerage & asset management, but would continue operating as a single company while Citi Holdings is tasked to seek "value-enhancing disposition and combination opportunities as they emerge", and spin-offs or mergers involving either operating unit were not ruled out. In Feb.'09 Citi announced that government would take a 36% stake by converting state-aid into equity. The bank's shares dropped 40% on the news. It was only now becoming clear that while bank funding had eased in price it remained high and government aid had not yet lanced the boil. The darkest hour, though less noticed by the public, there was one more major pothole on the road to restructured recovery, in March. Government state aid conditions included equity-raising, but shareholders felt angry, duped and battered, and so banks' share tumbled in early March. Bank shares only rebounded after the middle of the month when the Fed announced its $800bn Quantitative Easing inspired by the Bank of England's example of buying in $300bn of government bonds over the winter. The dollar fell but bond prices bounced up.
Ben Bernanke had previously insisted that the scheme would be buying mortgage-backed securities and other assets to unblock credit markets, "credit easing" not "quantitative easing" as per Japan as well as UK central banks. The idea was that if banks loan out the cash they raise from selling treasuries and households and businesses spend, rather than save, then the economy will be given a floor to bounce off, increasing the chances of a stronger recovery in 2009. This was reinforced at the G20 meeting in England when the world's leading central bankers promised to do whatever it takes to get growth back on track.
But, yet again, it was up to the politicians to take action. What they could see was traditional banks on which economic growth depends suffering from asset write-downs in their investment banking sides. What they did not fully appreciate is that these depreciating assets were regular traditional banking loan-books where the trade price had become divorced from underlying cash-flows. Nevertheless, the idea grew that splitting the banks between retail and investment banking would quarantine that side of banking that really matters (the side that does not pay massive bonuses) and thereby also quarantine government from having to risk its budget balances and break-up or nationalise banks!
Splitting of banks was politically and technically weighed in 2010 in re-framing the Dodd-Frank Bill leading to compromises, and may weigh similarly with the UK Banking Commission considering breaking up 'universal banks' to split Investment from Retail banking (or as others might term it "Wall St. from Main St. banking as was required in the USA by the 1933 Glass-Steagal Act repealed in 1999 as one of President Clinton's last acts since vilified as a direct cause of the Credit Crunch?)
Citi, like UBS and Bear Stearns less so, was arguably a little lucky its crisis became public before the melodrama of September 2008 when it might have been sucked into the most dramatic end of the vortex of that Autumn. Citi (Vikram Pandit) had already stated it had $500bn of "legacy assets" to sell, though clearly not at fire-sale prices that were panic responses by many in late '07 and most of '08 of at worst 20c in the $, or the minimum of 50-60% discount that hedge funds and vulture funds were seeking.
With government support sell-offs rarely fell below 30% discounts to book, except when whole banks were sold and merged when half of book value discounts prevailed. Citicorp 9and many other banks) have since March '09 shown reassuringly stable share values. In my view this has much to do with shorting speculators recognising that they could not stage a replay of 2008 plus other factors such as signs of solidifying recovery, and not least a shift in volatility to Europe and the sovereign debt crisis. Citi said it wanted to reduce its 'legacy' or 'non-core' assets by sales to $100bn over the medium term, and by today it has almost achieved all of that, but getting there has been a bumpy ride or hard lessons learned that all need to consider.
From late '07, Citigroup raised over $36bn in capital to fund losses and write-downs from sub-prime mortgages and other assets. It sold $3bn worth of new shares after issuing $6bn of preferred shares that diluted shareholders who may or may not have been made aware of further losses (almost $15bn for the six months to the end of March 2008, second only to UBS).
Some analysts said there was more bad news to come and they were right. Deutsche Bank estimated in early '08 that Citi's $29bn mortgage structured products could suffer another $15bn write-down, which seemed excessive discounting and was simply reflecting the terms of the asset repo-swap with the Fed (FDIC) covering $360bn-worth of assets. But it still had $460bn in businesses and assets at 'real economic' (medium term cash-flow based valuation) book value to sell.
In Dec.'09 the Treasury's holdings in Citigroup were valued at $26.5bn and it announced it would sell these shares in an orderly fashion within six to 12 months (subject to an initial 90-day 'lock-up' period after the secondary offering).
In Jan.'09 Citi announced hiving off Smith Barney to be merged into Morgan Stanley, a move many shareholders disliked causing a 22% drop in share value.
In Mar.'10 government shares showed a $9bn profit. But actually the profit was far more than that because the shareholdings had not been bought (at $3.25 a share) with actual taxpayers' fund but in lieu of fees for the repo asset swap. Taxpayer profit (from selling 7.7.bn shares at $4.39 a share) was really all of the $33.8bn, though at a cost to other shareholders whose shares dipped instantly 26% that also wiped $250m off the government's gain, but that was nothing compared to $36bn temporarily wiped off other shareholders' holdings. It bounced back to $5 in April but since subsided to $4.10 or $118bn.
The latest asset sales by Citi are its private equity unit for $900m and EGG internet bank in the UK for perhaps $0.5bn. Another asset that could be for sale is Citi's over 80% stake in Student Loan Corp (STU).
Government still owns 18% of the Citigroup, down by half at its peak.
It is expected that the remaining stake (about $22bn) will be sold by the government as soon as it can be done profitably and without upsetting the market. Total government profit from saving Citigroup may be in the region of $40bn, but for now that's just a conservative guess.

Big Banks, Capital, Overleverage, and Living Wills

2010-07-31T06:34:00.001-07:00

Just like the question of whether BP's cap on its oil leak will hold, and whether the oil slick can be cleaned up at an economic cost affordable by BP and its cohorts, we still have similar anxieties about our banks. Credit Crunch writedown losses have recovered by 75% over nearly 3 years. BP's oil slick has been reduced by 75% by burning off, hoovering up, and break-up by sea action - but with another problem emerging that of the toxins in the enormous volume of dispersants used! It is three years since ratings agency Moody's announced that their securitized bond valuation models were buggy with bugs that meant the system was preposterously indifferent to defaults rates - and hadn't been updated for over 2 years for changes in mortgage obligor defaults until January 2007! That said, even Ben Bernanke got his mortgage default data spectacularly wrong in a speech in January 2007.
After six months to figure out how to deal with the errant valuation system, Moody's announced a replacement almost exactly three years ago, after which they and other ratings agencies and underwriters had to re-value all $2.7 trillions of securitised bonds in a batch process that inevitably took many months. This was like BP leaking oil well, operating at a depth that people and equipment had difficulties operating at. It was like Chinese Torture on the stock markets, on banks' share prices, or like the months of the Gulf of Mexico pollution crisis and the question day after day how can these streaming losses be contained?
Governments stepped in to try to quarantine the debt markets and banking systems. But these were long since not geographically containable like an oil slick, but global.
Note that BP's oil slick, to take the analogy further, has escaped the gulf and is threatening the USA East coast and spreading into mid-Atlantic (see graphic below of 10th June). The Credit crunch slick spread across The Atlantic not in nano-seconds as some may imagine the analytic speed of finance, but taking months to spread, speeding over some spectacular events such as the problems of Bear Stearns, Citi, UBS, NR, Dresdner, Hypo-real, Soc Gen, WaMu, Commerz, Fortis, Dexia, HBoS, Bayerische LB, until culminating in September 2008 with the implosion of Lehman brothers and AIG resulting in fire-sales of Merril-Lynch and HBoS and then nationalisations of RBS, Anglo-Irish, and partial state ownership of LBG, AIB, BoI, and so on. All happening as RMBS and other ABCP covered bonds were downgraded, subject to sometimes desperate sales or central bank asset-swaps, and on and on being reprocessed through the revised or 'new' ratings models when the graded assets fell sometimes spectacularly by as many as 17 risk notches, straight from triple-A to 'junk', thus dramatically and progressively shaking, and sometimes shocking, the confidence of 'wholesale' funding sources (including money-market funds and banks who would lend cross-border to each other) who lent to banks by buying banks' Medium Term Notes, on whom the banks were typically reliant for 20% to 30% of their liabilities. The long period over which this shock reverberated without any obvious end in sight was longer than a typical recession.
It is surely remarkable that bankers like Sir Fred Goodwin of RBS witnessing the growing slick of asset write-downs could think this is a temporary problem and the values would bounce bank to return to 'normal' sometime soon? Did he, and others like him, have any inkling, based on any analysis, of the likely balance sheet clean-up time and costs? That we still don't know, just as we do not know how many group risk officers or chief economists issued severe warnings to their boards or whether central banks did so other than buried in their stability reviews? There were warnings, lots of them, but whether they were sufficiently strongly worded or taken full account of by banks, or whether the banks thought it was too late anyway to avoid the storms ahead, we don't know. It is three years since the run on Northern Rock, the UK bank most reliant on short to medium term borrowings to fund its very large gap between deposits and loans. It could not book its next quarter's borrowings and could not envisage paying the higher spread demanded and temporarily losing its profit or changing its business model. Over the year that followed, US banks and EU banks were dragged into a vortex led by those most exposed to refinancing their own maturing securities. Then, when Lehman Brothers was allowed to collapse funding margins spiked and interbank money market deals failed to complete on a massive scale. Governments had no choice but to intervene on an equally massive scale, essentially by stepping into the vacuum wherever the private sector failed to fill the gaps in balancing both sides of banks' balance sheets, the gaps on the liabilities side of the balance sheets, that side that banking regulation had been least diligently concerned about!
What has changed in the interim 2-3 years to make the global financial system safer, better risk diversified, and prepared to change culture? The answer is not a whole lot so far. Why, because the general idea that everyone seems to have is to get back to normal, to how it was before the credit crunch and recession. But that 'normality' is not available and cannot be for some more years; the macro-economy balances of the world and in each country has changed. Therefore, banks have to change their lending profiles and their risk diversification - are they on the job of figuring that out? Banks are still in a stunned reaction, recoiling from lending like anyone would recoil from a fire after getting their fingers burned, or maybe like a seabird still dripping in oil. They are desperately cutting costs before looking for new business, defending deleveraging on the basis that they have a fiduciary responsibility to lend only to borrowers who they can be sure will pay back. What they cannot face is the accusation that if the banks all do this it is a systemic risk to all of them via the underlying macro-economy. How many SME firms on whom economies rely for most job-creation see banks collectively as their biggest single risk factors? The regulators want more detergent, fire-retardant hoses and fire-guards installed and bankers to wear oven gloves - but above all they want well-head caps on risk-taking, on leverage and on 'own portfolio' speculative trading that is seen as detracting from and displacing banks' proper focus on traditional 'transmission mechanism' banking, that of converting deposits into loans.
From the perspective of the banks they are being burdened with requirements that their systems have great difficulty processing. As I often repeat, most if not all banks need new general ledger systems with full risk accounting and have great problems obtaining solutions that work accurately and cleanly. The system suppliers are over-stretched and the banks are over-stretched - intellectually and technically. regulatory standards are one thing, but technical standards expressed in reliable templates and detailed blueprints that can be safely implemented are quite another. I doubt any major bank can say hand on heart that either their credit risk or market risk accounting and analytics grown from the bottom up, deal by deal, account by account, are totally fit for purpose.
Banks have increased their capital reserves and economic capital buffers and liquidity reserves. Before the credit crunch minimum regulatory capital reserve (Tier 1 common capital to risk-weighted assets ratio historically stood at 7¼% over 1997–2007 for all FDIC banks in the U.S.) compared to a requirement of 8%. You can monitor this by looking at total US banks reserve capital, which should be no less than $1 trillion where banks' domestic assets are roughly 100% of GDP, and about $2tn in the EU where banks' domestic assets are 100-200% of GDP.
In Q2 2009, the U.S. Supervisory Capital Assessment Program (SCAP) performed the stress tests to assess risks faced by banks, assumed a target of 4% Tier 1 common capital (before supplementary capital) to total loan assets ratio, which is lower than the historical standard but should be equivalent roughly to an 8% ratio to risk-weighted assets. The SCAP also assessed the capital needs of the largest 19 Bank Holding Companies (BHCs) under pessimistic scenarios. To achieve a 4% ratio, it found that the banks needed $185bn in additional capital and estimated that all U.S. banks would need $275bn of additional capital to maintain a 4% ratio (tangible common equity or 'own capital' to tangible assets) or $500bn to maintain a 6% ratio, over the same period. Now, a year on, the IMF says small US banks needs another $76bn in reserves. But FDIC has this surely under close monitoring control? Europe's banks have been subjected to a similar stress test that, however mild it might be at least comes on top of a crisis stressful period and shows us that even given sovereign debt issues, the exposures to loss in further adverse scenarios (double-dip so-called) should in net terms be relatively mild, or actually trivial, because banks are more risk-diverse than before. How they have achieved this is arguably economically damaging because the banks shrank their loan-books to all classes of borrowers (except Government) and run off amortising loans, cancelled undrawn overdrafts, sold operating units and other assets, and shrunk their 'own portfolio' trading exposures.
Regulators are concerned to improve banks' safety margins, like asking them to install two-stage airbags to cope with head-on collisions.This week, regulators set new standards for bank capital and liquidity, except that the Bank for International Settlements (the global authority in these matters) has, according to most of the media commentary, diluted earlier proposals and gave banks eight years to comply. This is not so. BIS has insisted on a longer parallel working period of reporting both old and new reserve ratios, before the new ones are the only only ratios. The time frame of 8 years will take us into the next cyclical downturns and recessions if the past is any guide.
The idea expostulated by politicians is that the new safety standards will mean that the governments' ambulance services and fire brigades (central banks and treasuries) will not be required to save anyone next time. No one who know anything should truly believe that, nor should they want that to be true, in my opinion. Why would bankers listen to central banks and regulators if they are no longer to act as lenders of last resort, ready, willing and able to intervene to save the banks.
This is where the moral hazard argument falls down. The moral hazard argument supposes that if important banks know they will be saved from insolvency they then indulge in excessive risk-taking. But, against this, is the argument that there remain plenty of disincentives against excessive foolishness and furthermore, regulatory and government authorities exert a full market price for saving banks and without this role of final guarantor of banks, which includes rights to exert penalties, why should banks be motivated to listen to central banks and regulators and to follow their advice about systemic risks?
What were the leverage ratios before the credit crunch?The fact is that leverage is not a precise science and has many issues below the simple ratios taken straight from the balance sheet.
Governments are in the business of protecting vital interests and these include major banks. Who can envisage an economy where major banks are not vital economic interests? There are restrictions on them in the Frank-Dodd US Banking Bill, in various measures being worked on in the EU, and in the UK the government has formed a commission under Sir John Vickers (Martin Wolf, the FT economics columnist, is among its members and I'm providing briefing papers) to consider whether big high street banks should be split? The impressive but Future of Banking Commission that involved many politicians, experts and submissions from bankers advocated splitting investment from traditional banking. Vince Cable, the business secretary, supports the idea but is at present most concerned to persuade banks to lend more not less to small businesses. Such issues may be re-manufactured as tradable levers? Arguably such policy issues were traded in the compromises in the Frank-Dodd bill over the Volcker Rule. All this is about seeing in the iceberg above the waves, in what is in public view, the true scale and structure of what lies below. Regulation is also about making such matters more transparent and there is inevitably a conflict between what is systemically important to show, what is necessary for shareholders to know, and what is commercially sensitive or only for the regulators to see, and therefore not even subject to Freedom of Information Acts?BIS is above such things, one imagines, but it does see the technical and timing issues of enforcing major changes all at once on the whole banking sector. Some of the reform issues are significant but relatively minor or merely technical such as reducing hybrid instruments in Tier 1 capital. The FT says "It is extremely hard to understand what “mortgage servicing rights” and “deferred tax assets” are, let alone what use they will be to any bank when the next crisis blows up, as it inevitably will." But, these are straightforward matters of what counts as usable revenue sources to predict net cash-flow and internally-generated capital. The FT says, "Yet the BIS succumbed to pressure from Germany and France not to be too hard on their banks by allowing both these oddities to count towards core capital." I don't see that - the matters are simple ones of what is operating revenue? In the case of deferred tax, obviously this is available capital if it reduces with bookable losses.
Regulatory changes (up to about 100 by my reckoning) to respond to banks’ misjudgments and deceptions (including self-deceptions) are still in process, inviting comment and further analysis. Many legal actions are in train that will take years to process through the courts and court judgements will add to regulatory law.
As the FT rightly comments, "By and large, however, as they break for the summer with their bonuses and jobs intact, bankers can reflect that it could have been a great deal worse. Conversely, the rest of us are left to wonder how all that regulatory resolve slipped away?"
The Ft says, "reforms are not only inconsistent but – particularly in the case of the BIS – have a lowest common denominator feel. Taken as a whole, they only go a small way towards addressing the two problems made obvious by the 2008 crisis: that global banks are too big and too interconnected to be allowed to fail." I disagree; they are not inconsistent. There are inevitably some national and even regional variations, but most reforms are merely fleshing out what is already in Pillar II of Basel II. The above graphic of the supervisory process that is Pillar II typically underplays the key element that is the biggest challenge which is how to macro-economically model and forecast under different scenarios the banks exposures and performance relative to economic factors.Modelling all the above and a lot more is technically daunting and stretches banks' intellectual resources to the maximum. The more regulators agree with that view the more they will think simplifying banks is a very good idea. And maybe they are right, maybe large banks have not just become too big to fail but too complex to manage? John Gapper of the FT, reflecting the views of many writes, "The most disappointing aspect of the reforms is how easily these banks have brushed aside the obvious solution – to break them up into retail and investment banking operations. That would help to curb excessive risk-taking subsidised by retail deposits and taxpayer guarantees – what Martin Taylor, former chief executive of Barclays, calls investment banking divisions’ “parasitic” nature." 'Parasitic nature' maybe, but this is not obviously a solution - we do not yet know enough about it. Paul Volcker, the former chairman of the Federal Reserve, did include his 'rule' in US financial reforms provisions to ban proprietary trading at large banks and force them to limit exposure to 'alternative investments', hedge funds and private equity. But, we have yet to see a full analysis of what this means.
BIS in its report this week says other structural reforms are needed to curb incentives for banks to keep on getting bigger, more complex and more macro-economically powerful. My view is that the banks need to be guided by regulators forcefully to risk diversify better across the whole of the economies they serve. This idea is currently drowned out by the idea that banks are too burdensome on taxpayers, while in my opinion this view has failed to see how well taxpayers have been protected in the nature of the measures that governments and central banks have taken, and can repeat again in the future.
It is relatively easy for banks to define organigrams to cope with all operating lines of business and risk factors, but a totally different task to combine all of that into a holistic view and then take decisions based on how 'the risk appetite' (a much over-used yet vital term about which bankers have very poor understanding) is an altogether different problem. here is the risk organigram of troubled Commerzbank, which is not especially different from any other large bank. The US is looking for new legal powers including to be agreed internationally to regulators to collaborate to be able to seize and break up very large financial institutions (as they contemplated doing with Citigroup until the FDIC pointed to the many cross-border legal problems of a bank with half its assets abroad) that they deem to be in severe solvency trouble, as well as insisting on banks preparing their own “living wills” to simplify how their internal group structures so that financial restructuring or breaking up is easier Nearly two years since Lehmans went bust and the shell broken up between Barclays and Nomura, we now hear that its financial balance sheet may be unravelling profitably? hence, it is clear that insolvency can be a difficult matter to judge. What was true however was that Lehmans' net cash-flow had petered out and in the short term it was technically bust. Some US politicians suppose that new laws will end the “too big to fail” problem but that is surely a naive and vain hope.
The US problem banks appear to be currently concentrated among small banks with assets of under $1bn, many small local banks with less than $0.5bn. Private equity and vulture funds looked at buying these as entry into banking, but now that looks less attractive, an entry cost problem new entrants find everywhere, the cost of capital adequacy, and yet the set up cost of a bank from scratch is also daunting. But when all banks need new core banking systems to accommodate risk accounting and transition from US GAAP to IFRS accounting standards, and when most banks have zero or very little brand value, building a new bank from scratch looks relatively sensible. essentially a traditional bank should have a balance sheet that may be viewed succinctly and where connection between different lines and sides of the balance sheet may be known and the factors driving the performance (the net interest and other income) should be easy to model for different scenario forecasts. But, of course, even that is quite a complicated task, even for such a simple bank as the balance sheet below: In the UK, some networks are for sale, but new 'green field' banks formed by JS Flowers, Virgin, Tesco, Blackstone and other groupings that may or may not buy existing networks as well. In the USA, Apollo is taking advantage of a change that allows banks to operate in multiple US states without a national charter. It has $55bn under management, and hired a team from Countrywide Financial, and is awaiting regulatory approval. It is asking its investors to put money in the new bank, which will have a separate board and operate independently of Apollo. Like others keen to own banks who believe they can set up a new more attractive customer service model, Apollo has a back-to-basics model based on the belief that bank lending will become more important as capital markets lessen in importance and so long as the securitisation market remains frozen.
Most private equity groups appear to have abandoned plans to create banks based on buying FDIC 'saved' banks that were thought could be lucrative 'fire-sale' deals. In FDIC auctions, it became clear FDIC preferred strategic banking sector buyers over private equity groups, probably because the former offered better prices.
Blackstone last week said it had “changed focus from assisted bank deals”. Others ar looking at buying minority stake in banks for sale.
If the biggest banks are too big to be allowed to fail that is certainly not the case for small banks. And yet their failure can be traumatic for local communities and need protection of regulatory oversight that the FDIC provides. Regulators can impose limits through capital, leverage and liquidity rules, and by refusing to accept banks' risk accounting. Auditors do not audit banks' risk accounting - only regulators do this. In my view banks' quarterly and annual reports should be signed off by both regulators as well as auditors. But, until now, regulators lack sufficient resources to risk-audit all banks. they should however be able to audit the biggest banks and to provide published opinion in the banks' financial reports. That would go far in ensuring banks listen carefully to the regulators.
All this is a lot more than just about over-leveraging by banks, so called exuberant risk-taking. Over-leveraging is a blanket concern but it remains a subjective judgement until precise studies are published that look at all major risk factors and can size and sequence them. The regulators have to equip themselves with precise analytical tools and make these work in the wider context of systemic risk.
Over-leveraging is a factor "among other things" as th e FT's John Gapper rightly caveats. The links between investment banking, especially 'own portfolio' trading, and traditional retail and commercial banking, how these worked, have yet to be rigorously examined. It is generally adjudged so far on the basis that the higher the leverage the bigger trading books are in banks' assets - hence, less own portfolio trading means lower leverage means safer banks - if matters were so simple. Insolvency risks in a systemic risk crises hit all banks, small as well as big. Property bubbles bursting can hit small retail banks and building societies or mortgage banks most, as we saw spectacularly in Japan in the early '90s and asian banks in the late '90s and western banks in recent years. Credit crunch hit those banks with maturing debt that had grown recently fastest and had to refresh their borrowing in the middle of the credit crunch. Arbitraging between what is in trading books or banking books given the much lower capital reserve required to support trading book value at risk compared to banking book credits is being squeezed by new regulations that should triple the capital reserve for banks' trading books and arguably by other regulatory requirements and accounting treatments that are still feeding through into banks' implementations. We should see a reversal therefore of the growth in trading books versus banking books in banks' total assets.The above factors may appear more important than national leverage and sovereign risk, but while this is less obvious to track and more a problem after the fact of the credit crunch, it is an area into which funders' risk assessments now appear to be focused, even if, as I believe, the sovereign risk crisis is hysterically over-blown, not least because of the opportunities that debt-shorters see in the turbulence of the sovereign debt markets. It may be that the bigger issues are really to be found in the area of management systems and management skill, in insufficient macroeconomics education as well as lack of in-depth regulatory risk training of senior bankers, especially of those in the boardrooms. Attendant on that is the question of not just whether boardrooms can steer the risk appetite of large banks in and across all their constituent business units and franchises, but how is it that they actually do this?
Are executive boards and supervisory boards truly in masterful control of large banks or are they dogs wagged by their tails instead of being led by their heads?

US FINANCIAL SYSTEM REGULATORY REFORM: Dodd-Frank Wall Street Reform and Consumer Protection Act

2010-06-29T01:45:00.000-07:00

As I have argued before, US legislation has a similarly direct comparable impact on UK legislation as does legislation from Brussels via the UK's EU membership. In practical or empirical terms the UK political-economy behaves like a semi-autonomous region of the USA more intensely than as an integral part of the EU; the UK economy often follows the ups and downs of the US economy more predictably than Canada, or even Texas or California!
Of course, Brussels legislation is influenced by the USA too and vice versa; there is a two-way flow, which in financial services arena is also because of coordinated legislation from the G20 agenda that has nearly 100 tasks to complete most of which will result in new laws as well as new rules and new prudential supervision powers for authorities to intervene early as well as ensure back-stop measures are a collective cost to banks, or to the financial services sector more broadly.
Last week, a House-Senate conference committee agreed a compromise version of financial services legislation. Both Houses will soon debate and will vote to pass the new H.R. 4173, the "Dodd-Frank Wall Street Reform and Consumer Protection Act", also called the 'Frank-Dodd' or 'FinReg' Bill.
H.R. 4173 is intended to protect consumers and investors, to enhance Federal understanding of insurance issues, to regulate the over-the-counter derivatives markets, and to create a number of powers such as breaking up banks that cannot deliver an adequate 'living will' i.e. a streamlining of big bank group structures so that if at risk of insolvency they can be efficiently fixed in any number of several ways. The ideas include make resolution and state aid measures or 'regimes' more transparent, more on-budget, and thereby ensuring no banks are technically too big to fail. Such matters to work require international coordination of laws so that if a bank like Citicorp fails in the future there will not be international legal barriers or complexities standing in the way of breaking up the bank!
The Euro Area's Stabilisation Fund is a back-stop for the sovereign risk aspects of indirectly resolving bank failures in the EA, and a new EU bank resolution fund and or national funds will provide what I call 'undertaker of last resort' funding to complement central banks' 'lender of last resort' liquidity provision. Several countries are setting up national funds via special bank taxes because saving banks remains a national member states more than a multinational EU responsibility.
In the UK, the FSA has been ahead of others in requiring banks to build up liquidity risk reserves, and the break-up of banks and related issues are to be examined by the new UK Banking Commission to report by September 2011, and resolving the split between micro- and macro- prudential supervision is to be ended by creating a new Consumer Protection and Markets Authority (CPMA) when the FSA is split in two, with its micro-prudential supervision of banks coming becoming a department of the Bank of England, which must more actively exercise its responsibility for macro- or 'systemic' risk. It will be 2012 before legislation is passed for the new institutional structure to begin, but the implications of the new arrangement of responsibilities are already with us.
The USA is perhaps with the Frank-Dodd Bill 2 years ahead of UK in equipping the Federal Reserve, SEC and the Fed's FDIC. A few thousand new financial supervision hires will see many poachers turn gamekeepers. The USA's 2,300-page bill has 15 separate new laws dealing with issues raised by the financial system crisis. The measures are under review or closely echoed already in UK legislative changes currently in plan or subject to a Banking Commission review, whose work begins this Summer. Key decisions in watering down aspects of the original bill will influence the UK banking Commission to follow suit.
Rather than forcing banks to spin off all derivatives trading as separate businesses to stop them supposedly "gambling" with depositors’ funds, which they didn'y except very indirectly if at all - Congress let banks keep trading derivatives if hedging their own risks or for interest rate and foreign exchange swaps, which is all they claimed to be doing anyway? Banks have up to two years to move derivatives that can’t be cleared through a clearing house, including credit default swaps, into separately capitalised subsidiaries.
The Volcker rule, named after its proposer and former chairman of the Federal Reserve who is an Obama adviser, stands, almost. Banks are prohibited from trading for their own account, but not banned from investing in hedge funds and leveraged-buyout funds; allowed to invest up to 3% ratio to Tier 1 capital in such funds. That, for example, lets JP Morgan Chase invest $4bn that way. The ban on proprietary trading is intended to shift bank culture back to transmission mechanism banking and to protect bank shareholders from speculative risk-taking with their money. Banks also lose their setting of prices on derivatives they write; that goes to central markets where prices are set by all traders. Otherwise, the banks continue as before, focusing on trading not just traditional banking, important to windfall profits and bonuses.
Cost estimates by the Congressional Budget Office (CBO) for H.R. 4173 has just been published. An earlier estimate placed the government budget cost of the bill at c.$70bn. I usually find CBO projections to be simplistic. The latest is not that.
see; http://www.cbo.gov/ftpdocs/115xx/doc11560/hr4173senatepassed.pdf
CBO and the Joint Committee on Taxation (JCT) estimate that H.R. 4173 will increase tax revenues by $12.1bn in 2011-2015 and by $33.5bn over the 2011-2020, and increase direct spending by $25.0bn and $53.2bn over the same periods. CBO estimates those changes would increase budget deficits by net $12.9bn over the 2011-2015 period and by $19.7bn in 2011-2020.Implementing the act should increase Federal spending by $4.6bn in 2011-2015 and $13.2bn in 2011-2020 period.
Similar measures in the UK would not be proportionately less relative to UK's GDP as 1/7 of USA given the proportionately larger UK finance sector. We could assume the costs for total EU of similar measures would exceed the USA cost estimates.
US House of Representatives will also examine a bill to spend additional funds in fiscal year 2010. The Senate will debate H.R. 5297, the Small Business Lending Fund Act of 2010 to create a Small Business Lending Fund and authorize the Treasury Department to invest up to $30bn in small financial institutions that plan to increase lending to small businesses. The UK version of this is only worth over $2bn. But, these depend on how the funds are used to pump-prime related lending.
H.R. 5297 will create the Small Business Lending Fund Program to direct the Secretary of the Treasury to make capital investments in eligible institutions in order to increase the availability of credit for small businesses. Also envisaged is a Small Business Credit Initiative to authorise $2bn to assist states to increase the amount of capital made available by private lenders to small businesses. Presumably the effect intended is pump-priming such as via credit insurance guarantees so that the gross effect may be to boost lending by about $30bn.
Questions have been raise in UK and Europe about how consumer protection and quality of wholesale financial markets can be culturally, institutionally, conjoined in a single regulator entity? It is case, however, that the custom is to view quality of price discovery and general transparency of the markets in consumer and small investor terms, with consumer interests also expressed via the rights of pension and insurance funds.
But, there is more at stake in wholesale markets including solvency and transparency about what brokers and dealers are doing in how they handle risks, innovate new instruments, dilute the integrity of markets, relate to global markets trading and pricing and so on. In capital markets (fixed income and derivatives) central banks with macro-prudential concerns intervene. In security markets (equities and derivatives) some exchanges continue to retain responsibility for quality, but increasingly due to the fragmentation of markets this has to be undertaken by multi-market, multi-exchange, regulators, especially in Europe, and including commodities amrkets, over-the-counter, on-exchange, and via third party and internal crossing networks, 'dark pools' and inter-dealer brokers.
These are hugely complex issus requiring massive computer analytics engine tools that regulators lack leaving them dependent on market data providers such as Thomson-Reuters and Bloomberg, and the clearing houses. How these matters are regulated by SEC in USA or various equivalents elsewhere cannot be subsumed merely within consumer protection principles, even if those take us a long way forward. Therefore there is bound to be a large overlap with macro-prudential regulators as well as micro-prudential investigators chasing breaches by individual firms.
The technology and opportunity for market distortions and anti-competitive practises are legion, and far beyond the mind of individuals or small teams to get to grips with. The misunderstanding of how stocks and markets may be 'shorted' and how rumours and insider-trading can be tracked, rogue traders etc., all after-the-fact ex-post, are instructive. Insider trading int he USA can be widely interpreted and furnishes the biggest single crime for arrest and arraignment of bankers and dealers. The same cannot be said in Europe.

