MONETARY & FISCAL

ABS Problem and solution?

2011-12-29T03:16:00.001-08:00

Recent articles in the UK press have noted how asset securitisations (ABS)including those based on mortgage debt (underling loan assets)have held up well in terms of yields despite the fall since 2007 in their market prices. The suggestion is that banks need to refinance and issuing new securitisations are the obvious solution (selling to ivestors instead of heavily discounted by 'haircuts' to central banks). The problem this solution faces is how to restore market confidence in this asset class. It can only be done by better information - more transparancy - on reliability of the yields (investment income returns) in the hope that confidence in capital values will follow?
The shock to the ABS market in 2007 was the 'discovery' that asset value (secondary market liquidity & prices) could divorce from yield value. Most commentators assumed that large haircuts and fall in ABS prices were a reflection of the opaque complexity of the structures and on deteriorating risk (rising defaults) of the underlying. It would have been more astute to recognise the problem of how ABS purchases were financed (using prime market deposits and other short term borrowings). The ABS confidence collapse was triggered by margin calls and distressed sales, notably Bear Stearns, Citicorp and then many others.
There was never a liquid transparant secondary market for ABS (and none previously tested over a whole credit cycle).
The markets still struggle to know market prices and try to determine these as global prices. Their default when they fail at this has to be to rely on ratings agencies ( essentially weighted score card models). In all the media and even analysts' commentary the emphasis has been exclusively on volume of ABS issuance and not on the yields and how they persisted through the crisis. This is where the complexity of ths structures did have a most damaging effect by simply making it very difficult to tell the story graphically of ABS yields. These need to be visually expressed but have to distinguish between tranches and underlying assets and even countries of origin of the underlying. No charts and graphics can be found in all of the media coverage since 2007 to show this!
But, as we should all know, the first generation ratings engines of Moody's and then S&P and Fitch were fundamentally flawed by being indifferent to default rates. When Moody's introduced a new model (a debugged version now sensitive to default rates) every week from July 2007 onwards ABS issues were re-rated, dropping as much as 17 notches in some cases. The creditworthiness of bank debt tumbled reslting in failures to refinance banks' funding gaps so as to maintain banks' business models.
This Chinese water torture on the market blew the credibiility of ABS ratings even though investors were stuck with continuing to rely on them (by regulatory laws) and asset values veered sharply away from yield values. Banks's share prices were easily shorted as they inevitably fell - because banks refused to pay the higher funding gap refinance costs. Many major banks would have saved themselves many times those costs had they accepted borrowing at the higher wholesale rates but could not break from their past business model margins, especially those whose refinancing was an aggressively large portion of their balance sheet. Banks who had to refinance funding gaps (gap between deposits and loans) in the ehat of the Credit Crunch were nailed to a cross and looked potentially insolvent. They were lambs to the slaughter for the shorting speculators. Arguably there was no speculation involved for about 18 minths because shorting these bank stocks was a sure-fired profit winner egregiously helped by irresponsible stock lenders.
Insurance (double-default risks) lost credibility fast as did too the providers of standby liquidity to SIV structures (though less known to public information) except spectacularly AIG among insurers and the "we are not directly invested in securitisations" Lloyds Bank as a very major liquidity provider (on both sides of the Atlantic) to SIVs.
It is true that ABS seen to have been the problem also has to furnish the solution. We see several cases of 'bad banks' and other ABS work-outs proving to be very profitable. ABS yields continue to be very high relative to the ratings they had in the past and even now. The problem continues however to be the amount of borrowed money versus 'own capital' and client funds used to buy the instruments and these borrowing remain suject to excessive margin calls on collateral underpinning the borrowings that were also often ABS whose market prices collapsed.
It is correct to say we require far more transparancy on securitisation issues yield performance. The overhang on that in Europe is however recession and fears of double-dip in USA and UK however exaggerated the latter really is.
If other economies turn down (e.g. in Asia) one fear is securitisations being again dumped on an illiquid secondary market!

CENTRAL BANKS DOING A GOOD JOB OR NOT?

2010-08-06T08:59:00.000-07:00

Central banks and other bank supervising regulators have advised banks to seek longer term funding-gap finance in the hope too that lending can be placed on longer maturities. The stability of the cost-of-debt-financing is as important as its price level, especially when government wants industry to invest in equipment, infrastructure, and stock building, and do so somewhat ahead of expected higher consumer demand when revival in consumer credit and residential property values return. That is a strategy in trade deficit countries that have been biased to credit-boom or 'endogenous' growth like UK, USA and notable others such as Greece and Spain, and where a restructuring is required to shift the bias to industry, to tradable goods and services.
In export-led economies like Germany and China that are reluctant to encourage domestic consumer demand in the hope that world trade will revive and they can return to export surpluses as the mainstay of economic growth, banks are being supported to lending predominantly to manufacturing industry. In PR China, such a strategy has been spectacularly force-fed by massive deposits of foreign currency reserve securities into the banks (96% of banking sector is state-owned) to both boost lending to over-borrowed industry and to provide capital reserve support.
The order to the banks was to lend to enterprises for capital investment, and while enterprise deposits is high loans to enterprises is far higher. Below I present my own data comparing USA and China's banks lending and deposits at end of 2009.China, like Germany, is an extreme export-led economy. That is its global brand, and therefore it is politically obsessed with the appearance (if not the actuality) of high GDP growth regardless of obstacles and constraints such as lower world trade, repressed wage levels, and low consumer demand. Wage levels are a market that covers domestic enterprise as well as exporters, and therefore when wages paid in exporting firms could have risen they were held down by low domestic consumer demand. The economy is severely strained by this distortion to maintain external competitiveness in the crudest manner.Most PR China GDP growth is accounted for by capital investment valued at cost without depreciation or market price, by whichever is higher. Thus GDP is inflated compared to how other countries calculate this in accordance with UN accounting standards. PR China's GDP is most likely one third less than claimed and possibly 40% smaller than claimed. That aside, we see here a central bank and government fully prepared to finance growth in bank lending, much of this additional credit going to state-owned or state-controlled enterprises, roughly half of all enterprises.
In better balanced economies and in trade deficit countries and where economic sectors are less state-controlled, there is also a need to shift bank lending to gain faster-paced recovery through higher capital investment. But, one sign of growing nervousness in EU/EA Europe is fears of value of loan collateral.Business cash flow dominates collateral thinking among German banks. In the UK it is property collateral. The UK has an output gap, but more importantly a long run industrial capital investment gap. In the UK, gross fixed capital investment at 15% of GDP is less than one third that of PR China as a share of GDP, and far more of it in property infrastructure and far less in capital investment in manufacturing and other industry (except petro-chemicals).
To encourage business investment to anticipate demand requires longer assured cost of financing i.e. for base rates to remain stable for a lengthy period. In my view central banks would do well to agree to forego monthly base-rate reviews in favour of quarterly meetings.The FT LEX column takes a disparaging view of central banks, beginning with the idea that heads should have rolled; "...for central bankers the worst financial crisis and recession in a generation has not dented job security. They once downplayed the dangers of asset price inflation and ignored or even cheered the build-up of financial speculation. Now they are trying to undo the damage."
The FT believes ECB and Bank of England are over-generous in maintaining a 'loose' monetary stance. Was the ECB wrong to extend liquidity to Spanish banks? Spain is where a quarter of Euro Area unemployment is. ECB should do all that it can to help fill gaps in Spanish banks' liabilities. When central banks cannot directly order where banks should lend it takes a generous shotgun approach to hope that enough credit will trickle to where the economy needs it most. The FT reports that "...predominant thinking within the central bank fraternity of major developed economies is plausible: neither the economy nor the banks are in good enough shape to cope with policy interest rates higher than near-zero. If anything, the temptation is to go in the other direction, towards providing more support for troubled banks and governments through quantitative easing."
The banks and property sectors are in such weakness, but manufacturing industry's weaknesses are not bank debt. In the UK, for example, debt servicing by industrial enterprises is only 10% of net operating profit. They could afford to invest more if the banks would lend them more or encourage them to borrow more for capital investment.
The easy money stance may appear defensible in the abstract, but easy or new credit is not getting through to small firms or to the SME sectors generally, that are expected to be our best bet for employment growth and employ about 40% of the engaged workforce.
FT Lex says grandly, "Central bankers’ natural preference should be to protect savers, not to give money away and help out reckless bankers and governments."
This is a moralising view that lauds savers while forgetting that bank savers cannot exist without bank borrowers.
The moralising view implied is that borrowers should borrow less and save more. In the real world borrowers and savers are mostly different people and different firms; let's not forget that deposits are not assets but liabilities. However it is that banks borrow funds, via customer deposits or by selling medium term note securities, they are attracting liabilities. They need to shift away from funding gap wholesale finance which in Credit Crunch years become hard to get, expensive, often impossible to roll-over, hence short-term, not sticky, and not yet dependable or economic from the borrowing banks' perspective.
Banks hope that household and enterprise deposits, even inter-bank deposits, are stickier, but these can only grow if the economy grows, and, in the absence of powerful net external demand, growth has to continue to rely on domestic demand, on borrowers getting loans and productively spending them.
FT 'Lex'ologists' accuse central banks of "...a comprehensive intellectual failure... that central bank independence, inflation targeting and output gap monitoring would lead to endless years of smooth growth. It seemed to work, until the economic train ran right over a cliff." I don't recognise this as how central bankers thought.
Banking regulations like Basel II was centrally concerned about encouraging banks to take account of economic and credit cycles - no suggestion of an endlessly smooth road ahead - that's how young people thought, or junior and middle managers, who were paid not to think, least of all about the factors driving cost of loan insurance that suddenly reared up like a the creature from the black lagoon.Our problem was surely that board room bankers did not read what central banks were reporting and were not trained to understand it anyway while their juniors were all too aware of the mortality of message-givers reporting to senior execs (no bonus for being a risk manager) desperately preferring the role of message-takers - it was far better work, better security and many times better paid to be the galley slave driver or drum-beater in banks than the lonely look-out in the crow's nest!

EUROPEAN STRESS OF BANK STRESS TESTS - a sovereign debt battle at sea

2010-07-06T11:11:00.000-07:00

The Credit Crunch and recession is like a great sea-battle. All banks like the great galleons at The Battle of Trafalgar have been damaged, some boarded and taken for prize money, some broken up and sunk, and all variously crippled having to try to return to port in the one of the greatest storms of the century, just like the enormous storm that battered all survivors after Trafalgar in 1805, victors and defeated alike. The Credit Crunch and recession has become a competitive battle between countries to see who can look least damaged and take the prize money thanks to the sovereign debt crisis, which as the last G20 meeting showed has this year severely weakened the collective spirit of G20 that we are all in this together and must cooperate to solve what is a global not a national problem.
The new message is that it is every country for itself, and this changes the use and meaning of stress tests by the banks. What looked like a climatic disaster for the global economy is now turning into a battle between countries. Germany defeated Greece and the PIIGS in the Euro Area, but the Euro Area is now at economic banking war with the Anglo-Saxons, USA and UK, within the EU and transatlantic. At stake may be the coming recession for the Euro Area and how deep and prolonged this will be. But, I know that there will not be a comparable or even roughly precisely similar modeling of the stress test scenarios by all banks; they will each be as different as the pictures shown here of the battle of Trafalgar, partial, subjective, and incomplete. Public transparent stress tests in the middle of the sovereign debt crisis concern risks whether the Euro Area can hold together as well or better than the G20 agenda, or whether the Euro Area splits between externally strong and externally weak states, surplus and deficit countries, competitive and less competitive.
These are the analyses of banks in each national sector that we experts will be examining. The Euro Area does not seem to have recognised and decided openly that sharing a common currency means they are mutually dependent. There remain strong political voices advocating the break-up of the Euro Area, letting some sink so that others can survive. Sensible people know that way lies defeat for all. Euro Area divided will lose and set back for another generation Europe's dream of action as a counterweight of equal strength in the world to the Anglo-Saxon economies who do operate as a group even though not formally so. Greece, Spain and Ireland thought Euro membership protected them; it hasn't. Germany and other export-led economies, including far-flung China, think they are protected by their trade surpluses, and have yet to discover fully that is not so either! Stress tests by banks are like war gaming, and at least as complex as a sea battle between two gigantic fleets. They are a regular requirement dictated by law, by Europe's CRD (Basel II and Solvency II) legislation adopted by each EU member state. the "stress tests" are central to Pillar II of Basel II.
Arguably, the Credit Crunch was worse than it would have been if only the major banks in Europe had focused earlier on Pillar II and completed Pillar II before the crisis; none of them did so! They had been advised strongly by audit firms (insofar as they said clearly banks must begin by building up their historical data including data covering at least one earlier recession) and consultancies like myself to start with Pillar II back in 2005 and not to wait until Pillar I implementations were complete; none did so!
It is debatable if the regulators communicated the same signals. I don't think they did even though intelligent regulators knew long ago that Pillar I of Basel II was really only a temporary learning process and that Pillar II is the entire battleground of risk regulations. They knew this at least by 2007 when it was obvious banks were dragging their anchor chains on Pillar II work, if not earlier, including about the inter working required with IFRS accounting standards that also reflect the scenario modeling requirements of Pillar II stress tests etc. What is Pillar II?
It is not merely the supervisory pillar as the audit firms wrongly advised by simplifying or summarising the meaning of Pillar II. Pillar II requires firms to combine all their risk exposures into a set of macro models with scenarios based on cyclical changes in the underlying economies. Essentially it is all about getting banks to understand how their performance depends on the macro-economy. Unfortunately this was not a message they either understood or wanted to hear. Bankers are deeply suspicious of power grabs in the boardroom by economists 9who would then displace mere accountants and mathematicians) despite the latter showing no signs whatsoever of being hungry for such responsibility. Economists were not involved by banks in their efforts to build econometric models for scenario stress testing. The regulators required them to forecast using current risk accounting data in the context of a range of severe economic downturn factors. Bankers assumed this could be done by simply tweaking their risk accounts and the result universally was amateur hour quality. You can see it in the results and also in the recipe provided of headline numbers the banks were tasked to work with, not unlike battles led by generals who had never seen a war, didn't know what a whole fleet or army even looks and behaves like. Banking had not only become too complex for traditional regulations but also too complex for management, for new management that unlike traditional predecessors had less than a comprehensive understanding of basic banking.Then in 2008 and 2009 along came just such a crisis, full-on war of survival, survival of those banks who could look at least relatively better than others, and as they had avoided modelling full recession, but also Credit Crunch, which effectively more than doubled the losses that they should have had calculations in place to anticipate. If they had been more on their own case I calculate their capital buffers and reserves would have been half as much again, but this would only have ameliorated half of the Credit Crunch impacts. Governments would still have had to step in. But, in any case, only the US and UK met the crisis with sufficient financial muscle and innovation. There was little prospect of banks surviving unaided unless regulators were more on the ball about systemic risk already by 2006 at the latest, but in every country that was less the remit of regulators, more the responsibility of central banks, who weren't asleep at the tiller on the poop deck and in the conning tower so much as merely lacking a sense of urgency to get anywhere fast. They relied too much on visual sightings from the crow's nest, lacked a plan and lacked modern guidance systems to see over the horizon.G20 and Government ordered stress tests on both sides of The Atlantic in 2009
With the Credit Crunch and resulting recession suddenly stress tests were no longer about speculating about an indeterminate time in the future, but about what is happening all around and in the banks yesterday, today and tomorrow, modeling the war while fighting it. But clarity was now precious and just as hard in the fog of war. This changed the character of stress tests as defined in the regulations to a real world modeling exercise with real data and lots more of it to be urgently computed than any theoretical abstract ideas hitherto had offered banks to work with. Banks, however, found themselves more lost than ever about where they were and to start and how to do such sophisticated intellectually demanding and at the same time dangerous work. While before capital reserve ratios were at risk now the banks saw stress tests as threatening to their independence and solvency! To make matters worse the banks were now being told in no uncertain terms by governments, using a force majeure that the central banks and regulators had not dreamed before the crisis they could muster, to do stress tests pronto beginning with the top banks in the USA and where the stress tests in the Spring of 2009 were not about years hence but about their economic capital over the next 6 months! They still did not employ their economists, leaving such corporately sensitives matter toa few trusted risk experts and accountants who are generally hopeless at economic models. Why, because economics is about dynamic changes over time, over months, quarters and years, and not about point in time cut-off audit figures for tax purposes; a wholly different game, a different language and culture. The USA results were eventually published but months later, only once the world had moved on.
Europe followed suit for its top banks and decided to keep the results secret. The reason for all this secrecy was less to do with corporate confidentiality or fear of the Jacobin mob and more to do with fear of real economists calling the whole exercise amateur, lies or even a sick joke. Economists weren't that interested, however; banking has always been somewhat beneath them. Traditionally finance was considered by economists to be immaterial to how economies behave - they have been learning a new hard lesson about that, but the lessons haven't yet sunk in and I suppose many economists are reluctant to acknowledge what they dangerously overlooked for so long. Sensible academics know better than to get involved in institutional mess of others just as the best bankers knew to steer clear of risk because there are no bonuses in risk management.Now in 2010 all these stress tests are to be done again and banks have to consider the impact of an imminent recession and to think of it as double dip. banks hate this because it goes against their entire approach to Basel II, having believed it should be a way of reducing their capital requirements when it is obvious to all that the stress test results merely give regulators the perfect excuse to raise capital ratios to two or even three times what banks currently hold. They wouldn't do that, but the ammo is there should they wish to, to turn the clock back on capital reserve ratios to those prevailing 50 or more years ago!
In Europe, because of the sovereign debt crisis that has shifted the targets of capital markets short term speculators from attacking individuals banks to attacking all of national banking sectors, governments are fearful about the stress tests too and anxious that they should put their own banks in a competitively (defensive) good light. Even the very intelligent and feisty Christine Lagarde is anxious to use the tests as a good PR. That is of course the exact opposite of what the stress tests are for; they are for measuring worst-case not for showing relative better case.
In the case of France there is considerable suspicion that french banks have got away (with only a few exceptions) almost scot-free in their balance sheets, which look as though there had been almost no credit crunch or recession. German banks have not been so lucky and have had to evidence more financial embarassment than french banks. Belgian and Dutch banks were holed sunk (Fortis, ASBN-AMRO and Dexia) while ING and Rabobank were only holed above the waterline and continue to sail merely minus a few of their mainsails.The results of bank stress tests will show that the eurozone’s financial services industry is in good health, France's finance minister Christine Lagarde has stated, thinking of course first and foremost about the reputation of France and her banks in the sovereign debt crisis. She made the comments at a conference as she announced that the test results will be unveiled on July 23rd. Financial regulators and watchdogs have been running the tests to quell investor concerns over the stability of the banking sector within the territory. But this is not what they are for! Banks are also worried now that they may be facing additional pressures from special taxes, regulation and stricter rules surrounding capital requirements, which they are already trying to postpone, the so-called Basel III requirements for higher economic capital buffers and liquidity reserves and for contributions to stabilisation funds. Ms Lagarde said: “You will soon be seeing the number of banks that will be submitted to the stress test, you will have better understanding of the exact criteria we apply and of how heavily we stress the system.”
There is a French phrase "un coup de Trafalgar" which one might be forgiven for thinking it relates to be defeated. The phrase is certainly in the minds of the French, but "Non, pas de tout!" Un coup de Trafalgar translates as “an underhand trick.” You’ve got to love and admire the French who can turn defeat into a sneer, and there is something of this in how all countries and banks are actually managing their stress tests on a national banking sector basis as an arena for trickery to show things are better than expects, understandable perhaps in the presence of a submarine wolf pack of hedge fund capital market speculators who are hoping to profit from break-up and defeat of the Euro system, a defensive line of ships that are being broken apart just like at Trafalgar.“Banks in Europe are solid and healthy,” Lagarde added.
The stress tests are expected to include approximately 100 of the largest banks in the Euro Area plus regional and local banks that are government owned. nationalised banks strictly do not have to comply with Basel II risk regulations but governments are concerned about how much their guarantees may be called upon and the embarassment this could means for budget deficits and national debts, given the parsimony of the ECB and the limits of the new €720bn stabilisation fund in the exclusive hands of the European Commission whose banking and accounting skills are not legendary. €720bn is five times one year's annual Commission budget. Has it got the what it takes to manage this responsibly or technically - non, pas dout! In the UK, the FSA claimed that it is not worried over what will be revealed about the health of UK banks by the tests. Is this also flag-waving? Adair Turner, chairman of the FSA, was quoted by the WSJ saying rigorous domestic analysis on British financial institutions has been ongoing since the start of 2009. Of course, except that it is still more a matter of great seamanship more than great technical means. The pan-European stress tests are overseen by the European Union’s Cebs as supervisor of supervisors. The tests are said to be bigger, potentially more credible – and certainly longer winded. But, from the point of view of the banks there is still not explicit miodel and formulae that they can follow precisely. They are still being relied upon to innovate their own models and that for banks is a huge challenge. At best it will be 2 or 3 years before this work can be called professionally credible, possibly not even then?
According to people involved in the European testing process, the initial exercise of testing the biggest banks in each country – 26 institutions had been done and is on schedule for publication on July 15. July 14 would have been a more resonant date. In my view if the tests and results are available by then, then the process has been far too rushed and the chances of credible results even less probably, certainly no time for boards to approve them and no time for any interative reworking to improve on the initial fag packet models.
CEBS questionnaires will have to be sent out via national banking regulators to about 125 institutions. The big question is whether the process will work in its aim to restore battered confidence in European banks. To repeat myself, if this is the aim it is wrongheaded according to the regulatory laws and the experts know that. European banks are worth 10 per cent less on average than two months ago, according to the FTSE Eurofirst 300 banks index. Enlarging the test should mean it takes to the end of July. I'd have specified end of September, but who wants to be worrying about all this while on their August holiday breaks.
Spain in particular is desperate to restore confidence in its banks quickly. Spain, which has tested all its banks according to CEBS guidelines is desperate to publish the results, has been instrumental in strong-arming other countries into extending the remit of the test, according to several people involved in the process. But, since this has become a competitive sovereign debt battle all have to publish, to fire their guns, at the same time. Germany was persuaded that to limit its test to only its three biggest banks was self-defeating, implicitly damning other untested institutions, notably the state-owned Landesbanken. The FT and others have commented that it is far from clear that the parameters of the tests will be tough enough to restore confidence across Europe. The same was said in 2009, and actually the CEBS tests are broadly a repeat of the exercise carried out in 2009, the quality of which I know to have been work that I would not pass if brought to me by first year undergraduates in either economic or business management school.
The banks to be stress-tested are:The parameters would be broadly a 3% GDP (in real inflation adjusted terms, which are useless for banks) undershoot, a 1% increase in unemployment and 10% further fall in property prices. Where is the figure for fall in corporate profits or spike in interbank borrowing rates, sovereign debt ratings and business profits wholly absorbed by debt servicing, insolvency rates and other such data - banks have to make those up.Adding to parameters widely seen as credible, CEBS is poised to settle on a higher hurdle rate for passing the test, increasing the number from a 4 per cent tier one ratio in last year’s test to 6 per cent this time, in line with the US stress test last year which helped restore confidence in banks there. This in itself is simplistically not the whole picture. The total capital reserves of all types and qualities should be included, including all capital buffers and other liquid and near-liquid reserves, including over the medium term between nominal losses to realised losses and collateral receovery and selling off business units. Net interest income is critical and this has to be modelled over a cycle, not based on point in time calculations. the results of all the stress tests will be predominantly point in time calculations.A key part in the exercise is how the tests choose to measure the sovereign debt risk impacts on the banks on both sides of the balance sheet. One regulator said to the FT that Europe had decided the test should assume a “haircut” of about 3 per cent on all eurozone sovereign debt investments. This is significant for otherwise highly rated instruments, but foolish as a general rule for all. 25% haircuts operate on asset swaps and 20% on debt restructurings such as Greece. That 3%, which is less than the haircut on most collateral receovery costs as already imputted in Basel II, will be controversial because it would discount solid German Bunds at the same rate as troubled Greek government debt. In that regard it is at least right because inflation alone could have that much impact, but of course how inflation is treated from real GDP to actual bank cash flows is a messy business.
“Given the difficulties, the preferable solution would be for each bank to disclose exposures so investors can base decisions on the facts, rather than questioning an imperfect test,” said Huw van Steenis to the FT, an analyst at Morgan Stanley. However, one senior official told the FT that the alternative idea of disclosing each bank’s sovereign holdings would be implemented as well. Combined with the running of simultaneous testing on a “top-down” basis by European authorities of the systemic macro-economic solidity of various banking sector exposures, such as commercial property, there is a growing belief that these stress tests could reassure the market sufficiently, as planned, is the FT's conclusion, adding that some analysts have suggested that panic about European banks’ exposure to sovereign debt could be overheated. All experts, including myself, agtree it is appallingly overheated and overheated by politicians as much as by speculators and runour-mongers and bloggers, but that the tests results will be reassuring I and other very much doubt, because the quality is easily comparable to the reassurances banks issued in 2008 saying they have no funding problems. The actual fact is that banbks do not know what their funding problems actually are because the uinterbank funding markets ahave been relatively closed in recent months and these tests are part of the battle, treated as a weapon not merely the half-time scorecard.Moody’s, the discredited, and in Europe deeply despised including openly by the ECB, credit rating agency, last month concluded that the largest lenders would be able to absorb “severe” losses on their exposure to Greek, Portuguese, Spanish and Irish assets without having to raise additional capital, after carrying out its own stress tests on more than 30 European banks. I believe them. It does not take much analysis at all to know that much. Moody's test assumed a forced sale of public sector bonds at 20 per cent below the steepest fall in market valuation in recent months, an event Moody’s described as very low probability.
The credibility of CEBS’s latest tests will hinge on whether enough weaker banks fail, said one senior central banker in London this week, reported by the FT. “The tests need to be published, the parameters need to be fully transparent, and some banks need to fail.” That is in my opinion silly and irresponsible because as anyone must know the authorities will intervene before absolute failure, and in any case we don't have perfect agreed measures for what counts as failure.
There are more competing theories for how to measure a banmk's insolvency than there are stress test factors and scenarios. Several industry groups, such as the British Banking Association, have come out against bank-by-bank disclosure, saying that league-table-like results could trigger a panic run on an otherwise healthy institutions. However, many bank chief executives and chief financial officers concede that full disclosure might be the only way to address investors’ concerns, according to the FT.
What all seem to miss is that this is in the sopvereign debt context now and therefore the stress tests are of national banking sectors, not about individual banks. This is macro-prudential systemic risk stuff not microprudential. Anyone liuving in the let some fail so others can survive better totally misunderstands the interdependencies of banks and of banks and economies. Christine Lagarde understands that. What the tests will again prove is that bankers don't understand the economics of banking, least of all investment bankers, no true perspective or realistic sense of proportion. Unfortunately our economies are in the hands of banmks as much as the banks are in the hands of the economies where they do business but neither lendfers nor customer want to acknowledge their vulnerability to the other. Governments and central banks understand what matters most in this crisis but they are being attacked and weakened by the buccaneers and privateers of the capital markets!

