ABS Problem and solution?

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?

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

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

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!

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?

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."