PROFIT FROM TBTF BANK BAIL-OUTS

2010-03-29T12:56:00.000-07:00

It has taken analysts and FT a long time to catch up with the reality that Governments will be making substantial profits from bank bail-outs (or bale-outs). I've been playing that saw (or beating the drum) on that for nearly 2 years. Yet, only now have mainstream media published estimates that the US government has made over $10bn profit on banks’ repayments of TARP funds, which is only the tip of the state's profits. But, since TARP is on-budget, it is easier to state that "taxpayers might turn a profit on the unprecedented help extended to the financial sector during the crisis" -FT 8,April 2010. This is based on rates paid by Goldman Sachs and American Express for warrants received in return for the aid (annualised return of 8.5%). There is, of course, a difference between paper profits and money in the treasury coffers, between forecasting and realising profits. But, 8% plus fat fees plus insurance premia and much else is the international government standard rate and 5-8% is coupon paid by sequestered and swapped ABS. This $10bn is merely profits on $250bn of TARP (one third)and not all of it. Why now? There is a political backlash (however long-running) against the use of taxpayers’ funds to help companies like Citigroup, Bank of America, Goldman and Morgan Stanley. But, as in the UK, the bulk of the balance sheet aid funding has been off-budget and off-balance sheet of the Federal Reserve as too the Bank of England. Even just what is on balance sheet bodes a massive return. There is, of course, some insoucience here. Governemnts do not want to admit to the general public the precise methods of their remedies for fear of accusations of "funny money" and because general voters don't understand that not everything governments do is with taxpayers' money, and because they do not want the accusation that government bailed the banks to make a profit but to provide stability to the financial system. This is because, supposedly, that the government’s job is not to make money off the private sector. Ha Ha! I don't see what is wrong with that at all in the circumstances. If Government replaces private funding sources and reaps either the same returns, or higher returns by taking advantage of the distressed circumstances that is surely great either in paying down the national debt or recovering much of the budget deficit.
More critical of course is what the impact on the general economy is of bank bailing if banks continue to shrink their balance sheets? The government profit-raking news coincides with a legislators' commission into the causes of the crisis that is due to three-degree Alan Greenspan, former chairman of the Federal Reserve, and Citi executives this week (week beginning 7th April). perhaps they really need a commission to publicly examine how well the general economy is being served. We know the economy blew a tyre and stopped moving up the hill. The tyre may now be fixed, but before raking over what went wrong and why, again, it is surely more vital to understand if the economy is moving again or if something else is wrong?US Treasury says it still expects to lose $117bn on TARP, which I think is absurdly pessimistic, except that it includes investments in the motorcar industry, FM&FM and AIG. On banks the Treasury forecasts a possible loss of $76bn, but I believe that will prove profitable, as will the total.
49 firms have repaid Tarp funds plus dividends on government’s preferred stock plus deposit insurance and either repurchased or let Treasury auction the warrants that alone have yielded a profit of $10.5bn. Goldman Sachs and American Express delivered annualised returns of 20% and 23% respectively after repurchasing warrants in July 2009. Goldman, under intense political pressure over its bonuses and its behaviour during AIG’s collapse offered Treasury a good price to buy back the securities, no doubt not least to protect its bonuses.
Of course, there is also the profit from resurgence in banks' share prices. Bank bailouts with government as disposal facilitator, guarantor, undertaker, zombie bank owner, or back-to-health nurse, is a profitable business over time.
US Federal Reserve for US Treasury, will sell the government's preferred stock in Citibank group worth 27% stake that grew in value to $33bn worth an $8bn 'taxpayer' profit. Private shareholders have gained $2bn as a result of the government having saved the bank. Should the government wait another year and get maybe a $16 billions profit? On Friday, the stock closed at $4.31. At end October 2007, the stock was $38.89 paying over 5% dividend. It is surely likely to reach $10 sometime fairly soon?
GS, JPM, Citi and Merril-Lynch (now part of Bank of America) got $97bn help. After the sale of the Citi stake plus earlier repayments $49bn will have been returned in the current tax year (to September) leaving at least $65bn yet to be repaid.
Other big returns will come later from AIG (nationalised for $182bn), Freddy Mac and Fannie Mae.
FDIC seized $41 billion in assets seized from failed banks as of the end of January 2010, of which $15.6bn are real estate loans of which about 4% involve participations by other lenders. It sold $6bn in 4Q'09 for 40% ($2bn) while retaining 60%. A 31% discount is possible on the next $2bn sales of property loans where 70% are delinquent - when FDIC has to provide insurance compensation to failed banks that it underwrote (after banks' premiums to pay for this and whatever 3rd party insurance underwriters pay up). FDIC earlier sold $1.66bn book value for $1.16bn, at 61.6% of book value.
FDIC is trying to encourage public sector pension funds with over $2tn to buy all or part of failed lenders, according to insiders.A few hundred small banks have failed so far. The FDIC had 552 banks with $345.9bn in assets on its confidential problem list, of which 23 are teetering on insolvency. There were 3,400 banks supervised by The Federal Reserve before the credit crunch. The FDIC insures more than 7,000 banks. 26 banks failed in 2008 with about $400bn assets, of which the largest was WaMu with $307bn in assets (sold to Bank of America for $2bn). The second biggest was IndyMac with $31bn (sold to IMBMH for $13.9bn). Roughly 140 banks failed in 2009 with about $110bn in assets, and so far in 2010 141 banks failed, but with only $23bn assets in early 2010.
By contrast, during the last banking crisis, 381 banks were seized in 1990, 268 in 1991, and 179 in 1992. 307 banks is the total so far this crisis.
By September last year, bank shares were up 141% since the boom in early March '09. The banks index was still down 56% on two years earlier, and by late 2009 it seemed worth buying bank shares again, and by March '10 banks gained only 7% to today's level of 52% below September 2007.
It is this levelling off of bank share rises that possibly prompts the Federal Reserve and FDIC to consider that selling share in banks and their seized collateral assets may help reinvigorate positive interest in the banks i.e. by selling to hedge funds perhaps who should know how to trade up the value of bank shares as effectively as they traded them down? Maybe there is another $16-20bn in Federal profit from doing so with small banks, and then another $70bn profit from selling AIG (bought 80% for $85bn) plus other holdings, leaving FM&FM (bought for $182bn topped up to $200bn) with $5tn in assets and $1.6tn debt that together reduced retained assets to $1.9tn and may now be combined into a single entity. There may be another $30bn of profit to be gained here.The grand total is $582bn returns to The Fed of which $70-80bn is net revenue for the Federal Budget perhaps.
And then from various places another $300bn or so must return with maybe another $30bn profit?
In total something like 15% profit is returned from the $700bn TARP funds - very reasonable.

PRINCIPAL USA MORTGAGEE DEBT WRITEDOWNS?

2010-03-09T05:09:00.000-08:00

Can you carry your home on your back underwater? A year ago I advised US officials (unnamed) that they should look at 15-25% writedowns of mortgage debt for obviously distressed borrowers by the banks, and Federal agencies Fannie Mae and Freddy Mac etc. to be supervised by FDIC whose responsibility is the solvency of the banks. In the absence of this, banks were having to take write-downs on their p/l and capital reserves and then sell the collateralized debt at larger discounts to vulture fund investors - which became the TARF scheme. In a country where keys may be handed in and borrowers face no further redress, the risk of defaults and 'key drops' is very high when borrowers find themselves in severe negative equity i.e. where the principal to be repaid is worth more than the market value of the property and is unlikely to become positive in say the next 3 years. My argument (alongside that of using TARP for 'insurance' purposes, of which various schemes also including Bank of England's SLS and APS are versions) was that providing liquidity and capital support only to the banks directly risks providing help at the wrong end of the economy's food chain - and is what was wrong with Japan's response to the property bubble burst and long term low growth of the 1990s. japan consumers found themselves drowned in multi-generational property debt just to live in troglodyte holes.I suggested it could be more efficient and economically lower losses all-round, for several million mortgages to have their principals discounted - at a rate substantially less than how much CDOs (RMBS, securitized retail mortgage assets)are being discounted/devalued. It now looks as if the US Treasury Department, or at least FDIC, is going to help homeowners who owe more than their homes are worth? They are at least thinking about it. Yesterday, a US Treasury official hinted the department is moving to write down mortgage principal. Congressional legislators, arguing the interest of 'main Street', economics analysts such as myself, commentators and consumer interest groups have called many times over many months for such a shift in policy focus. Then, according to Huffpost, Treasury spokesman Andrew Wiliams e-mailed to say, "Treasury is NOT poised to roll out a major principal write-down program. As the [official] said, we are looking at a number of tweaks to existing programs to help reach more borrowers." Note that 11 million mortgagees are in negative equity, a quarter of all residential mortgage borrowers - who fear they are 'paying good money after bad'.
FDIC Chairman Sheila Bair, at a housing conference on 4th March, said she is "actively looking at principal write-downs" to help homeowners get sustainable and affordable loan modifications. "We need to recognize the evolving nature of the mortgage problem...The initial phases of the crisis involved poorly structured mortgages that posed an affordability problem. Now we're dealing with underwater mortgages." 'Underwater' can now be said to have been formally elevated to a financial technical term.

Writing down principal is "one possible way to encourage borrowers to stick with their mortgages," she said. "This could help reduce defaults, keep people in their homes, avoid costly foreclosures, and enhance the value of these loans.

DOOM LOOP IN UK AND USA BANKING REGULATION - let the market decide?

2010-03-05T03:15:00.000-08:00

Policies and new laws in the UK are as often, or perhaps more so, inspired by examples set in the USA than in the European Union. There is an economic logic to the UK copying new developments in the USA alongside political treaty necessity to comply with EU rules. In the case of financial regulation, the UK Conservative Party is minded to copy US thinking. There are always problems with borrowed policies helicoptered in from other jurisdictions and cultures, however close to our own. One such problem is politicians relying on solutions arrived at only intuitively, unchecked, untested, relying on what looks good flashed across the Atlantic or the English Channel - and sometimes relying on sound-bite ideas merely because they make good media headlines. One such intuitive assumption is that it should be possible to copy the USA if it turns its own clock back to split investment banking from narrow banking ('traditional banking'), an idea linked to 'narrow-thinking' in many legislators' minds that regulation of banks is merely about consumer and taxpayer protection - as if by splitting the banks we can ensure that only one side of finance is safe, the part that matters to 'ordinary' customers, consumers, taxpayers, while the other part may safely prosper or curl up and die to no great effect on the real world of the real economy? This is wishful thinking. However ugly high finance seems today, giving it two faces or two heads will not solve the the fact that all of finance is part of the same economy. The idea of a return to narrow-banking is strenuously resisted by Europe's 'universal' banks even more strongly than on Wall Street. The UK is currently in two minds about this, but looks like resisting the idea at first sight too, but that may change if there is a change in government - if we believe Conservative election-speak?
The UK is arguably politically and economically somewhere betwixt and between USA federalism and EU federalism. Some politicians and other policy-makers would like to see the UK government system become more like that of the USA with a Presidential Executive and two elected legislative chambers, whether or not within a more federalist EU system. Similarly, there are those who cannot but look to the USA's system of regulatory agencies and seek to ape that too. UK and USA policy-makers dominated the creation of the G20 agenda for global financial regulation. There is no doubt that UK and USA responses to the credit crunch have been highly coordinated - so why not have the same (US) regulatory systems? All countries are striving to comply with Basel II capital Accord rules and laws.How regulation is organised is, however, a movable feast in both form and content. Changes are being tabled to recombine some responsibilities and separate out others. What new regulatory jigsaw emerges in the USA and UK, may depend on how keen both major parties in each country are to woo populist gut-feel instincts of Main Street while at the same time leveraging (some say 'blackmailing') campaign funds out of Wall Street and The City - made so much easier in the USA now that there are no limits following The Supreme Court's decision to class all paid-for private funding of political parties (directly and indirectly) under the constitutional right to free speech - the result is that the policy debate may pull more strongly than before in a number of directions - the marketplace of ideas is also a financial marketplace and now no more appropriately so than in financial regulation. US policy-making, whether in foreign affairs, health, banking, or anything else, is market-led, market-driven, more so than ever. Moral and ethical choices, however technical, let the market decide! In the somewhat less self-confident UK this may mean letting the US market decide? A fortnight after the FSA's Hector Sants announced a new structure to beef up financial stability supervision and provide a combined overview of all major retail and wholesale risks, The Conservative Party said it would abolish the FSA. On 19th July 2009, George Osborne, shadow chancellor, announced his intention to turn the FSA into a Consumer (Financial) Protection Agency within the Bank of England, while reserving the idea of creating an copy of the USA's SEC out of the FSA's securities regulatory role covering financial intermediaries - no mention of insurance and other non-bank financial sector firms. Consumer Protection is only a small part of what the FSA does, which is mainly to clarify and enforce European law in financial regulation. It appeared as if the Conservatives had taken their understanding of what the FSA does merely from a cursory reading of newsprint? Despite FSA CEO Hector Sants' resignation in January 2010, and many objections to the Conservative plan from other quarters, there is so far no sign of Osborne thinking again? Let's recall what he said and then let's see what the Arianna Huffington said about the same idea in the USA.Osborne said retail banks engaging in risky investment activity would have to set aside "very large amounts of money" as an insurance policy to protect the taxpayer from the cost of a bail-out in the event of a failure. [This was already happening, but he goes further to suggest splitting and breaking up the big banks.] He said certain "risky" investment banking activities "cannot really easily sit with taking retail deposits", [But stopped short of saying banks with investment banking alongside narrow-banking operations would be split]. He said such things were "best done internationally"... "If we just did it in Britain we would see the industry either leave this country or people get round the rules." [The UK Government and EU governments and regulators have ruled out splitting banks according to The Volcker Rule that President Obama is keen to see implemented as a law restricting the banks' prop trading or splitting traditional (narrow) banking from investment banking - a return to pre-1999 Glass-Steagal? This is based on the idea that banks risked insolvency because they minimised their capital to divert funds to investment trading on the banks' own account (proprietary trading) and on top of that over-borrowed to speculate more. Research by the FSA however shows that only 13% of banks' losses came from 'prop trading' while 70% was from asset write-downs in 'structured products'. Because 'structured products' are predominantly the buying and selling of slices of banks' loan-books and because this enormous many-$trillion market failed to develop into a liquid secondary cash market (and therefore grew massively as a derivatives market) it remained arguably within what could be defined as traditional banking related? To understand banks' insolvency problems, it cannot be done by picking on certain markets only; the answer needs a full double-entry balance sheet treatment to show how the credit crunch impacts liabilities (bank borrowings and deposits) as well as assets (loans and investments).
The crisis can also be defined by extreme bias (too much concentration in certain assets, especially mortgages) that compromised risk diversification in banks' balance sheets that in the case of the largest banks should balance traditional risk exposure across the whole of the economy and trading exposure across all of the markets - not chasing after where profits appear most bonus-friendly, not altogether unlike children chasing balloons in the playground. Regulators can be divided between micro-prudential (single firm) and macro-prudential (all firms together) regulators, such as between FSA and Bank of England, or FDIC+SEC and The Federal Reserve. Taking a diversified all risks combined view is not helped by the idea of splitting regulators according to different financial markets. The Sunday Times reported that Mr Osborne may float the idea of a separate markets regulator, like the US SEC, or the UK's LSE role before the FSA was set up by Labour, in addition to the Federal Reserve and Bank of England's supervisory role of systemic risk (macro-economic financial market risk). Osborne has said he believes some banks were allowed to become too big - and he could set out plans to allow the Bank of England to break up banks whose size threatens the stability of the wider economy. In the UK, six banks have 85% of the domestic banking market, but five banks are especially large because of their multinational global presence, only one of whom, RBS, is fully (85% state ownership)in the power of the UK to break-up and shrink. It could also seek to break up LBS (43% state ownership), which is mainly a domestic UK bank, but it has options to wriggle free by buying its way out of that and by offering competition safeguards by keeping operations of its two banking licenses separate in cross-selling and geographically - maybe? Both of these banks have been scrutinised by the European Commission and the disposals agreed are not major. The combined disposals amount to roughly 10% of the UK banking market.
The thinking that inspired the idea of making the FSA's regulation of banks into an internal division of the Bank of England was inspired by similar ideas in the USA now gaining more traction as Tim Geithner recognises on behalf of President Obama that he has to make his actions more appealing to Main Street, which means being seen to punish the banks overtly somewhat harder. and media comments suggesting that the credit crunch in general and individual bank failures in particular were in large measure due to regulatory responsibility falling between the legs of a three-legged stool, HM Treasury, Bank of England and the FSA, and in USA Treasury, Fed Reserve and FDIC and a host of others. It was claimed that too many regulatory authorities result in everyone's failure to coordinate and share information and see the catastrophe coming. This begs an answer to the question: was there information that if combined would have provided advance warning sufficient to prompt decisive action?" Most experts, including myself, would answer NO for reasons that are institutional as well as technical. Advance warnings were available in macro-economic forecasts but these were not readily linkable to macro-financial events because the central bankers did not have such models. It was not possible to access the equivalent of an engineering map such as of the US grid to determine probable failure. A few Keynesian models such as The levy Model could and did do this,but the results were lost in the cacophony of other voices.There were fears and concerns and warnings expressed by central banks, but these largely went unheeded until it was too late. Therefore the central banks could only respond decisively, mainly after the crisis broke in the Summer of '07, and, in my view, the US and UK authorities did a brilliant a job and continue to do so.At least with FSA and Bank of England separate, micro-prudential and macro-prudential issues are in the open, clear and distinct. If the FSA becomes merely a division of the central bank will conflicting perspectives merely be hidden within one institution, especially if micro-prudential actions always have to negotiate for approval first from the macro-prudential central bankers? This is the issue highlighted in the USA where moves are afoot to abolish the FDIC (already part of the Federal Reserve) by making it a more junior integral part of the Fed within a wider Consumer Credit Protection Agency.
In both the UK and the USA the thinking is partly that and partly 'taxpayer protection' when in both countries in fact not only bank depositors but also taxpayers have been protected - although how taxpayers are protected has not been made clear by the politicians and central banks, even if it is clear to me. They do not like to publicly expose how off-budget and off-balance sheet government and central bank accounting works - that part of governments' and central banks' financial funding that is floated on asset swaps and repos but hidden from public view 'below the line' like most of an iceberg.One idea announced in October 2009 is 'living wills' - a form of self-assisted euthanasia now adopted on both sides of the Atlantic inspired by the FSA to be supervised by the G20 Financial Stability Board FSB. Thirty giant financial institutions have been chosen by the FSB (set up by G20 in Summer of 2009) for cross-border systemic-risk oversight and are especially tasked to write "living wills" that outline global wind-down plans in the aftermath of a solvency crisis. The banks are:- N.America: Goldman Sachs (GS), JPMorgan (JPM), Bank of America (BAC), Royal Bank Of Canada (RY); - U.K.: HSBC (HBC), Barclays (BCS), Royal Bank of Scotland (RBS), Standard Chartered (SCBFF.PK);- C.Europe: UBS (UBS), Credit Suisse (CS), Societe Generale, BNP Paribas (BNPQY.PK), Santander (STD), BBVA (BFR), Unicredit, Banca Intesa, Deutsche Bank (DB), ING Group (ING);- Japan: Mizuho (MFG), Sumitomo Mitsui, Nomura (NMR), Mitsubishi UFJ Financial Group (MTU); and Insurers: AXA (AXA), Aegon (AEG), Allianz (AZ), Aviva (AV), Zurich, Swiss Re. Banks will be required to draw up "living wills" - the global 30 most likely to cause a meltdown in the financial system, and within UK more than the top banks will have to set aside extra capital under new proposals by the FSA. To address the "too big to fail" concern, banks must demonstrate how they could be wound up without taxpayer bailouts. This is tricky, because the ratings agencies have warned that would lead to downgrades if banks could no longer be able to rely on lenders of last resort? The Government's City minister Lord Myners referred to "morbid wills", adding that Too big to fail is a moral hazard that has an adverse affect on competition and the effective operation of markets. The popular view of markets is that they are interconnected and self-regulating like cogs in a fine watch. If the cogs have got jammed, mechanism over-wound, speeding or slowing recorded time, it must be because of some external interference like government or central banks' over-borrowing or cheap money. It is also believed by many that just as a watch tells the time, markets tell us where economies are and where they are heading to. The truth is that today's markets are like watches that have been taken apart nationally and globally. How they function is in some disarray. Market practitioners are not constrained by some super-prevailing hidden hand logic, but as easily moved to over-reaction and opportunism, counting on public fickleness and fearfulness, as driven by media comment and politicians' statements, and, of course, only as professionally ethical as their own greed versus fear will condone. It is perhaps out of such cynical disappointment with the hitherto idealised view of market mechanisms that regulators now want banks to plan and fund their funerals in advance. Living wills are to function in 3 ways: 1. Pre-resolution: to allow banks to restructure operations before they get insolvent; 2. For when in resolution, have blueprints for break-up to help the authorities; 3. Post-resolution; funds to smooth problems in the aftermath of a bank's failure. Essentially, this is a funded manual of how to unwind insolvency problems painlessly without recourse to public funds. But, if a bank can provide that, the question arises why it has to fail, especially if a large part of the planned 'self-assisted euthanasia', as I call it, banks would also need to set aside more and better-quality capital. Banks have to choose and organise their coffins (let's say 'caskets') and leave taxpayers only with memories not an unpaid bill. The idea is that "Systemically important banks will require a further increment of capital and the most risky aspects of banking will need the support of a multiple of the existing capital requirements – a process which will itself lead to a significant reduction in the profitability of 'casino banking' and its ability to pay high bonuses," said government minister Lord Myners, adding, "Long term, the impact of this approach is that it should provide incentives for firms to dismantle corporate or capital structures that might have been developed to exploit tax or regulatory arbitrage".
In my view, there is a balance sheet illogicality about this. The idea sounds intuitively promising, but the cost-benefit impact on banking and the macro-economy is not computable, and won't be for at least a few more years, not until regulators have macro-financial models to test the scenarios.
Coming on top of introducing new regulations (that collectively some call "Basel III"), institutional reorganisation to regulators is disruptive for minimal, hard to calculate benefits - should therefore not be an urgent priority.
In the USA, the FDIC is very clear about government support by insisting that banks have to pledge collateral in sufficient assets to more than cover the value of the support. But, in the USA as in the UK, the reality of how banks are supported; how the structured financial aid works is being lost in political grandstanding to reorganise the regulators, as if that is the problem. Let's consider the US critique. FROM WWW.HUFFINGTONPOST.COM BY ARIANNA HUFFINGTON - to which I have added some pictures.
Update: The Consumer Financial Protection Agency continues to be a moving target for opponents of financial reform. The latest cave in compromise proposal being floated by Senate Banking chairman Chris Dodd now has the agency being housed within the Federal Reserve. An earlier "compromise" would have placed it in the Treasury Department. The end result is the same: a toothless regulator lacking the authority to enforce the consumer protection rules it writes.
Original Post:
A "doom loop." That's what Andy Haldane, executive director of financial stability for the Bank of England, warned last fall would happen if serious financial reform wasn't enacted.
Well, we appear to be a step closer to that "doom loop" with the leak this weekend of Senate Banking Committee Chairman Chris Dodd's plan for a seriously watered-down Consumer Financial Protection Agency.Back in June, President Obama released a proposal calling for the creation of a Consumer Financial Protection Agency that would be "independent," with "broad authority" and the power to "combat the worst abuses in mortgage markets." The agency, Treasury Secretary Tim Geithner said, would "have an independent seat at the table in our financial regulatory system." Well, that was before the banking lobby went into action. A couple of hundred million dollars later, and we're left with this punch-to-the-gut of reform, from the top-line summary of Dodd's plan: "the independent agency proposal would be dropped." Seven words dirtier than George Carlin ever uttered. Instead, according to the Dodd plan, the agency would be housed within the Treasury Department and called the Bureau of Financial Protection. And that's not the only compromise. Senate banking Committee led by senator Dodd.
Here's how the eviscerated entity would work, as laid out by HuffPost's Ryan Grim:
Each time the agency wanted to write a rule, it would have to consult with bank regulators. The agency would then have to respond to the objections of each and every bank regulator in the Federal Register. If the bank regulator was still unsatisfied, it could appeal to the 'systemic regulator,' whose mission is to protect the safety and soundness of the banking industry. Anytime a new rule is proposed, bank lobbyists argue that it will be burdensome and make the system less safe and sound. If the systemic regulator agreed with the banks -- as they often do -- then the consumer protection rule would be voided. Notably, the consumer protection agency has no veto power over any rules issued by bank regulators, which demonstrates which regulator will be superior. The first concern is the banks.
So much for "independence" and "broad authority." The proposal will no doubt be very popular with the banks that, as Sen. Dick Durbin put it, "own the place." But it's already been met with criticism from consumer groups."Effective reform is once again being blocked by opposition from the big banks that caused the current financial crisis, " said Heather Booth, director of Americans for Financial Reform. "The revised proposal does not provide what is needed to protect American families or the financial system as a whole."
This view was seconded by Nancy Zirkin of the Leadership Conference on Civil and Human Rights: "Big banks and abusive lenders fought responsible regulation before the crisis, and we are all paying the price. It is unacceptable for Congress to allow them to succeed again," she said.
But, then, we seem to be living in a time when the unacceptable is routinely accepted -- and written off as unavoidable.
On Saturday, Dodd told Bloomberg Television's Al Hunt that he prefers an independent agency, but said it might not be possible to reach the 60 votes needed to break the inevitable Republican filibuster. Maybe so. But how about at least trying before waving the white flag? Instead, Dodd, in the hope of attracting Republican votes, appears to have preemptively surrendered. But there's no evidence that Dodd's concession has achieved anything other than kneecapping the bill. Democrats have mastered the art of negotiating against themselves.It's hard to believe that even the messaging-challenged Democrats could fail to frame to their advantage a bill that would prevent banks from abusing the public and engaging in the same practices that brought on the financial catastrophe taxpayers have paid so high a price for. Instead, the attitude seems to be, why even try? That's assuming, of course, that a powerful consumer protection agency is something Democrats -- including those in the White House -- think is important enough to fight for. "Here lies the crux of the problem," write Simon Johnson and Peter Boone. "The Obama administration lacks an inner core of smart, well-informed advisers who are deeply skeptical of big banks and eager to do whatever it takes to break a cycle that points to financial and fiscal doom."
So how likely is another ride on the doom loop of financial crises? Johnson and Boone lay out some sobering statistics: Fifteen years ago, the combined assets of our six biggest banks totaled 17 percent of our GDP. By 2006, that number was 55 percent. Right now, it stands at 63 percent. Note: those GDP ratios are modest compared to those of some European banks such as the following graphic shows with Cyprus banks (each with about $50bn assets) at the top (where Icelandic banks used to be) - the GDP ratios are a key issue for the scale support that a central bank can provide? In the Bloomberg interview, Dodd claimed to still support the so-called Volcker Rules banning proprietary trading and capping the size of banks, as does, we're told, Obama. But Johnson and Boone argue that even the Volcker Rules wouldn't make much of a difference -- and that something much bolder is needed. "It is still possible that the White House could go all-in against the distorted incentives at large banks and the corrupted regulatory structures that have created our 'doom loop,' and make this the central campaign issue for November," they write. "Branding opponents as supporters of too big to fail could get traction, at least if led by an articulate and impassioned president."Well, we know he'll be articulate, but his passion for reining in the banks remains to be proven. The Senate Banking Committee is expected to take up Dodd's proposal this week. Some strong leadership from an "impassioned" Obama could shoot down this deflated trial balloon and ensure that what the committee sends to the full Senate to vote on is actually closer to what Obama called for last year -- and, indeed, closer to the stronger package, including a stand-alone consumer financial protection agency, that passed the House in December. During last week's health care summit, President Obama very cogently explained why piecemeal health reform won't work -- connecting the dots between the need to prevent insurers from denying coverage for those with pre-existing conditions and the need for universal coverage. How about doing the same for an issue that is even more sellable to the public? Of course, reforming our broken health care system would have been sellable, too -- if the White House had not ceded the messaging playing field to the Republicans for most of the last year. The good news is, there's still plenty of time to do for financial reform what Obama should have done for health care -- go out and sell a clear and specific package. And he needs to make the point that, much like health care, doing it incrementally won't work. Leaving too-big-to-fail banks to continue doing business as they have been is like operating on a cancer patient and taking out only half the tumor -- the disease is guaranteed to come back. And eventually prove fatal. The president can take a page from the How to Win Bipartisan Support By Playing Hardball With Your Opponents playbook used so effectively by FDR, LBJ, and Ronald Reagan. Or he can go along with the preemptive surrender strategy favored by Senate Democrats: negotiate against yourself, water down what you know is right, earn your bipartisanship merit badge... and get absolutely nothing in return.

