Monday, December 31, 2012

The Geithner Doctrine and the Credibility Trap

For those of you who were wondering, the Geithner Doctrine is the classic example of the Credibility Trap.

Under the Geithner Doctrine as stated by Yves Smith on NakedCapitalism,
Nothing must be done that will hurt the profits or reputation of any big that is pretty big or well-connected.
This doctrine is simply a restatement of the imperative of the Japanese Model for handling a bank solvency led financial crisis to protect bank book capital levels and banker bonuses at all cost.

Both the doctrine and the Japanese Model fall squarely into the Credibility Trap defined on JESSE'S CAFÉ AMÉRICAIN 
A credibility trap is a condition wherein the financial, political and informational functions of a society have been compromised by corruption and fraud, so that the leadership cannot effectively reform, or even honestly address, the problems ot that system without impairing and implicating, at least incidentally, a broad swath of the power structure, including themselves. 
The status quo tolerates the corruption and the fraud because they have profited at least indirectly from it, and would like to continue to do so. Even the impulse to reform within the power structure is susceptible to various forms of soft blackmail and coercion by the system that maintains and rewards. 
And so a failed policy and its support system become self-sustaining, long after it is seen by objective observers to have failed. In its failure it is counterproductive, and an impediment to recovery in the real economy. Admitting failure is not an option for the thought leaders who receive their power from that system. 
The continuity of the structural hierarchy must therefore be maintained at all costs, even to the point of becoming a painfully obvious hypocrisy. 
The Banks must be restrained, and the financial system reformed, with balance restored to the economy, before there can be any sustainable recovery."
Even before the Geithner Doctrine and the Japanese Model were adopted, it was clear that they would fail.  All one had to do was look at Japan since its financial crisis began in the late 1980s.

The only reason for adopting and pursuing the Geithner Doctrine and the Japanese Model is leadership ensnared in a credibility trap.

The question is will 2013 be the year that leadership breaks free of the credibility trap.

Banking industry's year of shame ends

A Guardian column by Heather Stewart and Jill Treanor highlights all the shameful activities that banks engaged in that came to light during 2012.

Included on the list is manipulating a benchmark interest rate, Libor, money laundering and mis-selling financial products like insurance and interest rate swaps.

By themselves, each of these activities is bad.  Together, these activities highlight the need for a radical cultural change not only at the banks, but at their regulators too.

The last time there was a need for such a radical cultural change was during the Great Depression.  What emerged to change the culture was the FDR Framework and a focus on ensuring that market participants had access to all the useful, relevant information in an appropriate, timely manner so they could independently assess and make a fully informed investment decision.

The reason for this focus is that it brings about a radical cultural change as sunlight is the best disinfectant.

What allowed the bank culture to slide back to where numerous parts of the banks were engaged in shameful activities was the re-emergence of opacity in the financial system.  Opacity re-emerged because regulators both failed to ensure transparency and encouraged its re-emergence.

For example, bank regulators jealously guard their monopoly on all the useful, relevant information in an appropriate, timely manner for each bank.  Regulators have access to each bank's exposures 24/7/365.

This is the data that market participants, including competitor banks, need if they are going to assess the risk and solvency of each bank and properly price their exposures to each bank.

In the 1930's, banks routinely disclosed this data as it was the sign of a bank that could stand on its own two feet.  By the 1980s, banks no longer made this disclosure.

The SEC failed in its responsibility to ensure that bank exposure data was made available to all market participants.  It did so with the blessing of the bank regulators.

By protecting their information monopoly, bank regulators enhanced their importance to a properly functioning financial system.  With the monopoly, bank regulators were relied on for analysis of the risk of each bank, communicating the risk of each bank to other market participants and disciplining the banks.

The financial crisis that began in 2007 revealed the wide path of destruction created by regulator driven opacity.  It is this opacity that let banks engage in manipulating Libor for example.

It is this regulatory driven opacity that also prevents the financial system from recovering.  Without transparency into each bank's current global asset, liability and off-balance sheet exposure details, market participants cannot assess the risk of each bank and whether it is solvent or not.

Experts back Deutsche whistleblowers

The Financial Times ran an article describing how experts back the whistleblowers' version of  how Deutsche's credit derivatives position should have been accounted for over how it was accounted for.

Regular readers know that the questions surrounding how the credit derivatives positions were accounted for highlight the need to require banks to provide ultra transparency.

By making the banks disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details, market participants aren't reliant on the bank's "accounting".  Rather, market participants can value the positions for themselves and determine the true financial condition of the bank.
Accounting experts say Deutsche Bank appears to have improperly accounted for billions of dollars of credit derivatives trades by failing to value adequately the risk that its trading counterparties could walk away. 
The Financial Times reported this month that US regulators were examining claims from three former Deutsche employees who have accused the bank of failing to recognise $4bn-$12bn in paper losses on complex derivatives, known as leveraged super seniors, with a notional value of $130bn. 
The trades involved Deutsche buying credit protection from investors on highly-rated corporate debt. When the financial crisis hit in 2007, the value of this insurance increased and Deutsche booked profits. But the complainants argue that it failed to properly account for the risk of its counterparties walking away from the trade rather than paying out on the insurance – known as “gap risk” – which rose along with the value of the insurance and could have led to big losses. 
Charles Mulford, accounting professor at Georgia Tech business school, said: “I believe that the gap risk should have been adjusted to market value – consistent with the views of the former employees,” adding: “One cannot mark-to-market the upside but not the downside.” 
The bank does not dispute that it booked profits by marking-to-market the protection but argues it did nothing wrong in not marking-to-market the gap risk. ... 