SOROS, TRICHET, MERKEL & IF PIIGS COULD FLY

2010-06-29T08:34:00.000-07:00

Otto von Bismarck made a speech in 1862 saying, "The great questions of the time will not be resolved by speeches and majority decisions... but by iron and blood", and thereafter was known as The Iron Chancellor, an appellation all subsequent Kanzlers aspired to, some far too much so. of course. There is more than a whiff of iron in the air of the sovereign debt crisis, Governments' own Credit Crunch, iron being also the smell of blood. Angela Merkel and her Finanzeminister Herr Wolfie Schäuble have not appeared tolerant of Diskussionen, preferring summit policy agreement only by Edict of Maastricht, the Euro Growth & Stability Pact.
Since January there have been oft-repeated calls among politicians, public, market traders and newspapers for Greece (its commercial and treasury paper now junk status) to leave the Euro, then later calls for Germany to leave, and most recently France saying it might leave if Germany does not change its economic stance (these two countries being the only ones with triple AAA status left in the Euro Area!) Netherlands should have triple-A status except it allowed its biggest banks to collapse in ignominy (I hope Nout Wellinck becomes the next President of the ECB at the end of next year to replace Trichet?)
The UK stands hunched offshore, on the sidelines, hand-wringing, and navel-gazing only at its own public finances. Ireland, Spain,and Portugal are teeth-chattering to see who or what hits them next, Italy somewhat secure by comparison, a novel experience for Rome, and France feeling it must be the unity champion, but not if Germany fails to hold up its half of the EU project deal.
This story below is a reduced form of the debate, a triangle with Angela Merkel (whom the Daily Telegraph called "brass-necked") representing the EU's biggest economy that stands as creditor counterpart to most of the rest, Jean-Claude Trichet the Euro Area's financier ECB, and George Soros representing international capital markets.
Trichet has decided he must side with Germany that some might conclude is ECB's biggest paymaster, but also its biggest customer-borrower. Germany has net foreign assets of €1tn, while the rest of the Euro Area's is minus €2.5tn, and germany owna 40% of ECB's reserves. It's ex-Euro Area trade surplus also halves the rest of the EA's deficit. These apart from any other reasons are good ones for why ECB President Trichet should remain on Kanzler Merkel's good side.Trichet said after the G20 last week that "Merkel’s actions will boost confidence among households, investors and companies and will help consolidate the recovery", speaking to Italy's La Repubblica. That view is at odds with what many economists and veteren arbitrageur George Soros said on Wednesday, telling a Berlin audience why the euro is flawed: "By insisting on pro-cyclical policies, Germany is endangering the European Union... "I realize that this is a grave accusation, but I am afraid it is justified." Trichet dismissed this, saying the euro [EUR/$=1.2182] is a very credible currency that kept its value and guaranteed price stability for 11'5 years, with average annual inflation of 1.98% in the euro-zone. "A currency that guarantees such stable prices, it's of value in the eyes of domestic and international investors" Trichet told La Repubblica. Of course, as every investor knows, supposedly past performance is no guarantee guide to future performance. Yes, but?
The day before, Wednesday, Soros said that "by cutting its budget deficit and resisting a rise in wages to compensate for the decline in the purchasing power of the euro, Germany is actually making it more difficult for the other countries to regain competitiveness."
That is correct if Germany's €250bn foreign trade surplus is 60% earned within the EA, which I think the data allows us only to suppose to be probably true.
If so it's $120bn ex-EA surplus helps pay via the ECB for most of the rest of the EA's non-€ trade deficit with the rest of the world but for which it gets €150bn trade & payments gain from the rest of the EA, a nice trade. Netherlands also earns a substantial trade surplus, as do a few others, much of it from Germany as in Ireland's case. But, it is from the above interesting that we could put a figure of €50bn on how much more Germany should be importing annually net from the rest of the EA, which I suggest works out at a rise in gross imports from the rest of the EA of €200bn roughly to get a change in the net surplus of €50bn.
That means Germany increasing its imports by over 16%, and from the reast of the EA by 27% or three months worth. That is a big adjustment and practically impossible; looks easier and cheaper just to pay over €50bn annually, but how? The Europen Stabilisation Bank fund of €720bn of which €250bn is from the IMF (using EA member states deposits and drawing rights perhaps) equates to a decade of such payments if the balance all came evenNtually from Germany. Its contrubution is just shy of €150bn.
Merkel defended her actions last weekend, saying they will prevend future crises. Well, er, no, that's what they said about TARP in the USA. All experts are saying that Europe's banks have not disclosed their full losses from the Credit Crunch and Recession. Indeed, looking at some banks such as certain french banks, others too, one would be hard pressed to find signs of either Credit crunch or recession in the balance sheets such as BNPP, with certain notable exceptions as SocGen and of course the small local banks. But, experts can be wrong. Anglo-saxon experts would be wrong if they expect to find continental European banks except for Spain and Greece to be so heavily exposed to property as US-UK banks. The Netherlands banks bought in foreign property exposure e.g. Fortis, and ABN AMRO, ING too but less so, to their cost.
Ireland, remarkably for a small country with a surprisingly huge trade surplus, its banks ran with the credit-boomers, didn't lend to business much, lavished all on property lending and incurred a massive balance of payments deficit double-negating its trade surplus - truly bizarre! The UK banks lent far too heavily on property and mortgages but unlike Spain, and Ireland there is no poperty surplus so residential values fell less than expected, while only commercial property did the expected and tanked. hence, the collateral damage of Credit Crunch and recession is a curate's egg in Europe. let's not forget that Germany is another China in trade volume, surplus and massive over-lending to business while relatively neglecting property and household consumer lending.
In any case the Credit Crunch did not result in a Euro Area recession so much as a big short-lived negative growth shock from the USA-UK bow-wave. The Euro Area boat (Das Boot) has its normal recession still due, if it arrives on time, before this time next year! The socvereign debt crisis may take the blame including Germany's Iron Kanzlership, and people will talk of "double-dip" and UK will catch a feverish cold from it, a dunking from a Euro bow-wave, but actually this would be a misinterpretation. Continental Europe regularly has its recession 24-30 months out of synch with the Anglo-Saxon cycle. Hence, there is something tobe said for battening down the hatches on government finances to make some room for expansionery spending when recession hits.
Could Euro recession be avoided like the UK avoided recession in 2001 by pre-emptive spublic spending increases. The answer is possibly yes, but more probably no, because the Euro Area is too evenly split between credit-boom and export-led economies. Will another or prolonged crisis sound the death-knell for the Euro system, and also be triggered by assuming greater writedown losses to please the Anglo-Saxons, haha? The writedowns from Credit Crunch currently stand as follows: Whatever the triffers appear to be, the Euro System is in a "Merkel of all Crises" (Scots: muckle; US usage 'Mother') such that the Euro system's collapse is more probable than diplomats assume to be thinkable. The currency union may not break-up or the Euro actually crash to the floor, but the system must change. And, do not under-estimate the power of financial speculators to smell blood in the water and what they will do to garner the tens of $billions of speculative profits on fears of Euro-collapse, even if the Euro never truly falls apart! Pitted against that is the political will of the EU, which should prove stronger, not least to avoid political security crises within and along EU borders.
This is more than just deflation Risks. But Trichet does not believe that austerity measures being by European governments will cause deflation. can he back that up with systematic evidence - no! he hasn't got a macroeconomic model to tell him what to say on that score. his job is spin-doctoring for confidence raising.
Some bearish investors are betting that cuts in government spending across the European Union will add to deflationary pressures at a time when consumers and businesses are de-leveraging, lending and borrowing less, battening down until the storm passes.
Growth will fall sharply, with zero growth effect coming from household consumption, business investment or bank lending when government too is deflationery. Where is growth to come from? Will it be trade with the rest of the world or asset sales to foreignors? hardly. Whatever is imagined cannot be currently foreseen or computed by the financial markets experts, words I offer up with a dry taste and pained smile. Some speculators seem more like agent-provocateur rioters or muggers to me. Private sector deflation is pushing yields on 10-year bonds down to 2 percent, triggering a new wave of quantitative easing, Bob Janjuah, chief markets strategist at RBS told CNBC. Is that telling us something? Not in my book. Markets are not economists and they read their capital market screens like Chinese courtesans read tea-leaves.
"I don't think that such risks could materialisee," said the great seer Trichet, adding that inflation expectations are well anchored. They would be if deflation's coming? "As regards the economy, the idea that austerity measures could trigger stagnation is incorrect." one has to ask, why not? How can stagnation be triggered except by austerity on all fronts beginning with government? trichet has an answer to that chiming with merkel but totally opposite to Soros. This is not a love triangle at all! Reforming the real economy in each country in the euro zone is what is needed, according to Trichet.
That is just so easy to say and as anyone knows it is a long term gameplan, but not one that governments sho believe in leaving matters to free enterprise and financial markets engage in trying to achieve beyond a relatively passive (supply side fiscal economics) second guessing.
"We ask all governments to be determined to carry out structural reforms to increase the potential growth," trichete said. "I insist on the need to boost work productivity: in the medium- and long-term, growth depends right on this." If PIIGS could fly!
It is bizarre that Trichet can say Governments have to restructure, or economies do so, when we know it is already proving exceptionally hard to restructure the banks, something the ECB needs to take more responsibility for and relieve EA member states of the bruden on their budget balance sheets. None of this economic competitiveness restructuring can happen unless Europe's banks in all countries dramatically change the composition of their lending between productive and non-productive investment, from demand to output and vice versa. Export-led economies' banks are far too heavily exposed to industry assets and credit-boom economies' banks even more exposed to property assets. If the EU and EA simply rely on radically restructuring without coordination and financial rebalancing measures how the chips will fall may turn into a game of chance. The Commission's meisterwerk of a €720bn stabilisation fund appears to be a keystone, but it has to cope with Europe's banks refinancing €5 trillion in funding gap finance ove the medium term that could very easily take all of that and more.
There is more darkness to come before the dawning dawn.

Verdammtnochmal; diese einseitige Konjunktor schon wieder! - of Europe' biggest economy!

2010-03-06T11:08:00.000-08:00

GERMANY as usual yet again plays only its one note economic flute - a picture postcard to the rest of the world hiding a domestic ruthless economic selfishness that does not extend to its over 3.1 million unemployed and rising (or 5 million, 3 or 5 depending on your preferred measure)! Since the mid 1970s Germany has maintained a high unemployment rate and in most years a depressingly low consumer spending. The effect is partly borne by migrant workers, but less than imagined; very much by German youth and by early retirees. This coincides since the 1970s with local and regional government spending restrictions and cuts. German industry has been forced to rely heavily on exports. Germany's economy is a good example alongside Japan of how year after year substantial trade surpluses do not a happy economy make, and do not translate well into general economic growth. In US dollar terms the economy experienced long recessions and near-recession periods in the first half of the 1980s and second half of the 1990s and first half decade of the twenty-first century - half of the last three decades. These were only growth periods in Deutschmark terms.Both Germany and Japan have been inflation, export surpluses, high currency exchange rate, and monetary policy obsessed with one major difference, Germany kept its national debt low and unemployment high while Japan did the opposite. Both countries, however, sacrificed domestic consumer-led growth (thereby restricting imports) on the alter of exports above all else. They do not make happy trading partners - a model and brand followed by China that can at least claim some good reasons for doing so until now. Following their failures to become world military superpowers, Germany became mesmerised like Japan by the wonder of being perceived around the world as an economic superpower. Once the post-WW2 decades of reconstruction ended in the 1970s oil-price recession shock, since then Germany and Japan preened themselves as creditor nations, and in Germany's case especially the cost has been lower growth, mainly export-led and therefore high unemployment. Economic conservatism was excused for many years by national anxiety in general, a pervasive sense of economic insecurity, paranoid fear of inflation, and of hyper-inflation in particular. I know Germany very well and can confirm that these feelings of fearfulness were genuine even in the halcyon days of fast growth and full employment.
The second half of the twentieth century confirmed Germany's reputation as a strong economy, the world's engineer, a land of discipline, quality and precision in design as in manufacture. Japan developed a similar production ethos supplemented by diligent sales-marketing, reverse-engineering innovation, and price competitiveness. The problem is that what impressed foreign markets became the sum total of what impressed Germany and Japan about themselves! Their only wish is for this to continue indefinitely. Meanwhile German manufacturers have been not even reliant on German bank loans but able to self-finance investment and rely on bank borrowing in its trade partner countries. Today, Germany's goods exports are 41% ratio to GDP, one third more by value than total of German industrial output (compared to goods exports in UK of 17% ratio to GDP, 40% less by value than total UK industrial output, and 6% in USA, only 30% of total industrial output). Services in Germany are 66% of GDP, compared to 82% in UK and 77% in USA. Germany's imports are 33% ratio to GDP (half of which is energy and some of the rest for re-export), compared to imports ratio to GDP of 23% for the UK and 10% in the USA. Germany can claim to be a substantial importer, but its greater reliance on the external account bespeaks an repressed domestic economy. This, it was hoped by other EU members, would change with the Euro single currency whereby the German economy as the EU's largest (equal to UK and Spain combined) would open up more to become a more balanced two-way trading partner with the rest of the EU, not least because of the reconstruction and development of East Germany. That did not happen! German policy setters did not allow it to happen! The Einheitssteuer tax to fund reconstruction was sufficiently harsh to dampen demand in the whole country - it was a totally unnecessary tax other than helping to keep the economy relatively closed within the EU. Unlike the UK in the nineteenth century when it ran decades of trade deficits because of following a 'free trade' policy alone that benefited the growth of continental Europe more than the UK, Germany found ways of maintaining trade surpluses even within the free trade zone of all of the EU!
Germany’s reliance on manufacturing to spur export-led growth was highlighted on Friday by an exceptional spurt in industrial orders, reported as parliamentarians showed the fiscal discipline they are famous for by trimming €5.6bn from this year’s German budget. Industrial orders leapt by 4.3% in January, largest monthly increase since June '07, helped by the weaker euro.
The rebound followed a 1.6% fall in orders in December at the end of a period when de-stocking dominated over output investment. Eurozone services have been hit by weak domestic demand causing and caused by rises in unemployment and cut-back in governments' stimulus measures.
As usual, cuts in the German federal budget will mostly affect spending on welfare and job creation. This beggar-my-neighbour via trade action should trigger complaints from trading partners, especially in EU countries that have been urging Germany to increase public spending to stimulate domestic demand and help the recovery of the whole of the eurozone.But, like Japan, Germany is well-versed in evading domestic stimulation (also known as endogenous growth impulse). As a recipe for everyone else it is of course impossible for all others to similarly shift their policy stance to focus only on export-led growth; exporters need importers - if some countries insist on running high trade surpluses other countries have to run high trade deficits. It does not therefore behove Germany to tell Greece or any other countries how to manage their growth, and certainly not on the German model, a model that can only ever suit the few, not the many!
Members of the ruling centre-right coalition pushed through the cuts, which will trim government spending from €325.4bn ($443.5bn, £294.5bn) to €319.5bn, and reduce the forecast deficit for 2010 from €85.8bn to €80.2bn, to only 2% of GDP, which is simply callous, appallingly low when the EU and the rest of the world is recovering from recession, and shows an indifference to national unemployment, which today is only 16% below what it was in the Germany of 1933 (although 6 millions unemployed was only the official figure; other figures suggest 11 millions)!
There is a historic logic to Germany's obsession with exports. The German economy failed to heed the export mystique only in the years up to and after 1933-45 that was, however, also based on seeking economic independence from the global economy. Between 1910 and 1913, exports accounted for 17.8% of Germany's GDP, then 14.9% in the second half of the 1920s falling with the Great Hyperinflation and persisting in falling to only 6% in the second half of the 1930s under the Nazi regime, then the war. But by 1950 accounted for 9.3% of West Germany's GDP. With postwar economic boom, exports rose to 17.2% of GDP in 1960, and to 23.8% in 1970, rising through economic downs and ups and domestic retrenchment to 26.7% by 1980, and 33% in 1990, up to 41% today. Fine, but this cannot continue! The original budget was tabled by Wolfgang Schäuble, the finance minister, and proposed the highest deficit ever recorded in absolute terms – more than double the previous peak figure of €40bn (but if today only 1% of GDP!). The FT commented that "it is rare for parliamentarians in Germany to attempt to reduce federal spending, rather than try to increase budget lines for their favourite projects". Er, not so, what planet has the journalist been living on? The coalition government's majority Christian Democratic Union party and minority Free Democratic Party decided that Germany needed to send a signal to the rest of Europe – particularly in light of the ongoing Greek economic crisis and pressure on the euro. What Europe do they imagine they have been living in?
The gradual recovery of the German economy, and the continuing only relatively lower unemployment by Germany's high levels it has become inured to, made the cuts supposedly possible. The spending figures and the cuts were opposed by Social Democrats and Greens (a party I helped to found in the late 70s), but will be passed March 19.

CLUB MED COUNTRIES GET ROD OF IRON?

2010-02-24T23:11:00.000-08:00

Portugal, Spain, Italy and Greece are all in breach of 3% Maastricht crieria budget deficits and 60% national debt to GDP ratios. That is an issue currently shaking the Euro system and is being talked up as a major challenge to EU integrity - even if everyone else in the EU are also in breach of the 3% ceiling for budget deficit ratios. It is not far fetched to point to a North-South EU divide between the self-proclaimed prudent beer-swilling cold-hearted North and an imprudent impudent wine-savouring sunny South, between an iron north and a malleable south? Passing our Edinburgh statue to one of my great great grandfathers, The Duke of Wellington (Duke of Douro in Portugal), I was reminded in a Radio 4 discussion about the history of UK national debt, by historian Niall Ferguson that Wellington was nicknamed the Iron Duke not for his defence of Portugal or for victory at Waterloo, but for installing iron shutters on his windows at Apsley House that were regularly being stoned, almost daily, by the mob protesting about economic hardships and his opposition to the Great Reform Bill in 1831. Today the stones are being thrown for similar reasons in the so-called 'Club Med' countries, and the The Guards charging the mob, who were nicknamed the "Piccadilly Butchers", are in today's EU supposedly the Germans. FT's Lex looked at the Club Med countries as a group perhaps because they are currently each experiencing street protests, sometimes violent, against budget cuts imposed. some say at the behest especially of 'Iron' Germany, to make them and all other fiscal recalcitrants comply with Maastricht deficit rules, that Germany itself is marginally in breach of? Two centuries ago, to help balance its books, the French under King Joseph invaded Andalusia and began the long two and a half year long bloody siege of Cadiz! Let's not indulge economic equivalents, to traduce the idea of the EU as having kept the military peace in Europe, only to replace it with open economic-warfare. The EU runs a modest trade deficit with the rest of the world. If Germany persists in maintaining a substantial export surplus internally and externally to the EU, then it has to live with the fact that many of its EU fellow member states must run deficits and therefore Germany has to buy the deficit countries' bonds to fund the current account imbalances.German politicians have particularly decried the profligacy of the Club Med states, no doubt mainly for domestic political consumption plus a little leverage at the loans negotiations. Athens politicians complain this is Berlin bullying and the mob and expert commentators agree. FT Lex says, "Amid a rash of strikes in Greece, Spain and Portugal, emotions are running high. Yes, Greece and the other big-spending Club Med countries must tighten their belts. They also need to increase their competitiveness. But to insist, as Berlin has done, that austerity is the only way out for these countries is both unrealistic and untrue. Germany must play a role too." I agree, except this is not yet the time for so-called 'belt tightening'. Much of the anciety is caused by the evidence of Greek sovereignty rating crisis hitting the Euro, example of tail wagging dog, or as Soros would say 'tails' given similar problems in Ireland, Portugal and Spain. Greece, Spain and Portugal, less so Italy, have been running large trade and current account deficits for many years. Italy, unlike the others, did not indulge in credit boom growth. In credit crunch terms, Italy has been the most prudent economy in the EU. The ECB has provided loans to support bank aid, abd as can be seen Germany and France have also received support.Last year, these current account deficits summed to about €127bn, of which trade deficits were €100bn, half of which was due to trade within the eurozone. The 4 countries shrunk their deficits significantly in 2008 and 2009's recession.
Germany, meanwhile, retained a large current account surplus of a $135bn (€120bn c/a), down from €200bn in 2007 – over half of which is from trade with EU partners. For decades Germany enjoyed export-led growth, while the rest of the EU supplied the demand for much of its exports - a synergy that continues.
Germany's advocacy of fiscal austerity may be merely political grandstanding or a genuine concern that market confidence is more important than economic realities - whichever? Even germany must know that if now the four Club Med countries deflate their way to shrinking their budget deficits to 3%/GDP ratios, this means a €135bn cut, or about 7% of German output - a huge slump in demand, including for imports -see data below.
And, then what if everyone has to do the same in the EU? Economies and markets do not run on straight lines. Maastricht criteria are an equilibrium ideal and the Euro is a strong currency protection of sorts, but underneath that allowance has to be made for very different, countervailing, if complementary, economic structures and growth policies. The kicker in all this of course is that The Euro and its Maastricht Treaty conditions are being levered to make the case for political union.
We took a big step in that direction with the Lisbon Treaty. But, so far, the new voting dispensation, our new President, the various councils, and the European Parliament, are not on the battle-scene.
As lex concludes, "Germany would not be able to substitute with increased exports to other countries. The economy, which is already stalled and only currently propped up by exports, would go into reverse. Berlin would then face some tough choices... If only out of self interest, German opposition to a Greek bail-out plan is therefore likely to soften."