US HEALTH ECONOMIC FORECASTS ARE SICK?

2010-02-28T00:24:00.000-08:00

USA Health Care has a spending budget from government and medical insurance that is 15% ratio to GDP. It employs 16 million people in full and part-time jobs (the same number as are employed in all retail trade). Is it remarkable to consider a nation's propensity to fall sick supports as many jobs as its propensity to go shopping?
Total USA employment is 151 million. 20 million net new jobs are expected over the next decade and a fifth of these in health care (according to US Dept. of Labor forecasts).
Health care has grown faster than other sectors of the economy. Its employment growth over the next decade is only expected to be exceeded by employment growth in all of business services. Health has grown faster than the economy generally and may continue to do so, but some foresee it growing out of all proportion. The Congressional Budget office (CBO) projects health care spending to a ratio of 50% to GDP over the next seven decades and doubling to a third the size of total GDP by the 2030s! It is such projections including massive concomitant increase in national debt that is excercising objectors to Obama's Health Care reform bill (plus private health sector and pharma lobbying, which in this Congressional election year can make unlimited political contributions following a decision by the Supreme Court). The complexity of the facts of health care makes it easy prey for rabble-rousing politics. Both sides of the debate, which is polarising the electorate almost exactly along party lines, claim that a majority of voters oppose the reform. In this political balance statistics and damn lies play a dominating role, none more so than the Congressional Budget Office's forecasts (see www.cbo.gov) for federal debt & deficit. It is in my memory a report very similar to that on future pension costs by the CBO used in the mid-90s CBO attack on Clinton's budget, which also projected that half of national debt and 50% ratio to GDP costs for state pensions by mid-century. That furnished the Republican Party with an attack on Clinton for being negligent of public finances even as he was balancing the budget (before heading for a budget surplus). The current report on health care provides technocratic arguments for attacking Obama's medical insurance plan. CBO reports are authoritative sounding and may be capable of swinging the vote on The Hill, but that is where the realism ends! . One has only to ask, when health spending is 80% labour costs, how it can ever be possible for health care to attain a size of 50% ratio to GDP? Can anyone envisage a USA economy in which one in every 3 or 4 employed works in health care? - maybe 60 million health care jobs in the US total of 280 million jobs by 2080? This is the CBO implication, although its study did not ask questions about jobs. 60 million is 40% of the total of jobs in the USA today. To understand it, that is twice the population of California, twice the economy of France or Italy or the UK as they are today! Could it come about that 5-10% of the US population? Well, a quarter of the population is obese and people over 50 require 5 million surgical procedures. 15% of the USA population will be aged 65 or over by 2025.
Short of mass Euthanasia to save the economy, the CBO has little to offer except a monetary and fiscal cause for general anxiety or inter-generational panic!
This is not about hospitals. There are 6,000 in the USA of which over half are not for profit publicly-owned. Total hospitals budget is about $800 billions (under 6% of GDP) with 1 million beds and handling 40 million admissions (ave. cost $20,000). Hopsitals are less than half the total health care cost.
But, will all health care grow to requiring long term health care necessitating a quarter or more of all jobs to be in health care? CBO's trend projections are silly and artificial. The weaknesses are:
- CBO projects real GDP at steady 2.2% but ignores inflation on amortising debt (an average of 2% in this aspect would transform the debt to GDP ratio projections)
- CBO ignores multiplier/ feedbacks between health revenue & spending in the wider economy
- tax revenue rises in real terms, but spending costs rise with inflation
- interest on fed debt is 3% above inflation (i.e. always above nominal growth?)
The CBO's The Long-Term Budget Outlook, June 2009, on page 26 shows a graph showing excess cost growth + ageing population together costing equivalent to 15% of GDP by 2080. If US economics undergraduates produced this, the professor would send them back to Economics 101 (or advise them to apply for a job at CBO). Reputable economists should look at this charlatanism and publish a strong critique or I fear Obama's medical policy and with it much of his domestic credibility (including at the mid-terms) will be lost. There are many ridiculous assertions in the CBO forecasting reports - my list would be nearly as long as the June '09 report!

SEVERE WINTER AND DISCONTENT HIT ECONOMICS

2010-02-24T02:08:00.000-08:00

Winter 2009-10 has been especially severe across USA, Europe and Asia all the way to Northern China. There was a similar deep freeze in 1994/5 that knocked a full 1% off economic growth and that panicked treasuries including USA and UK to boost deficit spending for fear this was an advance indicator of a severe economic downturn. Winter even effects policy formation. Mr Bernanke began unveiling details of the Fed’s exit from bank support strategy two weeks ago in congressional testimony, but his actual appearance before lawmakers was cancelled because of a snow storm. It convenes today.
When January's UK tax revenue for 2009 was predictably low at 6% down, slightly below expectations, and government cash-flow borrowing appeared high, there was also a Winter effect in this. Do not expect first quarter 2010 GDP therefore to be a sound indicator of how recovery and fiscal deficit impulse are behaving.
In addition there is palpable weakening in consumer confidence driven by political cynicism, party ya-boo politics, all the normal uncertainties in election years (UK general election in May and USA mid-terms: House - all 435 seats - and Senate elections - 36 seats - in November, to form the 112th Congress) when the voters will among other matters judge how well governments have dealt with the credit crunch and recession. In China, the response has been erratic, much juggling with ups and downs of money supply and snowing us with unbelievably positive statistics.Yet, the country’s banking regulator has had to order lenders to cut back on credit to local governments’ financial arms in an attempt to reduce future bad loans. Bnks exposure to property development is only rivalled by Rmn 6 trillions (c. $1 tn) of exposure to state entities, much or all of which is non-recourse loans! No politicians anywhere underestimate confidence factors e.e. the Brown-Darling spat recently reported in Andrew Rawnsley's book over whether to tell the public last year that this would be the longest deepest recession or not! The 3 letters to the newspapers signed by 87 economists focus on market confidence, loose or tighter fiscal stances for longer or not, but acually UK recovery will be dictated more than anything else by what the USA policy makers do - twas ever thus for over a century, one reason why we go to war together. Commentators are confused about the virtue of prudence and not having national debt or the private business and household sector debt overhang, and the risks or benefits of higher private saving, failing to appreciate that you cannot have private and public sectors exhibiting the same prudence at the same time; private savings are the exact (in macroeconomic accounting terms) counterpart to higher public sector borrowing, plus the economy's external account balance. Inbetween, private and public debt balances and the net external account, is also the new (on an unprecedented 'peace-time' scale) and very fuggy world of central banks and treasuries off-budget and off-balance sheet operations. And central to that are the length of commitment and exit strategy by government from providing liquidity and capital support to banks. This is the subject of Ben Bernanke's grilling on Capital Hill a fortnight ago on the 10th. What the USA decides will be scrutinised and in some form copied by the UK though policy inspiration also flows from UK to USA.
What may be surprising to those who know that banks remain very stressed, US banks have $1.2 trillions in reserves, also called "excess liquidity", not to be confused with 'capital' that is also about $1 trillion. The UK equivalent is about $500 billions, much higher in proportion to the size of the economy reflecting the immensity of international banking in the UK and UK banks' international exposures. The Federal Reserve’s following after its Quantitative Easing comes Supplementary Financing Programme to drain excess liquidity from the financial by selling $200bn in short-term debt and store the proceeds at the central bank. The Fed is shrinking its balance sheet to begin preparing for when it is economically a good time to tighten monetary policy. Congress at the same time has authorised a raising of the Federal Debt Ceiling by $1.9tn to $14.3tn when the limit on total public debt of the USA is just shy of 12.4tn, after it was raised by $290bn in December to ensure the government could continue to function. This limit has been reached. The Senate and House similarly also passed amendments to legislation raising the debt ceiling requiring new budget items to be paid for, dubbed "pay-as-you-go."
Ben Bernanke on the 10th faced US legislators about his central bank’s “exit strategy” from banking sector support - like preparing to packing his resources onto the down escalator as soon as it is clear eveyone else is on the up escalator. “BB Gun” as he is affectionately known in some quarters, has had to deal with criticism from both Republicans and Democrats over the Fed’s role in the financial bail-outs, the ballooning of its balance sheet and its inability to foresee and prevent the boom and bust in US housing (mid-2005 – 2010). This is not unrelated to his plans to shrink the money supply in order to avert any splurge in inflation even if a dose of this might be helpful to shrinking debt burdens.
US realtor firms websites all have picture of keys being handed over to represent 'sale agreed' - today the pictures are as likely to mean the opposite 'un-agreeing the sale'. Unlike in Europe, US mortgage borrowers cannot be pursued for the balance of the debt, and unlike Japan where mortgage debt can be pursued through three generations to the grandchildren of the original mortgage borrower - the only collateral for mortgage deals in the USA is the property itself, and getting foreclosures processed in court can take up to a year and a half. When non-defaulting mortgagees decide to 'hand in the keys' without recourse, to become defaulters on houses that say were worth $500k and are now only $400k and maybe sit tight rent-free for 16 months saving $40k before foreclosure, the question arises ‘would it be better if banks took some of their mortgage credit losses by reducing mortgagees’ debt’ to ensure voluntary foreclosures are less, and, if so, how can this be done cost-efficiently and fairly? Sub-prime mortgages (a fifth of the total) are showing 25% defaults when prime borrowers’ defaults are less than 2%. The possibility of higher interest rates, and therefore higher borrowing costs for consumers and businesses, and mortgagees has politicians of both stripes concerned – particularly in an election year, r stoked by the Fed’s move last week to raise the discount rate – at which banks can borrow emergency loans from the central bank – 25 basis points from 0.5 per cent to 0.75 per cent, even if for now this will not filter through to impact borrowers much who are already bearing a high credit risk margin in rates of at least 100-200 basis points above un-stressed, more normal, period risk margins.
The Fed has explained several times that the move represents an unwinding of emergency liquidity measures set up during the crisis, and is not a shift in monetary policy. That is yet to come and may be some way off, given the fragile state of the economic recovery.In written remarks BB indicated that the central bank would tighten monetary policy in this cycle after ramping up tools, such as “reverse repos” and a “term deposit facility” to shrink the Fed’s balance sheet, which increased from $800bn to more than $2,000bn during the crisis.
The $200bn plan – which also would have the effect of reducing excess reserves – is seen by some economists as another helpful manoeuvre .The FT view is that the Fed is developing its option – which central banks rarely have – of choosing by how much it wants to affect short-term interest rates through rate rises or, conversely, long-term interest rates through mortgage asset sales. I’m not sure this is totally the case given that US banks, if not so much as EU banks, have to buy and hold far more government bonds than in the past, for regulatory reasons, to increase and improve the quality of their capital reserves, and therefore demand for government paper remains high.
The main issue that should be addressed is how to halt banks and borrowers deleveraging to narrow their net personal and company debt or grow spare surplus, or in case of banks narrow their funding gaps.
The FT makes a spendid observation that the Fed (and we may add bank of England too) now have a significant degree of flexibility, by having entered the politically tricky territory of being able to allocate resources via the banking sector and other agencies within the economy.
The Fed, by holding so many mortgage assets on its balance sheet, “has opened itself up to criticism from various sources and has encouraged the idea that monetary policy decisions may be influenced by political or other special interests”, said Charles Plosser, Philadelphia Fed president in a speech on Fed independence last week. His view is that “This is not a healthy development.” Why not? His solution was that the Fed should, at the earliest opportunity, sell the mortgage assets and return to its pre-crisis balance sheet composition of mainly US Treasuries.
BB in his congressional testimony on the Federal Reserve’s “exit strategy” made clear that there were no imminent plans to tighten credit in the US economy, whose recovery is still early and fragile. But, he signaled that the US central bank is preparing for unwinding the extraordinary support for the financial system – and the enormous increase in its balance sheet – that it built up during the crisis. This means taking profits from the support, or if early letting other investors in banks have more of that? “He’s walking a tightrope,” said John Canally, an economist at LPL Financial reported by the FT; “He can’t afford to make a mistake.”
The Fed chairman did not give any hints about exact timing; that depends on US economic and financial conditions. The UK government’s stated view is similar, although the Conservative Opposition is more gung-ho to exit earlier, seemingly more confident about economic impact and less concerned about the profit to taxpayers. When the moment comes, the Fed is considering tightening the money supply through a combination of several measures, including an increase in the interest rate on reserves, which is now 0.25 per cent. “to put significant upward pressure on all short-term interest rates, as banks will not supply short-term funds to the money markets at rates significantly below what they can earn by holding reserves at the Fed banks.” The interbank wholesale money market rate spreads are currently still 100 basis points.
That focus on interest rates on reserves – though expected by many economists – represents a big departure from previous practice at the Fed, which for years has used increases in the Fed funds rate as its main policy tool to remove money from the system. But BB indicated that the Fed funds rate might not be as reliable in this cycle because activity and liquidity in that market declined with massive increase in the Fed’s reserves during the crisis. He added that a “term deposit facility”, which would encourage banks to store more money at the central bank instead of lending it out, and “reverse repos”, to allow the US central bank to borrow short-term (t-bills)in exchange for cash, to allow the Federal Reserve to drain hundreds of billions of dollars of reserves from the banking system quickly if it choose to do so. One has to wonder whether the Fed's measures and indications may bestir the banks to stop building up the Fed's reserves by doing more themselves to unravel the bank-support by reversing the swaps or buying back pledged assets and re-conditioning these as instruments to support their liquidity and capital balances.

The real overhanging question, however is when will the banks stop deleveraging and at last begin expanding their lending. Surveys all show that consumer and business investor confidence are highly linked to ease of borrowing. This is circular, however, since banks take their cue as to whether and when to let lending expand based on consumer and business investor confidence!
Note that just like the Fed is sitting on measures to tighten credit conditions, it is sitting on massive mortgage assets it could see, just as banks are sitting on massive real estate portfolios they could sell, but none want to do this while the economy remains fragile. Hence, for now, the US Fed has no plans to sell mortgage assets before they reach maturity and is not expected to do so at the beginning of any credit tightening phase.
One of the earliest moves, as a sign that it view economic recovery to be hardening, Fed officials might increase the discount rate – at which commercial banks can borrow money from the US central bank at a preferential rate. Before the crisis, the discount rate stood 100 basis points higher than the Fed funds rate. This spread was lowered to 25 basis points amid the credit crunch turmoil after mid-2007.
“The economy continues to require the support of accommodative monetary policies,” BB said, adding,“However, we have been working to ensure that we have the tools to reverse, at the appropriate time, the currently very high degree of monetary stimulus.” Should we see this as a firm indicator? BB says no, because of the large amounts of reserves in the system there was a possibility the Fed funds rate would for a time be a “less reliable indicator than usual”.
It only hurts when I laugh!

STATES OF USA RECOVERY?

2010-02-22T21:53:00.001-08:00

Economic recovery is arriving in fits and starts – the starts are positive growth and the fits are restructuring including using fewer jobs to produce goods and services i.e. rapid productivity gain, also banks and borrowers deleveraging and continuing bouts of short-term profit taking and anxiety attacks. All that is said here about the USA, applies almost exactly to the UK as well, which is lagging 6 months behind the USA, which is the UK traditional response lag with a century of consistent history in support.
USA unemployment remains unacceptably high, hence President Obama’s new supplementary spending initiatives announced in his address to both houses of Congress in January to focus directly on job creation.
Real GDP, the broadest measure of total output, rose at a robust 5.7 % (annual rate) in Q4 2009 - best gain in 6 years. If sustained this would be a V-shaped upswing as in the last few recessions, in which case consumer and investment confidence would rapidly recover – but that is unlikely, not least because of the deeper and longer recession period of Q1’07 to Q2 ‘08 !
The Q4 ‘09 leap in GDP overstates the underlying bounce-back of the economy - much of it reflects slowdown in manufacturing businesses selling off inventory and a resort to more new production. Less than half of the Q4 growth reflected higher consumption - it only grew by 2.2%. Manufacturing and retail & distribution are getting inventories more closely aligned to short term sales, but such adjustments can only deliver a growth spurt only for a few quarters. The government’s deficit spending effects including shifts in composition to focus on job creation have to take up the slack. A sustained robust recovery will only be certain when realised sales to end-users and consumer are seen to grow at 4-6%.
Consumers and investors remain cautious. The big weight hanging over everyone’s heads is jobs security and the sight of construction projects at standstill – the cranes aren’t moving and recovery in property housing values and office occupancy rates are uncertain. Real estate market recovery will not be uniform but patchy by area, county and state. Shift in spending and demand will also see industries and services recover in a similarly patchy manner – not uniformly across the country except in those sectors that directly benefit from government deficit spending and which are relatively recession immune.
The current persistently high level of non-farm payroll unemployment is severely restraining income and undermining confidence as people worry whether they can be confident of their paychecks in the year ahead, and see some signs of new jobs, plus signs of easier credit. Even those with secure jobs worry about debt burdens that where close to historic highs at the onset of the financial crisis and wealth factors after equity and house prices fell sharply. Households are paying down debt and saving more, a development that partly reflects banks reluctant to lend to households and businesses as the banks restructure their balance sheets, making them smaller to reduce their own borrowing, the gap between loans and deposits.
The housing sector appears to have stabilized, but there remains a large overhang of empty housing and office properties held off the market. So, no continued sharp turnaround. New home sales and construction finally stopped declining in 2009 and appear stable, but at low levels. Home sales surged in late 2009 in temporary response to the Homebuyer Tax Credit - it expires this spring. The housing sector also benefits from the Fed’s buying of mortgage-backed securities, but the Fed is now tapering off these purchases and plans to stop them by end of March. The housing market could then weaken again.
In past recoveries, business investment typically grew rapidly once the economy turned up, but banks were in much better shape then to respond rapidly to the upturn. In this recession, businesses sharply curtailed capital investment. There is some rebound in business replacement spending on equipment and software. Businesses remain nervous and exceedingly cost conscious, focused on process efficiencies, core sales not new developments, keeping supply chains lean, waiting for purchase orders before they produce, and meeting increases in demand with higher productivity from existing workforces. Similar is true in services – there are always some sector exceptions. Generally, bank financing remains an impediment to fully-restored confidence. Credit is available, but collateral requirements are onerous. What’s more, the crisis made businesses keenly aware that they can’t count on being able to get credit.
Meanwhile, commercial real estate will stay depressed for some time yet with high vacancy rates for office, retail, warehouse, and other income-producing properties, despite lower rents, severely reducing demand for construction. Lenders and investors demanding extra compensation for risk, drove up commercial real estate financing rates compounded by banks anxiously and urgently reducing their exposure to property. The market for commercial mortgage-backed securities remains distressed, despite support from the Fed’s Term Asset-Backed Securities Loan Facility, or TALF.
Put it all together and you have a recipe for a moderate growth. Q1 2010 appears on course for around 3% annual rate GDP growth – perhaps 3½% for the year as a whole, maybe 4½% in 2011, with private demand and consumer spending tightening the slack as government stimulus programs fade.
Much depends on banking and financial systems recovering as asset values restore and much lower losses are realised and capital reserves are shored up by higher equity values. Second, losses on mortgages, commercial real estate credits, and other loans continue to arrive, and the full weight of foreclosures and bank failures on the economy has yet to be felt, but net interest income and asset sales should recover sufficiently to ensure rising profits. Monetary policy reached the limit of its stimulus and fiscal policy is facing political limits. Despite the high deficit spending ratios in government budgets it is not clear that these can give the same kick-start to a low-inflation economy as in past recoveries.
The “output gap,” the difference between the actual level of GDP and the level where GDP would be if the economy was at an optimum low-inflation near full employment was at minus 6% at end of 2009, based on Congressional Budget Office estimates - equivalent to $1 trillion of lost annual output, or roughly $3,000 per capita. This will continue. The San Francisco Fed estimated potential level of output grows roughly 2½% annually due to growth in the labor force and higher productivity. Hence, over the next two years, potential output will increase by about 5 %, and if real GDP grows 8% ( 3% more than potential output) then the output gap will shrink to around minus 3% by end of 2011 and that may not reduce to zero until 2013.
The U.S. economy shed 8.4 million jobs since December 2007, more than 6 % drop in payrolls, the largest such decline since the demobilization following World War II. Unemployment was 5 % at the start of the recession, rose to around 10 % in late 2009, 0.7% in January. New jobs are at very low levels. The pace of job losses has slowed dramatically and there may be a turnaround in the labour market soon.
The unemployment rate rose sharply last year, partly a delayed effect from loss of service sector jobs and the particular nature of a banking-crisis triggered recession.
GDP was basically unchanged over the four quarters of 2009. But payroll employment fell by 4 percent over the same period. In other words, the economy produced roughly the same output with 4 % fewer workers, a productivity growth well above the long-term trend. Is that a temporary aberration or a new trend? The government is very concerned not to have a repeat of the relatively-speaking jobless recovery of the early 1990s and early 2000s.

EUROPE TO REJECT OBAMA BANKING REFORM

2010-02-18T08:01:00.000-08:00

Michel Barnier (on the left), the newly appointed EU internal market commissioner at a meeting of European finance ministers explained it wouldn't be possible to "transpose" Obama's banking rform idea to the EU. This somewhat confirmed US anxiety triggered when France’s President Sarkozy characterised Mr Barnier’s nomination as a “victory” against Anglo-Saxon capitalism, which is a rhetorical concept i.e. one fit for political grandstanding in the long postwar tradition of fingerpointing across the English Channel and that larger one called the North Atlantic. Is there a gameplan afoot here to win a transfer of wholesale banking from the US to Europe, and will EU's rejection of the Obama plan to ban prop desks be torpedoed by banks' lobbying in Congress not to pass what Obama proposes - his plan to limit proprietary trading by banks now that not only UK government but also the European Commission say this will not work in Europe? yet, the ECB seems to think it is a step in the right direction while JP Morgan's analysis suggests it could be severely damaging including to traditional banking! Obama’s plan to curb proprietary trading if implemented will cost Goldman Sachs Group Inc., Morgan Stanley, Credit Suisse Group AG, UBS AG and Deutsche Bank AG about $13 billion in revenue in 2011, according to JPMorgan Chase & Co. analysts. Of the five banks analyzed, Obama’s proposals will impact Goldman Sachs the most, resulting in an estimated $4.67 billion drop in earnings in 2011. UBS stands to lose the least, with revenue declining an estimated $1.92 billion. Sounds quite good to me? The 'against the ban' lobbyists might include a slurry of high tech firms who supply the banks and the Exchanges and market data vendors such as Bloomberg and Thomson Reuters? Those who support the ban are supposedly Main Street sickened by the carpet-bagging gains (read 'bonuses') of Wall Street traders.
There is sense in the idea. It is clear that banks got into trouble (credit crunch) when they could not finance (via wholesale financial borrowings) their funding gaps between deposits and assets, now made even more difficult by having to divert additional substantial own funds to capital reserves and the still bottom feeding level of their share values. Much of the funding banks borrowed was to support their own trading in the markets and corporate loans including lending to hedge funds via prime brokers or to fund their own internal private equity and hedge fund operations. The idea is to restrict banks' operations as deposit-takers to serving their customers in traditional ways and not chase after higher profits (realised or simple paper profits) from speculative trading and investments.
Distinguishing these two sides conventionally known as commercial banking and investment banking is not entirely straightforward notwithstanding how they were so divided until President Clinton as almost his last act in office repealed the Glass-Steagal Act. Many concur with the view that this repeal was the start of a slippery slide into a situation where banks focused far too much on speculating directly on their own accounts instead of only net interest income and fees from serving their banking customers and investment clients.
How far the split would go is as yet unclear. Would banks have to give up offering retail investment products, underwriting and asset management as well? Would banks be restricted in how much they could trade in the markets in FX, money markets, bonds and equities wherever this is not merely executing customer orders e.g. market-making to churn and keep testing market prices. 85% of wholesale markets liquidity (turnover) is churn. Would the result be merely that a host of new trading firms would be spun out of the banks perhaps in rteurn for loan contracts that include share of profits, or would any profit sharing and minority stakes in trading entities by banks be banned? Will some banks deregister as banks and will this mean that many new financial firms will be created who are less regulated than before when part of the highly regulated banks? There may be some sort of compromise that emerges allowing banks to limit their prop trading to a % ratio to total assets such as say 10%. But a great deal of derivative and other trading by banks is arguably hedging of their risks, but that is very hard to distinguish cleanly from speculative poprietary trading?
One effect may be that much of market trading is done by less well capitalised firms who are therefore forced to trade even more on a short term basis and thereby skew the quality of the markets. There may be a net reduction in trading desks and a shift further towards algorithmic trading i.e. where computer programmes rather than human beings drive selling and buying in the markets using questionable models that are very hard to risk assess when they are employing extremely short time horizons? The abolition of Glass-Steagal may prove to be a genie that cannot be put back into the bottle.
What is the European (and Asian) perspective. Like many big banks in Asia many big continental European banks such as the Germans especially have relatively small retail networks and rely on wholesale funding more backed by their corporate loans and have become very dependent on own trading revenues. A major reason for creating the Euro was to create bond and equity markets in Europe to compete on the scale of those in the USA. In truth, while the European primary markets were smaller, the secondary markets were already as big or bigger than the USA's pre-Euro but the conception was based on primary market calculations, while the secondary market calculations were confused by the many currency and money market interest rate differences. Post-Euro trading volumes shrank in Europe because currency and interest rate differences between 10 currencies had been removed and banks lost massive trading income for years as a result. Nevertheless, the idea was to compete on at least level terms of similar scale to the USA and in part compete with what was then beginning to be termed Anglo-Saxon capitalism. This idea today extends to seeking to replace the dominance of the US ratings agencies, much blamed rightly for the credit crunch shock in the second half of '07.
Barnier says, "[In Europe] there are more problems with interconnection of banks rather than specific nature of operations or scale of individual banks.” This reflects a view that systemic risks in future must focus on how failure by any one bank can trigger losses via how banks are networked, which is essentially a piss-poor approach that ignores the wider macro-economic analysis. The Credit crunch is not a shock created by a few but by all banks influencing and being hit by economic and credit cycles. That some banks lost more is mainly due to to the the roll-over timings of the borrowings as much as their exuberance about structured products and property loans.
Barnier believes, however, that although markets are different, meaning Europe's from the USA's, though how he figures that I'm unsure, there needs nonetheless to be a global approach to reform in line with the G20 agenda. Obama's problem is therefore whether he can get his proposed cap on prop trading by banks onto that agenda and this now appears very doubtful. There is a commitment to cap bonuses, but the banks so far, while at first politically naive or insenitive in under-estimating the political force of public anger, now feel they can simply postpone the matter by translating current bonuses into shares and share options for staff to be encashed at a future time.
President Obama’s reforms were drawn up by the octogenarian former chairman of the Federal Reserve Paul Volcker that would directly and indirectly limit the size of banks beginning with allowing none to have more than 10% of total US bank capital (i.e. market share) or assets of more than 10% ratio to GDP (an absolute size constraint that if Citicorp including its foreign assets was so measured it would have to shrink) and the new proposed US legislation (not yet published) would also prevent commercial banks from making investments in hedge funds or private equity operations - or these may be limited to minority shares much as institutional investors in both US and EU are limited in their shareholdings of banks.
In Europe the desired limit of any one bank's market share is 15% on a state by state basis in retail and corporate banking but with no caps on investment banking arms. problems with this however are that market shares are not reliably calculated and banks are also trading with each other and act in collusion including with other financial firms i.e. they do not necessarily compete. determining what is real competition is a very complex matter.
Part of Europe's difference in financial culture terms is its invention of unversal banks who combine retail and investment banking with asset management and insurance. Regulators in Europe have in practise, however, sought to divorce insurance arms from their parents such as in the cases recently of Fortis, ING and RBS, but they face a pronlem of insurance companies forming banking subsidiaries. Fortis for example began as an insurer.
The ECB - European Central Bank - response to Obama’s bank reform is was indicated in Milan by Lorenzo Bini Smaghi, ECB exec. board member, that the “Volcker rule” - splitting traditional banking from high-risk proprietary trading - was “heading in the right direction” and “a first step to ensuring the financial system can effectively support the real economy and is not weakened by the most volatile market fluctuations”.
But he worried such a step may drive higher risk trading beyond the control of regulators. He added that while initially there had been a global determination that no part of the financial system would be left uncovered, “Over time, this resolve has dwindled and attention has mainly been focused on banks” and the US initiative should not distract from strengthening independent supervisory authorities, and “regarding the developments in the current debate in the US, where the most independent institution, namely the Federal Reserve, is subject to attacks and pressures from various corners, including legislative initiatives aiming to curtail its powers.” FT comment: Central bankers of the world unite!
JPM is worried by all this. It echoes others in suggesting this is regulatory overkill, that fixing “too big to fail” (TBTF, that some quip should read "too big to feel") will take a compensatory toll on the economy.
Research by JPMorgan estimated total cost of the regulatory initiatives now targeting the world’s big banks following shot-gun weddings between banks and a few suspicious deaths during the credit crisis. In 1990m there was only one bank with total assets worth more than 50% ratio to its home country's GDP. Today, more than half the world's top 25 banks are in this position. Is that important in respect of banks' insolvency risks, and is there a level at which TBTF begins?
Recent bank failures show low correlation with size. But, that is only true when %numbers of failures is unweighted by size of assets. Many failures were small single-product banks alongside large, diversified ones. But, the dependency of the former on the latter is a factor. Arguably, what failures have in common is therefore not scale but high leverage, low underwriting standards, inadequate risk management and excessive reliance on wholesale funding.
Actually, that's not exactly right. What killed some banks more than others was the timing at which their wholesale funding had to be rolled over. Inadequate risk management is universal among banks, but some were better had disguising the fact. High leverage was undoubtedly a problem, but required excessive concentration in illiquid instruments and markets. Generally, all banks risk diversity was dictated to them by their markets, their size and competence whereby small size and incompetence to engage in some complex areas saved them while not being an indicator of superior judgement. Mostly, all banks showed themselves to be economically insensitive and naive.
In the worst scenario, JPMorgan reckons regulators imposing higher capital requirements and the the idea of separating casino banking from more socially directly useful activities such as deposit-taking to suppor traditional lending could reduce the profitability of the big bank model by about 60% - maybe therefore too, however, reducing exposure to unexpected loss by the same %? Returns on equity would plummet from 13.3% (expected in 2011) to 5.4%. This is a bizarre conclusion since traditional banking can generate 15% net interest margin returns on capital. JPM has not convinced me! Truth is that a prudently managed traditional bank will earn 1-1.5% return on assets and that delivers 10-15% return on equity.
JPM estimate that to keep profits (return on capital) constant, banks will need to hike prices of (retail) financial products by a third. If big banks have half their assets in non-traditional banking, does this imply double returns on assets and equity in investment banking compared to retail banking - if so surely far too high, and may be much of that return is paper profits in unrealised asset gains and treating good years as normal. Much of banks' profits were in the past inflated by unrealisable asset gains e.g. when banks sought to realise their structured credit assets the secondary market proved to be illiquid showing that so much profit recorded in the past was illusory/delusional - merely gains over several years of one-way markets where issuers kept issuing and primary investors kept buying but no one was selling much into secondary markets i.e. the instruments were not really tradable except as derivatives of derivatives.
One alternative is to slash compensation, perhaps by making bonuses dependant on realised profits not paper profits. Taking compensation down to 35% of revenues from the historic average of 45-50%, would mean raising prices by a quarter to keep returns on equity constant. Customers of retail banks, which have higher fixed compensation costs, would be milked for higher charges. I calculated that happened in Europe in the wake of the Euro's introduction and consequential loss of liquidity in intra-European FX and fixed income markets.
What JPM forgets is that stock-quoted banks had for a decade double the return on equity of the rest of the stock markets - it should be a good thing to align banks better to the economy they serve.
The Governor of the Bank of England, Mervyn King, in late January called for a "radical" overhaul of the banking system, which could include a break-up of the banks, and praised President Barack Obama's controversial plan to take on Wall Street. King told MPs yesterday that "we have to reform the financial system" and warned that if anything less than extreme measures were taken "we are doomed to make the same mistakes on a bigger scale".