William Cohen: Fed policy more of a problem than fiscal cliff

In his Washington Post editorial, William Cohen looks at the Fed's monetary policies and concludes that they are more of a problem for the economy than the fiscal cliff.

Regular readers know that these policies are the result of the pursuit of the Japanese Model for handling a bank solvency led financial crisis.  Under the Japanese Model, bank book capital levels and banker bonuses are protected at all cost.

One of the ways to protect bank book capital levels and banker bonuses is to drop a bank's cost of funding to zero.  Since bank make money on the difference between what they charge to lend out their funds and what they pay for their funds, zero interest rate policies maximize their income.

This income is then divided.  First, it goes to pay banker bonuses.  Second, it goes to "build" bank book capital levels.  Third, it goes to pay dividends to shareholders.  Lastly, it goes to absorbing some of the losses still being hidden on and off the bank's balance sheet.

Maximizing bank income comes at a huge cost to the real economy.  Specifically, when the bank's cost of funds drops to zero, so too does the income earned by savers on their money.  Lost income that savers attempt to offset by cutting back on current consumption.

Savers cut back on current consumption rather than chase yield because they learned in the run-up to the financial crisis that this results in the loss of principal.  Savers have adopted Mark Twain's investment philosophy:  they are more concerned about the return "of" their money, than the return "on" their money.

The reduction in current consumption creates recessionary pressure on the real economy so long as zero interest rate and quantitative easing policies are being pursued (just look at Japan which has experience 2+ decades of economic slump).

In the short term, Washington lawmakers are understandably preoccupied with trying to avoid the “fiscal cliff.
But the decisions that are likely to affect the economy’s long-term health are happening not on Capitol Hill or at the White House, but at the Federal Reserve — specifically, Chairman Ben Bernanke’s policy of continuing to drive down long-term interest rates until unemployment hits 6.5 percent. 
This tactic, called quantitative easing, could remain in place for years. But is it helping the middle-class Americans who need it most? 
Unfortunately, the answer is no. 
Quantitative easing not only hurts older Americans on fixed incomes and those who have dutifully saved for retirement, it also frustrates younger people who can’t afford to take advantage of historically low mortgage interest rates
Mainly, Bernanke’s quantitative easing helps Wall Street’s banks and traders, a dynamic that could be setting us up for another financial crisis as investors again seek out higher-yielding, lower-quality investments that Wall Street is only too happy to provide....
The bad news is that the Bernanke policy is a most unwelcome tax on savers and the millions of older Americans who live on fixed incomes.... Savers and fixed-income investors are getting very little reward for their prudence and might be struggling financially, because as Bernanke forces interest rates lower, the amount their savings yield on a monthly basis dwindles, too.... 
So who benefits from the low interest rates on checking and savings accounts? The big, consumer-oriented banks such as Bank of America, Wells Fargo, JPMorgan Chase and Citigroup, all of which were bailed out by the federal government four years ago....  
Who else benefits from Bernanke’s creativity? A similar crew: Wall Street’s bankers and traders. The Fed’s policy means their profits and bonuses are higher than they would be otherwise. The bankers benefit because, with interest rates so low, they can reap huge fees by underwriting the explosion of corporate debt that their clients are eager to issue....  
Traders, meanwhile, know that Bernanke will be there to buy their Treasury securities or mortgage-backed securities — to the tune of that $85 billion a month. They can make a killing buying the securities in the market, for their clients or themselves, sure that when they are ready to sell, the Fed will buy them at the market price, which, thanks to the Fed chief, has been rising steadily....

For all the well-deserved plaudits Bernanke has gotten for being creative and for doing something while economic indecision reigns in the rest of Washington, his policies are badly hurting savers, benefitting Wall Street greatly and only marginally helping those people lucky enough to be able to get or refinance a mortgage. Worse, he may be the cause of another financial crisis long before we have fully recovered from the last one. 
No less a legendary bond authority than Bill Gross, the founder and co-chief investment officer of the investment firm Pimco, made a similar argument recently
The time is long overdue to take the morphine drip out of the debt markets’ arm and let interest rates be based on genuine supply and demand, not propped up because of a creative Fed policy. Otherwise, this is not going to end well.
And the only way to end the morphine drip is to adopt the Swedish Model and make the banks absorb the losses on the excess debt in the financial system.

Sunday, December 30, 2012

Merkel says eurozone sovereign debt crisis far from over

Reuters reports that in her New Year's address, German Chancellor Angela Merkel will say that the eurozone sovereign debt crisis is far from over.