ARE EURO STATES A MUTUAL SOCIETY OR NOT?

2010-02-16T23:12:00.000-08:00

Otmar Issing, who was very important in dictating the form of European Monetary Union (EMU) has issued a provocative challenge using the fiscal embarrassment of Greece within the Euro Area. He makes several statements of partial facts. His purpose is to argue that EMU’s rules are absolute and can only be flexed by European Political Union (EPU), as if to swing the Euro rules like a bat on the pivot of Greece to hit a home-run for EPU, which he argues, as he did in the 1980s, should have preceded EMU. To be fair, Issing clearly dislikes the idea of leveraging EMU to gain EPU – that it should have been the other way about, but that is how he sees matters now standing.
What are his provocations? They include that the Euro Area system is a monetary stability system that does not permit any direct or indirect transfers of aid between member states. In truth, it does permit transfers far more than would be the case if the Euro did not exist. But, these are indirect transfers between states via inter-bank loans and bond sales i.e. private to finance trade deficits between states, for which, as the credit crunch crisis has shown us, central banks and state treasuries are ultimately solvency guarantors.
Jean-Claude Trichet, ECB President, also says, however, that there can be no special cases i.e. Greece can swap assets with the ECB for short term roll-over loans, but only if the assets are rated suitably high enough by the ratings agencies. This is a Catch-22 circular argument since the ratings agencies’ sovereign ratings for Greece are influenced by Greece’s EU, EMU and OECD membership, and too by the flexibility of the ECB’s lender-of-last-resort role. To play tough and say each state must absolutely balance its books as if there are no external circumstances, effectively makes policy responses to the credit crunch and recession within the Euro Area a hostage to the ratings agencies whose models and role in the crisis, while central, are profoundly discredited.
Issing concedes there are transfers at the full EU level via the budget of the European Commission, but he avoids any references to transfers via the short term money market operations of the ECB. In the 1980s, when EMU was conceived and Issing argued EPU first, EMU second, The Jacques Delors and European Recovery plans proposed up to a trillion in bond issuance that would be self-financing to provide for a system of transfers to ease the readiness for EMU. This sensible idea was voted for by all states except UK, Germany and The Netherlands. If today’s EU majority voting system had applied back then a system of transfers would have been part of the Maastricht, EMU and Euro treaties. I would go further and say if the EU had a system of transfers similar to what operates within sovereign states (to compensate for imbalances between regions) then there would surely be far more support and impetus towards EPU within the EU by now.
Issing says European taxpayers would not stand for ‘transfers’ from states who obey the rules to those who do not. But, following the rules is not the real issue and is not simple at any one point in time. It is more a question of what follows from very different economic growth policies within the EU. In the EU Single Market transfers are inevitable either private or public, interbank lending or inter-governmental transfers. When interbank lending (and buying and selling of net financial assets such as securitised bonds) broke down, governments everywhere have had to step into the breach. Greece may be rightly accused of running a far too high annual trade deficit and external account financing (up to 18% ratio to GDP). But its credit-boom led growth, while imprudent, was not outside of the rules. Indeed, Ireland, Finland, Greece and Spain were repeatedly praised for contributing to EU growth and jobs recovery much above their weight within the EU economy.
All states cannot seek after only export-led growth! For most of my lifetime it has been the case that the world economy has accommodated only a few net exporters (e.g. Germany, Japan and OPEC). The extreme special case of the past decade was that a few credit-boom economies (mainly the USA) generated trade deficits that allowed almost everyone else to generate surpluses or get nearer to balance. The conditions that led to the credit crunch were a boon to emerging countries generally, and of course to China.
What Issing neglects to say is that when states gave up their individual currencies they also handed all their off-balance sheet short term bonds operations (treasury bills) to the European Central Bank (ECB).
It has been precisely by using treasury bills that the UK and USA have been able to generate trillions of aid for their insolvent banks at no material cost to taxpayers – no taxpayers’ money applied, aid is off-budget in assets for treasury bill repo swaps. Greece, Ireland and Spain, and others in the Euro Area when directly bailing out their banks have had to issue bonds ‘ on budget’. They would not be in such fiscal difficulties if they could have relied on the ECB for a similar scale of money market response on behalf of the whole Euro Area and Single Market without regard to who got more or less help relatively.
The unstated implication of Issing’s argument is that only political union would permit such flexibility by the ECB. This is debatable. Some argue the ECB’s inflexibility is because it is not backed by political union. Another view, my own, is that the inflexibility comes from the EU being composed of countries that followed opposite growth impulses. Germany pursues export-led growth (why its employment gains have been less than others) alongside economies who pursued USA and UK style credit-boom growth (what we used to call deficit-led growth), such as Ireland, Greece and Spain, which meant having to sustain large trade deficits by selling financial assets. These diametrically opposing growth and monetary policies stymies the ECB in its response to the credit crunch.
Greece had further to go to catch up economically with the rest of the Euro Area and the banks went further than others in pushing a mortgage-led credit boom, and did so against Central Bank of Greece advice and in years when the ECB did not express its concerns. Like banks elsewhere, Greek banks capital reserves were wiped out and Government had to pick up a bill to provide support equal to one year’s GDP. But, Greece has to accommodate much of this ‘on-budget’ and that is hard to do and keep within the Maastricht Treaty rules.
Issing says “Emu is a “no transfers” community of sovereign states”. But, if taxpayers accept aid transfers internally between regions within states and externally at a global level why not within the EU? Does the ECB constitution and treaty really forbid ‘special cases’. Statements by Trichet and EU finance ministers in December and January did not seem to think so.
“No transfers” has clearly not been a macro-economic reality since the 1930s in the world economy. The idea of states sharing the same currency is that they may trade fearlessly with each other without currency problems. But, this happy view neglected to consider how external accounts are managed and financed.
The ECB cannot claim to be a force for stability when it ignored these fundamental stability issues. The ECB needs to broaden its operations and treaty scope or it risks becoming a force for instability by religiously enforcing rules on government fiscal policy as if this is the only monetary policy factor and thereby ignore the underlying economy’s money supply as dictated by commercial banks.

NOTE:
Issing is president of the Centre for Financial Studies and former member of the board of the Deutsche Bundesbank (1990–1998) and of the Executive Board of the European Central Bank (1998–2006). He conceived the 'two pillar' approach to monetary policy decision making adopted by the ECB. His statement in the FT (15th January):
"To bail out Greece or not? The question is grabbing headlines daily. Supporters of a bail-out argue that if Greece collapses, others would follow. Financial markets have already identified the next candidates. As such, European economic and monetary union is at risk. Only financial aid and “solidarity” with highly indebted members can rescue the euro.
It is certainly true that this is a decisive moment for Emu – but for the opposite reason. Greece will continue to receive support from several European Union funds. But financial aid from other EU countries or institutions that amounted, directly or indirectly, to a bail-out would violate EU treaties and undermine the foundations of Emu. Such principles do not allow for compromise. Once Greece was helped, the dam would be broken. A bail-out for the country that broke the rules would make it impossible to deny aid to others.
It seems that quite a number of observers have forgotten what Emu is, and what it is not. The monetary union is based on two pillars. One is the stability of the euro, guaranteed by an independent central bank with a clear mandate to maintain price stability. The other is fiscal solidity, which has to be delivered by individual member states. Member countries are still sovereign. Emu does not represent a state; it is an institutional arrangement unique in history.
In the 1990s, many economists – I was among them – warned that starting monetary union without having established a political union was putting the cart before the horse. Now the question is whether monetary union can survive without such a political union. The current crisis must be handled in such a way as to produce a positive answer. The viability of the whole framework – nothing less – is at stake.
By joining Emu, a country accepts its rules. Greece, moreover, also knew that adopting a stable currency that was not controlled by its own central bank implied a total break with the past. Devaluation of the national currency and an inflationary monetary policy were no longer options. A single monetary policy is implemented by the European Central Bank and it is the responsibility of each country to adjust its economic policies so that this one size fits all.
Participation in Emu brings huge advantages. The benefits of joining a stable economic area are greatest for countries that were unable to deliver such conditions before. Thanks to the euro, Greece has enjoyed long-term interest rates at a record low. But instead of delivering on its commitment at the time of entry to reduce public debt levels, the country has wasted potential savings in a spending frenzy. The crisis with which it is now confronted is not the result of an “external shock” such as an earthquake, but the result of bad policies pursued over many years. Bailing out Greece would reward such behaviour and create moral hazard of a dimension hardly seen before.
In this context, one conclusion becomes obvious: financial assistance for countries that violated the terms of their participation in Emu would be a major blow for the credibility of the whole framework. By its construction, Emu is a “no transfers” community of sovereign states. Transferring taxpayers’ money from countries that obeyed the rules to those that violated them would create hostility towards Brussels and between euro area countries. Among ordinary people, it would undermine a badly needed sense of identification with the great project of European integration.
This moment is a turning point for Emu, and for the future of Europe. Most observers point to the high risks – which cannot be denied. However, any crisis also presents an opportunity. This is a big chance – probably the last for Greece, and others – to adapt fully to a regime of stable money and solid public finances.
For Emu, the crisis represents a final test of whether such an institutional arrangement – a monetary union without a political union – is viable for an extended period of time. Lax monitoring and compromises when it comes to observing implementation of rules have to stop. Emu is a club of states with firm rules accepted by entrants. These rules must not be changed ex-post. Governments should not forget what they promised their citizens when they gave up their national currencies."

GREECE 'HELL'N ISM' BANKS

2010-01-31T03:52:00.000-08:00

Global investors and EU analysts are beginning to learn the lessons of Greece's crisis. It is delusional to think of Greece as an isolated case, like simply another Dubai.
Greece is credit crunch plus concomitant recession impacts in miniature. It is an example of a credit boom economy, more extremely so than the USA.
The US economy has massive size with a trade deficit and currency weight able to act as counterpart to the rest of the world, and with a 'soft dollar landing' power that economists know well. Greece may be tiny by comparison but it too has a soft landing capacity, if at one remove, by being sustained as part of the EU and of the Euro common currency Area. How Greece got into trouble is comparable. It was seduced by the examples of US, UK, Ireland, Spain - lend and borrow so long as property collateral is rising in value fast; banks only have to chase where profits are greatest and not worry about the sustainability of the economy - take the bonus first, ask questions later.
Among OECD countries Greece ran the highest trade deficit risng to 19% ratio to GDP. It is a classic example of 'isms, where Monetarism was the advice advised to the country externally, while most Greek economists are more intelligent Keynesians, but were politically sidelined in the policy debate. Greece's present and future is now Keynesianism. As in other countries there has been a shift in universities and growth of business schools tending toward micro-economics such that the big picture of the external account deficit's importance were greatly under-estimated,
The burgeoning trade deficit was both enforced and financed by Greek (Hellenic) banks pushing mortgage business out of all sensible balance relative to lending to exporters. Mortgage books were securitised and sold to foreign investors - about one fifth of total loanbooks worth about 30% ratio to GDP. The government also securitised future revenues to about 10% ratio to GDP. USA has a technology and services strength in exports, Greece a dominance in world shipping. Greek shipping operated at near 100% capacity for years and did not demand fast growth in borrowing. Other Greek manufacturers were, however, denuded of loans as banks weighed into mortgages, property boom and consumer credit - refusing to re-balance their loan books despite Bank of Greece pleas to do so. The banks took the view that as part of the Eurozone they did not need to worry about the external account. The Hellenic banks also bought and grew banking subsidiaries in SE Europe and Turkey.
In 2006, I forecast the coming crisis for Greece precisely, with 90% wipe-out of bank capital from recession impacts alone, mainly property and construction collapse.
With time, analysts will see Greece as epitomising the problem of unsustainability of credit boom growth when the country's external account is ignored. The budget and banks' solvency crisis of Greece is currently somewhere near the top of the EU agenda, even in some over-active feverish minds threatening to EU integrity! The symbol on its 2-euro coin is the rape of Europa (after which Europe takes its name) and also represented in a large bronze at Bank of Piraeus's HQ. The myth (see notes at end of this blog) may be exercising some metaphorial minds? How the problem is resolved is also instructive. Greece received ECB and EU loans and the Government has provided direct capital support to the big banks and is necessarily running a budget deficit fiscal stimulus. Because it is part of the Euro zone it has to do this on-budget by issuing bonds. If it still had its own central bank money market powers it could do off-balance sheet asset-repo swaps for treasury bills with the banks. But, had it not been a Euro Area economy, arguably, it would not have been able to sustain such a credit-boom growth. The Drachma would have depreciated to rebalance the external account and domestic growth would have been lower. Greece's property boom was its first based on massive mortgage growth i.e. on home-ownership. This broadened and deepened the domestic economy, but governments exploited that feel-good wealth without doing enough to ensure it was being externally supported by trade. The economy was on a trajectory that some hoped could defy gravity, so long as the risks could be rolled up and thrown as far away as possible - Europa's moon accompanying Jupiter would do just fine. Like other astrophysics, Greece's external trade is something of a mystery, not unlike the question of how big its GDP really is. In 2006, GDP was severely revised upwards to allow for a 10% (probably truly 15-20%) black economy and thereby squeeze its budget deficit and national debt ratios to satellite closer into cosmic proximity with the EU's Maastricht criteria. There was a debate at the time as to whether the Greek stock exchange should be classed as an 'emerging market' with the possible consequence of it losing its OECD status. This would have severely raised the sovereign cost of banks' cross-border borrowings. Political instability factors and exposure to the Balkan economies were also negatively viewed. Greece was the fastest growing EU country in GDP terms if only 3% of the EU total - both assuring and very worrying? Since the mid-'90s, Greek banks penetrated deeply the banking systems of Balkan countries. 7 Greek banks established 20 subsidiaries in Romania, Bulgaria and other countries amounting to nearly 2,000 branches, employing nearly 25,000 people, with the goal of growing retail banking (mainly consumer and housing loans and credit cards, which under-developed emerging countries' own banks are least able to compete in). By '05, Greek banks granted nearly 40% of loans in Albania, 30% in Bulgaria, 40%in Macedonia, 15% in Romania and 20% in Serbia, altogether totalling at end of '08, to €147.1bn, against €126bn deposits with transfer funding from parent banks of €121.8bn equivalent to one third of Greece's GDP, . This is quite a large and generous benefit to the economic development of neighbouring states, if also twice the black market valuation. Quite how and what the black market is and what it means for the economy is a study yet to be completed convincingly. Greece was not big enough to really matter to global investors, and not anyway so long as the EU stood by as a safety net. Athens port of Piraeus is the biggest in the Mediterranean and the suspicion is that imports where entrepot trade with much of its through-trade exports being smuggled across its northern borders and therefore not appearing in the official statistical records. Arguments rage back and forth still about the accuracy of its GDP national income accounting.
The trade deficit was financed by banks securitising large parts of retail loanbooks, as much as 20%. This should have been a major concern in 2007 and 2008, but it was not transparantly obvious to analysts, no more than the funding gaps in the big banks' balance sheets and how these were financed was obvious. They were financed largely by other banks looking to expand their business in Greece including Citicorp, among others. And, when the credit crunch hit USA, UK and EU, Greece was below the radar of global concerns, well behind Ireland with which it ould and should have been compared. greece therefore had some time to usefully spend before the ripples of the crdit crunch uncovered Greece's crisis. sadly, that time, two years, was wasted, not least because of poor focus by the government to understand the key issues. The Central Bank was totally aware, but its advice discounted in the general viw that a combination of being informally associated with emerging markets and being under the defence umbrella of the EU meant it might survive through to when US and other major economies would recover, which the EU did achieve generally quite rapidly. The error was in not seeing that unlike other emerging economies, which is what Greece really was, like most of central Europe and the Balkans, and there was a huge external debt that developed (in ratio to GDP) and proportionately at more than three times that of the USA.
Greece will be sustained of course, but by the time it gets back on track I predict the EU will then enter its normally due recession. The EU's brief recession in 2008 was a shock response to the credit crunch. It normally recesses 8 quarters after US and 6 quarters after UK. Analysts may class this as 'double-dip', which will not be exactly correct.
The advice of the Central Bank of Greece's advice to the country's banks still stands - shift your lending to productive and exporting industry, now including shipping, but especially small firms and SME's as well as the few big food processing producers. It will hard.
If any country is going to have a tough ten years it will be Greece. What will emerge is a much more savvy economic management of the country.
NOTE: RAPE OF EUROPA
Europa (Εὐρώπη) was a high-born Phoenician lady whose name became that of the whole continent. Her abduction by Zeus in the form of a white bull carryuing her off to Crete where Zeus made her the first Queen - a Cretan story.
Zeus today, in our more secular panoply must be the USA, and the modern Crete is Brussels, depressingly?
Most love-sex stories concerning Zeus originate (like also Leda & The Swan) in ancient tales describing his couplings with goddesses - Europa's name is also among that of daughters of Oceanus / Tethys. The daughter of earth-giant Tityas and mother of Euphemus by Poseidon is also Europa.
Europa's earliest literary appearance is in Homer's Iliad, a story of exuberance gone wrong, nearly 3 millennia old. The earliest vase-painting identified as Europa, dates from mid-7th century BC. As a goddess she represented the lunar cow, at least on some symbolic level, and therefore as a broad-faced moon of a Mother, Astarte, and mythical nymph beloved of Zeus, who was transformed into a heifer.
Such myths are as complex as the financial economy. Ovid's poem on the matter is depicts the classic first half stages of a credit cycle:

And gradually she lost her fear, and he
Offered his breast for her virgin caresses,
His horns for her to wind with chains of flowers
Until the princess dared to mount his back
Her pet bull's back, unwitting whom she rode.
Then — slowly, slowly down the broad, dry beach —
First in the shallow waves the great god set
His spurious hooves, then sauntered further out
'til in the open sea he bore his prize
Fear filled her heart as, gazing back, she saw
The fast receding sands. Her right hand grasped
A horn, the other lent upon his back
Her fluttering tunic floated in the breeze.

JC Trichet speech September 3 '09

2009-09-04T05:58:00.000-07:00

We have been waiting to see what the ECB will do to match the latest measures by US (sons of TARP e.g. TARF + US Treasury & FDIC soft terms for non-banks to buy impaired bank assets, Germany's 'bad bank' emulated by Ireland, both using bonds, and UK's Asset Protection Scheme with the innovation of payment by unremitted cheque as opposed to the usual Treasury Bills). The answer is ECS - enhanced credit support?
The ECB's concept here applies to the Euro Area. In the total EU, the regulatory authority is the European Commission, which is setting up an intricate approvals and review system to examine aid-schemes for banks by Governments (states) and each individual case to check for competition issues and possible restructuring requirements.
For the ECG, Trichet said in his speech (as per article in the FT), "Exceptional times call for exceptional measures. The European Central Bank, like other central banks, has introduced non-standard measures to tackle the financial crisis and cushion its impact on the economy – what I call 'enhanced credit support'. These have contained the threats to the stability of the euro area’s financial system and supported the flow of credit to companies and households over and above what could be achieved through interest rate cuts alone. Because of their exceptional nature, these measures will have to be unwound once economic and financial conditions normalise. We at the ECB designed the non-standard measures with our exit strategy in mind, and we are ready to implement this strategy when the appropriate time comes. Stressing the importance of the exit strategy should not be confused with its activation: it is premature to declare the financial crisis over. Today is not the time to exit. Four issues will shape our approach to exiting the non-standard measures." The criteria for normal conditions may be debated, but are likely to turn on whether banks continue to have a need for government and central bank help i.e. it may not be the ECB that can determine when consitions are normal, by which it may be inferred is also meant 'stable' where wholesale funding is again flowing thickly! Another implied criterion is maintaining flow of credit to households & companies. It has become assumed that the tap is turned on or off by banks. But, in reality, banks either respond to demand or not. At present, while many borrowers need loans rolled over and many may seek 'equity release' for high borrowing, the majority seem to be rentrenching and restructuring their debt as well as reducing their net debt. Banks may think they prompt borrowing levels, but are now learning that borrowing levels do also depend on what customers want, and customers (unlike banks) are not always seeking to borrow more even when rates are relatively low; they are risk averse. Furthermore, borrower confidence in the general economy and in their own businesses take as a strong indicator the ease with which they can borrow from banks. Whatever the central banks do, even in terms of conditions attaching to bail-out measures, the fact is that borrowing is now more complex and banks are giving out strongly negative signals about their ease and willingness to lend.
Trichet has four planks to his raft:
"First and foremost, should the non-standard measures trigger risks to price stability, we will immediately begin to unwind them and ensure the continued solid anchoring of inflation expectations. The timing and sequencing of our exit strategy depends on our real-time assessment of the economic outlook and the health of the financial system in line with our contribution to financial stability.
Second, a degree of phasing out has been built into the exit through the design of our measures. In the absence of new policy decisions, several of these measures will unwind naturally. Given that the overwhelming majority of the liquidity has been provided through repurchase agreements, a new policy decision would be necessary in order to roll these operations over once they mature.
Third, the ECB’s operational framework is well equipped to facilitate the unwinding of non-standard measures as the need arises. This framework comprises a varied and flexible set of instruments, including fine-tuning operations, allowing the absorption of surplus liquidity – promptly, if necessary. Moreover, with its interest rate corridor, the framework allows short-term interest rates to be changed while keeping some non-standard measures in place, should continued credit support be needed. The governing council can therefore choose the way in which interest rate action is combined with the unwinding of the non-standard measures.
Fourth, the outright purchases of securities by the eurozone’s central banks have been measured in both scope and volume. They have focused on the market for covered bonds and have acted only as a catalyst. We opted for a purchase programme with a volume that was significant enough to improve the activity and functioning of the market, but not so large as to dominate the market or the balance sheets of eurozone central banks. The measured programme facilitates its future unwinding or its offsetting by other policy operations." It is in the nature of the ECB being multinational that it cannot take action or make statements out of synch with its constitutional remit. It 'owns' the money market (treasury bill) operations of its constituent central banks on the basis that this gives it a collective firepower to defend the strength of the Euro. But, Treasury Bills have many other useful functions such as facilitating short term transfers and balances between arms of government, between Ministry of Finance funds and so on, and these days most of all in providing an off-government-budget on central bank balance sheet funding power to make asset swaps with troubled banks - to support the finance sector when it is in systemic crisis. This important aspect of the role of central banks has not been clearly enunciated in the ECB's charter and this is why Trichet has to refer to 'exceptional' measures. In reality, such measures should not be exceptional or abnormal, merely doing what central banks should be doing to ensure financial stability at any time, except this time on a much larger scale than is usual when economies are not at the bottom of a credit cycle and economic cycle. It is the use of "exceptional" and by stating there is a strategy well worked out for getting back to normal working that Trichet uses to be able to say, what he has been unable to say until now, that the ECB is thereby now 'unrestricted' in what it may do!
"With regards to future actions, we are unrestricted in our ability to take decisions, given the strong institutional independence of the ECB. This reflects the clear dividing line in the euro area between the responsibilities of the central bank and those of the fiscal sphere (Government deficit spending). That the ECB has not purchased government bonds is in line with this institutional framework."
The ECB is restricted in issuing bonds - how else could it buy Euro Area governments' bonds? It has been a political obstacle for two decades since the Delors Plan (which proposed one trillion in ECU bonds) that led to currency union that the Commission and ECB should not be able to issue a lot of debt to equalise national debts or make transfers between EU states. The ECB is stating that it absolutely dislikes having to intervene in exceptional ways and wants to get back to normal inflation-setting and currency defending for whcih it was exclusively established. Hence, the repeated emphasis on 'exit strategy'.
"The ECB has an exit strategy from its non-standard measures in place. Its implementation will build on three self-reinforcing elements: credibility, alertness and steady-handedness. These form the basis for the strong anchoring of inflation expectations in the euro area – our main asset. This strong anchoring is based on our determination and ability to act decisively whenever the need arises. The ECB’s governing council will continually assess whether policy adjustments are necessary and implement those adjustments to maintain price stability in the euro area over the medium and longer term."
Fine abstract phrases expressing conservative prudence - no Keynesian culture here. The ECB's main economic model for assessing all these matters in the wider economy is a New Keynesian model (a newspeak term for non-Keynesian micro-, supply-side, Monetarist & general equilibrium synthesis) with only about 90 simultaneous equations i.e. a small model that cannot really assess individual countries or the finance sector/s in any detail. Despite a prponderance of trained economists on the ECB board, the ECB is flying blind (a drone operated by humands back at the office working off a simple flight simulator). The ECB therefore will not be ahead of events leading from the front. For that the Euro Area will still rely on individual states to make their own assessments and pay for interventions expensively using longer term bonds (i.e. taxpayre' funds on account).
trichet ends with, "Our fellow citizens can have full confidence in the determination and ability of the ECB to deliver price stability. This confidence will, in turn, contribute to a sustainable recovery." I had hoped for more following the meeting of central bankers at Jackson Hole, Wyoming, but it seems we are still having to wait for the ECB to get all ducks in a row before it is prepared to envisage any real duck-shooting on the scale of USA & UK financial authorities. There will not be much complaint about this politically just now because the Euro Area states are hoping they are already through the recession, uniquely in history out before the US & UK despite falling into it later. My view is this was a fals recession period for the Euro Area, merely a shock effect of the Credit crunch. Euro Area's real recession is around the next corner.

