PRINCIPAL USA MORTGAGEE DEBT WRITEDOWNS?

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?

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?

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

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?

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

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".