Regular readers know this is true and that the sovereign debt crisis will remain far from over so long as the Germans continue to pursue and insist that the rest of the eurozone pursues the Japanese Model for handling a bank solvency led financial crisis.

Until such time as the banks do what they are designed to do and recognize all the losses on the excess debt in the financial system, the eurozone sovereign debt crisis will not end.

Modern banks, like those in the eurozone, are designed to continue operating with low or negative book capital levels because of the combination of deposit insurance and access to central bank funding. With deposit insurance, the taxpayers become the silent equity partner when the bank has low or negative book capital levels.

The euro zone sovereign debt crisis is far from over even though reform measures designed to address the roots of the problem are beginning to bear fruit, German Chancellor Angela Merkel has said in her New Year's address. 
Actually, the eurozone has yet to adopt a reform measure that addresses the roots of the problem.  The roots of the problem are opacity in the financial system and the related inability of market participants to figure out what is going on.
In a taped interview to be broadcast on Monday evening, Merkel urged Germans to be more patient even though the euro zone crisis has already dragged on for three years.
The Japanese have been patient for 2+ decades and have yet to see a positive result from pursuing the Japanese Model and protecting bank book capital levels and banker bonuses at all costs.

Perhaps it is not patience that is required, but rather a new approach.

Fortunately, there is another approach that has been successful at dealing with bank solvency led financial crises:  the Swedish Model.

Under the Swedish Model, banks are required to recognize upfront the losses on the excess debt in the financial system.  By not placing the burden of servicing this excess debt on the real economy, the Swedish Model protects the real economy and the social contract.
She drew a line linking German prosperity to a prosperous European Union.
"For our prosperity and our solidarity we need to strike the right balance," Merkel said. "The European sovereign debt crisis shows how important this balance is.
"The reforms that we've introduced are beginning to have an impact," she said. 
Yes, they have plunged Greece and Spain into a depression.  All the other eurozone countries that are adopting austerity are also seeing their recessions worsen.
"Nevertheless we need to have further continued patience. The crisis is far from over."
Merkel indirectly contradicted Finance Minister Wolfgang Schaeuble with those comments. In an interview on Friday in Bild newspaper Schaeuble said the worst of the crisis was over....
Mr. Schaeuble's comments were made after it was disclose by Der Spiegel that his ministry is looking at how to impose austerity on Germany as its tax revenue drops as a result of the deepening recession in the rest of the eurozone brought on by Germany's insistence on imposing the Japanese Model.

Rival to German Chancellor says austerity measures too severe

Reuters reports that a rival to Angela Merkel has said that the austerity measures being required of the eurozone peripheral countries are too severe.

Regular readers know that the austerity measures are the result of adopting the Japanese Model for handling a bank solvency led financial crisis and protecting bank book capital levels and banker bonuses at all costs.

By attacking austerity that has turned a recession into a depression in the eurozone peripheral countries, the rival has put the Chancellor in the position of having to defend the indefensible.

I call defending the Japanese Model and any of the policies that result from it indefensible because there is an alternative that has been shown to work everyplace it has been tried:  the Swedish Model.

Under the Swedish Model, banks are required to recognize upfront the losses on the excess debt in the financial system.  By recognizing the losses, the debt service associated with this excess debt is not placed on the real economy where it diverts capital from reinvestment and social programs.  This preserves the real economy and the social contract.

Former German Finance Minister Peer Steinbrueck, who is running against Chancellor Angela Merkel in next year's election, said austerity measures being imposed on struggling euro zone countries were too severe. 
In an interview with the Frankfurter Allgemeine Sonntagszeitung (FAS), Steinbrueck said austerity measures were pushing some countries to do too much too soon. He said there would be massive protests in Germany if such a heavy dose of austerity were to be imposed so quickly. 
"The savings measures are too severe, they're leading to depression," said Steinbrueck, 65, a Social Democrat (SPD) who was finance minister from 2005 to 2009 in Merkel's right-centre grand coalition government. 
"Some societies are being forced to their knees. Budget consolidation is in some ways like medicine. The right amount can save lives while too much can be lethal." 
Steinbrueck noted that some countries were being forced to make spending cuts that amounted to five percent of their gross domestic product (GDP). 
"In Germany that would amount to 150 billion euros (of spending to be cut)," Steinbrueck said. "You can imagine what the protests would be like on German streets with that." 

Issuance of debt by banks at lowest level in a decade

The Financial Times reports that issuance of debt by banks is at the lowest level in a decade.  Particularly hard hit has been unsecured bank lending.

Regular readers know that since the beginning of the financial crisis in 2007, market participants have been unable to determine which banks are solvent and which banks are not.  As a result, the unsecured bank debt market is effectively frozen and the secured bank debt market is slowly freezing over.

Bond issuance by banks is at its lowest level in a decade... 
Global debt issuance by banks stands at $1.26 trillion – the lowest since 2002 – according to figures from Dealogic, the data provider. 
The amount of senior unsecured debt, a mainstay of bank funding, is at its lowest since 2003. 
Issuance of covered bonds – debt secured against pools of loans that carries an additional bank guarantee – has also fallen, and the total raised via asset-backed securities continues to be a fraction of pre-subprime crisis levels....