US GDP & COMPONENTS

2010-01-30T09:40:00.001-08:00

The surprisingly high rebound to an annual growth rate of 5.7% in 4th quarter of 2009may (most likely) be revised downwards in the coming quarters. It depends on a suspiciously low inflation rate and a probably inflated value inventory build-up. Those of you aware of the high government borrowing requirement (budget deficit) may be surprised at the low contribution of Government consumption, but this is because the deficit is mainly to replace lower tax revenue, not to increase provision of government services and government employment. I would not be surprised to see growth in Q4 to be revised down by a third to a half. At the end of 2007 economists in banks were generally advising that growth would be positive in 2008 - how wrong was that? In Jan. 13, Bloomberg News reported, just as Obama was sworn in as President, from a survey of Economists in US banks that they had slashed forecasts for U.S. growth in 2009 and projected Federal Reserve policy makers won’t be able to start raising interest rates until 2010 - as if that was a possibility in 2009? The banks' economists consensus prediction was that USA would contract 1.5 % in 2009, a half percentage point more than projected in December. This was the median view of 59 forecasts, and that the slump will push inflation below what some Fed officials consider price stability. median consensus views are ALWAYS totally wrong! Banks' economists really must get their act together, like investment bankers they need to sit up and smell the cold coffee! How in darnation are banks to be relied upon to know the seas in which they are piloting their ships with this kind of groping-the-dark analysis. Back then, a year ago, the chief economist at JPMorgan Chase & Co. New York, said “It’s very hard to get anything into place to change the course of the economy in the first half of this year. We’re in the middle of something very deep here.” The economists were doubtful about the Obama government's
$775 billion stimulus package. The economists generally were hapless disbelievers and expected a long dark deep recession, worst since World War II.
What are they saying now that Obama has stopped the rot and is confidently pushing more stimulis bills to replace millions of lost jobs? 2009 4th quarter growth rate was the fastest since 2003 and marked two straight quarters of growth after four quarters of decline. Growth exceeded expectations mainly because business spending on equipment and software jumped much higher than forecast, plus improvement in external trade balance and continuing low inflation.
US economists' consensus expect 2010 growth to slow as companies finish restocking inventories and as government stimulus efforts fade. Many estimate the nation's GDP will grow 2.5-3% in the current quarter and 2.5% or less for the full year. But, already we are seeing massive jitters about Asia and a flight to USA pushing up the dollar. Economists are not good at assessing the global picture - it is not neutral.
At 2.5% GDP growth - that's not enough to reduce unemployment, now 10%. Yet, Obama has said clearly this will not be a low employment creation recovery like under Bush. This time jobs creayion is the number one priority - I believe him, why can't the banks?! Most analysts say they expect the jobless rate to keep rising for several months and remain close to 10% to end of the year.
High unemployment and stagnant wage growth will likely keep consumers cautious about spending. Wages and benefits paid to U.S. workers posted a scant gain in the fourth quarter. And for all of last year, workers' compensation rose by the smallest amount on records going back more than a quarter-century. The economic recovery could falter if consumers, who account for 70 percent of economic activity, lack the income to ramp up spending.
Well, I don't believe any of that doomster pish!

Krugman's View

2010-01-11T02:29:00.000-08:00

By PAUL KRUGMAN, Published NYT and FT, January 7, 2010
Health care reform is almost (knock on wood) a done deal. Next up: fixing the financial system. I’ll be writing a lot about financial reform in the weeks ahead. Let me begin by asking a basic question: What should reformers try to accomplish?
A lot of the public debate has been about protecting borrowers. Indeed, a new Consumer Financial Protection Agency to help stop deceptive lending practices is a very good idea. And better consumer protection might have limited the overall size of the housing bubble.
But consumer protection, while it might have blocked many subprime loans, wouldn’t have prevented the sharply rising rate of delinquency on conventional, plain-vanilla mortgages. And it certainly wouldn’t have prevented the monstrous boom and bust in commercial real estate.
Reform, in other words, probably can’t prevent either bad loans or bubbles. But it can do a great deal to ensure that bubbles don’t collapse the financial system when they burst. Bear in mind that the implosion of the 1990s stock bubble, while nasty — households took a $5 trillion hit — didn’t provoke a financial crisis. So what was different about the housing bubble that followed?
The short answer is that while the stock bubble created a lot of risk, that risk was fairly widely diffused across the economy. By contrast, the risks created by the housing bubble were strongly concentrated in the financial sector. As a result, the collapse of the housing bubble threatened to bring down the nation’s banks. And banks play a special role in the economy. If they can’t function, the wheels of commerce as a whole grind to a halt.
Why did the bankers take on so much risk? Because it was in their self-interest to do so. By increasing leverage — that is, by making risky investments with borrowed money — banks could increase their short-term profits. And these short-term profits, in turn, were reflected in immense personal bonuses. If the concentration of risk in the banking sector increased the danger of a systemwide financial crisis, well, that wasn’t the bankers’ problem.
Of course, that conflict of interest is the reason we have bank regulation. But in the years before the crisis, the rules were relaxed — and, even more important, regulators failed to expand the rules to cover the growing “shadow” banking system, consisting of institutions like Lehman Brothers that performed banklike functions even though they didn’t offer conventional bank deposits.
The result was a financial industry that was hugely profitable as long as housing prices were going up — finance accounted for more than a third of total U.S. profits as the bubble was inflating — but was brought to the edge of collapse once the bubble burst. It took government aid on an immense scale, and the promise of even more aid if needed, to pull the industry back from the brink.
And here’s the thing: Since that aid came with few strings — in particular, no major banks were nationalized even though some clearly wouldn’t have survived without government help — there’s every incentive for bankers to engage in a repeat performance. After all, it’s now clear that they’re living in a heads-they-win, tails-taxpayers-lose world.
The test for reform, then, is whether it reduces bankers’ incentives and ability to concentrate risk going forward. Transparency is part of the answer. Before the crisis, hardly anyone realized just how much risk the banks were taking on. More disclosure, especially with regard to complex financial derivatives, would clearly help. Beyond that, an important aspect of reform should be new rules limiting bank leverage. I’ll be delving into proposed legislation in future columns, but here’s what I can say about the financial reform bill the House passed — with zero Republican votes — last month: Its limits on leverage look O.K. Not great, but O.K. It would, however, be all too easy for those rules to get weakened to the point where they wouldn’t do the job. A few tweaks in the fine print and banks would be free to play the same game all over again. And reform really should take on the financial industry’s compensation practices. If Congress can’t legislate away the financial rewards for excessive risk-taking, it can at least try to tax them.
Let me conclude with a political note. The main reason for reform is to serve the nation. If we don’t get major financial reform now, we’re laying the foundations for the next crisis. But there are also political reasons to act. For there’s a populist rage building in this country, and President Obama’s kid-gloves treatment of the bankers has put Democrats on the wrong side of this rage. If Congressional Democrats don’t take a tough line with the banks in the months ahead, they will pay a big price in November.
MY COMMENT
One striking aspect of the public debate about the future of financial regulation and its restructuring is that most available experts employed by the authorities to formulate policy work for one of the major investment banks and, in respect of credit derivatives and other OTC markets, broker-dealers who are often also prime brokers responsible for feeding asset bubbles via excessive leverage (far too low risk spread-margin ratios). There are a few prominent and credible voices among people who are ex-senior bankers, Treasury, Central Bank and Regulatory officials and financial sector economists. There are also top academics like Krugman, but Government Ministers appear to often to be persuaded that they primarily need the help of experts in structured financial products, from people run M&A, underwriting and credit trading operations who cannot go on-the-record because they lack legitimacy with the general public and in the media who would be right to conclude this is akin to asking felons to dictate anti-crime legislation.
The Obama administration and UK Treasury too may be criticised from various angles for employing key advisors from the finance sector in policy-making roles. The US administration argues, 'Where else can we find people with sufficient expertise?' This is part of the very questionable assumption that private sector execs are superior to academics and is further part of a discomfort with using economists or academics generally?
As an analogy: the defense sector faced a similar problem after World War II. The fast-growing importance of new technology in combat meant that military needed highly specialist suppliers who would invest large amounts of private capital in developing tanks, airplanes, radar, space weapons and other types of equipment. But there was – and still is – the danger that these companies capture Defense Departments/ Ministries and push them, leverage them, to buy overly expensive and ever more complex systems, like IT, as if competitiveness requires continuous innovation whereby every new development rapidly becomes redundant and will be replaced as soon as money to do so is made available. There has been a similar 'arms race' in Financial markets whereby very little survives long enough to have its utility and stability determined. President Eisenhower famously warned in 1960, as he was leaving office, about the 'military-industrial complex'. Such a warning today about the 'Financial-economy complex' would surprise nobody! One can refer too to C. Wright Mills’ influential 'The Power Elite' (1956) that put weapons suppliers at the centre of US national power structure. Constraining the power of defense contractors is a hard problem – and you might say that we have not completely succeeded, depending on your view of Vietnam, Iraq, and Afghanistan. Can we be any more successful in determining how to reform global finance and then to implement reform?
At least in terms of weapons design and procurement, there was progress in developing a set of highly skilled independent engineering auditors as argued by Larry Candell in the latest issue of Harvard Business Review. The equivalent in Finance has to include independent macro-economists, such as my firm Risk Dynamics, which is the only independent risk model evaluator exclusively dedicated to this role - somewhat equivalent to a private sector financial regulator. Regulatory change needs economists who are able to analyse finance sectors nationally and globally in well-defined models - people like myself dare I say, but there are precious few of us.
Government should set up independent risk model validation labs (a role currently the responsibility of Central Banks and Supervisory Regulators, but which they cannot easily fulfill given their status as ultimate authorities) that would concentrate on testing financial products, markets and models in test bed-type settings before certifying for trading in real markets. With today’s computing resources and plenty of unemployed finance talent at hand, it is feasible to develop teams to test financial system stability. In the USA, the proposed National Institute of Finance (NIF) has such goals – the National Institutes of Health is an appealing model, like FDA and their equivalents in other countries. But, just as government agencies lose independence by employing investment bankers to advise, so to has NIF by proceeding with 'tied' industry-backing e.g., Morgan Stanley and Bank of America. We should be skeptical when absolute independence cannot be guaranteed. That said, of course, it is not always the case that University academics can evidence absolute independence. We definitely need independent experts who can be called to analyse for, report to, or testify before, legislators. They must have a deep understanding of financial markets, as well as hands-on experience with products that are dangerous to economic health.
It would be great if experts could break all ties with hedge funds, banks, or other financial institutions, who are capable and willing to step forward and contribute, but let's also recognise that many of our best experts don’t actually work for the big banks etc. Independent experts must be able to criticise major financial service firms and also the authorities. Many do so in private, but few are willing to step forward in public - this we leave precariously to journalists, and we should be thankful dor journalistic experts such as Krugman or, for example, the FT' feature writers who have done exceedingly well in documenting the crisis?

Politics of Exiting from Support for banks.

2009-12-23T22:42:00.000-08:00

The difference between book value assets swapped by banks at the Federal Reserve and the Treasury Bills obtained (created by 'valuation margin' plus fees) provided the liabilities side of the ledger for purchase of preference shares in the banks and for Quantitative Easing - and the same is exactly true in the UK. How much and from precisely whom what has been pledged and swapped is unclear except in abstract at high level, with details kept off the reported balance sheet of the central banks. As Ben Bernanke said Nov. 18, '08 to the House Financial Services Committee.“Some have asked us to reveal the names of the banks that are borrowing, how much they are borrowing, what collateral they are posting. We think that’s counterproductive.” Similarly, in the UK, the 2009 banking Bill made disclosure entirely a matter of Bank of England and HM Treasury discretion. There has been partial disclosure in both countries.
There are four purposes served: one, for Government to replace private sector funding of banks' 'funding gaps' (roughly difference between deposits and loans financed on medium term basis by banks rolling over MTN programs that could not be continued when private sector sources dried up in the credit crunch); two, to replace banks' reserve capital eaten away totally by asset writedowns and credit losses; three, to replace ordinary equity with Government-owned preference shares; four, to take troubled assets off the banks' balance sheets for up to 3 years. All this is facilitated by 'buying' in banks' loan assets in exchange for high interest repayable loans and treasury bills paying almost zero coupon. If the banks fail to be able to repurchase their pledged assets when the 3 years is up then Government buys these outright and retains flexibility to pursue for the loan balance, keep or sell the assets.
All this can be very profitable to Government if it retains the holdings well into economic recovery when the loan assets will have gained in value and over a number of years of bank paying interest and fees. But, with signs of junk bonds recovering in market value and banks share values trending up the banks are keen to pay off and take back what they can to enjoy as much as they can of this profit for themselves, and thereby also avoid direct controls and direction from Government. They are beginning with buying back government shareholdings.
Government is anxious to prove politically that the financial measures to save the banking system are only temporary and remunerative for 'taxpayers' and that the federal budget deficit can be narrowed, even though the support for banks was 'off-budget' and never actually a direct cost to taxpayers, except for one early cost items, TARP. Voters remain dismayed at the disconnect between several $trillions Government aid support for 'Wall Street', which seems to be restored to underlying profitability ahead of 'Main Street' i.e. the rest of the economy, which received it seems much less in loans and deficit investment.
Hence, with mid-term elections in mind in 2010, TARF will close to new deals in March and several repayments of government preference share holdings can be headlined. Citigroup and Wells Fargo this week unveiled a total of $30bn in stock raising to return $45bn to Government. This trades off reducing government supervision (seen as intereference in bonuses and lending levels) at expense of diluted shareholders and short-term profits (hitting shareholders and tax payable to Government). While the values are small in terms of obligations to Government (worth circa $3-5.5 trillion depending on how one looks at it or even up to $8 trillion when insurance guaranees are crudely factored in), but large in terms of shareholders' equity. Arguably, this is another blow to the myth of 'shareholder value' at least in short to medium term, and may be seen as bankers protecting themselves and their bonus culture at the expense of shareholders?
The repayments first by bank of America and now by City and WF are intnded to blunt government restrictions on pay and operations – and herald the beginning of the end of a period of extraordinary federal support for leading banks.
On Dec-02..President Barack Obama told bankers assembled at the White House that they should help boost the economy – particularly by helping finance “creditworthy small and medium-size businesses” – in return for the government assistance. “The way I see it, having recovered with the help of the American government and the American taxpayers, our banks now have a greater obligation to the goal of a wider recovery, a more stable system and more broadly shared prosperity.”
For several reasons it is difficult for banks to comply with this as it means switching off their credit risk systems and even pushing loans when borrowers are deleveraging and small businesses seeking to borrow more are viewed as likely to be heading for failure even if only because they are being squeezed to death in many cases by big business customers.
The Citi offering, which could be the biggest yet by a US bank, is another unexpected and unwished-for test of shareholder medium to long term faith in the company’s future. Under the agreement, US Treasury will sell up to $5bn of the bank’s shares, reducing its 34% stake to below 30%. The authorities have agreed to sell the rest of the government’s stake within the next year! Citi will also terminate an agreement with FDIC to backstop $250bn in toxic assets. As a result, Citi will cancel $1.8bn-worth of preferred securities held by the FDIC, leaving the regulator with $5.4bn of preferred shares. Adding insult to injury, as shareholders are diluted Citi will issue $1.7bn in stock to staff in lieu of bonuses and might sell $3bn in preferred securities in 2010. The measures may result in a $10.1bn pre-tax loss in 4th quarter but save Citi $2.2bn a year in interest and amortisation expenses, much of it to Government!
Citi’s stock issue will be accompanied by selling $3.5bn in convertible bonds to bolster its balance sheet but this dilutes the equity of existing shareholders (private $50bn, government $25bn, roughly) by roughly 5%, causing Citi shares to close down 6.3% on the announcemtn to $3.70. But total shareholder dilution could be far more than this?
Wells, which bought Wachovia last year will sell assets worth $1.5bn and save a further $1.4bn by paying employees in stock not cash. Once Citi repays the Tarp funds, Wells Fargo will be the only major bank still in TARP, which helped bail-out capital reserve equity shortfalls in 700 US banks, after Bank of America recently returned its $45bn bail-out TARP funding. But the banks are still heavily obligated to the Government in other programmes including TARF.
All US banks have received balance sheet support worth more than twice all US banks' reserves including support for mortgage assets via Ginnie, Freddy and Fannie agencies, plus other programmes via FDIC. Banks may not be able to repay more than half i.e. about $1 trillion within 3 years, hence another up to $1 trillion is envisaged being sold to Hedge Funds and similar 'Shadow-banking' investors supported by soft loans from the Federal Reserve - why? because shadow banking's normal leverage source has been the banks via prime brokers but they've dried up their risk appetite.

Federal reserve balance sheet

2009-10-21T06:02:00.000-07:00

In the USA many commentators are having a panic reaction to the spectacular spike in the federal Reserve's balance sheet e.g. Dr Martin Weiss's newsletter essay titled Bernanke gone Beserk! from which the above and following chart come from. Anyone could say the exact same about the UK's Bank of England (HM Treasury & DMO) balance sheet growth that is more imposing relative to GDP even before the massive £585bn ($936bn) awaiting approval to grow the Bank of England balance sheet dramatically (with the innovation that the assets will be swapped for Bank of England unencashable cheques that the banks cannot remove from the premises - a dangerous innovation only if banks start writing unencashable cheques to each other and treating them as balance sheet items!) There is no comparison with earlier Fed balance sheet hikes; none were of this magnitude or persistence. What is different this time is that the Fed (like the the Bank of England & HM treasury) is substituting for private funding sources to supply funding of banks' 'funding gaps' (previously filled by Medium Term Note & securitization programs). The liabilities that balance the central bank assets growth are heavily discounted securitised loanbooks (discounted below their mark-to-market and/or actual gross defaults impairment), subject to large fees, and with substantial interest margin in favor of the Fed (or Bank of England/ HM Treasury in the UK, or the ECB in the Euro Area). Terms & conditions are renewable every time the Treasury Bills (government securities with less than 1 year maturity) that the assets are swapped for are rolled over. In essence these are major repo swaps but with unusual informal as well as formal conditions attached.
Informally, if no less imposing, the banks must treat the T-bills as reserves they cannot encash except to buy back their pledged assets but must continue to roll-over until the private sector wholesale funding sources are again available at a near to normal price i.e. whatever banks consider safely affordable, though this is a high threshold given the profitable charges & rates asserted by Fed & FDIC. The Fed can sell the assets on as and when it chooses to, whether via the awkward subsidised TARF scheme or any other better one it can come up with. We need not worry this is 'printing money' as if new money injections into the economy and thereby boosting banks' lending capacity and the money supply. It is replacing private funding sources (of 'funding gaps' between deposits and assets much of whose private funding capacity has evaporated. It is a liquidity injection into a falling money supply. This too is very much the conscious awareness of the Bank of England's 'liquidity measures' (including APS, often mistakenly terms asset insurance, when that is the least of it). But net increase in money supply is hard to judge. When banks are shrinking their balance sheets(and hedge funds also) it does not appear in aggregate to be a "printing money frenzy" as Dr Weiss states (& many others) - all else in the monetary context has not remained stable but receded/ fallen. The Fed is filling a gap that has appeared as private wholesale funding capacity has receded, not adding on top to what was there in order to maintain monetary growth stability. It is only by looking only at the surface data of the central banks' balance sheets one can imagine there must be a money supply explosion - not so, and especially not in very low or begative general price inflation.
The superficial impression is that the Fed (Bank of England especially too & others) are behaving totally without precedent, somehow thoughtlessly or carelessly - but is that a realistic presumption? Do they not know what it is they are doing?
It is easy in a 'Federal Tax Dollar' obsessed USA to create panic over this as if the whole amount of Fed balance sheet explosion is tax dollars at risk - much as there is enormous misunderstanding already about the size and affordability to taxpayers (and to the exchange rate of the dollar) of Federal Debt looked at gross. In fact it is not hard to also calculate looking forward that the net returns to the Fed as all this unwinds medium term will generate profit to the central budget or via the Fed debt balances sufficient to pay for more than half of federal budget deficits in the coming years!