BANKERS' vBONUS pBONUS gBONUS fBONUS aBONUS

2009-07-22T09:56:00.000-07:00

There are many kinds of bankers bonuses as there are types of well-worn shoes and sandwich-for-lunch briefcases. Variable bonuses depending on relative performance measures using peer-group data, narrow performance bonus, guaranteed absolkute bonus, fixed % bonus, various algorithmic bonuses, and on and on. The general public is enraged. the fact is that for people employed in investment banking especially, remuneration is the only moral incentive, whether ethical or not, and the prospect of extraordinary above average lump sum winnings is what creates the culture of 'gold-rush city' that defines the society we know of as investment banking. Change the bonus culture and everything changes! Revolution!
Yet, it is wholly clear to shareholders and policy-holders that years of "we are here first and foremost to serve our shareholders/policy holder" was pure cant, apalling hypocrisy. This is how it seems to joe public and joe politician!
Ms Christine Lagarde, France's Minister for Economic affairs, according to Forbes Mag one of the world's 100 most influential women, acknowledges that it is “tough” imposing higher standards on French banks, in terms of pay, that could put them at a competitive disadvantage in recruitment. “It is not fair that some players are playing by the rules and that some players – especially when they are highly subsidised – are simply ignoring the rules.” This is surely an all too simple and obvious objection to reining back bonus culture. Are we to believe that higher ethical standards will not attract customers seeking to do business with more ethical banks? Why should stamping on the flames of bonuses not work when all countries apparantly agree they must do the same? What are bonuses worth for people whose jobs are no more taxing than keeping odds at a racetrack, something the cleaning staff could do just as well in many banks? But she said Paris as a financial centre stood to benefit from the enhanced reputation of its universal bank business model – combining investment banking with retail operations, – and of its regulatory system, and from London’s tarnished image. Why oh why must trivial inter banking centre competitiveness be part of the ethical equation? “I don’t think we have been guilty of the same excess, not to say that we have been paragons of virtue,” she said. Ms Lagarde has made the promotion of Paris as a financial centre one of her priorities since becoming finance minister two years ago.
Banks that have started to pay their staff guaranteed bonuses again are an “absolute disgrace” and should be reined in by governments at the G20 summit in September, according to Ms Lagarde. The same is being said by UK's Treasury select Committee. They valiantly continue to say that bonus culture lay at the heart of the factors creating the credit crunch crisis. All are however stumped not a little by Goldman Sachs recent quarterly results indicating average bonus of half a million per employee! The trading eranings may not be repeatable. In the US it is argued by some commentators that much of Goldman's golden performance was pump-primed by the cheap $10 billions loaned to it by the US Treasury? In what she described as a “cri de coeur” against the return of “the old ways”, Christine Lagarde urged other G20 governments to stop “procrastinating and introduce curbs on pay practices deemed to encourage too much risk-taking. I think it is an absolute disgrace that guaranteed bonuses of several years could still be paid, or that some people are thinking of reinstating the old ways of compensating with insufficient relationship between compensation and lasting performance and risk management” (in a Financial Times interview). Citigroup, Deutsche Bank, Nomura, and others have offered multi-year guarantees to recruit and retain key personnel, although they insist that the practice has been limited to recruiting and keeping top talent. bankers of the investment variety are very keen to maintain the illusion that personal contacts and individual intellects make all the difference.
One of the reasons banks have resisted economic models and linking their performance to macro-prudential analysis as required by Basel II Pillar II is because even when a rising tide lifts all boats they wish to maintain the fiction that absolute performance has been entirely generated by increased staff productivety and reward bonuses accordingly, however that 'accordingly' is calculated? It has undoubtedly been because banks have been diffident and negligent about economics that they have collectively got themselves into the mess of losing twice their reserve capital, double what a severe recession could be expected to diminish.
The staff retention and recruitment argument is of course bizarre since this is not formally part of bonus calculation models as banks describe them, in their annual report to shareholders, and because it is only arguable when banks are not all being forced at the same time to severely cut down on bonuses. The fact is that banks have always varied the golden hellos, share options, and wage rates and bonus deals to compete for key staff however and whenever they choose to. Ideally, we would make this a matter for shareholders to exert control over and for regulators to analyze from a systemic risk aspect. The problems are that shareholder votes are not open and fair, especially not when sufficient support for retaining the bonus culture is always available from the major shareholders who are also financial institutions with bonus cultures. The regulators and legislators however have built up ammunition to argue strongly for a radical change. The last refuge for the scoundrel has to be "but this will damage the competitiveness of our financial centre" argument. That is of course ludicrous. Bankers are sticking their heads in the sand with respect to admitting what went wrong and why, and moreover saying yet again to shareholders "we own this bank and this banking centre, not you!" Ms Lagarde's view is a shared one and correct to say this should be a G20 and therefore also an EU-wide issue. To set the agenda in proper detail, hwoever, some centres should and could move first. French banks have agreed to forego such payments, to link bonuses to the profitability of the bank and include claw-back provisions. If they do not they face the possibility of higher capital requirements imposed by the national supervisory regulator. The UK’s FSA this week warned that banks that have agreed to guarantee executive bonuses for more than a year risked similar heavy penalties. Undoubtedly others now have to follow suit, the quicker the better some may say.
In my view, it should happen anyway because those 'stars' at the top are not the performance difference makers they fondly imagine themselves to be. And, finance being global is inevitably forced to apply common accounting, risk regulation and therefore also remuneration standards. FSA'a draft 2,000 word code suggests higher fixed salaries, more emphasis on risk management and withholding back the bulk of bonus payments until it is clear they were based on good business sense. The FSA does not set any limits on the multimillion-pound rewards. The amount of pay that can be earned, says the FSA, remains "a matter for firms' boards". Are we supposed for 'boards' to read 'shareholders' votes? I wish the FSA had made that plainer.
Like much else, especially short-selling, one feels that the FSA's rules-drafting has been reluctant and duplicitous in allowing glaring gaps. Many banks demand that bonuses continue to be payable to persuade key staff to stay and reward talent, even though their firms would have collapsed into bankruptcy without government help.
A survey by efinancialcareers. com showed two-thirds of experienced bankers accept the bonus system requires reform. Amazing to think that one third does not? It is scarecely one third who receive bonuses! However, three-quarters of front-office operators oppose caps on cash bonus payouts and more than half said they would consider moving abroad if bonus caps are imposed. This response is the bonus-culture talking. It is the very fact that so many staff think they can walk and take business with them that is the delusion at the ehart of this culture. let them go and see what happens! Call their bluff!
According to the new FSA code, bonuses should be based mainly on profits, rather than gross or operating revenues, so that the net quality of business growth generated can be assessed. The individualism of bankers militates against a holistic accounting. They want to be rewarded for their profit centres and not for the the group performance. This shows how banks have become more like franchise conglomerates with only the capital at the centre! It is a view that is indifferent to professional financial risk management where risk diversification and liquidity management are key. Investment bankers believe capital is always available for a profitable deal and it makes no odds to them where that capital comes from i.e. from retail deposits or interbank funding gap finance.
Bonus payouts should also, according to the FSA, reflect the cost of capital and liquidity. In which case many profits of many profit centres would turn to zero or negative in the last 2 years. You try telling an M&A fee earner that because of cost of capital, risk reserve ratios and the collapse in private liquidity finance, that he, or she, should now get no bonus! These arguments make macro-prudential sense, but front line investment bankers treat such bankerly concerns with abslute derision and distaste, albeit for the most obvious self-serving reasons!
The code also says that staff must forfeit bonuses, regardless of profits, if firms have poor risk management or fail to work within regulations. this would be terrific in practise and suddenly the risk managers walking the trading floor might actually get some long overdue respect. Risk managers dream on!
The FSA also says that remuneration committees should use "independent judgment" and they may be asked to submit an annual report to the watchdog. The chairman of the remuneration committee may also be asked in for interview with the FSA to presumably explain the bank's various algorithms for determining bonuses. This presumes such matters must have a logic. But, the logic about staff attraction and retention, essentially blackmail or bluff, will drive a coach and horses through such deliberations. Some bankers undoubtedly believe themselves when they say or think that hedge funds would be only too happy to employ them and would not baulk at rich rewards and be unlikely to suffer the same constraints as banks. Hmmm, wait and see!
I, as a topflight investment banker, will have a lifestyle to maintain: school fees, club fees and a multi-million pound mortage plus my various other investments for pleasure or financial gain and these will tell me what my minimum annual bonus requirement is. A bank cannot argue with key staff unless it also forces the individual bankers to disclose what lies on their side of their view of the matter such as what they can evidence they need to remain personally solvent etc. Mostly, however, the arguments will proceed in the absence of that and be heavily mis-alligned, coded, and diverted onto bogus performance measurement issues. How different from the good old days of trade union negotiations? If only the banking unions were still in place the banks might have quite welcomed some long strikes in the last two years.
Risk and compliance staff, says the FSA code, must have different targets "determined independently of the business areas". "Firms must ensure that their remuneration policies are consistent with effective risk management." Hey ho, this is regulatory rule by guidance principle and as we know that doesn't work. Either the FSA comes up with precise models and equations or they may as well forget it. This is just political fig-leafing.
The new rules will cover all organisations regulated by the FSA, including the UK operations of foreign-owned businesses. The new code aims to ensure that pay and bonus structures in financial organisations do not encourage staff to take excessive risks. An FSA spokeswoman said the watchdog would "work with" firms whose remuneration policies it finds "inappropriate". Peter Montagnon, director of investment affairs at the Association of British Insurers, which represents many institutional shareholders, said the code was welcome and based on the right principles. But he added: "The code itself needs a lot more work on the details and we are ready and willing to help in this."
Michael Rendell, a partner at accountants PwC and the group's head of HR, said the code would ultimately have an impact beyond financial services and it was "absolutely right" that good corporate governance be placed at the top of the list of pay principles.
One has to laugh if anyone thinks HR consultancies have the capability to work with banks internal HR departments to tackle this thorny bush? The FSA consulted on its proposed code to the end of March.
In may the UK treasury select Committee issued its report. Committee Chairman John McFall said: "Bonus-driven remuneration structures led to a lethal combination of reckless and excessive risk–taking. The design of bonus schemes was not aligned with the interests of shareholders and the long–term sustainability of the banks and has proved to be fundamentally flawed. Our report outlines clear failings in the remuneration committees within the banking sector, with non–executive directors all too willing to sanction the ratcheting up of senior managers’ pay, whilst setting relatively undemanding performance targets. Looking forward, we are also concerned that the FSA seems not be taking tackling this issue seriously enough."
http://www.publications.parliament.uk/pa/cm200809/cmselect/cmtreasy/519/51902.htm
In June, the FSA awarded itself a 40% increase in bonuses!
A full treatment of this issue has to include all remuneration channels including soft loans, share options, postponed bonuses and pension contribution etc. two weeks ago Chancellor darling warned banks not to slip back into their old habits and accused some of complacency now that the credit crisis has eased. "If they go back to the way they were without asking themselves over and over again whether they understand what they are doing, that would be disastrous for them and the rest of the world," (interview in the Independent). "There are people who are too complacent in my view. They need to be brought back to earth." Yes indeed, but then the get-out.
Darling rejected the idea of a salary cap on City workers to stop previous excesses recurring. "You can't have a pay policy in legislation," he said, which seems contrary to his saying that controls on financial institutions generally will be tightened in forthcoming White Paper on financial regulation. Perhaps he believes that bonus culture may be curtailed indirectly rather than by directly capping remuneration per se? He also dismissed talk of a battle between the FSA and Bank of England over which agency regulates the UK's financial sector in systemic risk going forward. "It is not a turf war," Darling said in the interview. "It is a question of ensuring they both do the job they are set up to do and both do it effectively. They are not competing with each other. They are complementary". That is indeed true. The media comments overlooked the fact that the Bank of England always retained responsibility for systemic risk. And, it is arguable that bonus culture is a systemic risk or macro-prudential matter, not a micro-prudential matter at the level of individual firms.
The FSA Consultation paper 09/10 (http://www.fsa.gov.uk/pubs/cp/cp09_10.pdf) titled 'Reforming remuneration practices in financial services' was published in March 2009 on the same day as the Turner report thereby conveniently evading media scrutiny. Turner mentioned bonuses a dozen times, but made one definitive statement only: "...illusory profits were however used as the basis for bonus decisions, and created incentives for traders and management to take further risk. This carries implications for remuneration policies, considered in Chapter 2.5(ii)" (http://www.fsa.gov.uk/pubs/other/turner_review.pdf) Turner says, "A reasonable
judgement is that while inappropriate remuneration structures played a role, they were considerably less important than other factors already discussed – inadequate approaches to capital, accounting, and liquidity." This is I have to say an entirely subjective view. One has only to ask what is the motivation for bankers trading with inadequate approaches to capital, accounting, and liquidity, if not because of the short term bonus culture? Turner discounts bonus culture heavily as a priority. he rehearses the FSA discussion points but ends on a dismissive note. In this respect his judgment is in direct variance with that of the Treasury select Committee and politicians and the general public who see bonus culture as a high priority issue. The FSA draft code (over 80 pages of guidance principles) offered another period for consultation responses up to 18 May 2009.
HM treasury are moving ahead too. The FSA and the Bank of England are both set to get more powers, with hedge funds likely to come under the sway of the FSA. This will change the context considerably if hedge funds are subject to similar oversight and rules as apply to banks.
Ms Lagarde said that all leading economies should quickly adopt similar principles to those laid out by the Financial Stability Board, an international forum of central bankers, treasury officials and supervisors. “We have the rules now. It is not a question of reinventing the wheel, or procrastinating about them. It is a question of applying a set of rules that have now been agreed by the Financial Stability Board. The utmost priority should be given to their implementation,” she said. Her ‘cri de coeur’ is against a return of ‘the old ways’, but i have to say that such a return is porecisely what most of my banking friends and acquaintances expect once this temporary glitch of worldwide recession and credit crunch silliness is out of the way, and meantime what blind bit of economic good would be done by harming their "ability to pay the school fees and the five grand a month mortgage,I ask you? And the sooner Cameron and his chums get into power who at least understand this much, the better!" Oh, if only PG Wodehouse was alive and writing a City column!

Revision of "Bâle II" Directive gets green light in European Parliament - CAD4 arrives

2009-05-08T09:39:00.000-07:00

A Lenterne from the Basel Fasnacht Carnival, 2009
BLOG REPORT BY JOHN MORRISON OF WWW.ASYMPTOTIX.EUE
Brussels, 06/05/2009 (Agence Europe) - On Wednesday 6 May, MEPs debated two legislative proposals in the field of financial services: - proposed directive revising requirements in terms of capital for banks; - proposed decision establishing a Community funding programme for the activities of the three European committees of national regulators (CESR, CEBS, CEIOPS). In their support for the recommendations of each respective rapporteur, they have paved the way for these two legislative acts to be adopted at first reading before the end of the term in office.
Bâle II. "We have agreed on new measures" which this time go beyond the lowest common denominator, said Othmar Karas (EPP-ED, Austria), rapporteur on the proposed "Bâle II" directive on requirements for own funds of credit companies (EUROPE 9893). Amongst other things, the legislative proposal brings in a minimum level of securitised assets which banks must keep on their balance sheets, so that they are obliged to guarantee the quality of the financial instruments which they resell on the market in the form of securities. These highly complex financial products, to which it is difficult to put a monetary value, such as securities backed by high-risk mortgages, have contributed to the spread of the financial crisis worldwide and caused heavy losses among many banks, which have been obliged to turn to public aid to avoid bankruptcy. Lastly, MEPs gave their approval to the compromise which sets at 5% the retention rate for securitised assets and rejected amendments favouring a higher level: German MEPs of the EPP-ED were calling for 10%, the Greens/EFA 15% and the GUE/NGL 20%. By the end of this year, the Commission is to report back on the effects of the new rules and, if necessary, propose to tighten them up, in the light of, in particular, an opinion of the Committee of European Securities Regulators (CESR).
During the debate, most of the MEPs voiced their satisfaction at an agreement which, although far from ideal, marks a stage in the ongoing reform of European legislation on the financial sector, particularly financial supervision. On the issue of securitisation, there was "a debate on the proportion which must be held in own funds", said Mr Karas. The Commissioner for the Internal Market, Charlie McCreevy, who was pleased with proceedings, stated that the Commission still had reservations on this issue. He congratulated the EP on having resisted attacks from the industry on the introduction of a provision which he feels is "essential" to reinforce the stability of the financial markets. "We will see whether we need to increase the requirements for the retention level" when this provision is reviewed at the end of this year, he added. He went on to warn the banks to be prepared in future to constitute more own funds, which is the only way out of the current crisis of confidence. "10%" of securitised assets held "would be far more justified", said Werner Langen (EPP-ED, Germany), supported by Udo Bullmann (PES, Germany). Concerned that the hasty adoption of the directive could bring about new problems, John Purvis (EPP-ED, UK) expressed his disagreement with the requirement for a minimum level of securitised assets held, which would "slow recovery on the credit markets", and with limiting a bank's exposure to the risks of just one consideration to a level of 25% of its own funds, which "will make things complicated". British Liberal Sharon Bowles is convinced of the importance of the securitisation market, which "in recent years consisted of 800 billion in securitised loans, which may have been mortgages, car loans, consumer loans and even loans to SMEs".
Deploring the absence of the Czech Presidency, Pervenche Berès (PES, France) criticised Mr McCreevy's attitude, opposing regulatory intervention negated by the financial crisis at the end of this legislative period. "Fortunately, we won't be working with you any more!", she said. Her Dutch counterpart Ieke van den Burg called for the creation of a portfolio dedicated solely to financial services in the next European Commission. Zsolt László Becsey (EPP-ED, Hungary) spoke in favour of the systematic creation of "colleges" for the cross-border financial institutions.

THE COMMENT TO THIS POST BELOW IS MORE 'ANALYTICAL' THAN THE EXPOSITION ABOVE
Fri, 2009-05-08 08:55 — John A Morrison
European Parliament debate on CAD3 The Future of Securitisation
“5% of something is better than 55% of nothing” McCreevy
http://europa.eu/rapid/pressReleasesAction.do?reference=SPEECH/09/215&format=HTML&aged=0&language=EN&guiLanguage=en
This (above) is the speech of Charlie McCreevy of 6th May, to the European Parliament.
How many people do you really know who would understand the point of it?
I thought I would bring it to the attention of our many followers & put it on the record for my own purposes, since no-one else is reporting it. It’s McCreevy's speech to the European Parliament prior to their votes on his bill, at a first reading, legislating the budgets of CEBS etc (the 3L3), EFRAG (the accounting standards body) etc & effecting the change to CAD3 (Euro Basel II) to legislatively require first loss provision retention @ 5% in securitisation. This retention was initiated at 15% but “bargained out” by the industry and the Commission to 5%.
Note the parliament did not vote on his proposals on ratings agency reform at this session; this is the last meeting of the parliament before the elections in June.
Clearly Charlie believes that supervision is about reporting, it’s not a process, its not a pompous thing run by important people or huge bloated agencies of the European Executive, its about transparency to him (an interesting position). I hadn't seen it that way before; I don’ think Charlie has made his own philosophy on this so clear before. It reflects his professional background. Personally I think this is brilliant. After he leaves Brussels, would Charlie not be the optimal first chairman of NAMA in Dublin? Charlie got a hammering from some of the MEPs for bringing forward this legislation as “too little too late”; posturing of MEPs in my view; what Mr. McCreevy has achieved is simply ‘awesome’! As Charlie argued himself, this is a first step in a long process. McCreevy and his staff had pushed this through in a rapid expedited process which had begun on Monday night (I think I smell the cigar smoke!) and went on through Wednesday morning; ‘Trilog’ is the Euro-technical term, the agreement was reached one hour before the vote in the parliament...
There had been some extreme tension on the parliament floor over the scale of the legislatively required 1st loss provision retention in issued securitisation, with a French lobby speaking up the requirement to 20%; Beres Perveche MEP made it clear that she believes that the expedited process Charlie had used to get this legislation through this week was too fast for her. She was supported by a German MEPs arguing to lift the retention number to 10%.
But Perveche did make it clear that the European parliament will address in the session immediately after the elections enabling legislation to bring forward Europe'S institutional changes.