Bankia's mom and pop investors turn to courts to get money back

Reuters reports that mom and pop Spanish investors have turned to the courts to get their money back based on Bankia having mis-represented an investment in its preferred stock as being covered by the Spanish deposit guarantee fund.

Retail investors have had to do this as the Spanish government has once again failed to protect them.

Spanish savers and pensioners who have seen their money wiped out by investing in state-rescued lender Bankia are likely to seek redress in court rather than wait for any official inquiry, which looks increasingly unlikely. 
About 350,000 stockholders will share the pain of the bank's European bailout, many of them bank clients who were sold the shares through an aggressive marketing campaign for its stock market flotation in 2011.... 
"Going to the courts and seeing if a judge can bring us justice is the only path left to us," said Maricarmen Olivares, whose parents lost 600,000 euros (490,509 pounds) they made from selling her father's car workshop by investing in Bankia preference shares. 
Neither of the two main political parties want to push for a full investigation into Bankia's demise, which could draw attention to their own role in a debacle that has driven Spain to the brink of an international rescue, commentators say. 
"Investigations work when a political party has something to gain over another. In this case, no-one has anything to gain," said Juan Carlos Rodriguez, of consultancy Analistas Socio Politicos. 
"I don't see the big parties investigating this because if there have been errors committed, they have been committed by both sides."
Please re-read the highlighted text again as it is not just the political parties in Spain that committed errors when it came to the nation's banking system, but also applies to the political parties in the other countries too.

For example, the Nyberg Report on the Irish Financial Crisis documented this occurred in Ireland.

The fact is that the rest of the countries in the Eurozone, the UK and the US were not immune to this problem and none of them has set up an investigation of the role of the political parties in the financial crisis.
The Socialist Party was in power when Bankia was formed in 2010 from an ill-matched combination of seven regional savings banks, a union that concentrated an unsustainable exposure to Spain's collapsed property sector. 
Immense political pressure from the then government forced Bankia executives to push ahead with an initial public offering in July 2011 as Spain sought to bring private capital into its banking system and avoid a European bailout. 
Then chairman, Rodrigo Rato, a former chief of the International Monetary Fund, had strong links to the centre-right Popular Party (PP) and was finance minister in a previous PP administration. 
A small political party, UPyD, forced the High Court in July to open an investigation into whether Rato, ousted when the bank was nationalised in May, and 32 other former board members are guilty of fraud, price-fixing or falsifying accounts....
 Oh what a tangled web we weave, when first we practice to deceive.
The probe centres around Bankia's stock market listing, the formation of the lender from the seven savings banks and the gaping capital shortfall revealed at the bank after the state takeover in May.... 
Bankia, alongside other Spanish banks, sold billions of euros of preference shares and subordinated debt to high street clients, many of whom say they were tricked into parting with their savings and are seeking compensation. 
The investigating magistrate is not including the mis-selling of preference shares - hybrid instruments that fall between a share and a bond - in the probe. 
Holders of preference shares at Bankia will incur losses of up to 46 percent as part of the European bailout, receiving shares rather than cash in exchange. 
"We won't see our money again, that's for sure. They'll give us shares, but shares with no value or credibility in a nationalised bank," said Olivares, who said she had heard nothing from the bank as to how much their losses would be. 
The losses each investor will have to take has yet to be decided, a Bankia spokesman said, adding that hybrid debt holders at all rescued banks had to take losses, not just at Bankia. 
A source close to the court investigation said there would certainly be scope for a separate wider probe into the mis-selling of preference shares, not just at Bankia, but throughout Spain's savings banks.
However, nobody seems to have started this court investigation.
Olivares, like many other small savers at Spain's state-rescued banks, claims her parents were sold the preference shares as a kind of high-interest savings account and that the bank staff did not explain the risks attached. 
The government is in the process of setting up an arbitration process to compensate Bankia clients who can prove that they were duped into buying preference shares, Economy Minister Luis de Guindos said last week.
I think the fundamental problem here is that all of the mom and pop investors trusted the bankers they were dealing with.  Why would they ever guess that their government would allow them to be sold an investment that put their money at risk in an insolvent bank without the bank being required to disclose it was insolvent?
But many ordinary Spaniards who lost their life savings through the Bankia rescue say this is not enough and they want answers as to what happened to their money. 
"We want justice, at least some kind of recognition that we were swindled," said Raimundo Guillen, a 50-year-old electricity station worker who put 30,000 euros in preference shares with Bankia under the impression they were a form of savings account.
"It's as if they've stolen your wallet - blatantly, with their face uncovered."

Unpaid local government bills yet another way bank bailouts hurt real economy

The Wall Street Journal ran an article describing how local governments in Spain and the rest of the eurozone peripheral countries have been delaying paying their bills and the negative ripple effects that these delays are causing for the real economy.

The reason why the local governments are delaying making payments is a combination of lower tax revenue and limited access to financial markets to borrow money.