10 DAYS UNTIL BUDGET RUNS OUT - not healthy

2009-09-21T07:40:00.001-07:00

Congress is behind schedule for passing the bills that authorise spending for the 2010 fiscal year, which starts on October 1st. Congress was to have been well through the process in early summer, but several factors intervened:
1) stress-tests of the major banks to see what capital requirements they will need that could involve some items on-budget (most bank aid being off-budget)?
2) vituperative partisanship over Health Care plans?
3) waiting to see if predicted end of recession has arrived?
4) Republican legislators testing their minority power to see if a possible re-run of Republican stymying of Clinton's 1995/6 budget that partially shut down Federal Government in November and December 1995. This was the culmination of a process that began in '93 around both budget and health care and is being repeated as the tactic against the Obama administration today. The risk today as then is that Democrats lose their slender majorities in one or both houses of Congress as they did in '94.
In 1993, when Clinton squeezed his budget through in June, Republicans were a minority in Congress, but by galvanising their revolt, they recaptured Congress in the '94 year's interims. By failing to pass the '95 budget, and by insisting on a constitutional amendment to enforce a balanced budget by 2000 (which Clinton achieved 3 years earlier much to republican chagrin) the US economy had some growth shaved off and this coincided in '95 with one of the coldest hardest winters on record. Globally, the effect was to panic many OECD countries into thinking another recession dip was imminent in 1995/6 and consequently many, especially, the UK, upped their fiscal stance to compensate. Balancing the US budget and the political power struggles in Congress forced other countries into higher deficit spending.
We may face this in the next 2-3 years again when recovery globally remains fragile! By May '09 it looked like Congress would complete budget appropriations on time. The House passed all 12 of its spending bills. But, then, the Senate passed only four, and all twelve had to go to conference, where House & Senate versions are reconciled. That cannot happen now in the next 10 days, and the struggle to get the budget passed may also be employed to topedo the health care reform bill, on which so much of Obama's political capital is invested!
What happened in the early '90s? In Spring '91 - Minority Whip Newt Gingrich, predicted the "next great offensive of the Left will be socializing health care." He called on hardline Republicans to position themselves to stop Democrats from winning on this. The same strategy has been re-conditioned for use against Obama. In November '91 - arguing that every American should have the right to a doctor, Harris Wofford defeated Dick Thornburgh to become the first Democrat to win a U.S. Senate seat in Pennsylvania in 30 years. In January '92, the Clinton campaign issued a health care white paper as its opening salvo for the 8-month long campaign. In June '92, Clinton began using a new jargon for health care reform called "managed competition." In July, Clinton accepted the Democratic nomination vowing to "take on the health care profiteers and make health care affordable for every family." (Obama, and also Hillary Clinton adopted similar platforms in 2008.) In August '92, when the election was in full swing, Clinton was warned by campaign aides that his position on health care is too unstructured; too unclear to be easily defended. The same has now been said to President Obama, 8 months into his presidency! By end of August '92, partly as a result of political pressures from incumbent George Bush and a deal negotiated between the two candidates (one that also included no prosecutions over Iran-Contra) and partly as a result of internal debates among rival advisers, a major effort was launched to reposition health policies, to merge Democratic left and right, and shed the "pay-or-play" label that was the focus of hysterical attacks. A policy-broker was Dem Sen Jay Rockefeller who argued against changing "pay-or-play", while warning that "Americans deserve or have a right to health care" (which is echoed today in Obama's current moral crusade that relies on the last public policy letter written by Sen Edward Kennedy). back in '92 Rockefeller said the policy presented problems in that "Although many Americans may initially react positively to this statement ("pay-or-play"), over time it can make them uneasy. Before long they will be asking: How would we pay for all that care for all those people? Won't it require a huge new government bureaucracy?"
Today, this dovetails with fanning flames of anxious ire about budget deficit spending (that also internationally encourages fiscal Conservatives to grossly exaggerate the lilihood of higher tax rates). Long term budget issues are being confused with short term crisis management. Long term health care reform in the USA is being sized up as if it it could be a burden long term similar to bailing out the banks, when in truth both matters rapidly become self-financing! But, opposition politicians are not averse to under-estimating voter intelligence about the long term in search for short term plitical advantages. Saving the Obama health reform bill may cost delay in passing his budget and in turn undermine economic recovery measures short to medium term. His response to being cornered is similar to Clinton's in '92 and '93. In September '92, Clinton pulicly revised his health reform, dropping the term "managed competition," to contrast his approach with the wholly private sector plan of President Bush. Obama did the same in '08. In November '92 and '08 Clinton and Obama respectively won the election. In both years, polls showed voters ranking health care far behind the economy behind the budget deficit. The majority of the public has only the fuzziest notion of what either Clinton or Obama had in mind for health care reform.
Clinton and Obama both addressed Congress a month after taking office.
President Bill Clinton's focus was on the economy, budget and taxes, he used the speech to make the policy link between health care reform and deficit reduction. The initial positive response bred false optimism in the White House. Advisers argued for a one-two punch: First, win a great budget victory by May; then follow up immediately with the introduction of the health care plan. But the consensus among Democratic congressional leaders was that there's not support for going to the well twice for difficult votes on health care and on budget cuts. Clinton then made the error of proceeding to put health care into the main budget bill.
President Barack Obama's focus was on the economy, budget and taxes, he used the speech to make the policy link between health care reform and deficit reduction, but not in a single budget appropriations bill. Obama is not doing this. The Health bill (650 pages) is hoping to get passed by year-end. He told Congress in February that an era of extravagant spending must end; the roots of the economic crisis is short-term gains prized over long-term prosperity. "And all the while, critical debates and difficult decisions were put off for some other time on some other day. Well, that day of reckoning has arrived, and the time to take charge of our future is here." He praised Congress for passing the economic stimulus plan, which he said would create millions of jobs and revitalise the US, and promised to deliver a tax cut to 95% of Americans by 1 April (that some said is April Fools Day). "We will recover," replaced "Yes, we can!" The recovery package, signed after compromises debated in both houses, was designed to channel federal money toward infrastructure projects, health care, renewable energy development and conservation programmes. The first month of Mr Obama's presidency also included a banking bail-out worth at least $1.5 trillion plus a plan to support "responsible homeowners" struggling with mortgages. He popularly told his audience that banks and bankers taking public money will be fully accountable, vowing that tax dollars would not be frittered away (bravery about hostages to fortune). "Those days are over... It's not about helping banks, it's about helping people." The speech came days before the unveiling of the first Obama budget, with a deficit at roughly $1 trillion. President Obama said the vast deficit and the "crushing cost" of healthcare made the need for wide-ranging reform more urgent than ever, and he pledged to reform and improve the nation's schooling and boost the numbers of students in higher education, restating a pledge to cut the deficit in half by the end of his first term, and to eliminate wasteful and ineffective schemes. Over 6 months later, President Obama had to address both houses of Congress again, after a struggle to pass his budget and serious obstacles in the way of health reform on which the Republican Opposition was now focuses much as it had been back in '93 against Clinton. Obama (9 Sept.) put the moral argument, which while gaining over 60% public support according to the pollsters, nevertheless has a hard climb to overcome medical insurers' and pharma companies' campaign contributions. His fighting talk called for serious proposals from Democrats and Republicans to address chronic health care problems and rising costs, warning that he would not "waste time with those who have made the calculation that it's better politics to kill this plan than improve it. I will not stand by while the special interests use the same old tactics to keep things exactly the way they are (to great applause from Democrats). If you misrepresent what's in the plan, we will call you out. And I will not accept the status quo as a solution. Not this time. Not now." In January '93, Clinton formed The President's Task Force on National Health Reform to "prepare health care reform legislation to be submitted to Congress within one hundred days of our taking office" with his wife, Hillary Clinton, heading it up. A blanket of secrecy was imposed on task force operations. Obama, like Clinton, has placed much of his political credit on Health Care. In both cases, such priority commitment instantly limits how far cabinet secretaries and White House aides can go in pressing alternate views.
In order to meet their hundred-day deadline and win swift congressional passage the Clintons sought to fit the health care into the presidential budget and pass it all in one gigantic package, seeking the advantage that under Senate rules the reconciliation bill can be debated for only 24 hours before it comes to an up-or-down vote.
Obama has even less time to try this, and has achieved little if any bipartisanship. Not one Rep legislator appears prepared to vote for Obama health care overhaul! Obama confronted the concern of opponents by pledging that any health care bill approved by Congress won't increase the federal deficit, repeating past statements that savings in the existing health care system will cover most of the cost of an overhaul bill. He also said, "not a dollar of the Medicare trust fund" would pay for the bill, but provided few details of exactly how, saying the plan will eliminate "unwarranted subsidies in Medicare that go to insurance companies" and create an independent commission of doctors and medical experts to identify further waste. In an emotional conclusion, Obama invoked the late Sen. Edward Kennedy citing a letter in which Kennedy called providing health care to all Americans "above all a moral issue." "'At stake are not just the details of policy, but fundamental principles of social justice and the character of our country...'". "I've thought about that phrase quite a bit in recent days -- the character of our country," Obama said to the hushed chamber. "One of the unique and wonderful things about America has always been our self-reliance, our rugged individualism, our fierce defense of freedom and our healthy skepticism of government." - adding that Kennedy recognised that with all of the drive of Americans to stand strong, there comes a time when government must step in to help. "When fortune turns against one of us, others are there to lend a helping hand," citing "a belief that in this country, hard work and responsibility should be rewarded by some measure of security and fair play; and an acknowledgment that sometimes government has to step in to help deliver on that promise." The opponents are claiming that while half of all personal bankruptcies in the US may be partially the result of medical expenses, the rising costs also mean the government is spending more and more on Medicare and Medicaid, and US government spending on the two schemes is expected to rise from 4% of GDP in 2007 to 19% of GDP in 2082, making rising healthcare costs one of the biggest contributing factors to the spiralling US budget deficit long term. This is similar to the hysteria that a Republican-dominated Congressional Budget office created in '94 about the long run cost of an ageing population, claiming, also very one-dimensionally, that the burden of old folk would absorb half of the Federal Budget and a quarter of GDP by 2050!
In March '93, the chairman of the powerful Senate Appropriations Committee, blocked the Clinton reconciliation bill strategy, calling it "a prostitution of the process" by pushing through "a very complex, very expensive, very little understood piece of legislation." We can expect the same tactic attempted now.
In April '93, media leaks were a problem, indicating that a value-added tax increase is under consideration. Hillary Clinton met with Republican and Democratic senators, imploring them to tell her what she is doing wrong and that she is having trouble getting dialogue with Republicans (Senate Minority Leader Bob Dole told Republicans not to meet with the First Lady). In May '93, a chart was leaked to the New York Times detailing health reform impact on national spending, altered to appear as if $150 billion is required in new taxes. private White House meetings are leaked to the newspapers. The Health Insurance Association of America (HIAA), restates support for universal coverage but complains of attacks on health insurance industry for "price-gouging, cost-shifting and unconscionable profiteering." Similar, brickbats were thrown this year in '09, also to diminish public support for reform. By the end of May '93 The Clinton Health Care Task Force is disbanded.
The health insurers started an advertising campaign with straplines "They choose, you lose" and "There's got to be a better way." And, the National Federation of Independent Business (NFIB) tried to kill a key element of the reform plan with mailouts and state by state meetings, to stop the "employer mandate" that would require all businesses to provide health insurance for their employees. This aspect is not in the Obama Plan.
In June '93, worried at having no effective political support team, the Clinton administration set up a "War Room" to monitor media, orchestrate responses to attacks on the Clinton health plan, and schedule administration and congressional visits to forums being held around the country. Obama may be doing the same today.
There was in '93 loss of left-wing Democratic support as the original principles were becoming less universalist.
In June '93, Clinton's budget got through only the Senate only with Vice President Gore's casting vote. Health care reform is therefore shunted off until another day. In early Summer '93President Clinton told the DNC (Democratic National Committee) to make grassroots efforts to support health reform. The DNC first tried to set up a tax-exempt "educational" foundation, separate from but allied to the DNC. When word of that leaked, critics said it will allow power brokers with their own agenda to curry favor with Clinton by secretly financing his pet project. The DNC backed off and offered to run the program itself, but they lacked a budget for any serious grassroots efforts, which was then junked in favour of a media campaign. Some called for the health care plan be delayed until '94, but others saw this as a death sentence for health care reform. Similar thoughts are the case today, for the next year means health care is a central part of mid-term Congressional elections.
Advisers are in disagreement, and President Clinton decided not to make any decisions until after his vacation. Obama did similarly, but returned to the fray with renewed vigour, except late in the Congressionl diary. In August '93 a plan is presented to a meeting of US state governors, but agreement is not found!
Ironically, while Clinton planners privately stress a conciliatory, middle-ground approach for reform, the public and many on Capitol Hill are beginning to gain an impression painted by opponents that the plan is a liberal, secretly concocted, Big-Government scheme to dictate how people get their health insurance and medical treatment. A rough draft of a plan embodying decisions on alliances, proposed price ceilings on insurance premiums, and Medicare cuts is used to brief members of Congress, but the supposedly secret plan is leaked to the press and to anti-bill lobbyists.
One difference this time is that number of congressional committees have been working on healthcare reform bills. The outlines of all competing bills are similar, and compatible with that of the White House. All favour tougher regulations for insurers, establish an individual mandate, set up insurance exchanges for those who do not have employer-provided coverage, offer subsidies for the less well-off (although the exact size of the subsidies varies from committee to committee), pay for most of the reforms by cutting waste in the Medicare programme. The major points of disagreement are on the "public option" and on how to pay for the remainder of reform. The Senate Health committee was the first to pass a healthcare reform bill
The House of Representatives bills propose to pay for reform by levying a surtax of up to 5.4% on families earning over $350,000 a year. In the Senate, the Health committee also backed the idea of a public option, but cannot rule on financial matters, the jurisdiction of the Senate Finance Committee, which has yet to produce a final bill. The Finance Committee has gathered together an informal, bipartisan group of senators - known as the "Gang of Six" - in an attempt to hammer out a compromise that will attract support from both parties. Will this work?
In September '93, President Clinton's advisers agreed on an explicit congressional strategy. Rather than start from the centre, writing a bill to appeal to conservative Democrats and moderate Republicans (while telling the liberals this is the best they can expect), they start from the left and moving as far to the centre only as needed to reach a majority. But, Newt Gingrich is determined there be no Republican support for any Clinton-designed reform and the whole effort be derailed.
The media ran stories describing and analysing Clinton's secret draft plan. Decisions are made, unmade, revised, and remade about what TV shows cabinet members and Democratic members of Congress will appear on. The result, according to one of those involved, is "piss poor planning and disastrous conflicts." Not unlike how fiscal policy and bank bailout schems are discussed today, back in September '93, opponents dismissed the economic calculations as "fantasy numbers" even to the extent of saying there is "no health care crisis."
Trying to replay the similar tactics in the run-up to next year's mid-term elections, not only health care bill but the general federal budget faces a struggle to pass in the Senate, for which very little time is left. That means Congress has to pass a “continuing resolution,” or a series of them, to temporarily fund the government, which would be a replay of '93, '94' and '95. That’s bad for a couple of reasons: One, a full federal budget for the year, federal agencies and sub-agencies can’t plan. They literally hold up recovery plans and programs because they don’t know if there’s money for them. Two, when Congress passes these bills in haste, lots of shenanigans will happen. Recall that it was in 2000, a provision was slipped into one of these big bills to remove Glass-Steagal that many claim ultimately helped cause the 2007-09 financial meltdown. That can be what Congress is playing with when it fails to get its work done on a regular schedule, and the rest of the world hanging on the economic and policy guidance teats of the USA!

US CORPORATE PERFORMANCE

2009-09-15T12:06:00.000-07:00

As we know corporates are like households de-leveraging if they can to reduce their exposure to financial markets and cut costs especially investment, to defend margins and business models, and maximise profits to restore share values or push up their shares in the current rising market, which may prove a temporary centre of a W or double-dip. But in the interests of recovery, are US profit margins unsustainably high? FT's Lex argued that US corporate profit margins are too far above their long-run average and should "return to the mean relatively quickly", implying significant risk to current earnings path. US corporate profits before depreciation, tax & interest amounted to about 35% of corporate output in 2Q '09 compared with a long-run average (since 1947) of 29% (which seems at first glance very high?)
The margins are indeed odd (spotted by Simon Ward at Henderson) in that pre-depreciation profits have been compared with net corporate output after deducting depreciation i.e. inconsistency in treatment of depreciation between numerator & denominator of the ratio. Two credible measures of profit margins are:
1) profits before depreciation, tax & interest as % of gross output, i.e. before depreciation; and 2) profits before tax & interest as % of net output.
These gross and net measures are shown in the first chart. The gross measure behaves similarly to the series in the FT Lex column, but net margins are much less extreme relative to history – 19.4% in Q2 '09 versus an average since 1950 of 18.1%.
The widening gap between the two measures reflects a trend increase in depreciation as a proportion of output, related to a rising economy-wide capital-output ratio and a shortening average life-span (working life - at least in theory) of capital goods, whether or not simply for "tax efficiency", and alo pressure in many quarters of industry to replace systems (IT etc.) and processes.
If gross margins were to mean revert, as Lex thinks likely, net margins would fall to the bottom of their historical range. Economic theory suggests that the income share of capital-owners should be stable over the long run but this refers to return rewards after costing for the erosion in value of assets (argument for using net rather than gross margins).
The FT focused on domestic profits, ignoring 25% share of total US profits accounted for by foreign earnings. The first chart (also from Simon Ward) compares total profits net of taxes and adjusted for inflation with a log-linear trend. This suggests that profits were 8% below trend in the second quarter after a 10% first-quarter shortfall – similar to the 13% deviation at the bottom of the last recession. The slope of the trend-line implies real profits growth of about 3.5% per annum. Assuming 2% inflation, nominal trend profits will be about 18% above the second-quarter actual level by the end of 2010. Consensus hopes of a significant earnings recovery next year are therefore not irrational, providing a near-term economic pick-up can be sustained.

GEITHNER'S G20 AGENDA

2009-09-05T11:05:00.000-07:00

Although analytically it is convenient to think of the real economy and financial sector as two subsets of capitalism, in reality, they are inseparable parts of the modern
political-economy, with a lot of two-way interdpendencies; finance sector is not just another boat bobbing up and down on the waves and tides of capitalism, but something as ubiquitous and powerfully a third as large in output but much larger in finabcial balances and cash-flows than government. The differences is of course that banking finances are private and dispersed and it is easy for bankers to duck political responsibilities. As we move into an era where banks have to be more macro-economic astute, they will become more politically active. At present that activism is weakened somewhat by needing government generosity of financial support.
The Credit Crunch has been a wake-up call to all to recognise that the interaction between the financial sector and the real economy is strongly influenced by
inter-government policies. The continuing financial turmoil is like a big stress test for theories on the interaction between the financial sector and the real economy and that stress-test is centred on the G20 agenda, about how our preconceptions about how the crisis will play out - the increasingly heard term "exit strategy". The US Treasury Secretary, Tim Geithner, other than Federal Reserve Chairman Ben Bernanke, may be the most important single person in the world of banking, if there is any such individual? At London's G20 agenda meeting the balancing trade-off (of private/public, individual star-players/ regulatory systems) seems to be between gaining France's agreement - and with Germany and ECB that of the EU and Euro Area - for the US & UK priorities in exchange for accepting a French (& EU) priority on reining in bankers' bonuses to pre-empt excessive remuneration from blinding bankers to excessive risk-taking i.e. a change in culture; a halt on where the 'star-culture' is leading, which is also about whether investment banking arms of large banks can continue to do competitive business with Hedge Funds and Goldman Sachs and attract and retain similar deal-makers. Do individuals or systems make the most difference to financial performance and social-economic benefits of banking, and can the governments who have saved banks from collapse dictate a new more macro- and micro- prudential banking culture? It is a perplexing question-of-judgment-balancing; do people or systems, private or public interests, animal-spirits or politics, count for most in how global finance works well or badly. Whose face should be on the dollar, Lincoln or Bernanke? The G20 meeting is therefore about whether the political leaders around the negotiating table can make a difference; collectively recognise the imperatives of what to do about the world's banking systems including the culture of star-player bankers or not? The crisis has eviscerated shareholders of banks and replaced private funding sources and capital reserves with state funding. But there is a mutual dependency and stand-off between banks and governments. Banks have various means to resist government controls, not least by the political insistence on behalf of capitalism as essentially a private matter that government intervention shoiuld be as temporary as possible. Governments are trying to ensure that before they exit their centrally supportive role that the banks are at least subject to new adjusted regulatory controls to ensure that banks recognise their macro-political-economic responsibilities and not simply return to 'business-as-usual'. There is a war being waged between politicians supported by angry general public and bankers on behalf of private finance. Does money or votes count for more in our democracies? The US finance sector as the world's most powerful is the benchmark against which everyone's else's banking sectors are defined, just as the dollar and the US economy dominate world asset values, trade and ouput and therefore G20 is about accepting or modifying or adding to the US agenda, Geithner's agenda:
US TREASURY STATEMENT WITH MY COMMENTS IN BRACKETS
The global regulatory framework failed (yet again for the umpteenth time) to prevent the build-up of risk in the financial system in the years leading up to the recent crisis. (Risk build-up is always inevitable. The global financial system, mainly following a US lead in dispersing credit risk internationally, but in debt markets of structured finance the originate-to-distribute model became an originate-to arbitrage model, with the effect of prolonging the peak of the credit/economic cycle by 2years thereby creating a stronger financial impact on the inevitable Anglo-saxon recession to produce a shock that became a brief Global Recession).
Major financial institutions around the world had reserves and capital buffers that were too low; used excessive amounts of leverage to finance their operations; and relied too much on unstable, short-term funding sources. (They were too low by being predicated on the recent past, not on future unexpected worst case - macro-model failure, ignorance or resistence to? Banks/bankers were not prepared to accept that they have collectively - and individually in the case of the biggest banks - a responsibility to be prudent by caring about the wider economy and their role in it a role that is not defined anywhere within the system except by the Basel II Accord issues on 'pro-cyclicality', something not taught by accademics, accountants or in Economics 101, and something that they are not motivated to care about by shareholders, by bonus remuneration, or by government tax & penalty-setting powers.)
The resulting distress, failures, and government bailouts of these firms imposed unacceptable costs on individuals and businesses around the world. (This is an inexact statement that is only believed by populaist political opinion. Bailouts removed half the pain so that individuals and businesses are in reality only having to cope with the equivalent of a relatively normal recession. The funding of bailouts is off-balance sheet of central governments that taxpayers' money so far is very little used. Furthermore, also rarely statd, the asset balloon build-up in credit-boom economies with massive trade deficits, US especially, that preceded the crash was a bonus to emerging market poor countries by giving them 2-3 years extra foreign investment inflows and trade surpluses, which were positively transformative, transferring from rich world to poor-world in a few years the financial equivalent of decades-worth of aid!)
Going forward, global banking firms must be made subject to stronger regulatory capital and liquidity standards that are as uniform as possible across countries. (This is already happening in a process preceding the Credit Crunch by 12 years). Today the Treasury Department set forth the core principles that should guide reform of the international regulatory capital and liquidity framework to better protect the safety and soundness of individual banking firms and the stability of the global financial system and economy. (This form of words is based on a perspective of banking and even government as merely large important cogs in the engineering machinery of the world economy, like water, transport and energy. Like any cog in a machine consisting working with other cogs, no cog can be allowed to spin at its own self-determined speed; it cannot have an agenda of its own. This is not a view of finance sector necessary restraint that appeals to the imperial egos of big bonus bankers. After all, the whole ethos of 'private' capitalism is that it should not need to take account of public interest, of the wider economy. The US Treasury proposes the following:)
1. Stronger capital and liquidity standards for banking firms:
Capital requirements should be designed to protect the stability of the financial system, not just the solvency of individual banking firms, including banks, bank holding companies, financial holding companies and large, interconnected firms. (We have minimum regulatory capital to cover worst case expected losses plus economic capital buffers for unexpected losses, which has been increased, and maybe now we may see a third category of systemic risk capital buffers? These should vary according to the too-big-to-fail relative size of banks.)
2. Capital requirements for all banking firms should be increased, and capital requirements for financial firms that could pose a threat to overall financial stability should be higher than those for other banking firms. (higher capital reserves means reduced leverage and reduced speed of asset growth).
3. The regulatory capital framework should put greater emphasis on higher quality forms of capital that enable banking firms to absorb losses and continue operating as going concerns. (This is saying that too much of banks' business models shifted from traditional funding from deposits to wholesale funding by borrowing and investment trading on the banks' own accounts rather than merely charging for services delivered to customers and clients.
4. The rules used to measure risks embedded in banks' portfolios and the capital required to protect against them must be improved. Risk-based capital requirements should be a function of the relative risk, including systemic risk, of a banking firm's exposures, and risk-based capital rules should better reflect a banking firm's current financial condition. (Giving systemic risk more prominence in the Basel Accord also means more prominence for liabilities, for liquidity risk, which were relatively under-played in the Basel Accords I & II, which are the basis for global banking regulation.)
5. The procyclicality of the regulatory capital and accounting regimes should be reduced and consideration should be given to introducing countercyclical elements into the regulatory capital regime. (These considerations are already there, but not systemetised in detail. Basel II authors and regulators repeatedly expressed concerns for sensitivety to pro-cyclicality risks i.e. banks knee-jerk responses to cycle downturns thereby making recessions deeper and longer. The risks are that while Government seeks recovery by deficit-spending to pump new circulating-money into the economy banks would be cancelling loans and not making new loans thereby sucking circulating-money out of the economy.)
5. Banking firms should be subject to a simple, non-risk-based leverage constraint. (This is the Comptroller of the Currency view that capital reserves should be a ratio to gross assets, not merely to risk adjusted assets net of risk-adjusted collateral and hegding. This leverage constraint could be a major restriction on derivatives generally though aimed specifically at arbitrage in credit derivatives.)
6. Banking firms should be subject to a conservative, explicit liquidity standard. (This will force banks to seek more government treasuries as part of their reserves and less reliance on shareholder equity. In consequence, banking growth will be constrained more by government deficits - bond issurance - and more controllable by central banks money market actions in dictating banks' CB deposits and short-end treasury bills - liquidity windows.)
7. Stricter capital and liquidity requirements for the banking system should not be allowed to result in the re-emergence of an under-regulated non-bank financial sector that poses a threat to financial stability. (The short end official money markets is essentially for unsecured short term lending & borrowing and is entirely for developed economy banks and governments only. Non-banks resented this and effectively created Money Market Funds and Credit derivatives to emulate siilar liquidity leverage, but by creating longer-lasting securities built up a massive credit derivatives inventory that became the focus of much leverage arbitrage that when it unravelled could bring down the world's banking system - the so-called ' financial weapons of mass destruction'. Hedge funds deny they are responsible for the Credit Crunch. There will be a major series of battles over the next few years o see how much that is unregulated & over-the-counter - off-exchange - and how much will become regulated & on-exchange.)
7. A comprehensive agreement on new international capital and liquidity standards should be reached by December 31, 2010 and should be implemented in national jurisdictions by December 31, 2012. (We may interpret this as the dates and therefore the announcement of Basel III Accord - or Basel II+?).

FDIC Receivership Banks

2009-08-28T06:03:00.000-07:00

There is much in the allegory of Moby Dick that smacks of our efforts to kill the great banking crisis. Those of you familiar with my Geneva bank, Banque Rupp et cie, (see blogs passim) may not know of its US subsidiary, Bank Pequod, motto: "blubber is blubber you know; tho' you might get oil out of it?"
My strategic problem is currently to decide whether my bank should become, to use old fishing terms, a whale or a whaler, to double my bets by buying other banks hopefully dirt-cheap, or sell my own bank on, either way through the FDIC FBA policy-scheme. On July 9, the FDIC sought comments on “Proposed Statement of Policy on Qualifications for Failed Bank Acquisitions.” The policy statement suggests tough terms whereby the federal agency can sell failed banks to non-traditional buyers i.e. private equity firms. 61 comments were filed during the 30-day comment period – most from private-equity firms, their lawyers, financial-services trade associations and lobbyists, plus comments from academics, 4 U.S. senators and 6 individuals. The FDIC also received 3,190 form-letter comments in support mostly saying “yeah, sell the bastards! Good riddance!” It may no longer be fashionable to own a bank, but could be fashionable to buy one and then close it to new business, strip out its blubber, the assets, to get oil, from foreclosures, take maximum income and charge 80% of any remaining losses at the end to the FDIC?
Selling off busted, near-busted, banks, or banks than look like they could go bust sometime, to vulture fund investors strikes a dissonant chord about private equity players (hedge funds, or private corporate banks like Pequod etc.) among voting taxpayers, and of course to other banks who wonder why anyone is foolhardy to want to own a discredited bank? It may inadvertently lead to another storm of political discontent and even trigger more possible bank failures some way down the river, wrecked out to sea or on a landbank? So far this year, 81 US banks have failed, costing FDIC an estimated $21.5bn. And the situation may worsen - currently 416 distressed banks - highest level in 15 years (at end-June ’09, up from 305 at the end of March), maybe 800 by next year? The FDIC had that many on its “problem list” last in June 1994, when there were 434. Assets at troubled institutions total $300bn –worst level since end of '93.
FDIC’s insurance fund (at March 31), was down to $13.5bn. Bank failures in Q2 ‘09 cost FDIC’s insurance fund $9.1bn - offset by an emergency special assessment (raisings) of $6.2bn + $2.6bn raised in the regular quarterly assessment on FDIC-insured banks. Colonial Bank cost $2.8bn and Guaranty Bank, $3bn. FDIC Chairman Sheila C. Bair is seeking from the U.S. Treasury a $500bn line of credit (by the way, equivalent to the assets of the IMF, the BIS, and ECB).
FDIC’s special assessment in Q4 ’09 and another in Q1 ‘10 may tip more banks onto the butcher's block of the credit crunch. FDIC not only covers insured deposits; if costs of a troubled bank is judged to be getting too high by the FDIC it can seek to ‘combine’ the bank with another, or sell its carcass outright, and if not that it can manage the “unwinding” of a bank’s stockpile of smelly blubber. With 100s of banks potentially in receivership trouble and few willing to acquire the hard to value assets, private equity firms have offered to buy failed banks in the asset-stripping belief these banks can be restructured, perhaps into larger groupings, and profitably turned around or sold on, though not necessarily continued to operate as banks, or not until all current assets have been sold and debt recoveries completed. In fact the whole deal may appear to be more like paying receivers to take over and make for themselves whatever they can. Let’s not forget that mortgage assets have commercial, residential and land assets as collateral that should cover at least half of the outstanding loans. An owner can cherrypick. banks can deem loan contracts any time. Many accounts may have foreclosable collateral larger than the outstanding loan. Hence, a 60% asset discount should translate into a profit over time, which may be substantial once property and business values begin to regain lost ground. The FDIC issued a new version of its plan after comments were received, this time with weaker terms & conditions. These raise questions about federal government’s respect for existing covenants and regulations if set against its perception of the broader political-economy interest, including that of the FDIC balance sheet. In one instance, instead of the initially proposed requirement that new investors maintain a 15% Tier 1 common equity capital ratio to risk-weighted assets, the new ‘hurdle rate’ is only 10% . Private equity firms are excused the requirement of other bank holding companies and will not be called upon as a “source of strength,” should their investment in a bank they have bought need shoring up. This is a cause of concern. Bank holding companies have to make their reserves available if operations need support, but private equity firms don’t want to expose their investors’ capital by dedicating reserves to any one investment. For example, Cerberus Capital refused to put any more money into Chrysler – leaving it to government to bail out. FDIC made other compromises to attract private equity such as excusing them from having to cross-guarantee their portfolio-bank investments – unless they own at least 80% of two or more banks. Private equity did not get all it wanted. The final policy prohibits “insider” and “affiliated” loan transactions and strips firms of using a controversial “silo” structure to obfuscate ownership and control. Private-equity got FDIC to agree to share losses whereby the FDIC bears the larger share.
Acquiring banks also have such loss-sharing agreements with the FDIC, but at least they are regulated entities while private equity firms are not. Nor will private equity firms become regulated in order to buy banks, though this may change if Hedge Funds etc. come under SEC oversight. Private equity firms can buy failed or failing banks by banding together and dividing the equity commitment and investment liability. If there is no recourse against other private equity firm assets or even any cross-guarantees against other acquired banks, unless 80% owned, the consortia cannot be called upon or relied upon to be a “source of strength” for their depository, taxpayer-backed portfolio banks. Regardless of any rules on self-dealing, private equity firms will most probably find legal ways to lend from their newly acquired banks to leverage their other investment portfolio and extract fees. If they don’t lend to their own portfolio companies, they will surely lend to other private equity firms’ portfolio companies in a modified version of the “club deals” that bind them together. These firms have a mutual interest in generating deal fees, cutting up the assets, re-packaging ans selling on. The problem with banks is if over-leveraged they cannot borrow to fund their funding gaps because they cannot set aside sufficient “reserves,” and must rely on “off-balance-sheet” vehicles to sell assets, or if they cannot grow assets, then to acquire leveraged pools of assets, becoming leveraged inside and out. But now the originators of the leveraged-buyout business model want to apply another round of leverage to already crippled banks in order to squeeze out all possible profits. The FDIC needs therefore to be aware of the risk that ‘saved banks’ sold to high return financial engineers may become problem banks again in the future, much as Lehman Brothers did on a large scale having been saved several times in it history. In a comment letter to the FDIC, the Private Equity Council, without recognizing the irony of its comment, suggested that higher capital ratios for private equity buyers of failed banks would increase the risk at those banks because their owners would essentially have to employ more leverage to generate sufficient returns to meet the higher capital standards – while still generating returns high enough to satisfy the investors in their private-equity funds. This is a self-made argument by hedge funds/private equity funds for why they are inappropriate buyers of banks. They clearly do not understand that capital reserves must be ‘own funds’ clear of obligations, not loans to them by investors.
Private equity should be allowed to buy banks, but should also be held to a higher standard, and no less high than for fully-regulated banks. They have a proven record of success at leveraging companies when they have access to cheap funding, and they also have a record of spectacular failures. The last thing US banks need is management that leverage them to generate rates of return at double or triple the average for traditional banking. FDIC is probably aware of this, of the need to avoid resorting to solutions to problems that will repeat past behaviour. The original herbert Melville's Pequod's quest to hunt down Moby Dick itself is allegorical. To Ahab, making a big killing, the white whale, became the ultimate and only goal in his life, and if expanded allegorically, everyone's goals. His vengeance against the whale is analogous to man's struggle against fate, or the public's against the banks. The only escape from psychosis is seen through the Pequod's encounters with other ships, whose captains warn against the folly of risking all for the sake of getting the big win. Melville implies people in general need something to reach for in life, a goal that can destroy one if allowed to overtake all other concerns, and that seems a neat version of bankers, their bonuses and hedge funds and their 50% returns - "Nothing exists in itself. If you flatter yourself that you are all over comfortable, and have been so a long time, then you cannot be said to be comfortable any more."