DON'T PANIC ABOUT BANKING SYSTEM INSOLVENCY

2009-05-02T08:26:00.000-07:00

The International Monetary Fund has estimated total credit write-downs of $4.1tn, with $2.7tn in U.S. institutions. McKinsey Consultancy says there are still $2tn of toxic assets sitting on the books of U.S. banks. Nouriel Roubini estimates total losses on loans made by U.S. financial firms and the fall in the market value of their assets will reach $3.6tn ($1.6tn loans and $2tn for securities). The U.S. banks and broker dealers are exposed to half of this figure, or $1.8tn; the rest is borne by other financials in the US and abroad. With $2tn of write-offs to go, how could Treasury Secretary Timothy Geithner say to a Congressional panel last week, “Currently, the vast majority of banks have more capital than they need to be considered well capitalized by their regulators.”? Is he being economical with the truth? Does it matter if he is? The question and argument applies proportionately equally to the UK as to the US and to many otjher countries. The US banks balance sheet is given below: I've been saying publicly in FT and elsewhere, including saying that Nouriel Roubini is under-estimating, for over a year that the US banking system will have its capital wiped out twice over. I've also in the FT and to himself direct told Roubini that despite this 200% wipeout he is exaggerating the insolvency of the banks!
The US and UK governments and central banks, and others, are doing exactly the right things however they zigzag to get there. The story is capable of being simply told. The credit crunch is wiping out bank capital once and the recession once more. A 70-100% capital wipeout is normal in a recession, and that much banks should know how to recover from given the time to do so.
Governments and central banks are refinancing capital reserves and 'funding gaps' (difference between customer deposits and customer assets) by swapping bank assets for T-bills (subject to fees and large 25-30% haircuts i.e. plenty of headroom for taxpayr profit), but doing so whereby taxpayers money is not employed (bailout financing and guarantees are off-budget).
All writedowns and losses are generally capable of 40-50% debt-recovery over 3 years. Bank assets have roughly 50% collateral cover, but debt recovery is not limited to collateral, and of course some collateral such as property and land may take a few years before it is profitably worth selling on, but meanhile may be converted into various asset types and sometimes worked for development and cash-flow. That takes care of repaying government support.
The other half, also one times capital, has to be found by selling off non-core businesses, capital raising (internally and externally) and by cost-cutting, again over 1-3 years. That banks capital gets eaten into by losses and witedowns is what it is for. To be below recommended capital reserves (say 12% ratio to risk-weighted assets or 6% ratio to gross assets, including economic capital buffers) is not insolvency except temporarily. We do not actually have a strict measure of absolute bank insolvency except an irrecoverable cash-flow insolvency after full resort to central bank liquidity window and other measures. There is a kind of insolvency if a bank loses its unsecured borrowing credit rating, when in effect it has to be taken over or broken up.
Recessions and credit crunch are serious shocks to the system. We have to accept that they mean capital wipeouts. But the banking system, and all or nearly all important banks retain viable book value. If one or two fail they may drag down several others and as with lehman Brothers example the knock-on costs are excessive. Therefore, it is not an option to let a dominant bank fail in this way.
No banks are too big not to be temporarily insolvent, but they can be too big to allow to fail. So let's get real and take it in the shorts that we have to navigate through the capital wipeouts and accept that the Fed, FDIC, US Treasury etc. plus the banks own efforts if given sufficient time will keep going and recover as the economy as a whole recovers.
If banks and the banking system is deemed irrecoverably and disasterously insolvent, this means the same for the whole economy including all us. Insofar as we are not bankrupt insolvent neither are the banks.
The above issues should be mapped out by the banks scenario stress-tests modeled over the whole economic and credit cycle. But, serious problems exist in the technical difficulties banks find in correlating their balance sheets to the general economy. In a single jump that is in fact impossible. It is only possible by correlating the whole banking sector to the economy and then each bank to its banking sector including country by country and assessing the risk diversity and liquidity risk and reserve capital hits arrival rates.
I agree with William Black, former senior bank regulator, currently Assoc. Prof. of Economics and Law at University of Missouri. He says the stress tests conducted on the 19 US biggest banks a sham. In his own words:
If you did a real stress test, as Geithner explained them, you wouldn't just have a $2 trillion hole -- you'd impose regulatory capital requirements of 50%. (That I don't agree with since the deleveraging it would enforce would damage economic recovery fatally.) You can't conduct a meaningful stress test without reviewing (sampling) the underlying loan files and it seems likely that the purchasers of securitized instruments (not just mortgages) do not even have the loan file data. Moreover, loss ratios vary enormously depending on the issuer, so even a bank that originates (or has purchased a bank that originates) similar product cannot simply take its own loss rate and extrapolate it to the measure the risk on the value of securitized credit instruments. (This is true for complete accuracy, but the uncertainties involved are also managed by credit enhancements to the securitisations and it can suffice to have a rough accuracy since there is considerable scope for managing the outfall once the scale of the problems and forecast arrival rates of losses and recoveries are known. But, yes, this is not a spreadsheet game; it requires serious full-scale models and super-computing power.))
It is vastly more difficult to examine a bank that is engaged in accounting control fraud. You can't rely on the bank's books and records. It doesn't simply take more, far more, FTEs -- it takes examiners with experience, care, courage, and investigative instincts and abilities. Very few folks earning $60K are willing to get in the face of the CEO and CFO making $25 million annually and tell them that they are running a fraudulent bank and they are liars. FYI, this is one of the reasons, why having "resident examiners" never works. The examiners don't even get to marry the natives. They get to worship God's anointed. Effective examination is good for you, but it is very unpleasant, ala a doctor's finger up your rectum. It requires total independence. So, the examination force doesn't have remotely the numbers or the relevant experience and mindset to examine the largest banks with the greatest problems.
Examiners certainly can't do the stress testing that Geithner describes or evaluate the reliability of a large bank's proprietary stress test. If they were serious about constructing reliable stress tests, which they aren't, you'd require their analytics to be made public. You'd have the industry fund independent investigations by rocket scientists chosen by a committee selected by the regulators of the soundness of the analytics. You'd also have the industry fund competitions to rip them apart (a bit like we hire legit hackers to test security by trying to defeat it) and show where they produce absurd results. The geeks would have a field day (that would probably last a decade). There are probably zero examiners that have the modeling skills required to evaluate the most sophisticated stress test models. The concept that there are 100 examiners with these skills, suddenly freed up from all other duties, assigned to conduct stress tests is a lie.
I agree about the lack of skilled examiners. It follows from the failure in Basel II to provide a blueprint for its Pillar II scenario stress-tests even though this is central to the whole Basel II scheme = to make banks more aware and sensitive to the underlying economy. I disagree with Black insofar as I believe the authorities should be able to stress-test whole banking sectors. Central banks should have this capability. Their shared problem is that government and central bank macro-economic models lack a sufficiently detailed disaggregatd financial sector. This is a solvable problem, but there is little sign yhet that this is being addressed even though the problem is becoming recognised.
On Monday we will see how much transparency and disclosure the Treasury and Federal Reserve will provide regarding the not so stressful tests. The runours are that six banks have failed their tests. Sheila Bair, Chair of the FDIC, says that the $110bn left in the TARP kitty is enough to cover capital shortfalls. This is more hope than reality, but TARP is not the only capital resource. The U.S. banking system will need close to $1tn more capital infusion, but this can be recovered. Some commentators ask if the Federal Reserve was so keen on disclosure and transparency, why haven’t they released the names of the banks that have borrowed from them, and the collateral provided for the loans? The obvious and sensible answer is the need to maintain confidence and this confidence is justified by the US government, like other governments do, standing behind the banks.
Some critics go back to the question of hy was all this allowed to happen and choose to blame governments and especially Alan Greenspan’s part. On his speaking tours he gets paid $100,000 to tel us: The presumption that you could incrementally defuse a bubble was a fantasy. Clearly, you cannot defuse these things, unless you hit them right on the head and break the economy. Essentially, break the potential profitability that is engendering that sort of stuff. We could have basically clamped down on the American economy, generated a 10 percent unemployment rate. And I will guarantee we would not have had a housing boom, stock market boom or indeed a particularly good economy either.
From an economics viewpoint he is right; bubbles are inevitable. But, they can be defused as they have been many times in the past. What happens then however is that government actions such as choking off credit expansion by raising interest rates or variously slowing growth and seeking to rebalance external trade and defend currencies are blamed for economic slowdowns and recessions. Now we know what happens when government refrain from doing this on the basis of wanting never again to be blamed for economic cycles. To repeat myself: economic cycles are good and necessary. They just need more anticipatory management. They cannot be banned, nor should they be.

MERKEL MICROSCOPE

2009-04-22T04:34:00.000-07:00

As a foretaste of next year's UK general election, we have Germany's, Europe's biggest economy. Germany could be nearing the bottom of its sharp economic downturn, Chancellor Angela Merkel suggested in a bullish speech at the Hanover trade fair. This is not just political hubris, but is in German politics the equivalent of saluting the flag, of expressing modern German'ness, of what German means in the world, it means exports!
Everyone knows Germany's growth has for three decades been far too exposed to exports, to being export-led, while the domestic economy has languished in high unemployment for lack of domestic fiscal stimuli, but the german politicians won't stand up and say that. Arguably, it was China, Japan and Germany's joint failure to do little to secure domestic-led growth despite their generous external account surpluses that is as responsible as anything else for the global crisis, such that the US and UK and other major deficit countries were 'forced' to rely overmuch on credit-boom growth. Export supluses are seen as virtuous and responsible, conservative and prudential, and in the case of the world's three biggest non-oil trade-surplus countries net exports is their brand, their sinature tunes, their self-identity that they are extremely reluctant to abandon or dilute. German industry representatives also predict that the worst could be over by the middle of the year viz. collapse in demand for German exports.
One thinks of the "it'll all be over by Christmas" propaganda thinking, and maybe that is only to be expected in election politicking. But is a global crisis a fit subject for domestic politics? I this not being globally irresponsible and one-eyed about the the comprehensive picture.
In a general employers and conservative poltiicians touching of 'bottoms', the VDMA federation of equipment manufacturers (the mainstay of german exports dependent on foreign countries' upping investment in industrial capital, which seems a vain hope) backed the optimistic assessment, saying the steep drop in orders for German industrial products could be over by mid-2009. Hannes Hesse, MD of the VDMA, said the sharp reduction in inventories and government fiscal stimuli being implemented around the world (but much less so in Germany itself?) would have a positive impact on orders in the second half. This is a great example of lauding fiscal stimuli anywhere else but at home?
The fond notion that Germany’s steepest economic downturn since the terrifying '30s could soon too be history is not widely shared, either at home or abroad. Economists think industrial inventories are too high for the German economy to turn around in the near term, despite continued drops in machinery and vehicle production. Hans-Peter Keitel, president of the BDI industry federation, said even a rebound in orders in the second half would not prevent Europe’s largest economy from shrinking by 4-5 per cent this year, which is twice the shrinkage expected in the UK and USA.
Forty top business representatives, bankers, economists and trade unionists are today airing their much more negative opinions about the state of the German economy at a meeting hosted by Ms Merkel in Berlin, but probably doing so mostly in private, any chance to try and turn the Merkel telescope around and to take a proper look below decks and recognise that domestic fiscal stimulus (Interne Wachstumsimpuls, bitte, und mach schon, schnell damit!).
One of Merkel's top table guests, Frank Bsirske, head of the services trade union Verdi, is urging Berlin to spend €300bn ($387bn, £266bn) over the next three years to prevent a full-blown depression. This amount seem parsimoniously weak. Yet, that is several times the €80bn pledged by Berlin so far to kickstart the economy, and puts the union at odds with the CDU party and closer to its rival SPD. Merkel's CDU rejected a third stimulus package. The SPD and unions agree that he federal government policy led by the CDU systematically underestimates the magnitude of this crisis and its measures to combat it are too small. Verdi’s proposals, he said, would create or protect 2m jobs. In my view the government should be aiming to double this impact. But, if politicians have a weakness it is the belief that new facts should not change or alter whatever they have said from one year or decade to the next as a matter of firm principle even when only on the matter of not if or when but merely 'how much?' Such crises demand that governments should fear far more doing too little than doing too much;the latter is easier to deal with in hindsight than the former.
Verdi's union wants the government to spend €75bn annually until 2011 on public infrastructure and services, such as schools, hospitals, transport and broadband networks, plus €25bn each year for labour market measures; extension of unemployment benefits, more support for short-time working and introduction of a minimum wage. Berlin could fund the measures through new taxes but also by the measures own self-financing effects.
To those of us schooled in 3-dimensional economics, the codespeak means 'Keynesian multipliers' and they have been political anathema, banned, gulag'ed,under house-arrest, considered deeply un-German, missing-in-action from German politics for four decades! It remains to be seen whether the SPD has the wit and ofrtitude to run that flag up the glagpole and see how many will salute it at the polls?

Quantitative Easing, Asset Protection Scheme, and bank nationalisations

2009-03-06T08:06:00.000-08:00

QUANTITATIVE EASING IS ABOUT MONEY SUPPLY AND IN DIFFERENT WAYS ABOUT INSURING BANKS' 'BAD BANK' ASSETS, BUT ALSO ABOUT BANK FUNDING AND WHAT MAKES MOST PRACTICAL SENSE TO CENTRAL BANKS.
QE is a possible replacement (not just supplement to) for asset swaps at Central Banks' liquidity windows for banks in central banks money market operations (of the 'less open' sort). For those of you who don't read all the financial pages, the world-model for this is the Bank of England's Special Liquidity Window, SLS. This closed on 19th January, having operated since April 2008, since when it swapped about £245bn of UK banks' Asset-backed Bond Securities, ABS, (mainly mortgage loans. packaged into bond structures, and sold in Special Investment Vehicle companies, SIVs, that are firms only set up, and managed by agents, just to handle the payments and standby liquidity between banks and investors so that all of this is now 'off-balance sheet').
The £245bn or so ABS was swapped (after heavy margin write-downs and haircut fees) for £185bn of treasury bills (government bonds with less than 1 year maturity) that can then be used to replace private sector funding (and redemption of banks' maturing medium term notes and 'covered bonds' they issued) to re-fund the 'funding gap' between customer loans and customer deposits. The swapped bonds are worth far more than all the gold in the Old Lady's bottom drawer (as in our Bank of England vault pictured above). Assuming you have got that, now let's move on.
Next stop, "son of SLS", the UK HM treasury and Bank of England Asset Protection Scheme, APS.
APS is alongside, and arguably also part of the permanent "son of SLS" liquidity window at the Bank of England (BoE) that for an additional fee is available to UK banks any business day, not just periodically. The BoE might have continued with an exact repeat-copy of SLS, but it had some second thoughts - intelligent ones. The way SLS was heading was that £500bn would be swapped by end of 2009. But, was this enough if it only provides 3-year roll-over compensation for UK banks' credit crunch asset write-downs, even when that will exceed the total of the UK big banks' total equity capital? As much again would be needed. But should this still be done via treasury bills?
The problem with SLS is that the assets swapped are held as collateral to support the T-bills. The assets are held for 3 years and therefore the T-bills must be rolled-over. But, what if the banks that got the bills sell them or run into any difficulty such that the bills fall in other hands and are presented back to the BoE for payment on maturity date and not for roll-over (paid for with some new bills)? The difference between collateral held after swapping for bills also backed capitalisation investments in UK banks' preference and ordinary shares, off the Government budget, and if UK banks did not hold their bills to maturity for any reason, which in theory and for accounting purposes they did not have to do, then those capitalisation investments could be disrupted.
This then brings us to QE, Quantitative Easing.
In QE, a UK bank's bonded assets are swapped for a BoE cheque that is paper cash (just as a Bank of England banknote is a bearer's cheque) but to be held on deposit as part of the UK bank's liquid deposits (reserves) at the BoE. That way the central bank has direct liabilities (deposits) to balance-off against its bought-in assets (3 year collateral). The press comment noted, however, that the BoE will swap cheques for assets with non-banks! That's just a technicality, 'non-banks' only means from SIVs that UK banks set up to process their ABS off-balance-sheet; it does not mean 'shadow-banks' like hedge-funds (unless we count SIVs as parts of shadow-banking - and why not?). The cheques have to end up remaining at the BoE as part of UK banks' deposits there, which is not something for any actual non-banks to be able to do! The media also imagine that the BoE's MPC Committee must approve this? Well yes, but only because the academic literature defines Quantitative easing as a sort of 'printing money', actually signing cheques, which means boosting the money supply and thereby risking an inflation-response in the economy! This is just a pro-forma idea, more supposition than reality. The money supply is global as well as domestic and inflation is not currently a threat or undesirable. A dose of inflation, like negative real interest rates, or even if imported inflation, could speed up debt repayments and debt rec-cycling and might put a floor under property price falls. Property is involved in everything and banks accounts (unlike inflation-adjusted GDP growth numbers) are unconcerned about inflation so long as not making credit risks worse or squeezing net interest income. Inflation might help to draw a line under the number of banks to be saved. Why also QE is attractive is because under liquidity windows, the BoE SLS-type, the t-bills received by banks, bought with off-balance-sheet bonded loan-assets) could be sold, traded, to get cash, when BoE need the banks to hold the T-bills in capital reserves where they can then be rolled-over so the debt issuance doesn't have to appear on the Government budget like Government bonds (gilts) do. Then, if banks sold their t-bills, there is a theoretical fear of short-term crowding-out of private capital by government capital (actually the opposite happens, but no mind this is more than half-respectable Monetary Theory)- but it's not that really anyway; that's just very hard to prove theory, Keynesians say unproven and wrong because treasury bills and bonds are nearly 100% liquid instruments. Worth repeating: the BoE (ECB too in Euro zone) fear that if sold on (possibly by forced-sale due to cash-flow embarassment or takeovers) these t-bills reappear to be presented for payment, when central banks want to be sure they can simply roll them over i.e. not redeem them, not for 3 years, the period they will hold the swapped assets. The central banks don't want to redeem the t-bills until they've made money from the collateral assets, and from the difference between the face and write-down values that they've used to back other treasury spending on capitalisation of banks. Hence the safest way to proceed from BoE (ECB and Federal Reserve too) perspective with "son of SLS" is QE. And, yes, having fully liquid deposits at BoE means the UK banks have that as backing for 'cash' payments i.e. so-called 'printing money', but actually no different than t-bills except t-bills have to be sold on, or borrowed against as short=term collateral, to get the money and could come back to embarrass the BoE. Cash-flow support via QE does not come back to haunt the BoE i.e. like people demanding gold for their grubby notes. And, yes, there is a money supply and inflation aspect, but also consumption spending and higher imports and wider trade deficit. BoE might like to be telling the banks to use the money to support loans to infrastructure, fixed investment customers e.g. property developers, to keep the building of new housing stock built, or better to assist industrial manufacturers to make exportable products, even if only building inventory ahead of recovery? I spoke about all this on Sky News today. The same is true, however, in the USA.
What is happening in the USA is also so in the UK. An important context for the Lloyds deal is the rise in CDS spreads this month that echo the jump in spreads in September when Lehman Brothers crashed that led in the USA, UK and other countries to bank bailouts. CDS spreads are risk price indicators for the cost of interbank funding, but also reflect risks within the net CDS exposures of banks because of the huge $50tn size of the CDO and Synthetic CDO markets that greatly exceed the underlying assets to be insured. Got that?
What was the lesson of Lehman Brothers? It followed from Bear Stearns, Northern Rock, and other reminder lessons that the most important asset a bank has is confidence, just as the most important lesson of a whole market is also confidence, direct confidence, not just confidence about the underlying assets or the underlying economy. If people are confident in a bank, it can continue to do business; if not, it can’t. For the last six months, where has that confidence been won or lost? Not in banks’ balance sheets, which is a big concern for audit firms as well as banks. The balance sheets are mistrusted when they absolutely should not be! Is confidence won or lost in the various bouts of capital and targeted asset guarantees provided by Treasury and the Fed, HM Treasury and Bank of England, ECB and others? These support a widespread assumption that the government will not let the creditors of large banks lose money, out of fear of repeating the Lehman debacle; only shareholders are at high or near-absolute risk.
Let’s say that AIG, Citigroup, RBS, or LBG are restructured (less ruthlessly than say Fortis) via government conservatorship so that creditors did not get all their money back (Unlike the 100% guranatee in Ireland or as applies to FDIC-insured deposits in the US or to recently-issued senior debt explicitly guaranteed by the government), they may be forced to convert debt for equity, higher risk/higher return, or be stiffed! A concern is that this could undermine further confidence in banks. According to the FT, bank bonds are one quarter of all U.S. investment-grade corporate bonds. I suspect the % in Europe is similarly high. Losses would be spread far and wide, hitting other banks, pension funds, insurance companies, hedge funds, and so on. If banks cannot support their derivatives exposures, then institutions that bought CDS protection from face further losses. (Banks were net buyers of CDS protection i.e. they invested in them for speculative gain more than just for default insurance.) The fear is that it will be impossible to predict how these losses will be distributed and who else might be dragged under. I'm indebted here to 'Contrahour' from seekingalpha.com
Lehman did not seem to force any other major firms into bankruptcy, although it may have severely wounded AIG since it was counterparty to a dominant share of CDS contracts. Once investors figure out that bank debt is not safe generally, they will refuse to lend to banks, and we are back in September all over again, and this is what CDS spreads are now telling us is the case today. But, now, this is despite governments' massive delivery of liquidity into their banking systems to keep banks functioning? So what changed this week?
One theory is that the semi-forced conversion of Citigroup, RBS and LBG of preferred into common shares is a sign that government may try to force creditors to exchange their bonds for common stock in future bailouts. Preferred shares are not, technically speaking, debt. But they are a lot like debt (fixed coupon dividends), and once you finish converting preferred into common, the next layer of the capital structure is subordinated debt. So the markets are left wondering, and we know markets don’t like large uncertainty. Another possibility is more people are thinking that the government may end up restructuring bank debt. In the FT, for example, Martin Wolf and Willem Buiter, both very serious and globally influential opinion-formers, question whether government should be protecting bank creditors. Wolf, I believe, favours yes for now, but Buiter says no.
Each time the lines on CDS charts, as above, spike up, government has to be seen taking action to imply that creditors will be protected, without making severely testable promises. Hence the bad bank APS in the UK implemented this week. Chances are we’ll see more along these lines. At some point, though, the government may lose credibility and then, disastrously, no source of confidence remains. But, next stop G20 in early April for a global confidence-building inter-government conference.
In June, Sweden takes over the EU's 6 month Presidency. One of the steps in Sweden’s sometimes-heralded bank rescue program was an explicit government guarantee on all bank liabilities, as per Ireland's response too and its nationalisation of Anglo-Irish. But, if any country could wholly-guarantee its banks, you would think it would be the U.S. But the real barrier to taking such a step is probably political - the accusation that this is the road to communistic socialist control of the commanding heights etc. No-one should underestimate US concern, sometimes bordering on paranoia, about the Federal tax-dollar, one reason why EU fiscal centralisation has not proceeded further. Usefully, to understand the technicalities of governments' current initiatives is Morgan-Stanley bank's definition of QE as follows (extract): "Unlike the Asset Purchase Facility already in operation, these asset purchases won’t be funded by the issuance of Treasury securities (which effectively withdraws money from the economy, offsetting the injection of money from the purchase of the assets). The Bank of England will buy assets in exchange for, effectively, a cheque from the Bank of England. The seller then deposits the cheque at its bank which (assuming it banks directly with the Bank of England) results in that amount being added to the commercial bank’s reserves at the Bank of England. The seller of the asset has less of one type of asset (e.g. gilts) and more cash. The commercial bank has more deposit liabilities and increased assets at the Bank of England. The Bank of England has increased liabilities in the form of commercial bank reserves and increased assets in the form of the securities it has purchased. Money has been created (‘printed’)." For ,ore see: http://www.asymptotix.eu/node/115#comment-8
Additionally, it is a moot point that the bonds and bills are actually HM Treasury property via the DMO (Debt management Office), not exactly Bank of England's and therefore aspects of that can alter the accounting in respect of national debt and budget deficits. By shifting to BoE cheques instead of treasury bills we get a build-up of liabilities at BoE that can then build assets in the banks itself and take the pressure of HM Treasury! This is politically neat.
The context for QE includes an agreed deal already for over £325bn between RBS and BoE. Another deal is being negotiated for £258bn Lloyds Banking Group, LBG. A problem has arisen here though, it seems? The swap requires fees upfront, writedown and haircut plus interest payments. If the assets are of the riskiest sort, then the coupon and standby first-loss liquidity protection can be quite heavy and may require 'paper losses' reported in the P/L which then further postpones coupon payments on preference shares and so on. The problem may be that LBG feels suitably cash-flow liquidity constrained that it wishes to make the payments to the BoE (in effect actually to HM Treasury's DMO which manages Government bonds and bills) in shares, preference, or given the scale ordinary full-voting shares. This could then take the Government's share of LBG above 50% and possibly to 70%! What happens then if almost half of the UK mortgage market is government-owned and more than half of everybody is doing financial savings and borrowings with government-owned banks, and so on, and maybe on to a degree of government control and knowledge about everyone, directly or by cutouts such as UKFI, Big Brother state, actual or potential, just imagine the leader writers of the press starting to write "know what, good citizens, we have asked our panel of professors are we or aren't we... and they have all agreed... the UK is now a fully-fledged, centrally-controlled Camminist State in all but name, Long Live Comrade Brown!" It is bade enough that Private Eye magazine devotes a whole page fortnightly to precisely this amusing idea. Imagine all this belonging to the Party of "hard-working families" (Chairman Brown's acclaimed constituency today), the party of hard-working taxpayers and the poor, but not of course of bonus-earners, non-doms, and unearned-income shareholders. This, as much as anything else, is what lies behind deep resistance by Government/s to nationalise the banks, because it means effectively, and variously, nationalising most of everything else. banks are that important, truly the commanding heights of the economy, Clause 4 risen from the dead and straight into power! Lloyds shares were up 6% in mid-morning trade and remained over 5% up at end of day, while oddly other major UK banks' shares fell? The oddity is that ordinary shareholders in LBG are about to be diluted. Perhaps they have calculated that on balance the bank will be worth that much and more, and that the long negotiation suggests that outright nationalisation, as Vince Cable MP says seems now only sensible, will not happen and the long term faithful shareholders will not be wiped out. Short-sellers too must be steering clear, or no-one is prepared for once at this sensitive time to lend out LBG shares only to get them trashed. Both the government and Lloyds said nothing had been agreed by mid-morning, after the BBC broke the story at 9am, and silence persisted.
The BBC reported that under the plan the government "would insure" up to £258bn of assets, and would get non-voting shares in return, which actually means that the preference shares would back the standby liquidity reserve for the SIV assets. The amounts are also significant in that for both banks, RBS and LBG, they virtually cover 100% of their current year 'funding gap' re-funding requirement. But what the experts and public may not know is that in fact the assets are not just those of the two banks, but very likely will include securitised assets from other smaller banks and building societies that included large dollops of theirs in RBS and LBG (LTSB and HBOS) securitised assets in SIVs and covered bonds such as the HBOS rolling $125bn program or Lloyds other SIVs, but not including the well-known SIVs, Grampian and Cancara.
The BBC speculation is that the deal could also mean the bank swapping some of the government's existing non-voting preference shares, on which the bank currently pays 12% interest, for ordinary shares and that it is believed the interest on these shares costs Lloyds about £480m a year. One can only suppose that there is a price for converting fixed coupon shares for zero dividend shares and this will be paid for in more shares too? I find it very hard to believe the bank is so cash-flow sensitive! But, although the numbers are large in ratio to GDP, they are not if we just consider that what is happening is the public sector displacing the private sector from what in reality is lucratively good business, bank-financing. The swapping of preference shares for ordinary shares would be seen as important for Lloyds' cashflow says BBC political correspondent Reeta Chakrabarti, who added that an agreement between Lloyds and the government should have been reached a week ago, but both sides confirmed discussions remain ongoing. A spokesman for Lloyds Banking Group said conversations had not yet concluded because there was still "a good deal of detail to be worked through", and actually this is as much to do with legal drafting paperwork as it is to do with spread-sheeting the financials and doing some risk modeling. Of course, had they asked me I'd have modeled it all before lunch and structured a call-off contract arrangement with an algorithm for quarterly revisions so that a provisional agreement could be announced and let the lawyers and investment bankers turn their clocks off. A HM Treasury spokesman said in almost perfect Rumsfeldian: "Discussions are ongoing. A deal will be announced at the conclusion of those discussions." Do we take this to mean that "no deal" is "no option"? [Agreement was announced next day, Friday, resulting in government shareholding in the bank growing from 43% to 65% voting shares and 75% overall, just under the 80% threshold.]
Meanwhile, across all channels, Liberal Democrat Treasury spokesman Vince Cable, a most honourable Member of Parliament, described full nationalisation of Lloyds as being, not just in his view, but somehow according to some Golden Calf god, "inevitable" and has called on the government to bring the whole banking sector under public control. I don't see it as technically or otherwise inevitable, whether desirable or simpler or cleaner is another matter. BBC political correspondent Carole Walker said Vince Cable is not alone in believing full nationalisation will restore confidence in the banks more quickly, saying, "There are a number of people in Westminster who believe we are getting closer and closer to full nationalisation... [They think] it would be simpler and easier for the government to nationalise the banks and that in the long-term it would save the taxpayer a lot of money." Sorry, but they are dead wrong there. Simple does not mean easier and this is about medium term not long term. Gordon brown wants to clean out the banks, but nationalisation means beginning with cleaning out the shareholders, but what problem are they, and how much less is the prospect of a profitable return for taxpayers if the banks shares are no longer quotable or able to rise on the good news in April from the G20 and possible GDP turnaround in late 2009 and in 2010?
Restoring confidence should extend to share values as a proxy signal to bondholders and potential bond investors who would profitably redeem the Government's stakes. Nationalisation removes some market signaling that in other improved future circumstances are useful, valuable. It also brings in some other problems of what is or is not in the national debt and on-budget and what is or is not in or outside regulatory supervision as well as competition issues. The Euro zone is operating on 2 year bailout timescale. The UK government is on a 3 year timeline. What happens then to level-playing field EU political-economy laws and markets? The deal is part of the Treasury's taxpayer-backed Asset Protection Scheme, APS,to "insure" banks' riskiest assets against further losses - actually much more than that and really funding gap funding and general balance sheet protection too. It was put forward by Chancellor Alistair Darling, no doubt with Mervyn King, to "restore confidence in the banking sector", which while true is a care-worn somewhat threadbare mantra after a year or more of endless repeating. the problem seems to be that Ministers cannot speak out authoritatively about banking in any detail, because who'd believe their professional credentials for doing so, and bankers cannot do so either, not even central bankers and regulators, because they are all disgraced and discredited publicly and no-one trusts them or their motives! This is why international coordination on bank regulation and fiscal responses is politically important apart from being economically important. The last bastion it is assumed where voters might venture trust and belief is when governments across the world all seem to agree. Gordon brown and his government is therefore hugely depending on the success of the G20 London Conference on 2 April. This was the essence of his speech today at the Scottish labour Party Conference in Dundee, which in turn repeated much of what he had been saying earlier this week in Washington and in addressing the Congress and Senate. He is truly a global statesman hero, Flash Gordon, and I truly hope, and believe, he can, and is, playing that role fully, with integrity, and most successfully. Conservative Shadow chancellor George Osborne, less than artlessly, continues to deliberately fail to get it, believing still that his best best is to undermine the last bastion of public trust, government handling of global economic crisis, by sniping in true ya-boo political bad-form that government efforts to get the banks funding each other again may be likened to "insuring the car after it has crashed". He is keeping pace with the Republican Party minority leader in the US senate who also says this is a time for government belt-tightening not taking the belt off! In my view both have their trousers round their ankles and should be thinking about how to restore some dignity to their politics in this time of crisis! This is absolutely not the time to be undermining confidence in governments' economic or political authority! Opposition parties should envisage the crisis as if we are in a wartime economy and value the importance of all loyally pulling together. Normal service in politics may stick with non-economic policy matters and otherwise wait until more normal political-economy conditions return.