Bailouts of the banks factor into this delay in making payments as money that is raised by a sovereign with limited borrowing capacity and used to bailout the banks is unavailable to be used to support local governments and help these governments to stay current on their bills.

While delaying paying their bills effectively gives the local governments a zero interest rate loan, the cost of this loan is absorbed by the firms that provide services to the local governments.  This cost reduces their earnings and hence the capital they have available for reinvestment, growth and hiring.
Nuria Jarque's company has maintained water-treatment plants in Spain for 25 years, but lately she is being forced to act like a lender of last resort. 
Local governments across the country, facing a steep drop in revenue and largely unable to borrow from banks or financial markets, have been paying Ms. Jarque and other suppliers of goods and services months behind schedule. 
Ms. Jarque says the delays amount to interest-free loans to fund government operations, and are pushing her company to the brink of bankruptcy. 
Thousands of companies are shouldering similar burdens as the financial woes of Spanish government bodies ripple across an economy amid its second recession in three years. 
By the end of October, regional governments had accumulated bills in 2012 for providers, interest payments and other obligations totaling €13.7 billion ($18.1 billion), more than 1% of Spain's gross domestic product, a government report found.
Suppliers are depleting their cash reserves, forgoing investments and postponing payments to their own providers. Many have dismissed workers, pushing up a national unemployment rate that exceeds 25%. A growing number are filing for bankruptcy—27% more through September of this year than in the same period in 2011, according to Spain's judiciary....
This is a direct consequence of the choice to bailout the banks rather than to focus resources on protecting the real economy and the Spanish citizens.
"Money is really, really tight, and the suppliers are having to bear it," said Ángel Saz Carranza, professor at ESADE Business School in Barcelona. "It is putting a further brake on economic activity." 
The central government has moved to cover some of the debts of local administrations, raising pressure on Spanish Prime Minister Mariano Rajoy to seek financial help from the European Union—a politically risky step. 
Overdue payments have long been a bigger problem in southern Europe than in the north. 
The debt crisis that has restricted lending to peripheral euro-zone governments is aggravating the problem, which is rising in Greece and Italy as well. 
Spain's crisis, set off by the collapse of a real estate boom nearly five years ago, is particularly acute in areas where declining revenue from real estate taxes pummeled municipal and regional finances.

Icelandic bankers jailed for pre-crisis activities

The Irish Independent reports that two Icelandic bankers have been sentenced to jail for their conduct leading up to the financial crisis.

Please note that this is two more bankers than the US has sent to jail for their pre-crisis conduct.

The reason that Iceland has been able to prosecute bankers for their pre-crisis behavior is that Iceland adopted the Swedish Model for handling a bank solvency led financial crisis.  Under this model, banks and bankers are not protected but instead banks are required to recognize upfront the losses on the excess debt in the financial system and bankers are held accountable for their conduct.

In the US, policy makers chose and continue to choose to pursue the Japanese Model for handling a bank solvency led financial crisis.  Under this model, bank book capital levels and bankers are protected at all costs.  Not only are the losses on and off the bank balance sheet socialized, but the bankers continue to draw bonuses.

Under the Japanese Model, bankers are protected from being accountable for their pre-crisis conduct while at the same time taxpayers and the real economy have to bear the burden of this conduct.
Two of Iceland's most senior former bankers have been jailed for making reckless business loans, following investigations stemming from the collapse of the country's banks in 2008. 
Larus Welding, the former chief executive officer of failed Icelandic bank Glitnir, and Gudmundur Hjaltason, a former director at the bank, have each been sentenced to nine months in jail for fraud, a court ruled. 
They were sentenced by the Reykjavik District Court after the two men were indicted a year ago on charges that they had "misused their position and grossly endangered the bank's funds" by lending €102m to a company called Milestone ehf without guarantees or collateral, the prosecutor said. At the time Milestone was a shareholder in the bank.

They are the first bankers from Iceland's three largest lenders to be sentenced to jail for activities linked to the country's financial and economic collapse in 2008.... 

Saturday, December 29, 2012

Why Japan's "Lost Decades" matter

In his post, Let's Cut the Crap about Japan's 'Lost Decade', Marshall Auerbach took on Stephen Mallaby's Financial Times column, Japan should scare the Eurozone, and cited a column by Steven Hill to show that Mr. Mallaby was wrong.

While each of these columns raises interesting points, they all miss out on something very fundamental to the Japanese experience.  Japan has an export oriented economy.

After their financial crisis, the Japanese economy essentially went sideways for over 2 decades while the rest of the world experienced tremendous economic growth.

This point needs to be repeated.  Despite being an export oriented economy, Japan's economy failed to keep pace with the economic growth experienced by the rest of the world.

Do you think this was because Japan Inc. suddenly stopped making attractive products or is this the result of not dealing with the bank solvency led financial crisis and kicking the can down the road?

Regular readers know that this is more likely the result of not dealing with the bank solvency led financial crisis and kicking the can down the road.  Your humble blogger refers to this as the Japanese Model.

Under this model, the burden of the excess debt in the financial system is placed on the real economy.  The result is that capital that is needed for reinvestment and growth is diverted to the unproductive use of debt service on the excess debt.