FDIC LLP to LLC

2009-08-28T05:25:00.000-07:00

Should governments feel free to sell banks and their assets to non-banks or to other banks simply to cut short the period of state assistance?
As we all know, Governments around the world have in various ways provided funding support for banks in trouble, which means for banks with under-performing or non-performing loans on such a scale that if written down fully and subtracted from banks’ reserves would endanger or severely question the current (or near future) solvency of the banks. That is at least the perception. It would be more accurate to say that the above applies most especially to medium and small-sized banks while for bigger banks a major additional problem threatening their solvency and thereby the economy generally has been inability to renew medium and long term loans to cover the ‘funding gap’ they have between loans and deposits.
What is much less well understood is that funding to secure the solvency of banks has not been directly at tax-payers’ expense, but mostly off-budget by swapping treasury bills for collateral consisting of larger amounts (by market value) of banks’ loans (variously securitized as bonds), i.e. heavily discounted (so-called ‘hair-cut’) with default risk covered by guarantees and insurance plus a substantial fee that may be repeated every time the swap is ‘rolled-over’.
The classic example has to be the US Federal Deposit Insurance Corporation, created by Congress in 1933 to restore public confidence in the nation's banking system. The FDIC insures deposits at the nation's 8,305 banks and savings associations and promotes ‘safety and soundness’ of these institutions by identifying, monitoring and addressing risks to which they are exposed. The FDIC receives no federal tax dollars – insured institutions fund its operations i.e. it is like an exchange for ensuring bank solvency with funding and insurance guarantees paid for by the members, the banks & savings associations.
Not all of the thousands of small banks need help, only about 8%. Some take pride in that, while at the same time using their FDIC membership as their solvency guarantee e.g. White Hall Bank, Illinois, which on its web-site states soberly "TEMPORARY LIQUIDITY PROGRAM - White Hall Bank has chosen NOT to participate in the FDIC's Transaction Account Guarantee Program. Our customers with non-interest bearing accounts will continue to be insured through December 31, 2009 for up to $250,000.00 under the FDIC's general deposit insurance rules. On May 20, 2009, FDIC deposit insurance temporarily increased from $100,000.00 TO $250,000.00 per depositor through December 31, 2013." Politically, however, for whatever blend of ideological reasons, including sometimes laws such as in the European Union, governments are anxious that their support measures should be paid off as soon as practical, and this stance can mean selling off the aid-supported banks and/or their impaired loan-books. ‘Impaired’ means portfolios of loans where the market value of the loans has fallen below ‘book value’ (to understand the accounting parlance I suggest you look it up).
Steps to increase transparency have reduced some of the uncertainty in the markets. FDIC specified simple indicators for short-term stress tests undertaken by major banks (19 of the largest). This framed the basis for ordering 10 major banks to raise a total of $75bn capital to protect against worst-case unexpected losses - a result better than many feared, leading to financial stocks trading at higher levels over the summer. Risks to the economy and financial sector remain as a pipeline of knock-on defaults feed through, and as the housing market has yet to reach bottom in terms of actual price falls appearing on for sale offers, and as additional unwinding of complex financial instruments progress, hopefully in an orderly manner without confidence-shaking shocks. Property values underpin almost everything directly or indirectly. Commercial real estate fundamentals, and therefore also banking lending growth, typically lag the economy 6-9 months. As a result, deep job losses in recent months are forecast to translate into rising commercial property vacancy through year end after recession may have formally ended, with rollbacks in rents and slow residential property recovery likely to continue through 2010. Commercial real estate fundamentals and the investment climate ultimately will benefit from improving capital flows and the economic recovery, especially since in the US that sector was generally not overbuilt heading into the downturn. On March 29, FDIC issued proposal for comments on the Legacy Loans Program (LLP). The FDIC and the Department of the Treasury announced the LLP (like the bank of England’s APS or Germany and Ireland’s ‘bad bank’ schemes), which will remove troubled loans and other assets from FDIC-insured institutions, but with the additional idea of attracting private capital with soft-loan terms to purchase the banks’ loans. At the time some banks let it be known they would like to be able to buy their own impaired loans back on the same terms as offered to non-banks, but of course that was a dimension too far politically.
The FDIC asked for comments from interested parties on the critical aspects of the proposed LLP to boost (some would say subsidise) private demand for distressed assets that are currently held by banks and thereby facilitate market-priced sales of troubled assets (even if no-one suggests the prices discovered are true market prices except in a very convoluted sense). It semmed necessary, however, really because FDIC funds were close to becoming exhausted, and because uncertainty otherwise about the value of these assets makes it difficult for banks to secure funding to support lending to households and businesses. At bottom, the fundamental aim is to avoid bank runs. The LLP combines an FDIC guarantee of debt financing with equity from the private sector and from the US Treasury. These private-public partnerships will purchase assets from banks and place them into what will be known as Public-Private Investment Funds (PPIF). Institutions of all sizes will be eligible to participate in the LLP to sell assets. It is expected that a range of investors will participate. The program will particularly encourage the participation of individuals, mutual funds, pension plans, insurance companies and other long-term investors. Investors will be pre-qualified by the FDIC to participate in auctions. For providing a guarantee, FDIC is paid a fee, a portion of which gets allocated to FDIC’s Deposit Insurance Fund. The FDIC is protected against losses by PP equity in the pool, the newly established value of the pool's assets plus fees collected. FDIC will continue to audit progress and it also structures the debt that a selling bank will get paid for when the legacy loans are sold by the participant banks into the market. Comments were required no later than April 10. Following consideration of various comments, by June the FDIC said it will develop this program by testing the LLP's funding mechanism through a sale of receivership assets i.e. assets of bankrupt banks. The first transaction to be offered, the receivership transfered a portfolio of (serviced) residential mortgage loans to a limited liability company (LLC) in exchange for an ownership interest in the LLC i.e. rather like an SIV. The LLC sold an equity interest to an accredited investor, now responsible for managing the mortgage loans. Loan servicing conforms to either the Home Affordable Modification Program (HAMP) guidelines or FDIC's loan modification program. Accredited investors were offered equity interest in the LLC under two different options: 1. an all cash basis, equity split of 80% (FDIC) and 20% (accredited investor); 2. sale with leverage, whereby equity split is 50% (FDIC) and 50% (accredited investor). The funding mechanism is financing by the receivership to the LLC using an amortizing note guaranteed by the FDIC. Financing is offered with leverage of 4-to-1 or 6-to-1 depending on bid offers by private investors. If the bid is 6-to-1 leverage, then performance of the underlying assets are subject to performance thresholds including delinquency status, loss severities, and principal repayments. If any of the thresholds are triggered over the life of the note, all principal cash flows to equity investors are applied instead to reduction of the note until the balance is zero. Performance thresholds do not apply if the bid is based on the lower leverage option. FDIC is protected against losses on the note guarantee by limits on leverage (in terms of a maximum ratio and $ amount), with mortgage loans collateralizing the guarantee & its fee. This is not especially controversial since it is a means of an orderly sell-off of impaired assets where government via the self-financing FDIC retains a role, but there is no taxpayer exposure unlike the cartoon above of Uncle Sam requesting citizens to invest in financial toxic waste (actually not abad deal if citizens could do so). And this is so far applied to collapsed institutions. What is more problematic is where still-operating institutions are sold off (see next blog).
My own preferred solution would be to restructure and bundle up mortgagees debt so they get some discounts by matching discounted bank assets to discounted house prices and outstanding loan values thereby reducing negative equity risk (at same or lower cost to banks and insurers), but that is not yet anywhere on the table for discussion other than something like that wished by more than a few legislators in Congress.

US rating agencies in the dock?

2009-07-22T08:32:00.000-07:00

For many people the credit crunch must feel like they were invested in Confederate bonds!
Among the worst of the blameworthy institutions responsible for the crunchiness of the credit crunch are the ratings agencies, Moodys, Fitch, and Standard & Poors. In structured finance Moody's has been the dominant player with perhaps half of the market. Why, are the ratings agencies in trouble - because their models were severely faulty, especially that of Moody's, in particular for confusion between underlying credit risk rating and credit enhancement and the macro-economy, and for having severely critical system design bugs. If you like you may buy various models from the agencies to calculate ratings including for complex instruments. The models you get appear quite comprehensive and suitably complex, but they rely for key input data on your finger-in-the-air assumptions, crude factor inputs, and abstract variables where real world data, especially economics data would be not merely wholly, but are solely, appropriate. The ratings agencies have two main strengths, 1, historical data, critical aspects of which were ignored it seems or failed to be incorporated in pre-2007 models; and 2, legal requirements that valuations throughout the financial services industry should employ ratings agency values, which enforces their market reference position as an oligopoly, collectively a near-monopoly. This does not mean, however, that the financial industry knows adequately what the agencies' strengths and weaknesses are, or necessarily believe their gradings are superior. The industry knows that everyone uses the 3 global raters and that is a power that must be supervised from a regulatory/quality assessment perspective and that their modeling approaches should be more transparent for expert review. New US moves will face the credit rating agencies with new disclosure rules and restrictions but would not be forced to overhaul their business models under proposed US legislation to be sent to Congress on Tuesday. From a European perspective the new rules fall well short of the European Commission's wishes. The main problem for the ratings agencies is whether rule changes in the US will do anything to protect them from law suits coming down the turnpike that should bust the companies if they get to court. In that context why invest in improvements, in anything other than what will defend their sorry records? The plan (of US Treasury) is aimed at managing better issues that were long known:
- conflicts of interest at rating agencies,
- providing regulatory oversight by the SEC and
- reducing the financial system’s reliance on credit ratings.
The plan is one major part of the Obama administration’s financial regulatory blueprint. The ratings agencies overlooked or under-estimated or mis-modeled or wrongly implemented software for assessing the risks of investing in securitisations, in complex, “structured” securities, especially those linked to mortgages. As all should know by now Moody's until June '07 operated a rating model that was indifferent to default rates - a glaring error that caused all securitisation issues (across what should have been 17 grades) to be all classed in one risk bucket, triple-A. The problems to be sorted out about the ratings agencies that were overlooked after LTCM, Enron and the dot com bubble burst have to be tackled this time comprehensively. The severe doubts about the companies' survivability is reflected in their share prices, though these also reflect fall-off in new structured product ratings business. Barney Frank, head of the chairman of the House financial services committee, on Tuesday endorsed the proposed measures to overturn requirements to use the credit ratings agencies. “There are a lot of statutory mandates that people have to rely on credit rating agencies. They’re going to all be repealed,” he told Reuters. This would trigger changes in Basel II statute law in Europe if the EU followed suit. The business models at Moody’s Investors Services, Standard & Poor’s and Fitch Ratings – which are paid by the companies whose debt securities they rate – remain largely intact. There has, however to be severe doubts remaining about these. We know that none of the agencies have macro-economy models that incorporate detailed financial sector statistics! It is unclear too, in the case of structured product bonds, whether credit risk enhancements were modeled when assessing the issues just because standby credit and insurance was part of the issue contracts, or whether the underlying was separately rated first? We do not know what macro-economic modeling correlations were used before the crisis and if these have since been changed? We do not know how comprehensively national credit risk ratings are determined and what the models are that determine watch-lists or if subjective judgments are part of the assessments? Defending the Treasury’s decision not to heed calls by some for a fundamental overhaul, Michael Barr, assistant Treasury secretary for financial institutions, said there were conflicts inherent in alternative models too. But, the conflicts being considered are few in number and yet little analysed. Tuesday’s proposals would bar ratings agencies from providing consulting services to any company they rated and would require them to disclose fees for a rating. It also attempts to stem “ratings shopping’’ in which a company solicits “preliminary ratings’’ from multiple agencies but only pays for and discloses the highest.
Ratings agencies will be required to use different symbols for structured finance products, which are perceived to be riskier, than for corporate bonds. What the point of this is when it merely means that financial service firms will have to construct converters or engage in major risk accounting system overhauls?
The plan is “a continuation of what the SEC has already done to a more limited extent’’, said Lawrence White, professor at New York University’s Stern School of Business, talking to Reuters. His view is that the proposal does not go far enough to reduce the ubiquity of the credit ratings in how they are hardwired into the financial markets via financial regulation (implication: Basel II) and did little to foster competition in the sector. To my knowledge it is worse than that insofar as ratings tables have in many banks been so hardwired that they have become inflexible to change in accordance for example with recent experience, experience that has bust the parameter limits of pre-credit crunch models. The SEC has appointed special auditors to oversee ratings agencies, and last year passed rules prohibiting activities such as executives providing both ratings and advice on how to structure securities, and barring those who evaluate the debt from discussing fees, as well as limiting gifts from debt underwriters to rating agency employees. S&P said it was studying the proposal. Moody’s said it supported the goals of “increased transparency and enhanced ratings quality’’. Fitch said the plans were consistent with its views on transparency. What the news comments do not broach is that there are issues here and others not addressed that go to the heart of the survivability of the credit ratings agencies, and indeed to the heart of investment banking as we have hitherto known it?

FEDERAL DEBT AND TAF ARE A PUBLIC SERVICE ASSET

2009-05-02T05:36:00.000-07:00

The Debt Clock in New York City shows the gross national debt, currently less than half in size of private sector debt and still below 100% ratio to GDP. But, 40% of this is intra-government i.e. internal to government. Thus government bond debt sold to US and foreign private sectors and to foreign governments is only about one quarter of US private sector bank debt. A third again of this is held anyway by foreign investors including foreign governments foreign currency reserves. US National debt and budget deficits however are not generated by the Federal Reserve and US Treasury 'bail-outs' of US banks. That is accomplished by swapping Treasury bills for securitized bank assets and subject to fees and large haircuts, and should generate substanial profit for taxpayers over the medium term (3+ years). Hence, the 'crowding out' theory scarcely applies to the US economy - that is the theory that government borrowing deprives the economy of private investment capital.
Federal assets and liabilities can go down as well as up. The assets are those pledged, bought, swapped in exchange for treasury bills. Fed assets fell $82bn this week in reductions to term auction credit and central bank swap lines offset by purchases of Treasuries ($14bn), MBS ($5bn) and agency debt ($3bn). That the Fed is able to shrink its balance sheet is an indicator the economy is being weaned from central bank life support and shows that banks have generated substantial internal capital (profit) in the last quarter. The balance sheet will have declines and rises and net rises, including from $800bn of commitments to buy-in MBS, Treasuries, and agency debt, with a steady total purchase target of $1.75t of which about $1tn has been processed. Much of the sharp increase in Fed Assets has occurred following the collapse of Lehman Brothers when medium term interbank lending costs spiked sharply and banks faced problems refinancing their 'funding gaps'. It is because of the stress pressures in short-term funding that the Federal Reserve System, following the earlier clear example of the Bank of England's SLS and APS schemes and generous liquidity window facilities and the ECB and other central banks with money market facilities variously also, approved a temporary Term Auction Facility ("TAF") program in which the Federal Reserve auctions term funds to credit/depository institutions i.e. regulated banks. TAF is a credit facility that allows banks to bid for an advance from its local Federal Reserve Bank at an interest rate determined by the auction. This lets the Fed inject term funds via a broader range of banks against a broader range of collateral than shorter term 'open market operations', the 'liquidity window', to ensure that liquidity is disseminated efficiently even when 'unsecured' interbank markets (borrowing and lending between high-rated banks) are under stress.
TAF auctions term funds of 28-day or 84-day maturity. All banks judged to be in sound financial condition by their local Reserve Bank and expected to remain so over the terms of TAF loans are eligible to participate. All TAF credit is fully collateralized; loans for which the remaining term to maturity is more than 28 days are subject to additional collateralization. Depositories may pledge the broad range of collateral that is accepted for other Federal Reserve lending programs to secure TAF credit. The same collateral values and margins applicable for other Federal Reserve lending programs also apply to TAF. Some commentators characterise TAF and related programs as buying in junk from banks that will only lose money. This is grossly untrue. Current commitments to buy bank assets outright at $700bn of which just over half has processed is actually less than that committed to by the Bank of England and HM Treasury.
To complete the picture, it has to bee xplained how useful a public service all this is to the US and the world economy where more than half of all world trade is denominated in US dollars. Similarly, dollar exposures are a large part of banks global funding markets. Additionally, US banks have foreign currency exposures and liquidity requirements that the Fed supports. It has swap lines agreed with foreign central banks for this but has not actually had to draw on these in recent months. The Federal Reserve coordinates with other central banks to provide liquidity via agreements for reciprocal currency arrangements (central bank liquidity swap lines): dollar liquidity lines and foreign-currency liquidity lines.
These lines are now authorized with the following institutions: the Reserve Bank of Australia, the Banco Central do Brasil, the Bank of Canada, Danmarks Nationalbank, the Bank of England, the European Central Bank, the Bank of Japan, the Bank of Korea, the Banco de Mexico, the Reserve Bank of New Zealand, the Norges Bank, the Monetary Authority of Singapore, the Sveriges Riksbank, and the Swiss National Bank. The FOMC has authorized these lines through October 30, 2009.
When a foreign central bank draws on its swap line with the US Fed, the foreign central bank sells an amount of its currency in exchange for dollars at the market exchange rate. The Federal Reserve holds the foreign currency in an account at the foreign central bank. The dollars that the Federal Reserve provides are deposited in an account that the foreign central bank maintains at the US Fed NY, with a binding agreement to reverse the swap at a future date at the same exchange rate. At the second transaction, the foreign central bank pays interest, at a market-based rate.
Other cenhtral banks operate similar facilities, as does the BIS and INF, each with about $500bn in assets. The foreign central bank lends the dollars to its banks and bears the credit risk associated with that.
The foreign currency that the US Federal acquires is an asset on its balance sheet. The dollar value of the asset swap is not affected by changes in the market exchange rate, and similarly this is also how asset swaps for bills operate with US banks, so there is no mark-to-market credit risk borne by the central bank. The dollar funds deposited in the accounts that foreign central banks maintain at the NY US Fed
are a Federal Reserve liability. However, the foreign central banks generally lend the dollars shortly after drawing on the swap line. At that point, the funds shift to the balance sheet line "deposits of depository institutions."
Dollar liquidity swaps have maturities ranging from overnight to three months. On April 6, 2009, the FOMC announced foreign-currency liquidity swap lines with the Bank of England, the ECB, the BoJ, and the Swiss National Bank to provide the Federal Reserve with lines to offer liquidity to U.S. institutions in foreign currencies should a need arise. If drawn upon, the foreign-currency swap lines would support operations to address financial strains by providing liquidity to US banks of £30bn, €80bn, ¥10 trillion, and CHF 40bn, authorized these through October 30, 2009, but so far, these have not been drawn upon.
One reason for this may be the withdrawel by banks globally from lending to foreign banks, which is quite serious for world trade as it is for banks, especially those in small countries where their assets are exceptionally larger than domestic GDP and their funding gaps financing heavily reliant on foreign borrowing. I suspect this and other aspects of liquiity risk have yet to be brought out in banks stress tests that 19 and 47 leading banks respectively in the US and Europe have been urgently tasked to complete by governments and central banks.
Following the rather insipient factors that FDIC asked US banks to scenario stress-test, liquidity risk (the essence of the credit crunch) appeared missing in action?
Nevertheless, 6 of the US top 19 banks stress tested need to raise additional capital. Two of the six are certainly Citi and BofA. The others may be SunTrust (STI), KeyCorp (KEY) and Regions Financial (RF) (according to a Morgan Stanley) but HSBC (USA), Citizens (RBS), and Wells Fargo and possibly even JPM might be candidates depending on the view of their credit derivatives and ABS and corporate bond exposures.
In the absense of a macro-economic model that reklates the banking sector to the domestic and global economies, the whole exercise still feels like a limp excuse to direct additional support to “systemically important” financials, although the pretext was to determine if any of these banks need to be nationalized.
There was a hope that stress tests may guide an 'over-the-cycle' analysis an basis for 'cleaning up' troubled banks balance sheets. The tests should also define solvency more concisely than hitherto, and uncover which banks need more capital with the aim of maintaining all US banks total reserve capital at about $1tn and then force them to raise new capital optimally over time against some reasonably realistic forecasts of the arrival rates of losses and writedowns net of internally generated capiutal. So far, we could say that a false economy was instituted by the banks when they balked at the lower net interest income of paying temporary higher rates for medium term financing only for this to result in many times this cost being wiped out in shareholder capital and being forced to sell assets at firesale prices. One solution now being canvassed as an alternative to straight capital raising which dilutes shareholders even further is that of executing debt for equity swaps to reduce liabilities and rebuild equity, but actually also diluting shareholders yet gain! 'Growing Shareholder value' as a creditable mantra of banks will not recover for many years, notwithstanding the large gains in bank shares from their postage stamp levels so far this year; the markets remain volatile and nervous.
But were the Basel II style scenario stress-tests ever a serious exercise?The “scenarios” to stres-test banks balance sheets are far too imprecise in being precise about actual months, quarters and years looking forward, and too benign or rosy. Already property prices are falling faster, unemployment going higher, and growth falling more steeply than the Fed, FDIC and Treasury offered up as scenario macro-factors.
Properly stressing the big banks’ balance sheets would demonstrate the liquidity risk issues and should encompass the full gamut of factors specified by Basel II Pillar II.
Critics say that no-one buys the argument that government off-balance sheet finance and guarantees to buy time for the banks will solve their problem. As far as I can see that is the only thing that can solve their problems. The UK, US and others governments are sensitive to the general cyncicism and disbelief and are now saying that taxpayers aren’t supposed to provide further capital support, not now, or little more this year; banks should go to private markets first and/or convert preferred shares to common voting stock etc. WShat governments are loath to admit to is that bail-outs are facilitated by everything except taxpayers money! That is too hard to explain and politically deemed a minefield. More like intellectual cowardice, a dangerous misdirection.
Private capital markets believe they know that banks are insolvent and should therefore be backed into hard corners and broken up and sold off, so they aren’t going to provide additional capital except on the severest of terms that might allow private equity funds and hedge funds at last to buy the banking market they have long craved to own believing they could transfer their carpet-bagging strategies to the central arteries of whole economies cash-flows. Only government and regulators can apply and enforce public service standards, ethics, and prudential risk management and it is on this basis that they know that the solvency of systemically important banks must be judged. Private sector vulture funds waiting to pounce see only the large short term profits to ne made from realising banks book values that are currently several times their market equity value. The deleveraging this would bring about is certain to guarantee long run Depression!

GEITHNER PLAN FOR BAD ASSETS

2009-03-26T04:22:00.000-07:00

For the full plan text click on 'comment' at the end of this blog. The popular criticism of this deal assumes that these assets will not recover value in the medium term and that they are so toxic that the defaults on the underlying assets will merely cost the government and FDIC (aka taxpayers) while banks and hedge funds (who will buy the bonds with TARP subsidy and FDIC insurance guarantee) will both make money. Geithner believes that the interest on the loans to the bank asset buyers plus a shared risk/return will in time prove profitable or negligible loss for government? This is part of a masterplan.Prof. James Galbraith, Univ. Texas, author of 'The Predator State' and Prof. Paul Krugman both are highly critical of the Geithner Plan. Krugman's view is that it is a complete mess based on a misunderstanding of how important 'confidence' is and that this is merely a repeat of the response to the S&L crisis. One context for this is the stress-tests dictated by FDIC for the top 19 banks. Krugman finds the stress factors to be too mild (see 3 charts on US economy below). The forecasts may be politically adjudged or simply the usual consensus type that smoothe everything and are unable to foresee short term shocks. Galbraith says that from Obama to Geithner to Bernanke, policymakers are like doctors dealing with a "mildly ill" patient vs. treating one who is "gravely" ill. The economist fears the economy is in terminal condition requiring much more intervention than already prescribed. Certainly, when for the first time in memory world GDP in aggregate is in recession and there are no external pull factors, only internal push, then fiscal stance and other measures have to be that much stronger. Krugman accuses Geithner of believing that if only the problem of toxic collateralized debt assets and their writedown effects can be cured, then the economy will pull through. Another way of putting this would be the idea that Geithner thinks if the CDOs are quarantined the following charts could be replayed backwards? Galbraith believes government "doctors" are engaged in a lot of "happy talk" about recovery based on a "fundamentally flawed model," hinged on the idea the economy is self-healing and only needs a booster shot before it "naturally" returns to trend growth and unemployment in the 5% range (the natural rate of unemployment concept that he rightly despises). He says success for the Geithner Plan is highly unlikely as it is framed so far, with limited direct scope for helping millions of Americans grapple with a crushing level of household debt. To help replace consumer spending, massive additional government action is necessary, he says, as discussed in the accompanying video link (URL at end of this blog) and in a recent Washington Monthly article.
I disagree that the assets are so toxic as the economists broadly suppose. The loan pools are amortising fast in the period when other measures are mitigating foreclosures and will in the medium term naturally improve in quality with much of the edge taken off by credit enhancements and foreclosure mitigation measures. Therefore, the defaults will not rise as high as otherwise. If the assets are representative of RMBS then 25% is sub-prime and default rates are heading for half of that. But the assets are already discounted 12-20% at the highest rated end, and first loss tranches may be witheld and kept on banks' books for work-out, assuming that is the nature of the $3-400bn of ABS and other impaired bank-credit derivatives left on the books on the top six US banks. My numbers are: Therefore the Geithner Plan may work in a contributory fashion, maybe, by helping the banks maintain a higher regulatory and economic capital reserve. My view is that these reserves need to be up around the $1 trillion level to cushion the next waves of credit risk losses that will eat into all of this. Geithner's economic modeling I believe, along with Krugman, is based on factor values of the mid-1990s to the 2001 recession. The world context is however more severe more aligned cyclically thanks to financial and trade globalisation than in previous recessions. The world's trade patterns are wholly disrupted and we have no certainty about the new shape to global trade and payments. In moving from a period of a decade or more when the US deficit was the counterpart to most of the rest of the world's trade supluses, now the rest of the world has to resort to domestic growth policies and had politically and otherwise almost forgotten how to do that! Geithner is buying time until end of September when the next federal budget is formed and the stress-tests are part of this. The banks will have their capital reserves next re-set in September. meantime he may hope that the credit default spreads that price the banks' CDOs will continue at a more realistic level. And then one consequence of that could be an easing of the interbank funding market. In my view, the Fed and US Treasury should simply de facto nationalize the interbank funding market for financing the banks' funding gaps. But there is immense political objection to more £trillions being facilitated. the general public do not understand what is on and off the taxpayers' federal budget balance sheet. The bailout measures are almost all off-budget and there is a balancing of assets and liabilities achieved to do this. It is not therefore taxpayers' money except in the broadest democratic political sense. To be effective the fiscal deficit needs the support of bank lending levels being kept up. The fear is that banks would have to deleverage by 30% or more if their capital reserves get wiped before debt recoveries start to flow back onto the banks' books. A remaining problem for the banks is financing their funding gaps. The US banks have had low issuance last year and this too so far compared to Europe. And that seems a major problem right now as I do not see the $1 trillion of assets to be sold off (beginning with $500bn only) to approved buyers as sufficient to solve that. There is little evidence of what the banks are acheiving in filling the $5 trillion or so refinancing they require for their funding gaps. Covered bonds and MT Note programs by banks are either down or out of sight. There is a fear that deleveraging will hit industry and corporate bond defaults will balloon. But, the publiv mood when the $trillion numbers get aired is very hostile and fearfully so. The government, banks and hedge funds all look like carpetbaggers to an angry mob. Underlying all this is the risk of prolonged recession (already 15 months old). Currently, it looks as if the majority of businesses are just about earning enough profit to make their debt interest payments. New corporate bonds are high coupon (junk bond rates) even for top retailers and manufacturers. Therefore, not a sign of restructuring of corporate debt to take advantage of historically low central bank rates. (For an exhaustive rip through the carpetbagger culture develeoping in the US see bankingeconomics.blogspot.com. 'The Great Game'). I prefer more repo swaps (after 25-30% haircuts) of the assets at the Fed liquidity window along the lines of the Bank of England's SLS and APS. In the US, if the assets all come off the top six banks' books who hold over 80% of banks' impaired securitised structured-credit assets then $1 trillion is a substantial cleaning out that should restore the banks' ability to hold or grow lending in the recession. This is not all totally toxic. In my alternative defaulting mortgagees motivated by negative equity to quit their homes should be banded together to gain direct benefit from the discounting of their mortgage debts and remortgaged to reflect that fall in the value of their mortgages. This is better than hedge funds being subsidised to gain the 17%-25% returns they are seeking from buying these bank assets. Hedge funds are evidencing some distress with number being bandied about that their funds are down from over $2tn to $1.4tn or $1tn only and how 20% of hedge funds are folding. But there are thousands of hedge funds and a mass of them are always folding, especially among the 1-5 man little hedge fund LLCs. And, sure, some big ones are in trouble, but there is no talk of these 'shadow-banks', including big private equity funds, are posing a systemic risk, unless maybe to some 'money market funds' but these are mostly bank-owned and robust. At the same time I also agree with Galbraith's alternative recommendations, which he says will cost $1-$1.2 trillion above plans already enacted, include: - Higher Social Security benefits: This will aid seniors hurt by the downturn in home prices, financial assets and the dollar's purchasing power. - More government hiring: Infrastructure spending can help, but major building projects can take years to gear up (a point also made by Prof Larry Summers, Geithner's colleague and ex-boss), and they can, for the most part, provide jobs only for those who have the requisite skills. Galbraith wrote, "So the federal government should sponsor projects that employ people to do what they do best, including art, letters, drama, dance, music, scientific research, teaching, conservation, and the nonprofit sector, including community organizing - why not?" I totally agree with this for a whole raft of reasons. Galbraith proposes a payroll tax holiday: "This is a particularly potent suggestion, because it is large and immediate," and puts income in the pockets of working families, he says. For me a key to recession-busting as it also is for development aid to poor developing countries, how to productively put money into the pockets of the poor, including poor pensioners especially, who all have the virtue that they spend what they get. Also, from Galbraith, Fix Housing: Put a moratorium on foreclosures and have the government buy homes from those homeowners who have no hope of making their mortgage payments, as detailed in a forthcoming segment. We may assume that the mortgage debts are thereby wiped out. This is implicit in the USA where the only collateral for the mortgage is the value of the home. In other countries any remaining debt remains an obligation on the mortgagee, and in Japan that can be multi-generational! Helping Main Street is already on the US policy agenda in the form of Fannie Mae and Freddy Mac re-negotiating mortgage contracts to restructure the interest and repayment burden to not more than 30% of mortgagee incomes. I would go for a halfway solution too, that of passing the debt discount right back into the original mortgage agreement thereby cutting back much of the negative equity problem. There is a logic, however, to the public housing solution in that the sub-prime crisis had its origins in the cutbacks by governments of spending on social housing to zero for nigh on two decades! Galbraith's view is that any or all of these programs "can be scaled back" as growth resumes, but that the government cannot afford to hold back any ammunition in its fight against the deflationary forces of the credit crisis. This echoes a similar view expressed by Martin Wolfe in the FT that I also very much agree with.
Some big banks that have received financial help are buying the 'toxic' assets. Citigroup and Bank of America, other banks and hedge funds, have been aggressively scooping up the discount-price securities in the secondary market. The banks' purchase of AAA-rated mortgage-backed securities, including some that use alt-A and option ARM as collateral, is raising eyebrows. Alt-A and option ARM loans have widely been seen as the next mortgage type to see increases in defaults. Yet both banks have been aggressive in their buying, sometimes paying higher prices than competing bidders are willing to pay. Recently, securities rated AAA have changed hands for roughly 30 cents on the dollar, and most of the buyers have been hedge funds acting opportunistically on a bet that prices will rise over time. However, sources said Citi and BofA have trumped those bids. Geithner's Plan (PPIP) offers banks an arbitrage opportunity to neutralize the writedowns that the problem may require. A bank that will sell $10bn MBS to the PPIP that are on the books for 70c/1$and will sell for 50c/$1, requires writing down the 20s difference. The government has however tasked the banks to buy such assets and thereby try to bring more liquidity to the secondary market. The buying can also have been on behalf of customers. But it is also much cheaper to buy these assets than to create new assets, for the purpose of keeping up the bank's ;evel of loans to satisfy government requirement of not deleveraging in the recession. If the banks can buy artificially (turbulent market distressed prices) marked-down MBS for 30c/$1 and keep it on the books, as the PPIP makes a market for MBS off the bottom, the 30c cost basis MBS, if bought before the program starts, will now be marked up to the market price of 50c/$1, counterbalancing the bank's write down of the assests when
bought. The banks may also be helping to push up the market prices thereby revaluing all their holdings.
FDIC head, Sheila Bair, said she is open to banks taking equity stakes in those the public-private partnership funds as partial payment that will buy up illiquid loans from banks. The banks would be allowed to pay for their stakes with the very loans they are selling into the partnerships!
Citigroup, say, has CMB and RMB securities that have become toxic because Citi says they are worth 87c/$1 but the market thinks they are worth 30c/$1. Now, Bair, offers loans to buyers to pay much higher amounts for the assets because most of the purchase price will be subsidised by cheap government loans and exit clause contract. The bank then sells the assets to a special vehicle (SIV,SPE,or SPV) set up to pay for the assets. It gets an ownership stake in that vehicle in exchange for the assets. So the bank will trade the assets for ownership in a special purpose vehicle that owns those assets. Why would the bank want equity in a fund that is buying assets it is trying to get off their balance sheet - because the scheme involves a huge subsidy, allowing buyers to make double-digit returns even if half the assets they buy are worth nothing, or nothing until the property collateral is foreclosed on. Essentially, the PPIP deals allow banks to move their risk off-balance sheet, but with much of the risk also taken by government, which in itself builds in a price gain. Geithner et al is convinced that off-balance entities are the key to restoring the banks. The same has been happening in the UK with SLS and APS.