AIG - Aiaargh - tuneless music - miss-timing PR!

2009-03-03T04:31:00.000-08:00

Economics and the markets are not unlike music, fingering the notes (yes, banknotes too) and knowing when to pluck, plonk, suck or blow (yes, the dealers' too and their coke habits). What we see are institutions that look like they have forgotten how to play, or are learning for the first time. Government responses have not yet played a tune. They are still getting the fingering positions right and learning to read Keynes notes. It is now time we heard some coherent tuneful music, but we may have to wait until April when the newly re-formed G20 orchestra gathers with all its instruments and sheet music in London. We hope they will agree to play the same classical pieces and agree on a new symphony.
Meanwhile, a good day is merely one without a Greek chorus of bad news like yesterday. Yesterday, world stock markets were expected to fall anyway, but had the added excuse of a flurry of badly-timed news, especially $30bn more government funding for AIG, the world's largest insurer, and an $18bn rights issue by one of the world's strongest banks, HSBC (see further discussion on this in my other blogs here).
Debate in the USA about all all this, AIG especially, is focusing on whether had more clarity been produced earlier, about firms' true balance sheets and about government response measures, then some major financial firms could have been allowed to 'fail' where failure means rescuing 'Main Street' but letting 'Wall Street' take the hits? AIG's 'Main Street' is over 70 million policy holders including 100,000 business entities employing 100 million Americans in domestic USA alone. Could they have been secured by AIG's insurance reserve funds and government support until all the accounts could be transferred and sold to other insurers? The idea is that if the main weight of government intervention had occurred say in the winter of 2007-08, then banks and others might have been better secured to support the economy in 2008 and 2009 to work with government positively and ant-cyclically. Now the burden is almost entirely on government and we have to wait for fiscal stimulus to trigger recovery before banks will return to their 2003 solvency level,and this reuires a 5% plus boost to the economy from Government. But, Government did not know until mid-2008 that it had the economy had been in recession already for 6 months! Once that was clear the stock market began steadily falling (short-sellers' heaven). In the UK, recession arrived six months later and was also only noticed when figures had been revised six months later. And the UK stocks fell steeply from mid-year. Various forward indicators now are looking more positive, and short-sellers are nervous. Certainly stock out on loan has fallen from 8-10% level in the S&P down to under 5%. But, the media response was in any case over-shocking; the media never balks at a 'good story' and good stories are not about what makes precise sense, not about talking up only talking down. The media is a short-seller of the news. Is that being irresponsible or just being news-professionals?
AIG had an $80bn infusion that included $60bn draw-down. The £30bn is half of that being drawn on (from Oval Office TARP) and remaining drawdown is $25bn after a $5bn loan. It would have been far better for the drawdown to have progressed gradually, not in one big hit notified to, and thereby spooking, the markets! One of the abiding lessons of this crisis is the damaging lack of a crisis-sensitivity in how press-releases are managed, and here I include Lloyds Bank interims and HSBC's rights issue along with many others where a pro-forma procedure is followed without context information to mitigate against panic-reactions!
AIG's $30bn is not a change in terms of the federal support as the markets assumed. The draw-downs are triggered by requirements that the “AAA” rating be maintained on AIG’s counterparty risk instruments. The policy behind federal support thus seems reducible to merely avoiding another Lehman-scale failure and wholesale-credit market meltdown. The devastation caused by Lehman’s failure was in wholesale funding (counterparty risk and liquidity risk). This is the complex market risk structure that is one of the main concerns of Basel II called double-default risk in which opposing parties of derivative instruments are dependent upon the credit worthiness of each other and where, for example, if the instrument requires a “AAA” credit rating, loss of the credit rating can become an element of default. The £30bn is therefore required as standby liquidity (like capital reserves) to further insure the assets so that at least the senior tranches retain AAA and contractual default-trigger thresholds are not crossed when investors can insist on liquidating the investments.
US federal policy is driven by the need to avoid another “Lehman” as we can see in support for AIG and Citigroup, while trying to stop short of the 80% stock ownership by government at which point the balance sheets of these come on-budget, onto the federal budget, adding to its deficit and debt. The international standards practice is for current debts to be added to national debt but not offset by current assets, hence the fear of a misinterpreted cost to taxpayers. This is the circle of the argument, how much do taxpayers stand to lose one way or the other, and this looms far larger than the offsetting question of how much do taxpayers stand to gain one way or the other? This is of course a biased argument driven forward politically by net taxpayers and not by net recipients of government transfers, and hence the divide here also appears in party politics. The Democrats accuse the Republicans of risking economic disaster by holding on to monetarist thinking and caring less about the systemic roundabouts. The Republicans accuse the democrats of bankrupting the country, by which they mean government finances at an enormous cost to future taxpayers. Ditto, between Labour and Conservatives in the UK and between centre-left and centre-right in all OECD countries.
We will spend years examining the many decisions, about Bear Stearns or Fannie Mae, lehman, other banks, fiscal or monetary responses, shareholder value protection or not, off-market, on-market, off-budget, on-budget, and many other such questions as exercises that will occupy students, economists, historians, and other analysts and academics for decades. But are those the relevant questions for banks, governments and other portfolio managers today? Decisions made today and tomorrow come down to (1) will government intervention via equity ownership, and or (2) huge expansion and fiscal stance on central banks and governments balance sheets, and or (3) trillions of contingent guarantees combine prevent prolonged depression and hasten recovery?
Economic history says the answer is yes. There are no limits to government credit that can be extended in support of this, whatever it takes, in whatever amounts necessary and with whatever tools needed. And this is especially, some say uniquely, true of the USA, which is the major counterparty via the US$ to the whole of the rest of the world. If you believe as I do, that the OECD economies will find some bottoming in 2009 or early 2010, then all the model and accounting calculations will find a new level for clearing between creditors and debtors that is economically affordable whereby taxpayer risks are much reduced and in prospect of earning profits.
Some would add that inflation will help and deflation massively hinder recovery. Whichever is more true, governments believe the former view and this too is what bailouts like AIG or RBS and many others are also all about. G20 in April should, for the first time, and on an international or global scale, issue clarifying plans that should take much of the anxiety that feeds off uncertainty out of the markets. This must especially include far less uncertainty with Western Europe’s approach including the deteriorating situation in Eastern Europe that is raising the bar with major questions for the whole EU and whether it can deliver a financial aid plan for the region. If not, then the EU project is seriously discredited and will take a long time to recover.
The Euro is just shy of its lowest level vs the $ since November, one reason for the low £ oil price. Global bond markets are the main beneficiary of the equity weakness today but these cannot recoup the credit weakness in all other credit sources.
In the US and other OECD countries consumers are shifting focus to saving from spending. Private saving will soar as Governments flood in with bond issues. How this translates in higher transmission mechanism flow-through to the economy is what is exercising government political-economists. For example, in the USA, the President's economic teams will be extrapolating from the following recent data:
In the US, January Income unexpectedly rose 0.4% vs expectations of a decline of 0.2%. Income was boosted by “special factors” such as COLA increases and more pay to goverment workers and military personnel. Excluding these and other special factors, Income rose 0.2%, still better than estimates. Spending rose 0.6%, 0.2% more than forecast and with a 0.2% gain in the PCE, REAL spending rose 0.4%. As a result of the income rise, savings rate rose to 5% from 3.9%, and is now at the highest since April ‘95 and would still be in the 4%+ range even after taking out the one time adjustment boosts to income. The savings rate is likely headed towards the 8-10% range and roughly speaking, for every 1% pt increase, there is about $100b less consumption spending. This will be a painful process of zig-zag adjustments on the path of the economy's credit and economic cycle.
FOR THE FULLEST ACCOUNT OF AIG's PROBLEMS AND CREDIT DEFAULT SWAPS AND HOW THEY SELL-SHORT THE MARKETS SEE: CRUNCH IMAGES BLOG VIA CLICK ON 'VIEW PROFILE'

EU KETTLE BOILS OVER BY $24 TRILLIONS OR 0VER 40% OF EU BANK BALANCES - DON'T BELIEVE IT!

2009-02-22T06:17:00.000-08:00

This essay follows on from that of the third one below this.
This week just gone saw explosive estimates in a secret 17 page document seen by the press. A bail-out of the toxic assets held by European banks' could plunge the European Union into crisis, according to a confidential Brussels document. European Council meetings are immensely secure - it is very rare for key documents to be leaked. Our Contintental partners will be asking themselves whether UK oficials deliberately leaked the secret document? It says things like: “Estimates of total expected asset write-downs suggest that the budgetary costs – actual and contingent - of asset relief could be very large both in absolute terms and relative to GDP in member states,” as seen by The Daily Telegraph. I smell a rat - a con-job? And, "It is essential that government support through asset relief should not be on a scale that raises concern about over-indebtedness or financing problems.”
The "secret 17-page paper" was discussed, it is claimed, by finance ministers, including UK Chancellor Alistair Darling in brussels on Tuesday. National leaders and EU officials fear that a second bank bail-out in Europe will raise government borrowing at a time when investors - particularly those who lend money to European governments - have growing doubts over the ability of countries such as Spain, Greece, Portugal, Ireland, Italy and Britain to pay it back. I don't doubt some that is reasonable to state, but scarcely news or at all alarming, not until the numbers that The Telegraph reports were in the paper (later removed from the website?)
The Commission's figures, if that is what they are, are significant because of the role EU officials will play in devising rules to evaluate “toxic” bank assets by the end of this month when new moves to bail out banks will be discussed at an emergency EU summit. The EU is also very concerned by widening spreads on bonds sold by member state countries. In line with perceived default risk, and the weak performance of some EU economies compared to others, investors are demanding increasingly higher interest to lend to countries such as Italy instead of Germany or Greece instead of France. Ministers and officials fear that the process could herald a spiral that threatens the EU's wider, and Eurozone's narower, integrity. The secret paper supposedly says, "Such considerations are particularly important in the current context of widening budget deficits, rising public debt levels and challenges in sovereign bond issuance.” And the Teleraph says, Toxic debts of European banks risk overwhelming a number of EU governments and pose a “systemic” danger to the broader EU financial system.“ If I may digress for a moment - It is not inappropriate for an organisation such as the UN, IMF or in this case, the EU, set up to provide the economic cooperation needed to secure long term peace, to remind ourselves of why Versailles failed in 1919 after WW1. The two greatest economists of the age, J.M.Keynes and A.A.Young both resigned in protest, and Keynes wrote the best-seller "The Economic Consequences of the Peace." The argument was that seeking proportional reparations would prolong the economic mess that led to war and one could not predict what extremities people would go to to get out of their misfortunes. His advice was taken thorough account of after WW2 and the world experienced exceptional growth and rising prosperity. Of course, wars were not banished and enormous problems persisted. But, similarly again now, when G20 is in effect setting up a system for a new financial world order, both to get out of the crisis and then to create a sustainable world economy, great care has to be taken to ensure conditions are not created for future extreme crises much as WW1's Versailles led to WW2. There are already, in Europe and the USA and in many other parts of the world extreme assumptions of the total collapse of the financial system, of the EU, of the economies of China, Africa and so on. The secret 17-page paper appears in how it has been characterized by The Telegraph to fit that anxiety-bill.
It says that estimates of total expected asset write-downs suggest that the budgetary costs of asset relief could be very large both in absolute terms and relative to GDP in member states to the extent that the ability of the EU to survive is threatened! It supposes that for some member states, it may be the case that asset relief for banks is no longer an option, due to their existing budgetary constraints and/or the size of their banks’ balance sheet relative to GDP. Ireland, for example, where voters are still expected to vote against the new EU Constitution despite the fact that the main banks are all sucking on the liquidity teats of the ECB for survival. Yet, if the UK was to allow the Irish banks access to its liquidity window the cost would be a relatively trivial addition to the asetts for treasuries it is already doing for UK banks. Unfortunately in the Eurozone, only the ECB can issue short term roll-over treasury bills off-budget from a national debt point of view. The situation demonstrates a valuable monetary lever available to the UK that would be much less so had the UK joined the Euro system. The UK is also enjoying no deflation threat due to its exchange rate having fallen by about 30% and its persistent inflation (currently about 3%) is an additional help in paying down debts.
The extent of any risks to the EU banking system as a whole from an inadequate response in these member states needs to be considered, particularly in the case of cross-border banks. No country is named in the so-called 'secret paper', but obvious candidates might be Greece, Ireland, Luxembourg, Belgium, the Netherlands, Austria, Sweden, Spain, and UK, and non-EU member Switzerland, which have large banking sectors relative to GDP or have sold proportionately large amounts of asset-backed securities. EU banks hold balance sheet assets of €41.2 trillion (£36.9 trillion). But, it seems to me that the toxic assets are a market price problem, not yet a problem of low income, not credit risk defaults to the extent that these assets are not paying substantial yields. The problem is more that of accounting for the market price writedowns on banks' books - so take them off into the Bank of England or bad bank entities, leaving the real cash-flow problem being funding the banks' funding gaps between customer deposits and customer loans. This gap is well within the financial means of EU governments and the ECB. Brussels refused to comment on the paper, but it is clear that officials are concerned about default risk in the weaker states where interest spreads on government bonds are widening most. The IMF has questioned the lack of a proper 'lender of last resort' in the eurozone, although it is more so than the current G20 plan for the IMF's similar role globally. The European Central Bank (ECB) is, however, not allowed to bail out individual states. National goverments' 'central banks' within the Eurozone (Euro single currency) countries do not control national monetary levers given that treasury bills, repos etc. (open market liquidity operations) and central bank interest rate are an ECB responsibility. The concern about the ECB being less than a full central bank because it lacks a less than full political master, i.e. a less than full federal government, is an old saw that is unlikely to be resolved anytime soon. Therefore, the ECB is especially sensitive to how well it and the Euro financial system are seen to survive its first full recession test.
The IMF says C.European and UK banks have 75% as much exposure to US toxic debt as US banks, yet have been slower to book write-downs ($738bn in the US, $294bn in Europe, $260bn short?) Global banks have so far written down half of the $2,200bn losses estimated by the IMF. On top of this, EU banks have another $1,600bn depreciating asset exposure to Central and Eastern Europe, viewed by some as Europe’s sub-prime over-indebted poor. EU corporate debts are said to be 95% ratio to EU GDP compared to 73% ratio in the US, a mounting concern (as default rates reach 6.7% in the US, with S&P forecasting 23% by 2011 and the fear this may be repeated in Europe). But, these are default rates for speculative grades only and will only be experienced in the bottom 25% of corporate debts. The EU secret document also highlights the “real danger of a subsidy race between member states” if countries start to under-cut each other in the way they value toxic debts in their `bad bank’ rescue programmes. Whenever the word "race" appears in a communitaire economy context it means "race to the bottom". The fears is that of covert state aid, undermining the single 'fair' market integrity of the EU. Actually, it pays no country to seek to under-cut or outpace the others since the benefits leak out via the external account. Therefore, commonsense should dictate that all countries coordinate their economic recovery reflation measures at roughly the same pace, the same ratio proportions to GDP. But, no-one wants to risk going at the pace of the least fiscally Keynesian, except the least fiscally Keynesian, Germany and Austria!
An explosion of budget deficits and national debts ratios are also feared. The budget deficit will hit 12% of GDP in Ireland next year and almost 10% in Spain and UK, no doubt others too. Therefore the secret paper says, “It is essential that government support through asset relief should not be on a scale that raises concern about over-indebtedness or financing problems. Such considerations are particularly important in the current context of widening budget deficits, rising public debt levels and challenges in sovereign bond issuance.”
It is not surprising that European Union finance ministers looked ashen faced in Brussels on Tuesday and will do so again today in Berlin where EU leaders have agreed the agenda for their contributions to the London G20 conference and this turns on a global financial regulator authority - something many of us imagined existed in the BIS, bu is to be backed by the IMF in the role of a central authority with substantial funds. Last Tuesday's coffee & croissents or madelaines with confitures Anglaises breakfast meeting discussed how EU governments should deal with "toxic" banking assets that all accept triggered the economic crisis, but by Sunday, today, this has transmuted more towards regulatory supervision and transparency. The figures in the secret EU Ecofin Commission paper, are startling. The dodgy financial assets are estimated, according to The Daily Telegraph, to total £16.3 trillions (€15 trillions, $20 trillions) in banks across the EU. The "impaired assets" may amount to an astonishing 46% of EU banks' loan-assets, which is in reality wholly as improbable as it is astonishing. Who produced these estimates, digging a deep ditch for bankers, regulators and friends in government to stumble into.
The secret 17 page paper, according to The Daily Telegraph, warns that government attempts to buy up or underwrite this scale of assets could plunge the EU into a Union-threatening deep crisis. This is equivalent to saying that the EU and Eurozone are equivalent to Iceland or Ireland in having a banking sector dispoportionate to what the economy can afford? It is like saying we cannot afford our banking system, much as has been said for years by anti-welfare state ideologues, about social services, state health and education (typically all three added together being 60% of government spending budgets). The anti-welfare state economists were just as piss-poor at macro-economics as the the authors of the secret paper appear to be - in fact I am forced to seriously doubt its authenticity, maybe another Hitler's diaries scam?
The Telegraph says everyone is terrified that a second bank bailout will push up government borrowing at a time when bond markets have growing doubts over the ability of countries such as Spain, Greece, Portugal, Ireland, Italy and Britain, to service and repay their borrowings. This is so ludicrous, worst kind of scare-mongering, based on upticks in government bond spreads that reflect the cost of capital elsewhere more than genuine perceptions of government solvency! This is typical of interpretations invented when mathematically-minded, economically-ignorant, analysts are forced to explain a number! The 'secret document' says, "Estimates of total expected asset write-downs suggest that the budgetary costs - actual and contingent - of asset relief could be very large both in absolute terms and relative to GDP in member states." These adjectives are relative terms and have to be sized over time, over the credit and economic cycle. There are no known actual absolutes involved. War economies showed us that much; cost is a matter of spreading over time time against present emergency urgency. Spread yields are widening on bond markets as investors apparently judge it riskier to buy the debt of a country like Italy than the debt of another like Germany. The fact is that these securities are a seller's market and there is a juggling of perceptions going on to dissuade governments from appreciating this. Such juggling is a time-honoured tactic ahead of known large government bond issues.
In line with the risk, and the low performance of some EU economies compared to others, the markets have demand a higher premium on government bonds issued to raise the cash - so says the Telegraph and others. Well, when banks are forced to buy and hold more than the 50% they usually buy this time round an desperately need the 'gilt-edged' bonds to rectify their capital quality - governments need take no notice and need not cave in to discounting face values. As Sarkozy might say "nul points". The secret paper is fuelling this concern, "Such considerations are particularly important in the current context of widening budget deficits, rising public debt levels and challenges in sovereign bond issuance."
Reasons for doubting the report is that it had its numbers removed after first appearing on the Telegraph website. What began as a secret 17-page report circulating among European Union finance ministers warning EU governments that toxic assets still held by EU banks and investment firms could total a massive £16.3 trillions or $24.4 trillion, and that Commission officials estimated as "impaired assets" = 44% of total EU bank balance sheets, was later sanitised by removed the numbers calling them merely "massive". I suspect this figure of £16tn/$24tn is a funding gap figure (not toxic assets at all) and a transposition from the 40% funding gap of UK banks to EU banks. One reason for disbelieving the numbers, quite apart from their rediculous scale, is that last week numbers circulated in Wall Street estimated U.S. bank toxic assets at $9 trillions. Frankly, also rediculous. $2 trillions each (my calculations) is the realistic ballpark figure on both sides of the Atlantic, with $2.8tn booked as impaired credits by October 2008, according to the Bank of England. Writedowns by Nov 2008 were over $710bn by banks worldwide and capital raising was $760bn roughly both aligned by world-region distribition (ECB Stability Review). Deleveraging by Euro Area banks required is estimated at €560bn (3% of all assets, 9% of customer loans, €19tn), of which the ECB has mitigated so far by half by providing liquidity to banks. Euro Area bank funding gap is roughly €4.5 trillions. The ECB is perplexedly not brilliantly specific about this. The banks' funding gap of Central and Eastern Europe supplied by EU banks is about €1.2tn only, not insupportable. I reckon that the Telegraph's figure of £16.3tn for toxic assets is actually 16.3% ratio to all of Europe's gross banking assets that are European banks' funding gap, that portion of their liabilities that are interbank borrowings, €1tn for UK banks, €4.5tn for Euro Area banks, €1.2 tn for C&E Europe and others. This makes me even more convinced the Telegraph story as originally put out is some kind of anti-EU malevolent concoction?
I got back late from Berlin today with my head full of figures only to find that Number 10's website had the story in its least quantitiative version: "European leaders meeting in Berlin today, ahead of next months G20 Summit in London, have agreed to the need for fundamental changes in the world’s economic systems. At a joint press conference following the meeting the Prime Minister called for a “global new deal” to aid the recovery of the world economy and provide a set of principles for a sound future. The “grand bargain” would involve global economic and fiscal stimulus, global financial control mechanisms and be based on sound banking principles. It would require the strengthening of international financial institutions and help deliver a low carbon economy, he added. The PM said: “We are resolved that global problems need global solutions. And we will work together over these next few weeks to make sure that by our co-operation and our determination to act together we can not only inject the confidence that is necessary in the world economy but also build anew the economic activity that is necessary for the jobs, for the security that the people of the world want.”
"The Prime Minister will travel to the United States next week to discuss the world economy with President Obama. On 1 April world leaders will meet in London for the G20 Summit to continue the work begun in Washington last year."