In addition, under this model, monetary policies like zero interest rates and quantitative easing are adopted.  These policies further deprive the real economy by starving it of demand and economic vitality as savers cut back on current consumption to offset the decline in their savings.

Looked at from this perspective that Japan's economy did not keep pace with the rest of the global economic expansion, there are plenty of lessons to be learned from Japan in how not to respond to a bank solvency led financial crisis.

Friday, December 28, 2012

High-speed trading lobby and its conflicted paid for research

The Wall Street Journal carried an article describing how the high-speed trading lobby is trying to fend off regulation using research it pays for.

This practice is routine for lobbyists as they use it to shape policy makers perceptions of the issues.  The banking industry has engaged in similar activities.
The chief executive of Knight Capital Group Inc. KCG told Congress in June that rapid-fire trading, the backbone of its business, is a boon to the overall stock market. He cited a study that cautioned regulators against unintended consequences of curbing the practice known as high-frequency trading. 
It was a 2010 study Knight itself had commissioned. Its lead author that year joined the board of a stock-exchange company that caters to high-speed traders and is partly owned by Knight. 
Less than two months after the Knight executive's testimony, Knight nearly imploded when computerized trades went haywire, costing it $461 million in losses. Last week, the hobbled firm agreed to a takeover. 
High-frequency trading firms are fighting to fend off regulation as scrutiny of their practice of unleashing blizzards of orders coincides with repeated technical glitches in the markets. 
As the firms work to convince policy makers their practices are benign or even beneficial, one of their primary tools has been research seeded by the industry itself, promoted by lobbying that has increased in recent years. 
Yet research conclusions presented as firm endorsements of high-frequency trading don't always square with reservations harbored by some researchers themselves, who question how far existing studies can go to pin down the effect rapid trading has on the overall market.
The studies have value but also shortcomings, says the researcher hired and quoted by Knight, James Angel, a finance professor at Georgetown University. "Not even the exchanges have all the data," Mr. Angel said in an email. "We see a big jumble and it is impossible to pick out the good from the bad."
Mr. Angel said Knight's payment didn't influence his conclusions. Knight's sponsorship was noted by the firm's CEO, Thomas Joyce, in his appearance before Congress in June, though not in written testimony ahead of the hearing that also quoted the Angel paper. A spokeswoman for Knight said the Jersey City, N.J., firm "supports research that helps foster a better understanding of market structure."
Other research that rapid-fire-trading firms have cited includes additional papers paid for by such firms and a study whose author was hoping to sell software to computerized traders.

Please re-read the highlighted text as it raises a number of interesting points.

First, it raises the issue of the need for transparency so that market participants, including academic researchers and regulators, have all the data and can pick out the good from the bad.

Second, it raises the issue of using the school's reputation to hide the fact that the research was paid for by the industry.  The researcher's credibility is directly linked to the reputation of the school the researcher works for.  However, the school is clearly not endorsing the outcome of the research.

Third, it raises the issue of using the school's reputation to hide the researcher's motivation.

In high-frequency trading, computers place thousands of buy and sell orders and instantly cancel many of them, having placed them just to test demand. Such trading has come to dominate U.S. stock markets, making up more than half of daily volume, and increasingly influences how currencies, commodities and other assets trade. 
It is at the center of a debate about the future of financial markets. 
Defenders say high-frequency trading keeps markets lubricated with a constant supply of buy and sell orders that enables all participants to trade more efficiently and get better pricing..... 
Critics, for their part, worry that the traders' order torrent makes markets more opaque, less stable and ultimately less fair.
The absence of data cited by the industry's own researcher strongly suggests the critics are right that high speed trading makes the markets more opaque, less stable and ultimately less fair.

Did losses on "London whale" trade succeed in defanging bank lobbying when financial crisis couldn't?

In his Wall Street Journal article, Scott Patterson lays out how the losses sustained by JP Morgan on its "London whale" trade effectively defanged the bank lobbying efforts when it came to implementation of the Volcker Rule.

Regular readers know that there are two elements to each rule:  what the rule says and how it is enforced.

Your humble blogger showed how this would work for the Volcker Rule.  The rule says that banks are not allowed to engage in proprietary trading.  This is enforced by requiring the banks to provide ultra transparency and disclose their current global asset, liability and off-balance sheet exposure details.  With this information, market participants could see if the bank were engaged in proprietary trading and exert discipline to stop this proprietary trading.

Compare this with the 200+ pages that is going to emerge from the bank regulatory complex and that bank examiners are suppose to enforce.  Enforcement which will be problematic because one of the cardinal rules of bank examiners is not to approve or disapprove of an exposure taken by a bank because this gets the bank examiners into allocating capital across the financial system.

Which rule and enforcement mechanism looks more likely to be successful in permanently ending proprietary trading by the banks?