And for Tim Geithner's own views in the WSJ see: http://online.wsj.com/article/SB123776536222709061.html
Also See: http://finance.yahoo.com/tech-ticker/article/yftt_216311/Part-I-Geithner's-Plan-%22 and: http://finance.yahoo.com/tech-ticker/article/216690/%22Happy-Talk%22-Won't-Solve-Crisis-Galbraith-Says-Much-More-Govt.-Action-Needed;_ylt=AtCWuOtcOPiFarNfSB_.sHpk7ot4?Extremely-Dangerous%22-Economist-Galbraith-Says
and also
http://krugman.blogs.nytimes.com/2009/03/21/despair-over-financial-policy/
see also: http://topics.nytimes.com/top/opinion/editorialsandoped/oped/columnists/paulkrugman/index.html
Roubini echoes Krugman. He is the ultimate doomster. His economics consultancy estimates a total of $3.6tn of loan and securities losses in the U.S., including writedowns on $10.84tn securities and losses on $12.37tn unsecuritized loans ( emphasis on the word 'on' since these numbers are total outstanding). Roubini's view is that bank nationalizations are inevitable. I don't think he sees the technical problems of nationalizing without a change in the law first - the FDIC's legalistic view of the problem.
http://www.bloomberg.com/apps/news?pid=20601087&sid=aZXiD0hnsSD8&refer=home

BANK STRESS-TESTING OF THE QUESTION: LET BIG BANKS FAIL? -US LEGISLATORS WANT TO GET MAD NOT EVEN

2009-03-12T08:09:00.000-07:00

THERE IS A MAD POLITICAL BATTLE GOING ON OVER THE FIRST OBAMA BUDGET. Figuring out the impact of the Federal government budget (and then the general government budget too) is central to economic models and forecasting. The external account (trade and payments) weighs heavy too, and Keynesian models, as also implicit in National income Accounting standards, have long linked the two. With the credit crunch we are all at sea in determining how world trade and payments patterns will now change, and change dramatically they will (Japan has recorded its first trade deficits in living memory and China's trade surplus is down by 90%). But, while the current year ahead Government budget should be pretty much straightforward it is not at all. The Obama biudget is variously described as $3.6 or $3.9trillion spending. But, predicting revenue and actual deficit outcome is harder, especially when property taxes and other property income and corporate taxes and unemployment etc. are all currently volatile. The political centrists tend to show that revenue will remain flat and the deficit will relentlessly widen and this is all the fault of the Bush tax cuts. The decoupling of revenue and spending is not credible. The right of centre however go further. They are anxious to show that there is a take-off here that will go up like a rocket and create a deficit that alone will absorb over one third of National Income and cause all kinds of problems from bankrupting the country to undermining the credibility of the currency. Bush is credited with adding over $3.3tn to the national debt over two terms, the right-of-centre Heritage Foundation claims Obama over two terms would add $8.5tn to the national debt. The Republicans accept from surveys that 62% of voters oppose increased government spending, and by implication oppose deficit spending. They also argue that the Obama budget is not proper deficit spending and enjoin advisors to the administration in this e.g. Council of Economic Advisors Chairwoman, Christina Romer, wrote, “Countercyclical fiscal policy is not achieving its intended purpose” and economic advisor Jason Furman saying, “In the past, infrastructure projects that were initiated as the economy started to weaken did not involve substantial amounts of spending until after the economy had recovered”. And even Prof. Larry Summers who wrote, “Poorly provided fiscal stimulus can have worse side effects than the disease that is to be cured.… Fiscal stimulus, to be maximally effective, must be clearly and credibly temporary—with no significant adverse impact on the deficit for more than a year or so after implementation. Otherwise it risks being counter-productive by raising the spectre of enlarged future deficits pushing up longer-term interest rates and undermining confidence and longer-term growth prospects.” These are more code-speak signalling to show respect for recent past economic-policy orthodoxy, not empirical assessments, just the usual necessary conservative acknowledgement. In any case a general problem of consensus views is that the consensus of what economists predict has never been usefully accurate. There are reasons for this, but no excuses except one, which is that official data tends to be neither optimistic nor pessimistic enough and only picks up sudden highs and lows after 6 months when revising the data backwards. The counterpart to not seeing holes in the road is to project massive holes in the long run. There is a persistent fashion (first established by the Congressional Budget Office, CBO, in the mid-90s) to make unsustainable 50 year projections. Even in 2003, after a massive set of tax cuts, and in the midst of the Bush iraq war years, the centre right felt scandalized by Federal spending projections doubling as a ratio to GDP of nearly 40% by 2050. Such projections are just political tokenism and unrealistic. They also tend to talk of 'shares of' GDP, not 'ratios to' GDP, as if all of government spending is entirely a share of National Income i.e. based entirely on taking tax from taxpayers and any borrowing is ultimately a net cost to taxpayers (loading debt onto future taxpayers etc.) The Economic Stimulus Act of 2008 provided about $170bn in tax rebates to stimulate the economy. The CBO estimated this "would increase budget deficits (or reduce future surpluses) by $152bn in 2008 and by a net amount of $124bn over the 2008-2018 period." The American Recovery and Reinvestment Act of 2009 (passed by Congress on 13 Feb.'09) of c.$800bn of spending rises and tax cuts is estimated by the CBO of increasing the federal budget deficit by $185bn to end September (end of fiscal year '09), $399bn in '10, $134bn in '11 ($787bn over all of 2009-2019). Clearly, this is not a major fiscal impact in the short term. And, obviously, the $trillions of bailout financial interventions by government are not part of this budget. The Obama budget inherits a deficit spending, or fiscal gap, and adds to that. But budget authorisations do not reflect actual cash-flow impacts in the economy. Some fiscal impacts will be feeding theough from past years and current authorisation will not have material impacts until future years. Long-term data suggests that the 2008/09 recession is part of a long trough since the last recession in 2000. Serious professional economists agree with this and would say that the asset bubbles and rising debt level have followed from inability to recover to earlier growth paths because the Bush administration responded wrongly via tax-cuts, the so-called 'Jobless Recovery'. Political critiques aimed at the layman voters rarely consider circular multiplier effects or that money taken from some taxpayers is paid to other taxpayers (many of whom are the same people) or that a quarter of all federal revenue is obtained by taxing its own spending; they seek to politicise the budget at its face value. This is not realistic, just good politics. The US conservatives want a repeat of Bush tax cuts, not Keynesian increased spending. The same critique is transposed onto the financial bailout, deeming it Keynesian, 'throwing money at the problem' and some are calling for a Financial Services Commission to spend a year studying the problem and determining if regulation is a big part of the problem. Looking back we can see a series of problems over the past 10 years. But, it is also clear that looking at credit-market cycle-conditions gives us strong economic-cycle indcators. The US Federal Budget is not comparable to European Government budgets (which include more of general government budgeting). The government consumption aggregate of all rich countries is 19% ratio to GDP out of at least 30% general government budget ratio to GDP. In the US, the federal budget has a total ratio of 28% to GDP compared to European equivalents of 35-40%. US general government spending is also over 30% ratio to GDP. The full fiscal stance can only be gleaned by the general government budget level. Because of the size of the state and county tiers, there is a large differentiated distribution like the differention across European states. All this causes considerable problems for even the largest banks in forecasting the economic demand context and its impact on their balance sheets, as they are now required urgently to do. This is a new experience. It has been a long time since the last time a lot of banks failed in the S&L crisis. There have also been relatively short interuptions in the pattern of banks balance sheet changes in recent decades until now. The S&L crisis caused some investment and retail banks to be taken over while hundreds of savings & loans banks failed. The effect then was contained within the USA. This is not possible now, hence why we have a policy of securing banks and of working out the asset losses, but also the means for swapping these assets off-balance-sheet so as not to cripple lending growth (as is said to have occurred for a decade in Japan). The asset writedowns of the US as shown below are also echoed almost the same proportionately to GDP in Europe. BANKS AND ECONOMIC STRESS-TESTING
Prior to finding evidence, and continuing on regardless of any such evidence, that big banks are doing well in their underlying internal capital generation (net cashflow profits from traditional banking and investment banking - see my bankingeconomics.blogspot.com), some Senate and Congressional Legislators, and a constituency of millions (not least millions of bloggers) are calling for letting some big banks fail i.e. not less, but more, of what happened to Lehman Brothers! Are they totally mad or just totally mad-angry?
Two powerful Republicans on Monday called on President Obama to "let some big banks fail instead of propping them up with public money". Richard Shelby, the top Republican on the Senate banking committee, warned that the US would end up following the same path as Japan, which suffered a lost decade of economic growth by tackling its banking crisis too slowly, unless some big institutions were allowed to fail. "Close them down, get them out of business. If they're dead, they ought to be buried," Mr Shelby told ABC News. "We bury the small banks. We've got to bury some big ones and send a strong message to the market." Asked whether he was referring to Citigroup, Mr Shelby responded: "Well, whatever. Citi's always been a problem child." John McCain, senator from Arizona, who lost the presidential race to Barack Obama, said the administration had evaded the "hard decision . . . to let these banks fail". These comments coincide with a debate in the US whether Government should nationalise insolvent banks or allow the so-called "zombie" institutions to fail. The term 'zombie' has caught the popular mood. Hard to say though who are the real zombies in this debate? Some politicians repeat themselves, sticking to the same ideological line, like clockwork 'speak your weight' machines, regardless of what's going on in the economy at any one time. I guess like stopped clocks they will be right two times every 24 times. The real problem is how to anticipate and compensate for or stop how banks cyclically respond to recession. We can see in the above graph how banks recoil in recessions by cutting loans relative to deposits by roughly 10%. Given the scale of lending in the economy having grown relative to GDP, a 10% loan reduction (partly write-offs, mainly zero new loans) would translate into 15% in ratio to GDP! That would profoundly deepen further what is already a deep eonomic trough! Deposits here include deposits by banks as well as by customers. We can see a rising trend to maximise retail assets (loans) ratio to the total of all deposits, using borrowed funds to finance corporate lending, and strive to make assets in wholesale markets more by self-financing i.e. offsettings within the markets, hence also the growth of derivatives. But, the unravelling of derivatives markets today may do less to free up bank capital than to add to accounting losses. The Democrats, the Obama Administrationa andn the large banks, and I would hope many others, maybe the 38% of the population who do support higher spending, all would want to avoid the same scale of deleraging of all debt as occurred after the 1929 crash, but has largely been avoided in subsequent recessions. Yet, it seems such deleveraging is what many voices on the centre-right are in fact calling for? Who to help, or not, among the banks, is depending on the Obama administration's 'stress tests' of 19 leading financial institutions. The banks and the government itself must be able to address questions such as those I've indicated above. Similar tests are being variously recommended for Europe's top 45 international banks.
The stress-tests are to be so structured to answer an apparently simple question: can the banks balance sheets survive the economics of the next 1-2 years ahead without becoming technically insolvent, in a period of debt deflation. The first problem is that short-range forecasting is not easy, however necessary. Some trends may appear stable, but it takes only small wobbles to make significant differences in profit and loss. Banks have to look at the big picture of the economy, the economic cycle, at the monetary conditions, the credit cycle, and how these impact banks nationally and markets globall, and then at the bank's own position within these contexts and the how balance sheet performance is thereby pushed and pulled and then also management driven. Many factors cannot be easily trend-line predicted, but some can, and it is credit market conditions alongside confidence factor indicators that give the surest cycle and recession predictions. Macroeconomists tend to look for insupportable balances, but it is innovation within banking fin ance that has many times broken those contraints. There is a lot in banking that is either only known for sure over longer periods thn a few quarters or which are specially and uniquely manufactured and managed at the time, not forecastable. The exercise requires designing, building, data-populating, testing, and running of several complex models that the bank do not corrently possess. The timescale to get this right is less than 6 months. One problem already stated above is that economists when viewed for consensus (taking averages of many forecast models, which weights the result toward conventional older models) never 'forecast' recessions until well after they have begun. The question is therefore can a consensus view do any better in forecasting recoveries? The Republican conservatives don't want the administration to rush in for fear of a Japanese 1990s result. But the Japan case shows the danger of waiting and holding back. Following the bursting property and construction bubbles at the end of the '1980s all Japanese banks became technically insolvent. The result was years of zero or negative corporate borrowing.
The US administration team wants to avoid that mistake and to move forward rapidly and not spend a year in analysis. It wants the banks and US Treasury to produce comprehensive assessments in 6 months. Europe is trying to get its banks capital forecasts even quicker, within weeks.
The US Treasury team to oversee the stress-tests with FDIC has some staffing up problems too. The White House this week announced the President's nominations for 3 top Treasury jobs to fill key positions among 17 that have been vacant under Tim Geithner - Mr Krueger, Ms Wallace and Mr Cohen who have been serving as counsellors to Mr Geithner at Treasury. But, their appointments to full office-postholders are not certain. Cohen announced today he is withdrawing. Alan Krueger, a Princeton University professor and former labour department chief economist, is proposed as assistant secretary for economic policy - a crucial position under Tim Geithner. Kim Wallace, a former congressional aide and ex-Lehman Brothers staffer, is picked for Assistant Secretary for Legislative Affairs, key to working with Congress on the financial and economic crises. But getting appointments confirmed is hard. Last week, Annette Nazareth, short-listed for deputy secretary of Treasury, a former senior staffer and commissioner with the SEC, withdrew after several interviews and vetting of her financial history. So too did Caroline Atkinson, a senior official at the IMF, who was expected to be head the Treasury's international division. Others have not been named yet because the administration is taking longer to vet candidates. Any already working as advisors (counsellors) are constrained in what they can do until formally approved as assistant secretaries (the third-rung in the administration) by the Senate. David Cohen, an ex-Clinton Treasury official and a law firm partner, was proposed for the job of tackling terrorist financing and then became the contender for the International post after Annette Nazareth withdrew. Reggie Cohen dropped his bid after an issue arose in the final stages of vetting. Not one of Geithner's 17 deputies has been confirmed. Without senior leadership, lower-level Treasury employees can't make decisions or represent the government in crucial conversations with banks and others. Obama has been blocked several times by the Senate (most spectacularly when Tom Daschle withdrew after minor tax evasion was spotted) from appointing key officials across his government, including at Treasury. Critics say this hampers the tackling of urgent issues. The second administration rung is in place, but not the third rung, and so senior heads are working round the clock. The Senate will grill candidates about their attitudes to the question of prudential care about tax-payers money. The tax-dollar is one of the biggest voter issues at any time in US political history. What legislators and the general public don't get is that tax-dollars and the federal budget have relatively little to do with how Treasury finances the banking sector bailouts. Government is stepping into the confidence void in banking and redirecting large assets and money flows through it, with everything part of a double-entry book-keeping i.e. whatever is paid out is backed by safely discounted assets that are interest and fee-income generating. Hank Paulson possibly made his biggest mistake with TARP by going to Congress for approval. He thereby convinced the legislators that this is their business to be political about. Legislators see only two kinds of money - tax-dollars (discretionery and non-discretionery taxing and spending) and soft-dollars (political-money, campaign contributions, lobby-money). There is a third kind, which is government activities in money-markets. Paulson let Congress think it should be involved in oversight and approval of whatever the federal government and treasury are doing with money market finance that is the main source of bank bailout funding. That maybe was a big mistake? It could be dangerous, or at least compelling drama, and something new if the government's off-budget balance sheet financial operations become as politicised as the federal budget's tax-dollars.

FEDERAL BUDGET NOT PASSING

2009-03-09T08:13:00.000-07:00

Following on from blog 3 down (26th Feb) more on the US Federal Budget that has been voted down in The Senate.
Yesterday, Republicans Party leaders wrote to the Speaker of the House and the Majority Leader asking for the upcoming omnibus spending bill to be posted online so everyone can read it. They wrote, "[T]he [Democratic] Majority has asked the American taxpayers to fund nearly $1.5 trillion in new government spending [roughly $14,000 per family] in just four short weeks. And yet now the Majority plans to spend hundreds of billions more without yet sharing the content of the bill with Republican Members or the public. In the midst of a severe recession, taxpayers have a right to see each provision of this legislation and evaluate the merit of each dollar of government spending their children and grandchildren are being required to fund."
Through the second half of 2008, the Bush Administration was pushing the bailout bill, TARP - worth (merely as a convenient measure) $3,000 per household in spending. The Federal budget year ends in September. So while TARP was voted down before being voted through, Congress passed a bill to authorise the regular spending of the Federal government into early March 2009, worth about $8,000 per household for 5 months. Congress didn’t finish the regular fiscal year 2009 spending process, and so kicked that can down the road until after the Presidential election by authorising funding until March 6th, until after both handover of the White House and time for the new administration to fully populate all office desks.
Then the priority became the Economic Stimulus Bill (fiscal stimulus or deficit-spending- that-we-hope- will-be-a-stimulus) worth $4,300 per household. Note deficit spending is Federal government spending minus revenue = net new Treasury bonds.
Funding for the regular operations of most of the government flashed "fuel tank empty" last week just as a bill to finish out the fiscal year was heading to final passage. But there were upwards of 9,000 'earmarks' (special interest projects, otherwise known as 'pork barrel') in that bill, and that didn’t sit right with a lot of people, especially given that in the Presidential debates both candidates were adament they would scrutinise each and every earmark and probably cancel most of them. So Senate conservatives took up the anti-earmark crusade and prevented passage of the omnibus spending bill on Friday 6th. So, instead, Congress passed another short-term spending bill. H.J. Res. 38 or £100 per household to fund the federal government until Wednesday, the 11th. By then, Congress must figure out what to do with the earmarks to get H.R. 1105 bill passed in the Senate to fund the government through to September 30th at about $4,090 per U.S. household.
The bill that’s in only very few offices on Capitol Hill totals about $500 billion, or $5,100 per household to cover 7 months and less than one third of the total annual Government budget. One solution might be to strip the earflaps out and put them all in a sperate bill for line by line debate. That should keep Congress busy for a few months?