PRICE THE STOCK BY THE FLOW?

2009-02-17T12:25:00.000-08:00

On both sides of the Atlantic Cable that first tied UK and USA financial markets and stock exchanges and then Continental Europe's too, that today has somehow determined that systemically important banks (economically vital), from that of Fifth Third Bancorp to Lloyds Banking Group, to Royal Bank of Scotland, Unicredit, Fortis, and others, the banks' share prices are the price of postal stamps and bank capitalisation is a mere fraction of book value; in effect the shares are more like 'options' and the actual 'options' must therefore be the best market bets going, so good in fact that short-sellers like UK hedge fund Odey (up 42.5% in $ terms last year) is now going long on such banks. Maybe they are anticipating a change about to be permitted to mark-to-market pricing standards, something probabilistically determined using the forward-looking dimensions of the new accounting standard IFRS7?
What does marking assets to market prices mean. It means pricing the stock far below the valuation that can be justified by net income to the asset just as in the case of major banks. For example, the prices of assets on the books of Washington Mutual, when it was bought by J.P. Morgan at a fire-sale price, were cited as a reason to mark-down the assets on the books of Wachovia. This, some say, forced the FDIC /Federal Deposit Insurance Corporation) to arrange Wachovia´s sale to Citibank even though these banks are cash-flow positive. Similarly,Fannie Mae and Freddie Mac, had positive cash flow when they were nationalized by the US Treasury. Fannie Mae and Freddie Mac have not yet actually had to draw down a dime from the Treasury's $200 billion facility that was created to bail them out. It was the use of mark-to-market accounting that allowed Treasury to declare them bankrupt when on a cash flow basis, they are solvent. Mark-to-market accounting causes mayhem for tried and tested accounting standards reasons, but with the awkward and often devastating proviso that financial firms are forced to treat all potential losses as if they were current cash losses, and indeed this is how the general public, including many shareholders, perceives all loss announcements. Even if the firm does not sell at the excessively low price, and even if the net present value of current cash flows of these assets is above the market price, the firm must run the loss through its capital account and into its P/L bottom line statement for loss provision, hitting dividends and tax provision. If the loss is large enough, then the firm can find itself in violation of capital requirements. This, in turn, makes it vulnerable to closure, nationalisation or forced sale. My stamp is my bond? Some large banks' shares are the price of postage stamps and their stock market trade-price is close to one year's net profit, even with G20 governments guaranteeing the banks' long term solvency! The news media informs and reflects widely held opinions of bank bonds (backed by assets comprising our loans and repayment schedules) that they're worth even less than postage stamps, certainly less than gold or diamonds that also pay zero income. It is possible to joke that postage stamps are rising in value: buy now and they are good to 'hold' for an annual 8% return? Are bank shares good to 'hold'? Medium to long term they must be.
In the short term now too maybe, if further dilutions by rights issues are avoided, and certainly if cash-flows can be decoupled from mark-to-market asset write-downs. This is the idea of assets valuations based on 'hold to maturity', and shifting assets from trading book to banking book, or the idea again (now called 'bad bank') of getting assets with below book value prices off the balance sheet, and so on, such as swapping toxic assets into bad banks or at central bank liquidity windows via SIVs or any form of medium to longer term warehousing, i.e. de-coupling cash-flow P/L so that banks share price valuations can move closer to banks book value (even if the latter is written-down, short or medium-term discounted by recession, cyclically) and if solvency is considered on a cash-flow basis, then bank shares must have tremendous up-side. But, the political authorities are reluctant to permit massive shareholder 'regains' (unless government or perhaps pension fund shareholders only?) If fiscal measures by US, UK and other governments deliver firm signs of recovery by 2010 (maybe with advance indicators in 2nd half of 2009) then the 'upside' potential of bank share prices becomes a powerful certainty!

FUNDING OF FISCAL RESPONSES TO THE CRISIS

2009-02-13T03:21:00.000-08:00

Solving the combination of credit & economic cycle recessions together amounts to doubling of our recent past experience of economic recessions. The solution has to be about restoring confidence as much as about restoring solvency. Trying to do just enough to win through may be foolish risk-taking. We can see this to be more like a war-economy situation where the only sensible risk-taking is to do as much as can be done and therefore much more than enough to win through.
Just as in wartime, it is essential that when trust in all else fails we do not lose trust in democratic governments too! There are far worse consequences than trusting in government, however flawed their efforts might be. It is my considered view, however, that remarkably our governments are doing a surprisingly intelligent and good job. Any of you luxuriating in angst and anger who wish to strike blows in all directions - you're being dangerously wrong-headed!
I task you with the quesion: what is the importance of not losing trust in what governments are doing and can do? I suggest that when trust is lost in banks and so much else, we have to be able to trust in government actions in this crisis for fear of far worse consequences when all trust is lost! In this respect is it not unlike wartime conditions where however flawed the Churchillian or FDR leaderships might have been, for example, they pulled together the national effort? While I don't want to make a party-political point, this is where the UK Conservative front benchers are mistaken in playing yah-boo politics. Would Labour Party have done the same in WW2 had it not been part of a National Unity government? I don't think so? But, it is undoubtedly with such thoughts that Obama is trying in the US to "reach across the aisle".
Overwhelming much else, more and more, is the immensely dramatic change to the pattern of world trade and financial flows, and this is also why Governments need to over-shoot in their measures. We could say we (Governments, and banks too) need to attempt a 'shock recovery', almost shoot first, ask questions later. And that means forcefully countering those who either emotionally or for carpet-bagger vested interest reasons oppose trying to restore as much as possible the map of how matters stood before the crisis. We can assess how much and where we can risk a clean break with the immediate past? In solving the banks liquidity risks, Governments can supplant as counterparty (and then as market intermediary) all of interbank wholesale funding of banks 'funding gaps' and also eventually bring credit and money markets on-market into regulated transparent credit and money markets. Part of the problem undoubtedlky was that these were off-mnarket, in 'over-the-counter' trading. This is not beyond governments financial resource to do so and would leave the previous sources of wholesale funding begging to get back into this profitable market - a good result for restoring balance to money and credit markets.
But, it cannot be accomplished if governments liquidity and SLS type measures are not transparent (e.g. The UK 2009 Banking Bill that permits non-disclosure for at least 6 months of precise details of government funding of the banks).
A related matter is that even the FT as well as all other media have failed to pick up that by law government holdings of commercial banks when over 50% are outside of regulatory supervision laws (CRD Basel II, Solvency II, IFRS etc.) and outside of the Companies Act and codes of conduct etc. This is clearly established at EU law by the Irish nationalisation of Anglo-Irish Bank and now applies to NR, B&B and RBS. (And similar is true of Fortis, ABN AMRO, and in USA of AIG, FM&FM etc.) Some assurances are needed here that regulatory supervision will continue in these cases!
Above all, the public want the reassurance of a clear statement of the game-plan. It is not enough that this game-plan is now diverted into the G7 and G20 agendas.
In my analysis of what's happening is as follows: banks generally in both UK and USA, and elsewhere, are losing twice their reserve capital, once to the credit crunch, once to the recession. Governments are replacing one times capital reserves and so far one quarter to one third of 'funding gaps' plus guarantees of deposits & bondholders. Banks have to recover one times capital reserve from recoveries and one times capital reserves from selling off business assets from which they can redeem government bank share investments (and will be anxious to do so before their share values rise sharply sometime in the medium term).
But, where are government measures in this to assure that banks will not endanger recovery by deleveraging, acting powerfully pro-cyclically? That, I believe, is to be found in the now long-run (not temporary) liquidity funding by central banks of banks 'funding gaps' - the reason why securitisation of bank assets has gone up dramatically in 2008 and will continue to be historically high in 2009!
This, so as to pledge the bond collateral with central banks as 40-50 year maturity paper (as in the UK, where this collateral after 25% discounting is pledged for 3 years holding periods in exchange for Treasury Bills, but this is likely to be prolonged beyond 3 years, and 3 years is now the US holding period too, up from 1 year) i.e. these are very long term Covered Bond, MTN and SIV funding programs under which the underlying loans are topped-up continually, replenished, rolled over. On this basis lending levels by the banks should be restored and maintainable.
In fact, we can envisage that insofar as all this government liquidity infusion is off-budget, the dividend & coupon revenues to Government are of sufficient size to balance US Federal and UK General Government budget deficits after 2009! Thus, there is a shift from private financial sector profit to Government profit to pay for the fiscal impulses.
If this framework is publicly recognised and managed intelligently that is a prudential way out of the mess.

EU emergency anti-crisis summits

2009-02-12T07:51:00.000-08:00

The EU has scheduled two emergency anti-recession summits ahead of the London G20 and G7 in an effort to suppress protectionism, sustain employment and prevent the bloc’s political fragmentation into old and new member states. EU heads of state and government will convene in Brussels on March 1 to discuss their latest steps to counter the financial sector crisis. They will meet again in Prague in May after the G20 to consider the recession’s impact on the 27-nation bloc’s labour market. This is in addition to a previously scheduled summit of EU leaders on March 19-20 in Brussels that will also deal mainly with economic issues from the G20 agenda for which the Commission has a large number of high priority tasks to progress.
“Only by co-ordinated and united action will we overcome the crisis. The internal market is the vehicle that will drive us out of it,” said Mirek Topolanek, the Czech PM, after talks with José Manuel Barroso, EU Commission President. The two announced the summits to limit the fall-out from a clash between French (outgoing 6 month Presidency) and Czech leaders (incoming 6 month presidency) that exposed cracks in EU unity just as the EU has to find a common united voice for the G7 and G20 about how to usher in a new financial world order and the most serious global economic difficulties in EU history.
The not at all plain fact is that while financial flows in most of history followed trade flows, and then were decoupled when major currencies all freely floated post end of Bretton Woods, there followed the fast growth but severely unbalanced trade patterns of the past 20 years requiring financial flows to be provided as packaged up financial assets (commercial bank securitisations etc.). Half of US structured products were bought by its foreign trade counterparty surplius countries such as China, Japan, Korea, and the EU, about $1.2 trillions.
The collapse of these securities, dramatic changes in exchange rates and energy prices over the past year, recessions etc. all have caused a massive re-orientation of world trade patterns. Most countries are totally lost in knowing what their extrnal accounts are going to be. We see this for example recently in Russia where a large fiscal stimulus was abandoned as the Government could see its foreign exhcnage reserves rapidly falling and the necessity to support its banking sectors external obligations with the necessity of buying in toxic debts!
The Czech views reflect to some extent that of central Europe where trade and investment flows with the EU have dramatically worsened. “My feeling is that this is something that’s very damaging to both of us,” Mr Topolanek said of his row with Nicolas Sarkozy. “We haven’t dealt with it in person because, frankly, it wasn’t worth it. Now I’ve learnt a lesson. It’s better to call each other up.” The dispute broke out last week when Mr Sarkozy suggested that French car manufacturers operating in new EU member-states, such as the Czech Republic and Slovakia, should switch production to France and protect French jobs. Tensions rose on Tuesday when Mr Topolanek accused unnamed eurozone governments of “deforming” the project of European monetary union with misguided responses to the financial crisis. The quarrel will become a broader conflict between the EU’s older, western European countries, most of which use the euro, and the newly admitted states of central and eastern Europe. This is a problem with a long history. The EC/EU has been traditionally weak or less effective than it should and could have been in addressing economies across its borders compared to the USA and Mexico for example, though mjatters can be strained there too. In the past this was explicable given that across EC/EU borders were either Soviet states or Muslim states which each had obstacles to capitalist development. Aid was more effective in sub-sahara Africa and in trade with OPEC and further afield.
Now within the EU there is a large group of central European states, most outside the eurozone and more vulnerable to severe financial disruption the longer the crisis persists. “Already we can see small countries entering into problems with liquidity, as the price of their bonds decreases and they are not able to sell them,” said Mr Topolanek, whose Czech Republic took over the EU’s rotating presidency from France on January 1. The Czech Republic is also angry and frustrated at the disapproving noises heard in certain western capitals about its weak leadership in the financial crisis. France's €6bn aid plan for the French car industry with attaching non-communitaire conditions is in breach of the free market, and Mr Topolanek's presidency has a right to reprimand France for this - hence the row - saying the real division in the EU was between “those who think it’s possible to violate the rules right now, and those who think it’s not, and I’m one of the latter”. Mr Barroso, striking a balance between support for France and defence of the EU single market’s integrity, said: “We must not let our industries perish because of a temporary downturn ... But we will need to scrutinise very carefully the details of the [French] subsidies.” He added: “All over the world there’s a real threat to the global economy from economic nationalism and narrow protectionism. We must resist this temptation. If one country decided to go it alone and take unilateral measures, others might decide to do likewise. But I reject the idea that it is a specifically European problem.”

WELFARE AS AN ENTERPRISING NECESSITY?

2009-01-11T05:52:00.000-08:00

Fiscal policy in the recession has been described by many on both sides of the Atlantic by reference to John Maynard Keynes' analogy or metaphor of £5 notes to be earned and paid for by cost of getting unemployed people to first bury and then exhume them. Keynes (according to a very good recent piece by Nick Fraser in The Independent saw this as an alternative to dole money (welfare checks)! http://www.independent.co.uk/news/business/analysis-and-features/john-maynard-keynes-can-the-great-economist-save-the-world-994416.html)
There is a current debate in the UK about whether to tax savings (or unearned income generally) or otherwise TO end any public subsidy of savings. This may be based on Keynes' comment that 'One man's saving is another man's unemployment'. As savings and borrowings are equal, the only way to reduce borrowing is to reduce saving. The purpose is to make those with money spend, so that the poor can earn instead of borrow. The originator of the idea was Silvio Gesell, who advocated a system of depreciating cash by 2.5% a year. In fact this idea persists in the idea of steady long run non-inflationary, optimal productive capacity, growth, by seeking a long run inflation rate of about 2-2.5%. Gesell's system was not comprehensive enough, but his present day followers have tried to deal with the defects. The view that some have come to now is that tax assisted saving should end. Others are advocating the exact opposite. Hidden behind this is the fear that the transmission mechanism by banks which converts savings into loans for productive enterprise is not working, and that Government dispersion of spending power would be more effective i.e. a shift from private to public money 'transmission mechanism'.
There are many ways of achieving such a shift that I will not rehearse here. But, looking at the matter more broadly, or philosophically, there is also a protestant, conservative as well as Marxist, work ethic here that money has to be a value for (and valued by) hard labour. Before the 'hungry thirties', the second 'great depression' (today's may become the third) there had been a century of poor law, public and private relief works etc. For example, in Ireland during the 1840s famine and in the depression of the 1880s and other times (and in Scotland and many parts of England and Wales too, if less so) relief work was proscribed to being non-commercial i.e. not producing anything that could be for sale! Hence, the work was building estate walls (private relief) or roads (public relief) but not anything that might furnish commercial exchange and thereby compete with or displace private enterprise. Similarly, in public housing provision, once it became a state activity, the dimensions and quality had to be to the lowest minimum standard i.e. less than that of private commercial housing - though ironically private homes and sub-divisions of townhouses etc. had presaged these low standards, and subsequently emulated these minima often at lower standards! The difference between private and public housing quality was usually in quality of location and often only superficially in building quality and design for living.
Also, this general bias of social provision being of minimalist quality also explains the city- or town scape cultural desert of council housing estates (or ghettos) e.g. having minimal or zero shops, post office, church, culture spaces, village hall, fire, medical or police stations. Imagine if the enormous benefit and ethos if the design had been more that of Prince Charles's Poundbury than Glasgow's Easterhouse (note that the 1998 social exclusion policy in the UK began rectifying this - http://news.bbc.co.uk/1/hi/uk/171530.stm ) Today, in the UK,there are 1.7m on the council waiting lists in the UK, nearly one third in Scotland
(which is only 10% of UK population) where last year 5,700 new social homes were built after 10 years of zero new builds.
The prejudices (by or, often spuriously so, on behalf of 'taxpayers') about the dole (public welfare) now extends in the credit crunch to governments baling out (or bailing?- joke) bankers' losses only so that private bankers can take all the profit again in the upturn. We have also had over a decade of prejudicial fear that the growth in pensioner numbers (in addition to all other welfare claimant's etc.) are becoming an insupportable burden on enterprise and on 'working families' (the beloved constituency of both US major parties).
A modern Keynesian way of seeing these is quite different, and possibly not one Keynes would have instinctively supported, that welfare safety nets and pensions are not external to the 'real' or 'productive' economy, but more of an essential central engine of the 'real economy'. Welfare system safety nets encourage entrepreneurship in business and the arts (and if also their close relative, crime) by taking away some of the downside fear of taking commercial risks. It also recycles spending from savings to incomes in ways that are more equitable (including geographically) to act as a very useful complementarity to the banks' transmission mechanism and thereby increases everyone's income i.e. 'the welfare state multiplier'.
The idea of welfare (and public infrastructure and services) as a beneficial economic necessity (benefiting general economic growth) as much as, or more than as merely a moral obligation (socialistic view) or a national security requirement (liberal conservative view) or as charity (caring conservative and religious view), has never caught on, not in the public imagination anyway - and that is a gross failure by economists and of all leading thinkers (philosopher politicians and academics).
Similarly, there is no history yet written to show or extol how the design of public provision has been variously innovative and leading (something socialists would love to be able to believe) and/or the very opposite (as neo-liberals firmly believe), a stifler of productive innovation and of 'free markets'.
In my view, political-economy philosophy would have had a very different development if Adam Smith had written some years later than he did and the dominant capitalist model would then have been based on productive growth of cities, as much or more than on the productivity of factories. Cities express the overall system of all transactions (goods and services) mediated by money and self-financing by increasing the velocity of capital (now 250 times GDP in the UK, world's highest), and not based on theories of value (whether on essential resources such as food and shelter production, labour-value, or gold standard and its variants, including Malthusian and Shumpeterian theories, physiocrats, mercantilism etc.). We are still at sea largely in understanding market price values in economics as a basis for fundamental models (except in physiocrat and mercantilist-based philosophy theories).
We also have dysfunctional thinking in relating short term to longer term and working life to total lifetimes. This was part of the debate around Keynes as Davis describes.
As a sub-note to some of my readers: I think it was a major calamity that Prof. Alan Abbott Young (Prof. Nicholas Kaldor's teacher at the LSE) died when he did (1928) before writing and publishing broader philosophical texts about economics, who I think might have more than marginally exceeded Keynes (who was inspired by AA Young) in our estimation today had he lived?

Save more or spend more?