The bank lobby already won when they ended up with a 200+ page rule from the bank regulatory complex.  What the "Whale" trade cost the banks is that it will be a little harder for them to engage in proprietary trading.
Wall Street banks entered 2012 confident they could stall a wave of rules that they feared would hurt profits. But they are ending the year largely resigned that their activities will be constrained and monitored more closely by the government. 
One big reason for the change: J.P. Morgan Chase & Co.'s "London whale" losses. 
The bad trades, ultimately resulting in about $6 billion in losses, disrupted the banks' campaign against the Dodd-Frank financial overhaul, according to regulators, lawmakers and close observers of policy debates in Washington. 
I find this a stunning statement for the simple reason that the banks blew up the financial system prior to the beginning of the financial crisis on August 9, 2007.

Apparently, the regulators tasked with writing the Volcker Rule forgot this and needed to be reminded by the losses on the London whale trade.
The trades damaged the reputation of J.P. Morgan, which suffered less than other banks from the financial crisis, and its chief executive, James Dimon, during a crucial period of policy debate in Washington, putting critics of Dodd-Frank on the defensive. 
Before news of the whale losses emerged, banks were arguing, with some success, that too-tight regulations were crimping lending during a time of slow growth....
And what exactly does banning proprietary trading have to do with crimping lending?

Ending the banks proprietary trading would in fact free up capital that could be used to support lending as the banks would be forced to shed the assets they bet on.
Perhaps the most significant fallout was on the "Volcker rule," which bans banks from making bets with their own money. While the final version of the Volcker rule hasn't been released, people with knowledge of the latest version said that it is likely to be more restrictive of bank's trading activities and might not allow broad hedging of bank portfolios.
Hello, it takes two paragraphs to both write the rule and its enforcement mechanism (see above).

Ordinary folks losing faith in stocks

A must read AP article (hat tip Zero Hedge) discusses how ordinary folks are losing faith in stocks because of a lack of trust.
Andrew Neitlich is the last person you'd expect to be rattled by the stock market. 
He once worked as a financial analyst picking stocks for a mutual fund. He has huddled with dozens of CEOs in his current career as an executive coach. During the dot-com crash 12 years ago, he kept his wits and did not sell. 
But he's selling now. 
"You have to trust your government. You have to trust other governments. You have to trust Wall Street," says Neitlich, 47. "And I don't trust any of these." 
Defying decades of investment history, ordinary Americans are selling stocks for a fifth year in a row. The selling has not let up despite unprecedented measures by the Federal Reserve to persuade people to buy and the come-hither allure of a levitating market. Stock prices have doubled from March 2009, their low point during the Great Recession.
The Baupost Group summarizes how the Fed's efforts to force people to buy riskier assets undermines trust.
Finally, we must question the morality of Fed programs that trick people (as if they were Pavlov's dogs) into behaviors that are adverse to their own long-term best interest.  
What kind of government entity cajoles savers to spend, when years of under-saving and over-spending have left the consumer in terrible shape? 
What kind of entity tricks its citizens into paying higher and higher prices to buy stocks? 
What kind of entity drives the return on retiree's savings to zero for seven years (2008-2015 and counting) in order to rescue poorly managed banks? 
Regular readers know that trust in our financial system is the result of transparency.

This is why transparency is at the heart of the FDR Framework and the government is given one simple responsibility:  ensure market participants have access to all the useful, relevant information in an appropriate, timely manner so they can independently assess this information and make a fully informed investment decision.

Market participants are willing to accept either a gain or loss on their investment decision because they "trust" the independent assessment they performed or had a third party perform.

The financial crisis that started on August 9, 2007 showed both opacity across wide parts of the financial system and the degree to which the government has failed to perform its responsibility of ensuring transparency.

Up until August 9, 2007, investors were willing to "trust" the independent assessment of third parties like rating agencies and the government when it came to structured finance securities and banks.  After August 9, 2007, investors knew that neither of these entities could be trusted to provide an accurate assessment.

From the AP article, the result of this opacity and the governments failure to ensure transparency is
"People don't trust the market anymore," says financial historian Charles Geisst of Manhattan College. He says a "crisis of confidence" similar to one after the Crash of 1929 will keep people away from stocks for a generation or more.
So the collapse in trust among ordinary folks was completely predictable.

In fact, they have been adopting Mark Twain's non-trusting view on investing:  more concerned about the return of their capital than the return on their capital.  Remember, ordinary folks understand that under the principle of caveat emptor (buyer beware), they are going to have to absorb any losses.

One of the entities that failed to ensure transparency was the Fed.  The Fed is responsible for regulation and supervision for the largest banks.  As the Bank of England's Andrew Haldane says of these banks, they are 'black boxes'.  Black boxes that leading up to the financial crisis the Fed insisted contained very little risk.

This is the same Fed that is now trying to force ordinary folks to take more risk by buying opaque securities that they don't trust.  And the Fed thinks this will work why?

Thursday, December 27, 2012

Are European bank debt funding models broken?

An IMF paper (hat tip The Big Picture) looks at the questions of are European bank debt funding models broken and, if so, how to fix them.

Regular readers know that the answer to these two questions are:  yes, the funding models are broken and fixing them requires the banks to provide ultra transparency and disclose their current global asset, liability and off-balance sheet exposure details.