FINANCIAL STRESS-TEST-DUMMIES AND BANK-SIMULATORS

2009-02-28T15:25:00.000-08:00

The Obama administration this week ordered the 19 biggest US banks to run stress tests to check how well they can hold up if the economy deteriorates much further, and to thereby calculate how much more funding they will need before recovery is underway. This is like asking jumbo-plane aircraft pilots to land with faulty instruments in fog safely with minimal damage. When recently a pilot with extremely well-honed skills landed in the Hudson River and all passengers and crew were saved that was sheer brilliance. Would any flight simulator have allowed the same result - no, the built-in tolerances and probabilities would have dictated failure! And, would any other pilot have succeeded - maybe a few, but most not! What made the difference between success and failure was partly the plane, largely the pilot and also largely the conditions including the availability of the liquid landing zone. In banking terms those are the conditions to be determined by Government. The stress-tests are not just to test the banks, but also their strategy, operations and risk management, and then also to provide evidence, clues, indicators, stories of events so Government can also determine what it is that it must do to manage the financial and economic conditions. These stress-tests should also stress-test government bail-out measures. The pilots of the economy are also to be thereby tested. Banks think this is about testing their balance sheets and detailed accounts as seemed to be what stress-testing is in the dealing rooms and in Basel II Pillar II banking regulations. No, this is big picture stuff, and this is always what this stress-testing was meant to be, to test how well bank managements understand the economic context in which they do business. The crash-test dummies are in the boardroom.
To take the analogy further, it is not about how many passengers are on board to be saved or even what the plane is like. This is about how good, how comprehensive, the instrument controls are, and how responsive they are? Markets may be more or less liquid and customers and counter-parties more or less risky, but how much finger-tip control is there and how intelligent and powerful is the auto-pilot and do the pilots decide to dump their fuel over the sea, or save fuel for a possible quick take-off again, or to fly another 500 miles to the next airport? Are the cockpit controls and the accounting system completely accurate and the pilots fully experienced and trained in all weathers. Or is your bank's stress-test capability actually less like a complex flight simulator and more like a car-crash-dummy-test, more like a metal cage with car seats, and safety-belted nodding dummies round the board table? If you don't have the systems, then car-crash -dummies is your bank's default stress-test mode and I don't care how clever you think your guys are with their spread-sheets; this is not a spread-sheeting exam, and not merely a self-assessment exam either! Just ask yourself, can your bank model and explain why and how asset prices, stock values, have disconnected so blatantly from income-stream valuations? Ask yourself if your risk accounting and general ledger actually validate each other and then whether you can compute dynamically and in full double-entry styles in both banking and trading books for the political-economy, global markets, domestic retail and corporate banking for changes in PD, LGD, EAD, ELGD for the quarters ahead and for over the credit and economic cycles. If you think the answer should be yes, think again! The results are expected by or before the end of April. Banks will then have 6 months to raise the extra funding they think they may need from private sources or accept federal aid with conditions attached. The Government, like an air traffic control tower, wants to avoid taking over the flight instructions, it wants to dictate height and heading and make sure there are no air-to-air collisions and that the runway is clear and well-lit up. But government does not want to take over flight-pilot controls, not of large banks. Fed Chairman Ben Bernanke says government may take substantial minority stakes in Citigroup and other troubled banks only if they can't raise sufficient new funding elsewhere. Six months from now the technical recession should be over and modest positive growth returning. But, banks will have a difficult time just to survive the turbulence until then and to steady themselves onto exactly the right path for a soft landing. For important advice on various ways of determining your liquidity risk and solvency tests see the attached lengthy comment below.
Barack Obama on Wednesday described some principles for new financial regulation, signaling that the government would oversee a much wider range of financial activity and take a stronger hand in doing so. Gordon Brown and his team in the UK are doing and saying very much the exact same, including calling for stress tests. And he has begun to use a new repeatable phrase that of 'cleaning out the banks', words that have now taken on a whole new meaning quite different from the Hole In The Wall Gang, the James brothers or John Dillinger. I can't recall any time in the past when respectable people were going to clean out the banks? Of course, if Governments want to do that they can. But President Obama says, "While free markets are the key to our progress, they do not give us free license to take whatever we can get, however we can get it," and "Strong financial markets require clear rules of the road, not to hinder financial institutions but to protect consumers and investors." Let the banks be warned; these stress tests are about whether your bank needs cleaning out in a good way. "Cleaning out" in a bad way is what variously happened to Bear Stearns, Merrill-Lynch, Wachovia, HBOS, Fortis, WaMu, Dexia, Citicorp, RBS and others, though I am impressed with the new managements at both RBS and LBG. These banks were variously shown up to be flown by poorly equipped pilots, and in some cases by dummies (HBOS) or crash-test fighter-pilots (Lehman Brothers). The cleaning out will also extend to restructuring the regulators and bringing in new much more solid expertise. This is happening in Europe, the UK and USA.
Speaking after a meeting with key lawmakers and senior advisers, Obama said his government needs to overhaul the frayed patchwork of regulatory agencies that oversee the financial industry. He expressed support for increased consumer protections. He indicated he favoured empowering the Federal Reserve as a regulator of systemic risk (gosh, where was that responsibility hitherto?), with authority over any financial firm or instrument that could destabilize the economy. That's the key question stress-tests have to answer, who's next for a military-style haircut and strict exercise regime? The European Commission and ECB want similar answers, the IMF too, and, in the UK, the Bank of England. This is not an academic research project taking 4 years. The answers to these complex questions are required in 4 weeks. But improving on stress-test models and cockpit risk management control systems will require banks to focus on these in the boardroom regularly for at least 4 years (cost across all banks in Europe and USA = $8bn estimate). The US Administration will present a more detailed plan for regulatory reform in early April, when leaders of the G20 wealthiest nations, each with their own stress-tested plans, meet in London. By then, round the same table, all will know the global depth of the banking industry's political-economy crisis, and no dummies any longer tolerated there. That's my expertise, all of this, and I and my colleagues at asymtopix.eu and union-legend.com and what we know of the companies we talk to, none any longer can afford to under-estimate the challenges involved here.
WHAT IS THE CHALLENGE?
If you are in or close to the executive and full boards of a major bank, let me say categorically: It is not bottom up deal by deal stress-test technology or risk models and risk policies from the dealing rooms. It is not top down, comprehensive, national and global economic modeling. It is not stressing of risk factor ratios or moving up and down risk grade tables. It is not reliant on what we already know, not about adding up all risk buckets and business lines, to collate and correlate. It is not about dumping spreadsheets and getting in the super-computers and a new general ledger system, new software, years of new external and internal data, new definitions and holistically integrating taxonomies for all credit risks and all market risks. It is not about liquidity risk and risk concentration versus asset class and economic sector diversification.
It is all of this, a triangulation, top down, bottom up and sideways along, outside and not just inside the bank, and a damn sight more than all of this too covering what's happening to the whole of banking, and in the markets and among government policy options and the bank's business strategy options, and can't be done by persons who only have silo understanding and not a full grasp of the totality. It cannot be done except by those who thoroughly and professionally understand the totality of a bank, in finance, accounting, risk and economics, and the totality of Basel II Pillar II and the coming of Basel III, and why even Pillar I implementations are deeply flawed, and why Pillar II is a dangerous distraction and probable big mistake! If you understand where this shopping list of a rant comes from, then you are halfway there and should be advising the top of your bank or already in the boardroom! Retail giants such as Bank of America, HSBC, RBS, Citigroup and specialty, less retail, and non-retail banks such as JPM, State Street, Morgan Stanley, Goldman Sachs are all now required to measure their likely losses in the event that the credit and economic gets worse before it gets better. Officials say the tests will assume that the unemployment reaches 10.3% by the end of 2010 (currently 7.6%), average home price fall from bubble-peak hits 47% (27% so far). Mortgage defaults are over 9%, sub-investment grade corporate bonds heading there, consumer debt maybe 6%, prime quality bank debts maybe still pretty low at variously around 3%. But what if default rates for many broad classes trend to some similar higher rates as the domino or systemic impacts pull down good quality with the bad?
What if it doesn't matter if your are a creditor or debtor nation, all lose similar growth, and what if most or all businesses, most or all creditors and debtors, good as well as bad banks, all suffer significantly? What if it is not about whether your balance sheet is 5%, 10% or 25% better quality than the next bank, because that will matter a lot less in 6 months time than it matters now? The test will also assume that economic activity as measured by gross domestic product shrinks by 3.3% in 2009 before recovering slightly in 2010. Great, but does your bank know how to translate that into anything meaningful. Is 3.3% inflation-adjusted GDP, 2% or 6% before subtracting for inflation? Can your bank survive better if other banks survive better, or better if your bank does better than others who are then doing significantly worse? Is it better to take government investment on board and central bank funding and insurance guarantee programmes or better to keep going without that - better for whom - your bonuses, your shareholders, your customers, and or the economy? Will your bank do better if it can somehow deleverage and behave pro-cyclically or better if it can grow lending and act anti-cyclically, better if it delivers higher profits from traditional banking or lower profitability from traditional banking?
As a bank, what is it you are legitimately doing apart from providing a transmission mechanism as a public service? Is your idea of success and benefits the same as the government's that has to care about the whole economy as you should be too? Is a much higher financial margin profitability of the whole financial sector better or worse for the economy right now? Does your economic capital model tell you anything to adjudge your answers to these questions? The answers to these questions in the longer term are no problem, but for the next 1-2-4-6 years that is another matter altogether? The Government does not care about individual players; it wants to see the whole picture of what banks need to be that fits intelligently with what the economy needs them to be right now? Do banks, or your bank, know how to think about that? Yes is easy, elaborating on that answer is not. The Government is your bridging loan, but only if your bank can determine how to be a bridging loan in turn for the economy, and maybe in several economies? There is also so much peer-review going on that looking for a presentational answer that cannot be validated in depth won't wash. Confidence is more than skin-deep, and loss of confidence is fatal. See: www.union-legend.com/index.php?page=references There is a certain rhetorical quality to these questions. Where they are not rhetorical is where we really do not have the political-economy macro-answers, and worse where not even the biggest banks have the data or the systems and completed models to find their own reliable answers with any substantial % confidence whatsoever? It is a wholly different game to forecast via scenario stress-tests for some theoretical set of future-shocks at some indeterminate time over the horizon. What can be done and how is to be done when already in the middle of the distress, in the middle of the fat-tail unexpected risk distribution, that's quite different and not to be understood in the Basel II and Solvency II regulatory advice notes, or even from the very best academic papers - they're being thoroughly revised and rewritten - who in your bank reads them?
Regulators are in the business of providing clues and indicators, not glide-paths for exactly how to do any of this. It is nothing like regulatory risk model equations. For example, regulators have calculated that there is roughly a 10% chance that economic conditions would reach say a 3.3% real GDP fall in 2009 based on a consensus of economic forecasts, which has never been much of a reliable benchmark. Therefore, prominent economists are saying the probability is much higher than 10% and banks and government should test for a more catastrophic scenario. I agree, do you? But, some analysts say the worst projections are not much more dire than what many private forecasters already expect e.g. 5% real GDP fall in 2009. And, anyway, the worst scenarios are not that, not how bad will 2009 be, it is whether the economy might remain flat for a few years thereafter i.e. not a V- or U- shaped recession but an L-shaped one. That will test banks capital reserves to destruction beyond the 200% wipe-out currently being faced. It would not be hard to show a bad year wiping out reserves by another 50% and 3 years flat growth by over 100% again! According to the new Treasury Department guidelines, the banks would have to assume that the economy contracts by 3.3% in 2009 and flat in 2010, and housing falls 22% generally on top of the 15%+ so far, then maybe recovery is regionally patchy after that, especially across the US States in 2010, while unemployment goes up to 9% then over 10% in 2010. Does your bank know what PDs and LGDs could become in these years. Can you even dynamically model for that either at portfolio, aggregated bucket, level or for every account in the books? Have you got integrated accounting and computing power to process all that in less than one month? If not, how else will you get a realistic approximation - try talking to Lloyds Banking Group, or RBS, or central banks or others?
"I don't think they (the stress conditions) are harsh enough," said David Hendler, analyst at CreditSights, who says the dire projection is too optimistic about how much growth will be generated from President Barack Obama's fiscal deficit stimulus programme. "That would be a pleasant outcome, but you have to plan for the worst." I agree. The average outlook of private-sector forecasters envisages the economy shrinking by 2% this year and unemployment peaking just below 9% in 2010. But, even the biggest banks are regional not just national and regional variations in a country the size of the USA are significant. Big banks are also internationally exposed, and globally in respect of wholesale financial markets, which hardly anyone has ever been able to soundly model in respect of national or international or global economic models, and of which there are not many around. The trading books have small RWA calculations but we know these are now unreliable. Can your bank stress-test collateral, security, hedges and cross-border financial flows, corporates and industry sectors, and interbank credit in the trading book as readily as credit risk and collateral in the banking book? The stress-tests must adjust for changes in market liquidities. Do you know how to measure the liquidity of markets, never mind liquidity risk of your own bank. By 'model' I and regulators and economists do not mean 'make assumptions' but integrate all major factors into accounting models over time whereby factors constrain each other? Is this a high-level project with top quality people do the work or a low-level delegated work relying on simply processing every combination of likely factor values?
Everyone's recent forecasts including by the Federal Reserve and most private forecasters have undershot the severity of the downturn. Big banks — those with more than $100 billion in assets — have to carry out supervised analyses by April of how much their capital would be depleted under the Treasury Department assumptions. If U.S. banking regulators conclude that your bank may not have enough capital under those circumstances, the bank has six months to sort the problem - is 6 months realistic and practical? It is only if the tests show that your minimum regulatory capital survives at least 6 months?
The Treasury said that it would provide new capital in exchange for shares of preferred stock that could be converted to shares of common stock at a price slightly below the level at which the shares traded on Feb. 9. The UK seems to be offering similar but with conversion rates at markedly higher prices than current share prices. For many of the US big banks, 9 Feb price is slightly higher than today, but still at fire-sale levels. In a telephone conference call with reporters, officials from the Fed and OCC said there would be no simple measure for "passing" or "failing" a test. The FDIC has firmer standard tests and these might kick in on insurance guarantee rates sooner. It's not exactly clear if the FDIC and the fed are singing from exactly the same hymn sheet? "It sure sounds to me like they are designing this to make it sound like the banking system is in great shape," Paul Miller, an analyst at Friedman, Billings Ramsey, a brokerage firm that specializes in bank stocks, said to the Washington Post. This is his interpretation of officials says their goal is to increase confidence of investors and depositors in the big banks, providing tangible evidence that the institutions would have enough money, whether they had to raise it from private investors or get it from taxpayers.
What this is really about is trying to get a consensus view of the expected shape of the credit cycle and economic cycle from the perspective of banks' capital resources. Fed officials said there is no cap on how much money a single institution could get. But that is of course how banks got into funding gaps that proved hard to maintain, so maybe some ratio caps to current funding gap or deposits might seem sensible. Officials declined to estimate how much money the government would end up injecting before the crisis was over. This is a sensible answer given the variety of means available, but over $2 trillions would be the ballpark just for big banks. Banks and other "qualified financial institutions," which now includes investment banks and insurance companies that are part of bank holding companies, can start applying for more money immediately.
Christopher Whalen, MD at Institutional Risk Analytics, said Citigroup and other major banks would almost certainly become insolvent once they absorb the full brunt of losses from the economic downturn. That is absurd, since it fails to see that banks don't just stand still in their liquidity management. He said, "The stress test is about politics. The OCC and the Fed already know the answer. The answer is that we're going to have to come to a decision: are we going to put in more equity or are we going to resolve the banks through bankruptcy?" This is now classic doomster headlining for the media. This is not the question or the answer. Bankruptcy is not an option. replacing ownership and getting rid of managements and bad bank work-out funds and much else are options, active choices in play right now.
Europe is focusing hard on the G20 concerns to take urgent steps to overhaul regulation of big cross-border banks. President Obama met with Congressional legislators to discuss an overhaul of how the financial regulatory system manages risk in the future. Emerging from the meeting, Obama said the first principle of a new system should be that financial institutions "that pose serious risks to the markets should be subject to serious oversight by the government." The EU European Commission has exactly the same intent to be applied to the top 45 banks. Obama also said that the regulatory system should be strengthened to withstand major stresses and that the government should take steps to rebuild trust in markets by promoting transparency. This also means bringing off-exchange markets on-exchange. With the exception of government spending, every major component of the economy shrank in 2008.
Output fell 6.2% at an annualised rate in the 4th quarter of 2008 (also by 6% in 4th quarter in the UK), revised downward from a previous estimate of a 3.8% decline. The drop was steeper than the consensus estimate of 5.4% - far steeper than 0.5% of the previous quarter.This was enough to have immediate ripple effects globally. The economy took the biggest hits in exports, retail sales, equipment, software and residential fixed investment plus contraction in inventories (usual sign too of drop in loan financing) of unsold goods despite lower consumer sales. But this data will continue to be severely revised for another year. The trade gap that had been narrowing widened as exports fell at an annual rate of 23.6% shaving a full 1% of GDP and is a sign of downturn spreading through the rest of the world. This all bodes ill for business investment and sure enough it fell at an annualized rate of 28.8%, also a sign of bank credit being choked off or debt restructuring. deposit savings crept up but private savings will only jump significantly once the Government bond auctions for 2009 are well underway and hopefully banks will grow their loans by an aggregate of 10% minimum, what Government is hoping to see, and that means growing capital reserves proportionately too. For much more read comment below.

Obama's Budget and new $1,750bn deficit forecast

2009-02-26T07:30:00.000-08:00

The Media has got suddenly animated that the US budget deficit is really going to be double that previously announced (see previous blog below). This is because, Barack Obama’s budget figures, released today, include a $250bn item for future bailout funds. This has correctly been calculated to imply the White House is planning to ask Congress for up to $1,000bn more in emergency funding for the banking sector, which seems wholly sensible to me, by the way.
A senior Oval Office source told the FT that a $250bn “placeholder” provision is part of the Aministration’s new approach to upfront budgeting, a provision in accounting terms for likely future net costs.
In line with budget accounting rules, last year’s authorisation of $700bn in emergency TARP funds was scored at $200bn net in the budget, implying a ratio of authorisation to budgetary cost of over three to one. What this means is that the $700bn of financial asset purchases would be written down by $200bn, and that writedown is then required to be taken on-budget, the balance being netted off-budget. On this way of thinking the £250bn placeholder provision implies up to $1,000bn in new funding capacity. But in his speech to the joint houses of Congress on Tuesday night, Mr Obama clearly indicated substantial new resources would be needed for the federal government to help restore the credit pipeline in the financial sector. In the UK similar measures, most recently the £500bn 'bad bank' APS, Asset Protection Scheme, are accounted somewhat differently. The writedown discount and haircut is translated into capitalisation money for taking banks' preference shares and thereby netted off-budget, with the writedown also reflected internally and variously in the banks' balance sheets. If this is not precisly clear to you, don't fuss, it is not yet precisely clear to me either?
Today’s 10-year budget will, the FT says, project a fiscal deficit this year of $1,750bn – a number that shatters all records and which is significantly higher than the near $1,200bn forecast by the Congressional Budget Office in January. The sharp jump largely reflects the cost of this year’s portion of the two-year $787bn emergency fiscal stimulus that was signed into law by Mr Obama last week.
The 10-year federal budget will be released at 11am east coast time, to include a roadmap for the creation of an economy-wide carbon emissions cap and trade system by 2012, from which the proceeds will fund the “make work pay” tax cut for middle class "working" families that Mr Obama included in last week’s short-term stimulus. The cap and trade permits are to be sold off in a 100% auction system. Additionally, the budget creates a $634bn healthcare reserve to pay for universal insurance (partly by raising taxes on the wealthiest Americans earning over $250,000). This follows Mr Obama’s speech to Congress on Tuesday night saying he would make a “substantial down payment” on the future expansion of healthcare. The analogy between affordable healthcare for the sub-prime population and financial health for the sub-prime, toxic, blood-poisoned banking sector cannot be lost on the general voter.

Small Politics, Big Economics, or vice versa?

2009-02-22T02:03:00.000-08:00

If politics is Ajax, then economics must be Cassandra?
Is the $800 billion stimulus package too small, as many Democrats claim (such as Paul Krugman), or too big, as most Republicans claim? The answer is yes, too big politically and too small economically. It is too big insofar as it underestimates profitable return from funding support for the banks and too small by being spread over more than 1 year; it won't all get spent in 2009 and most of it not soon enough within the year, but that's just normal practicality of getting plans shaped and approved and the money-spend rolled out - all takes time.
If the criterion is how much annual fiscal stimulus to demand is needed to bring the economy back up to the level of potential output in 2010 and beyond, and to bring the unemployment rate back down to the monetarists' natural rate of unemployment, then $800 billions is not quite enough at 5.7% ratio to GDP. A more effective figure would be $1.1 trillion or 8% ratio to GDP, but that takes it over the psychological "trillion" number that PR people envisage triggering investor panic! The Congressional Budget Office (a depository of Republican neo-con economy spread-sheeters) estimate the economy will fall short of potential output by about 7% of GDP, in both 2009 and 2010. (As OMB Director, Doug Elmendorf testified on January 27 – ex-Brookings who seems more monetarist than 'fiscalist' see http://www.brookings.edu/experts/e/elmendorfd.aspx.) The news on jobs and other economic indicators since then shows the economy losing air like a pricked balloon, or maybe like a potholer finding the passage-ways getting narrower, or like a bunch of office-workers in a stuck lift that lurches from moment to moment downwards - choose or invent your own claustrophobic metaphor.
The $800 billion will spread over several years; the peak is to be $356 billions in 2010, which is about 2½% of GDP. The most optimistic estimate of the “Keynesian multiplier” that anyone has is 2, implying a 5% boost to GDP. That's below the 7% "gap of gloom", not enough to return the economy onto a path to full employment. The fiscal stance should not be the only impetus. There may be some restructuring of spending, but more important than this will be the push-through effect on the banks of their bailouts and how their 'funding gaps' are refinanced.
Last week's grilling in Washington of Wall Street's CEOs asked them, "why, when banks have received billions of dollars of taxpayers' money, is it harder for people to borrow?" Some bank chiefs said their lending continues - and in some cases has increased. But, reality is that availability of credit is tight and may tighten more. Critical to this is the Geithner Plan, the scale and details of TALF. The problem of the lack of detail is that TALF is being pulled in several political directions. These are funding as per the Bank of England's SLS example, or towards 'bad bank', or 'insurance cover', or direct payments to bail-out mortgage borrowers on 'Main Street'?
There is near-total collapse of the private interbank funding market using securities backed by loan assets such as payments on residential and corporate mortgages, consumer credit cards, corporate bonds, student loans, lease-finance loans etc. The straight option is for Government to step in and replace the private sector in interbank lending, and take the profits of that until the private sector clamours at the legislators doors to buy their business back. The 'funding gap' is the gap between bank customer deposits and bank customer loans. While in the UK in 2008 banks issued a record volume of ABS (£245bn) to swap for treasury bills (£185bn), in the US it was much less. In the UK in 2009 there will be another £250bn swapped, while in 2009 in the USA so far, according to Dealogic data, there has been a mere $2bn of bonds backed by auto loans and student loans. In 2007, before the credit crunch took hold, more than half of the $5.6 trillions borrowed in the US credit markets was financed through ABS. The UK banks' 'funding gap' is £800bn over 3 years (including UK banks' funding gap in US loans), in the USA it is $6-7 trillions (my estimate). See also: http://www.bankofengland.co.uk/publications/fsr/2008/FSR08Octexsum.ppt#1
Funding gap problems are the essence of the meaning of "credit crunch", but should not be confused with credit risk losses (provisional before actual realised) as in the graphic below that is worth repeating again here. The Congressional hearings came just as the biggest annual securitisation industry conference ended in Las Vegas (appropriately, where the slot machines are less noisy of late). Numbers attending the American Securization Forum event fell to 3,600 from 6,000 in 2008. The US government knows that securitisation markets remain key to interbank credit, hence it has a plan for the Fed to lend up to $1 trillion to hedge funds and others to buy banks' ABS. This is Term Asset-backed securities Loan Facility (Talf). Last week, the size of the scheme increased from $200bn to $1,000bn as a result of hedge funds lobbying for this. In my opinion TALF could be better kept entirely in-house by the Fed, but it has possibly another $5 trillions of such swaps to do and so engaging the hedge funds for 1 sixth seems sensible enough. Others estimate the US banks' funding gap, at only $2-3 trillions, hence the split between private/public funding looks for now more 50/50. Citi led the way in growing banks' funding gaps after 2003. Today, Citicorp has its funding gap mostly covered thanks to its Government deal and therefore it is not too surprising to hear the spoiling comment from Citi director Mary Kane, "The Talf will result in a two-tier market and will not do anything to help traditional, real money investors. This will hinder the recovery of the markets."
The Banks as borrowers and lenders allowed interbank funding costs (spreads) to get too high to support past business models. But by balking at the deals the result was that panic set in about the banks' funding and the result was a hundred times more was lost in shareholder value (even after discounting for recession impact). Many private investors ('traditional investors' more than hedge funds) continue to balk at buying new issues, even with mouth-watering high yields, partly because of the uncertainty about the new US government plans. Hence the so far negative impact on confidence of Tim Geithner keeping his options open by not pinning down the details. But, the administration has also learned that there is no point in rushing to precise detail only to find that a temporary stock market spike is manna to short term profit-takers and then everyone concludes that the deal hasn't got long term effectivesness!
A survey of 450 of the Securitization conference participants this month in Las Vegas found most do not expect "return to normal" until 2011. Bet-the-odds investors remain concerned about the disconnect between the high income stream from these bonds and their low market price. This is a general rabbit-in-the-headlights problem of looking a gift horse in the mouth, if it seems too good to be true, it is, etc. i.e. how can the near-perfect-information markets so mis-price income-generating assets? Answer is simple - yields change and when capital is scarce yields go up dramatically as asset prices fall - just a matter of knowing some economic history! Investors, nevertheless want some reassurance as to how far defaults (borrower delinquency) can rise, not only of the underlying mortgagees and consumer credit borrowers, but also of loan-brokers, the finance-backing banks and their securitisation vehicle intermediaries (the previously "fail-safe" SPEs and SIVs).
This concern takes the question of this matter on to the effectiveness of the Government's 'fiscal stance' (budget deficit) and monetary 'easing' (zero bank-rate when consumer price inflation is falling). In practice, even if interest rates stay very low, the actual multiplier effect of the government's boost to deficit-spending will be less than 2 i.e. less than 5% boost to GDP. 5% is the figure deemed necessary to return the banks' funding gap to what it was in 2003, to the point when banks competed too hard and too recklessly to gain market share by allowing their funding gaps to ballooon! Much of the fiscal stimulus takes the form of tax cuts, but what % of this will be saved (paying down debt) and not therefore contribute directly to boosting demand by not entering the stream of GDP spending and income. But, of course, banks' customer deposits should rise, if slowly, to add to closing the 'funding gap'. But, the question remains how to stimulate demand that has been lost in the crisis so that jobs are saved, stemming job-losses in the pipeline, and begin creating new jobs (the Obama 5 million jobs target)? And, the part of the tax cut that is another 'one-year AMT patch' will have no effect on spending because the beneficiaries, forecasters, and everyone else assumes they would not be paying this anyway, notwithstanding the 20-year IRS concessions to banks. If we are lucky, the American Recovery and Reconstruction Act will close half of the gap, relative to the yawning magnitude of the recession, but not enough alone to refloat the economy. Hence, we need the banks to do their bit and roll-over domestic lending and expand lending where the wider economic benefits will be greatest. In another sense, a political one, $800 billions is too much. The 2009 fiscal-year deficit is expected by some calculators to end up at about $1.2 trillion, and if so we're talking deficits thereafter of 10% or higher ratios to GDP - levels that are deemed danger signals in any other country. Until now, the US has not been “any other country.” The trade surplus world has been willing to finance American deficits by buying its bank bonds alongside government treasuries. But while there may be no choice but to continue, the fact is that US imports have slowed dramatically and the pattern of world trade generally is changing dramatically and therefore buyers for new US paper will increasingly need to be domestic not foreign. Foreign countries are all becoming nationalistic about how to apply their capital reserves and therefore international obligations are being settled first on the basis of what domestic financial sectors demand of their own governments. Global banks now recognise that they have to have national homes, the globalised world is not their new country of origin; it has no world government, no central banks, albeit that G20 is running fast to create precisely that in practical terms.
In that light it is ironic that US politicians who warn against the size of the stimulus bill, the Congressmen who voted against it, are same Republicans who supported the Bush fiscal policies that doubled the national debt via the long-term tax cuts of 2001 and 2003 and that accelerated government deficit spending. We need now a bigger Obama fiscal policy that maximizes short-run demand stimulus, that gets through to people's pockets who will spend the money, just not save it. Lots of bang for the buck (recovery with jobs), not lots of buck for the bang (jobless recovery). Conservatives/Republicans continue to argue that tax cuts give stimulus while deficit-spending does not - but without an economic theory in support (supply-sider monetarist theories now seemingly discredited); endlessly repeating “tax cut” like the Hari Krishna "OM" mantra, like a cult that believes in the god-given literal truth of the Bible but has no interest in geology or any demonstrable proof. A perfect example of this prudish insanity is Senate Republican Leader, 'Mad' Mitch McConnel saying,"Unfortunately, at this juncture, while the American People are tightening their belts, Washington seems to be taking its belt off!" He obviously doesn't get what "Financial Stabilization" means or what the economic role of Government should be in a recession. The 134 page Budget Report obviously has some reluctant readership among the country's legislators. Obama inherited a 12.5% budget deficit that he wants to cut to 3% by 2013, not in a straight line, but up and over the deep gully of this recession. The Republicans intend to fight this all the way theologically, not constructively or rationally. They are not alone of course; they do have a large constituency of like-minded opinion. What do central bankers think of all this - see comment below for a sample of their political-economy lines.

LETTER FROM SANTA BARBARA

2009-02-19T02:01:00.000-08:00

Our MPs and Ministers and local newspapers (across Europe) could and should soon (once Spring Budgets are published in March) be able to write me letters like the one below from my friend Senator Barbara Boxer, Senator for California. The European Commission should also publish its details of the European Recovery Programme. The London G20 (April) will also have positive spending news regarding aid for the poorest countries of the world alongside its new financial world order plans and progress reports. When looking at all this budget good news, will our media be doing the usual of focusing on what it means for the taxes of a typical surburban one and a half children, one and half jobs, family with a mortgage, 2 cars, 2 votes and one package holiday fortnight? This time round they should think macro-economically like the lovely Senator is doing. Lady Shriti Vadera, when you read this or Darling, please take note!
Dear Friend:
This week President Obama signed the American Recovery and Reinvestment Act (H.R.1), which will save or create millions of American jobs -- including some 400,000 jobs here in California.
In the face of the worst economic crisis since the Great Depression, this historic legislation offers help and hope. It will put Californians to work building the highways, bridges, transit and rail systems, and renewable energy sources of the 21st century.
The economic recovery package includes major investments in programs that will create jobs right now while laying the foundation for sustained economic growth in the future. Here are just a few examples of what California will receive under these programs:
Infrastructure
* $2.6 billion in highway funding that could also be used rail and port infrastructure.
* $1.1 billion for investments in mass transit.
* $444.8 million to address the backlog of drinking water and clean water infrastructure needs.
Education
* $4.6 billion to local school districts and public colleges and universities.
* $82.7 million for Head Start to prepare children to succeed in school.
* $1.2 billion for Special Education Part B State Grants to help improve educational outcomes for individuals with disabilities.
* $74.2 million in education technology funds to purchase up-to-date computers and software and provide professional development to ensure the technology is used effectively in the classroom.
* $1.6 billion for Title I Education for the Disadvantaged to help close the achievement gap and enable disadvantaged students to reach their potential.
Energy
* $224.5 million through the State Energy Program.
* $192.1 million through the Weatherization Assistance Program.
Protecting Those Hurt by the Recession
* $220.2 million to provide quality child care services for in low-income families who increasingly are unable to afford the high cost of day care.
* $89.8 million in Community Services Block Grants to local community action agencies for services to the growing numbers of low-income families hurt by the economic crisis.
* $843.9 million to extend Unemployment Insurance for workers who have lost their jobs in this recession.
* $13.2 million for the Emergency Food and Shelter Program, which provides grants to nonprofit and faith-based organizations to provide for the immediate needs of the
* Homeless.
Tax Relief for Families and Small Businesses
* Up to $400 for workers (or $800 for married couples) in the new Making Work Pay Tax Credit for 12.4 million workers and their families.
* $250 to Social Security beneficiaries, SSI recipients, and disabled veterans.
* $2,500 for each of 522,000 additional families in California who will qualify for the new American Opportunity Tax Credit that makes college more affordable.
We know that this economic recovery package alone will not solve the entire problem; we must also address the housing and financial crises, and we will do so. Be assured that I will keep working with the Obama Administration and my Senate colleagues to enact legislation to stimulate growth, create jobs, and make American businesses more competitive in the global economy.
BB's letter to constituents in March 2009
Dear Friend:
The recently passed American Recovery and Reinvestment Plan (H.R.1), better known as “the stimulus bill,” is often described as a series of very large monetary figures. But the real goal of the bill was to create jobs, jumpstart growth, and transform our economy for the new century. Almost everyone in America will see the change that will be created by this bill. Let me provide some examples of what it will mean for average Californians.
* About 95 percent of all working families will qualify for the Making Work Pay tax cut. Working families will receive between a $400 and $800 tax cut, with an estimated 12.5 million Californians eligible for this tax cut.
* If you have children in California schools, they may see classroom, lab or library improvements as part of the plan to modernize schools. More than 1,200 California schools will receive modernization funding. Other funding for schools will also help to update technology and enable disadvantaged students to excel.
* If you have children in college, 522,000 families in California will be eligible for the American Opportunity Tax Credit to make college more affordable. This program creates a partially refundable tax credit for four years of college and puts higher education within reach of more Californians. The Pell Grant for college loans will also be increased to provide more funds to pay for college.
* If you receive Social Security benefits, or SSI, you will likely receive a one-time payment of $250.
* If you become unemployed, you can receive an additional $100 per month in unemployment insurance benefits, and your benefits will be extended if you remain unemployed. More than 2,395,000 Californians have lost their jobs in this recession and this extra money will help boost them and our economy with their added purchasing power.
* If you or a family member have become unemployed and you had health insurance, you will receive assistance in continuing your employer-provided health insurance coverage for up to nine months. The federal government will pay up to 65 percent of your health insurance premiums during this period of unemployment.
* If your neighborhood has foreclosed and abandoned houses, funds are provided to help local governments buy up and improve homes and make them available to renters or future buyers.
* If you are in the military, funds are provided to upgrade military medical facilities, housing, and childcare facilities. Funds are also provided to upgrade veteran medical facilities and to make repairs at veterans facilities.
* If you are a first-time home buyer, you may be eligible for an $8,000 tax credit toward the purchase of a home. And if you live in a high-cost area, you will have greater access to low-interest mortgage loans.
* If you are concerned about increasing crime in these hard economic times, the bill provides federal funding to hire more police officers through the COPS program.
* If you have a health problem, or even if you just regularly visit your doctor, your medical records will be computerized, enabling faster access to medical records and saving billions of dollars in health care costs.
* If you travel on America’s roads, freeways, bridges, or transit, you are likely to see improvements, upgrades and modernization including freeway construction, modernization of infrastructure that includes energy savings, and rail and transit construction to reduce traffic and gas consumption.
These are just examples of the good programs included in this historic legislation. And while it is just a step in a long road to economic recovery, it is a crucial one.

Sincerely,

Barbara Boxer
United States Senator

ROUBINI'S RGE & STERN SCHOOL COLUMBIA ESTIMATES OF US ORIGINATED BANK ASSET LOSSES

2009-02-13T16:25:00.000-08:00