2009-01-10T10:14:00.000-08:00

Echoing a similar debate in the USA, the UK debate about getting savers to spend more, or to tax them, the prudish comments about a false economy based on credit boom, how our priority should be more savings, UK having highest household debt in EU etc. - this is angst-ridden baloney! The only important issue about our credit boom economy was the external account (net of our high FDI inflows) that had to be funded by selling financial asets to forewignors (exporting bank asset securitisations) and at some point this had to collapse necessitating severe changes in our terms of trade; lower net imports and lower pound (for a while anyway).
The viability quality of the economy is not given by how much we save or borrow. Export-led economies are not in better shape. Anyway, the definition of 'savings' is wrong - too narrowly conceived. When households pay mortgages they also believe themselves to be saving, similarly in life and pension schemes. Household debt did rise to highest in EU (among the bigger nations) but so too did assets and therefore UK households net position remained merely at the average for the EU. Even today with average loan to value ratios of mortgages at about 55% these loans are more than fully secured despite the 20% fall in house prices (even if likely to fall another 10%). Even defaulting mortages average about 67% LtV also in aggregate within the discounted collateral value of house prices. So far all defaults are likely to be at least 60% recoverable. When Government borrowing rises or falls, so too does private saving rise or fall and by exactly the same ratio to GDP. This is an accounting identity; these are not separate unconnected observations. Japan's high savings ratio was the counterpart of the Government's high borrowing. The low domestic consumption was caused by lack of Government domestic stimulis and the multi-generational household debt overhang from the heady property values of the late 1980s.
More serious an accusation is that following a major shift in lending to mortgages and consumer cards (In UK, Eire, Greece, Spain, USA) that lending to non-financial businesses suffered (when measured absolutely and not just in ratio to GDP) and net imports grew phenomenally - financed by foreign acquisition of net financial assets. There is a strong case for shifting bank lending to more loans for business sectors.
Lending to customers by UK banks is 2-3 times GDP (and not all this is UK specific). UK customers possess 3 times this again in assets at current market prices, i.e. one third at most is debt, probably only one quarter. Household savings in bank deposits alone are about one times GDP and this covers 80% roughly of loans to households. Therefore, the idea that UK households cash savings are perilously low based on reported annual 'savings ratios' is wrong, and wrong again when other savings are considered out of income i.e. pension, life, property equity net of mortgages and other private or personal assets. Taxing cash savings when expenditure is richly taxed and given recession circumstances is truly mad! Taxing unearned income (interest on cash savings and other) at source could be relieved and recovered in income tax returns is possible, but this gives non-doms a bonus.
Hence I prefer the idea of more money for the poor among whom in greatest number are poor state pensioners getting half of what state pensions were worth 50 years ago and almost half what French pensioners get for example. Rich pensioners are the fastest rising tax payer segment and pay more than enough to fund doubling of state pension to poor pensioners, whose net cost is low given that the poor spend domestically and can't save whatever they get.
Of course, household consumption is important to GDP, but too much attention is focused on the consumption side of GDP (a conservative choice) nd not on the output side of the same double-entry account. Output GDP is public and private earned income and profits. The ratio between earnings and profits varies over the cycle, but the total of the two has to equal public and private (households and businesses) consumption + fixed investment. Government counter-cyclical actions operate on both sides, but it should be fairly clear (before considering the external account, which is also very important) that action to maintain employment income is just as important or more important than consumer spending. If people save more in bank deposits or similar than they would spend at other times, this is merely a matter for the banks' transmission mechanism to extend more loans to productive industry and/or to buy and hold more gilts from new issues - something the Government is keen to enforce on banks in which it has shareholdings.
When household saving fell dramatically in the few years this coincided with 186% rise in house prices and fall in government borrowing. When sterling deposits at UK banks fell over a long period as a % of their assets this was also because of the international expansion of UK banks including wholesale business.
The media dogs, like Anatole Kaletsky recently in The Times, responding to the simple-minded statements by messrs Osborne and Cameron, and absurd questions about whether to tax household savings, have got their teeth on a meatless and hollow bone.

EUROPEAN EURO ZONE ECONOMY

2008-12-08T22:26:00.000-08:00

EU finance ministers have half-heartedly supported the broad terms of a proposed EU plan to fight off the ongoing recession, but removed references to the €200bn figure initially put forward by the European Commission. After early opposition, German Chancellor Angela Merkel pressed by UK and France moved to support a planned EU-wide stimulus package at a lower figure of €130bn. The 27 EU countries are tsked to give away 1% of their GDP to contribute to a Europe-wide economic stimulus package, including loans for automakers, to jump-start the economy and weather recession. MEPs are now working on a resolution to press European Council & European Commission to adopt EU bonds as an alternative financial resource to fund key European projects as part of the European Recovery Programme. "A quantum step needs to be taken to upgrade and adapt the structure of financial oversight in the EU," argues Karel Lannoo, CEO of the Centre for European Policy Studies (CEPS).
Recent comments by European Central Bank President Jean-Claude Trichet and EU Monetary Affairs Commissioner Joaquin Almunia at an economic committee of the European Parliament on Monday 8th December provide a concise summary of the condition of the European economy and monetary and fiscal policy settings. The EU's institutions have under ECOFIN direction given first priority to mitigating the financial sector crisis. Following the G20 Washington agreement and statement of tasks for building a new global financial & economic stability architecture around the IMF (for a new Bretton Woods system) and FSF (BIS's forum for financial regulators and standards bodies) on strengthening prudential regulation, the EU's Council of financial ministers (ECOFIN) stated that “…until financial stability has been fully restored, actions related to resolution and management of financial crisis remain the top priority within the EU”. Europe accounts for a third of the world economy and an even larger share of global financial services. It is not yet pulling its weight globally, ery much less so than the similar sized N.America. Critical to the EU's and member states responses are the actual economic performance of the Union and views on the main economic risk factors. Within the aggregate performance of the European economy there are distinct variations among member states. Hence, the Commission has temporarily relaxed the fiscal rules for budget settings (in ratio to GDP) allowing at least 8 members to breach the 3% ratio to GDP Maastricht ceiling on budget deficits. At the Community level the Commission is bringing forward spending plans and delivering a general GDP boost on top of the various actions of member states. For the Eurozone, the ECB has cut the central bank rate to 3%. Commissioner Joaquin Almunia reported, "Given the speed of change we want to deliver an up-to-date economic forecast on the 19th of January, which is when the Eurogroup will meet on the eve of the next Ecofin meeting, and of course member states should bear this in mind. They should be looking at the effectiveness and the degree of the fiscal stimulus packages adopted by member states... According to our estimates, we have an impact (from fiscal stimulus) in 2009 ... of 0.8 to 0.9% of GDP in the euro zone and member states of the EU... Eighteen member states have adopted fiscal plans more or less in line with the (European) Commission plan." This adds to fiscal stimulis at member state levels expected for 2009 ranging from 8% deficit spending by the UK to others more typically in the 2% to 5% range.
This amounts to a shift within the EU towards more 'endogenous growth impulse', which has a global importance, but also especially for non-EU Europe and Africa. The EU has an immense responsibility for its neighbouring states such as in he Mediterranean Area and its traditional economic hinterland including newly liberalised states in Central Europe, which are also 'economic partner' or 'accession states'. There is also concern for recent accession states, for example when Joaquin Almunia says, "Yes, it's possible that the (European) Commission may need to pay greater attention to the economies of the Baltic states. Particularly when they have difficulties like they have right now... If we are going to say that there is a region in Europe that really needs our attention, the attention of the economic services of the Commission ... it is precisely the Baltic region right now."
Jean-Claude Trichet, Governor of the ECB, with responsibility for Eurozone monetary policy (on top of actions by member states central banks) added to this by saying, "One of the consequences we are experiencing is that the capital has a tendency to go back to its headquarters. It's true at the global level ... it's true for all kinds of capital and it's true for the emerging world in general." This refers to the repatriation of investment funds from emerging markets back to Europe and especially to the USA, one reason for the strengthening dollar. The dollar's rise against the Euro is a major factor in the fall of the oil price on top of falling energy demand. The sharp fall in the oil price has reversed inflation expectations of only a few months ago when commodity prices rose sharply. The sensitivity of this is one reason why Trichet says, "I will not comment on the exchange market. As you know, we are in a floating exchange rate system." But, experts generally expect the dollar's rise to halt and reverse sometime during 2009, possibly before the US economy is expected to respond positively to an 8% fiscal stimulis by third or fourth quarter of 2009 and regain some positive GDP growth.
On monetary policy factors, Trichet commented, "It is true that all central banks are saying that their mandates ... are to deliver price stability... measured by the CPI. No central bank in the world would say they are targeting the asset prices, for a very large number of reasons. We do not think it would be reasonable to embark in this avenue. We have ourselves a concept of monetary policy based on two pillars: an economic analysis on the one hand and a monetary analysis on the other. The economic analysis looks very much like what you would do if you were an inflation-targeter. The monetary examination which is the strong tradition of the central banks that created the ECB ... drives you to take into account the evolution of credit, the fact that credit would gallop is something we would interpret as dangerous for price stability in the medium to lon term, and that has also an impact on asset inflation." There is of course a problem here insofar as different EU states have experienced sharply divergent domestic asset inflation, reflected in their GDP growth rates. Trichet does not explicitly prioritise the ECB's role and responsibility for financial sector stability or the current concern (underlined by G20) about 'pro-cyclicality' in bank lending i.e. banks amplifying the economic cycle by reducing credit to businesses and households in the downturn. He alludes to this implicitly by saying, "Financial institutions should avoid excessive short-termism in their behaviour." Trichet envisages Europe's self-confidence and global position as a relying on its effectiveness as a 'stability anchor', "We really trust ... that by being a solid anchor of stability, an anchor of confidence, by solidly anchoring expectations and particularly price stability in line with our definition ... then we are paving the way in various circumstances ... for the functioning, as smooth as possible, with the real economy behaving as well as possible." This is arguable, given the EU Eurozone's decade of low growth during the single-currency transition period and its weakness in these years in delivering a growth impulse to other countries in the European and African regions.
Five years after the Euro's introduction (in line with internal Commission economists' prediction) the Eurozone economy began a more positive growth recovery (much of it however merely export-led). Fastest growth in Europe was enjoyed by those economies that permitted large credit-boom endogenous growth impules, such as UK, Ireland, Spain and Greece. Asset bubble meltdown (and the financial crisis) has wiped out that difference. Italy, Ireland, UK and others are technically in recession - in Italy's case ironically because it was the least credit expansionery.
Low growth now is for different reasons. Trichet says, "Even without the financial crisis, we would have had a slowing down in the economy after long years of very active growth at the global level [though not long years in the Eurzone] and after the oil shocks that we had to cope with, and they had a very powerful depressive effect on every economy in the world." When the credit crunch worsened over the past two years the risks faced by banks looked like this graphic. In the next two years this pyramid will invert as economic and government aid become the dominant risk factors, possibly already the case. Europe's banks and finance sectors generally are proportionately fully impacted by the financial crisis. This is of course because finance is intensely globalised, beginning with globally interconnected capital and securities markets. Trichet says,
"I think what is very, very important is that we not only prevent the banking sector from very, very dramatic difficulties, which was the case clearly after September 15 [Lehmans bankruptcy], but that we permit as soon as possible a system to function on a more normal basis." September is also when stock markets began falling dramatically and credit ratings agencies downgrades of credit assets had fed more fully through to banks' balance sheets, and when recession was accepted as imminent for the EU. There is over a decade of history (political argument) concerning whether first the Commission, EBRD, and now ECB, should be allowed to delier fiscal boosts by issuing large amounts of bonds (backed by all member states). Trichet kicks this ball into touch by saying, "We are not ourselves in favour of issuing securities, treasuries that will be joint and several. We consider it is good that each particular state, each particular treasury has its own refinancing and has its own way of being on the market." But, this does not rule out short term treasury bills (maturity less than 1 year and hence 'off balance sheet'), "We have to permit the commercial banks to refinance themselves in an appropriate fashion, taking into account the tensions that we are still observing in general and (in the) money market in particular" and "We have also to protect the integrity of the ECB and the integrity of the institutions." This reflects the abiding concern of whether the ECB as a supra-national central bank can effectively support the integrity of the Euro, given that it can only do so via its Euro member national central banks. trichet said, "Each central bank in the world is doing what is deemed appropriate, taking everything into account... As regards the interbank rates, we were providing liquidity ... We have been extremely forthcoming in providing liquidity at fixed rates." Note that it is the Commission's direction that liquidity assistance to banks experiencing solvency risks should be at marginally penal rates conjoined with substantial balance sheet restructuring (i.e. asset reduction or deleveraging). "A large part of what we are doing in refinancing the commercial banks is designed to permit progressively to diminish those rates. And I would agree that they are too high on both sides of the Atlantic and both sides of the Channel and we are all doing what we can." Three month interbank funding remains stubbornly expensive (very wide spreads) indicating a very unbalanced (or or 'one-way') money market between lenders and borrowers, a lenders' market. Trichet sees the quarter on quarter recent falls in Eurozone GDP much due to this, to financial turbulence, not just commodity price inflation, "Turning to economic development, since September, there has been an intensification of and broadening of the financial turmoil contributing in the third quarter to a contraction of 0.2 percent in real GDP growth compared to the previous quarter." This remains the main problem now that, "Unexpected further declines in commodity prices could put downward pressure on inflation." But, like a good broker of 2-way signals, he adds, "while upside risks to price stability could materialise if the fall in commodity prices were to reverse", which is surely not imminent until after the dollar exchange rate should again show a trend fall.
On the world economy, he says, "Global weakness and very sluggish domestic demand can be expected to persist in the last quarter of 2008 and in the next few quarters. Subsequently, a recovery should gradually take place, supported by the fall in commodity prices and assuming that the external environment improves and financial tensions weaken. This outlook remains surrounded by exceptionally high uncertainty, risks ... lie on the downside." The controbersial aspect of his choice of words centres on 'external enironment' whereby Trichet appears wedded to looking for external not internal growth impulses. That is the dominating weakness of the (political) balance in the EU between fiscal and monetary policies. It is valid to ask 'what is the benefit and purpose of an enlarged EU into a major global economic bloc, a regional powerhouse, if it cannot deliver a substantial endogenous growth impulse just when the world most needs this?' This is a question that is holistic and for all EU institutions, not just the economic ones. Trichet ended his statement by returning to the core of the ECB's mandate, "With lower commodity prices and weakening demand, annual inflation is expected to be in line with price stability over the policy-relevant horizon." It is worth asking, given the G20 agreement and statement emphasising the importance on all of the world's financial sector to act counter-cyclically (or at least neutral and not pro-cyclically), and given Trichet's own warning that it is important for banks not to behave in short-termist ways, why this cannot be more explicitly applied by the ECB. Other financial authorities are asking the same pointed question?
The answer of course is that the ECB's hands are tied by its mandate and also by its lack of long term debt issuance capacity. ECOFIN and the Commission, in the light of the G20 aims and objectives, should actively consider adding to the ECB's aims and objectives and resourcing it appropriately, especially if the much vaunted new global financial stability architecture is to deliver for the long term, for all of the 21st century benefit. Europe risks the same approprobrium globally that once attached itself to Marie Antionette's reported quip "let them eat brioche!" Similar resource constraints limit what the European Commission can achieve. In the interest of pan-Euroepan equity, Lamafalussy Process (single market), and for righting imbalances across the EU, the central institutions of the EU should in some way be facilitated to deliver economic support closer to the scale possible in the USA. This has to be an ECOFIN policy decision, but is as fraught with political obstacles and practical problems as fishing policy. EU governments have so far pledged fiscal stimulus plans via Commission programmes worth only 0.8-0.9% of the bloc's GDP, below the level the Commission hoped for, an opinion clearly stated by EU Monetary Affairs Commissioner Joaquin Almunia. "It does make some progress but we do not reach the progress we hoped for," adding that 18 of 27 member states hae fiscal programmes to mitigate recession. This is on top of The Commission's proposal a month ago that the EU's overall fiscal boost schemes should be worth 1.5% of GDP, €200bn ($259bn)in a plan now backed by EU finance ministers.
Germany's coalition government is especially divided on whether or not to back proportionate fiscal measures. In some respects Germany's feet-dragging on this within the EU reflects the EU's external weakness. Possibly alluding to Germany, Almunia said some member states had been refusing significant fiscal boosts if these were to benefit other countries rather than only themselves. "I heard one (EU) minister saying he does not want a fiscal stimulus plan that would benefit others. I think he was missing the point," Almunia said. But, I would judge that the UK is also reluctant at the EU-level if only less so, even if UK officials joined the French in commenting that Germany is not making enough fiscal effort to overcome the economic downturn - a point underlined when Angela Merkel was not inited to a mini-summit in London yesterday with Manuel Barrosa. The UK (and Ireland), with half of the EU's banking assets, has less to gain economically and directly from EU fiscal stimuli compared to what it gains from fiscal measures in the USA. In the past, the UK stance was conjoined with Germany's in restricting growth in the Commission's financial resources. Now, Germany's continued stance merely undermines the UK's belief in the power of the EU to act decisively compared to the patently far more decisive action at much larger scale of the USA. UK's banking sector is very much more trans-atlantic than pan-European. But it nevertheless shares the same concerns as Europe, expressed by Almunia when he says European banks must soon start offering credit to companies and households at affordable rates or governments will alter the conditions under which they inject capital into the banks. This is a very imposing statement. "We need to put pressure on banks to continue lending to companies and households at affordable rates, this is what the capital injections and state guarantees were meant to achieve."
The European Commission approved France's bank rescue scheme yesterday (8 Dec) and said it expected similar deals with Germany, Austria and others in coming days, signalling an end to a weeks-long standoff. Denmark announced support for its banks to replace capital lost by the credit crunch, but without moves to nationalise any banks. Sweden said the new guidelines from the EU executive are insufficient. The new EU Competition Commissioner Neelie Kroes said she'd not compromised EU aid rules under political pressure, adding that France has tightened the terms under which banks must pay back aid and that Germany needs to make "minor changes" to secure approval for support to Commerzbank. "You will see that as far as state aid rules are concerned, no concessions have been made," she said. The Commission also expects soon to ease rules for state aid in general by raising the threshold under which it had to be notified of such schemes. The price exerted on banks for state aid is a hefty 8% on average, plus pressure for the early repayment of state capital and extra safeguards to ensure bank lending feeds into the real economy.
Commission approval puts an initial ceiling of €21bn on French bank aid. This is small, compared for example to Sweden's 1.5bn crowns ($182bn). Banks are encouraged to repay loans early as they face higher repayments from the second year. These are mutually conflicting conditions, and do not comply with the G20 ambition or that of financial regulators to dissuade banks from behaving pro-cyclically short term!

WARTIME RATES: MONETARY v. FISCAL

2008-12-07T23:24:00.000-08:00

I recall the satisfaction in Japan when the Yen/dollor exchange rate fell to 130, the rate before WWII. It did not stay there for long or mean anything historically. Today it is 93. The UK bank rate is today back where it was from June 1932 to November 1951 (except a couple of months in Autumn 1939, when it went to 4%). All the way from hungry thirties, global war against fascism, post-war Labour Government, then Churchill only defeating Attlee at the third attempt, rates stayed as low as they are today. If rates fall more - and some call for this and others expect it - UK monetary policy will be as never experienced since 1694. Some opinion-formers argue that a zero bank rate (a negative real rate until deflation catches up) is called for as an alternative to fiscal reflation (big increase in Government budget borrowing & spending). This is also called 'tax & spend' with the tax part merely postponed. A zero central bank rate will not be the case for interbank loans or for their customers. The debate generally assumes that businesses are happy to get cheaper money now and worry less about future tax than households do and that they also worry less about what they earn from cash deposits than personal savers do. Low bank rate is normally a filip to share prices via relatively higher dividends. But returns on equity are now already very high. The main argument is between those who prefer monetary responses (Monetarists) and those who prefer fiscal responses (Keynesians) by Government in a recession.
An ex-member of the Bank of England's MPC and FT columnist, Willem Buiter, urges all the main central banks to take their central lending rates to zero now. "If zero is the floor, there is no reason not to go there immediately... the recession in the US, the UK, the eurozone, Japan and the rest of Europe is, with probability verging on certainty, going to be so deep and so prolonged that the zero lower bound will be reached even by the most anal-retentive gradualist central bank before the middle of 2009. So why not get it over with in December 2008 and possibly do some good in the mean time?"
Bank rates briefly at wartime levels, but heading next to zero? A new financial architecture? Inflation may become deflation, with oil heading back to $25 a barrel from $147 at its peak. Most of us have never experienced this. Onlt those who remember the interwar years will know periods of falling prices.
Bank rate at zero doesn't exhaust the arsenal of monetary interventions by central banks, and will not do so if interbank lending remains at 200-400bp above. Even the experts urging zero now, like Professor Buiter, admit not knowing if it will make a substantive difference. Their hope is that this will "provide a major stimulus to financial intermediation and thus to aggregate demand. But even if it doesn't help, it certainly won't hurt," writes Buiter. It may not feed through to aggregate demand. It may help bring on observable price deflation - not good for pensioners and not good for savers who need income from cash savings. On the face of it, a period of falling prices sounds appealing, but not if you carry a debt burden, in which case income-inflation is better for reducing the relative value of the debt to income. Spare cash buys more now, but not if you save it. A sustained period of deflation leads consumers to put off spending decisions thinking to wait until each purchase gets even cheaper. Consumer Demand falls more than it is falling already, with self-evident drag on output & investment and adding to unemployment. Japan responded to the 1990 property and bank crashes with zero rates (negative in inflation terms)and endured over a decade of falling prices and stagnant domestic consumer demand. Even today the Japanese central rate is just 0.3%. Deflation is a genuine fear in the UK and other countries. Some argue that consumer prices, like house prices and other assets, have to periodically return to their long run trend. But, if our bank rate hits historic lows and approaches zero, how will this transmit through into the supply and pricing of secondary saving and lending and all the financials we experienced in more normal times. Bank customers want to know why banks are not passing on the rate cuts in full in pricing of loans, credit cards and mortgages that might make a difference to personal and small business survival or insolvency? Banking used to take in customers' deposits and lend out prudently to other customers plus obtain secured and unsecured wholesale money markets funding for making up shortfalls and to engage in investment trading. Secured borrowing has dried up except via the central banks, and unsecured borrowing is prohibitively expensive for the banks, demand greatly exceeding supply. As Eric Daniels CEO of Lloyds TSB says, "only around one-quarter of Lloyds TSB's balance sheet moves with the bank rate". And when banks needs to grow their deposits they have to build in sufficient interest amrgin to offer savers tangible rates. The biggest headache for the banks and central banks is how to get greater 2-way liquidity balance into inter-bank funding, Libor lending?
Given that banks are not lending to each other out of solvency fears and supply cannot or will not match demand, then it is hard to see what difference a zero rate will make? Governments will continue to push more capital into the markets by swapping illiquid bank assets for liquid treasury paper. But the interbank market remains unbalanced. Monetary responses therefore appear the lesser of the two choices between monetary and fiscal responses to recession.
Goovernment fiscal reflation by issuing bonds and boosts spending and incomes across the whole economy above what they would otherwise be. With low central interest rates, the price of already issued bonds is high (bearing % coupon from past higher rates), nut new issues will have very low coupons and may appear relatively cheap. Government therefore wants the banks to buy most of next year's several £100bn of bonds and apply them to higher capital reserves (keeping the bonds in effect as non-tradable, non-pledgeable), which may further constrain bank liquidity. The only hope is that reflation measures will put a floor under general confidence and as the prospect of economic recovery becomes imminent (by say end of 2009) then banks will gain more confidence in each other and in the value of each other's net assets? But, given that it may take another year or even two for banks to recover what they can out of loan losses and establish new reliable 'book values', we may have a painful wait before banks' wholesale funding returns to near normal. Hence, this is why Government has no choice but to arm-wrestle the banks into being kindly and soft-hearted about customers' repayment difficulties, and why Gordon Brown suddenly announced a not yet thought through policy of supporting distressed mortgagees for 3 years!