European bank debt funding models rely to a significant extent on borrowing money in the wholesale unsecured bank debt market.  This funding model failed at the beginning of the financial crisis because nobody could determine which banks that were looking to borrow were solvent and which were not.

Market participants could not make this assessment because bank disclosure leaves them resembling, in the words of the Bank of England's Andrew Haldane, 'black boxes'.

The wholesale market is still struggling to unfreeze due to the lack of transparency.

Unfreezing the wholesale market and fixing the European bank funding models requires the banks provide ultra transparency.  With this data, market participants with funds to lend can assess the risk of banks looking to borrow and can price their exposure to the borrowing banks based on this assessment.

Not surprisingly, the IMF paper never looks at the cause of the European bank funding models failing, opacity, but rather throws out a long list of proposals, like holding more capital and liquid assets, that will do not address the problem of "is the bank solvent".

Surprise, big companies used 'enhanced relationship' to minimize taxes

A Reuters article describes how since the UK tax collectors adopted a policy of 'enhanced relationship' taxes from large corporations have fallen at the same time profits at these corporations have increased.

This is likely to be a coincidence as companies and their accountants have become far more aggressive in booking taxable profits in low tax countries.

However, it does highlight how companies have limited their focus on doing well by all their stakeholders to only doing well by one group of stakeholders:  management/investors.

In the not so distant past, management and Boards of Directors use to include the impact of their decisions on stakeholders like the countries they did business in.  It was thought that doing well by the broader set of stakeholders contributed to doing well by the company over the long run.

After all, it was shown by Henry Ford that it is good for business to pay your workers enough so they can buy the company's product.

Big companies in Britain now pay less tax than they did 12 years ago despite a big jump in profitability, a Reuters analysis of official data shows. Tax campaigners say the trend is the clearest signal yet that tax avoidance has blossomed under a more business-friendly strategy at the UK tax authority Her Majesty's Revenue and Customs (HMRC). 
Large companies' payments of corporation tax - the UK equivalent of corporate income tax - totalled 21 billion pounds ($34 billion) in 2011/12, HMRC data shows. That was down five billion pounds or 21 percent since 2000/01 when the government, then controlled by the Labour Party, took the first steps towards a more collaborative approach to big business. 
At the same time, the gross operating surplus for all companies in the UK - a widely watched measure of companies' profitability compiled by the Office of National Statistics - has risen 65 percent, to 329 billion pounds. The economy has grown by 55 percent over the same period, and receipts of both personal income tax and small companies' income tax are higher....

John Christensen of Tax Justice Network, a tax campaigning group, said the figures show successive governments' attempts to create a more business-friendly administration - which includes a policy known as "enhanced relationship" based on mutual trust - have encouraged companies to use such tactics....

Prem Sikka, a professor of accounting at Essex University who has written extensively about tax avoidance, said that even allowing for the tax cut, the figures were "paradoxical". 
"How are they managing to reconcile higher profits with lower taxes?" he said. "It can't be done ... unless they are booking these profits somewhere else." Companies reporting for tax purposes are increasingly diverting UK profits to lower-tax jurisdictions, he said.

Anya Schiffrin: describes the true cost of austerity in Spain

In a must read column, Anya Schiffrin lays bare the true cost of pursuing the Japanese Model for handling a bank solvency led financial crisis.  Under the Japanese Model, Spain is bailing out its banks and by extension the banks of other eurozone countries while at the same time subjecting it citizens to austerity.

Regular readers know that pursuing the Japanese Model is the wrong choice as it has failed 100% of the time.  Rather, governments should pursue the Swedish Model and require the banks to recognize upfront all the losses on the excess debt in the financial system.

Under the Swedish Model, the real economy and the social contract are protected as the capital needed for growth and reinvestment is not consumed in servicing the excess debt.
In his entertaining lectures at Columbia Business School, the economist Bruce Greenwald likes to employ cite the line often used by Warren Buffett: When the tide goes out, you can see who is not wearing a bathing suit. This is the feeling I have in Spain. 
In year five of the financial crisis, I can see which of my relatives and friends had no swimming trunks. 
The slow downward slide is horrendous for the people living it. Over and over we see the bewilderment of those who worked hard and paid taxes. They don’t understand why they are seeing their first-rate healthcare system being undermined, pensions and salaries cut, and their education system — still not up to par — being squeezed further, while being told they have to bail out the banks because that is what Germany insists on.... 
Please recall that Germany's interest is in seeing that its banks get bailed out of the bad investments that they made and not in the economic well-being of Spain.
In this harsh new world, many people are now irrelevant to the daily functioning of the economy. Architects, graphic designers, book jacket designers–-these kinds of professions now seem like a quaint memory. No one needs them, and the fear is that, if and when the economy recovers, many won’t be needed then. The few friends who have jobs live with the threat of layoffs and repeated pay cuts.... 
Those who did the “right thing” and are managing can be smug — until they realize there are many others who did the seemingly right thing who are suffering. 
The hollowing out of Spanish society continues. Anyone who can leave is doing so, and so Spain is losing the educated people it needs the most and who would be the basis of its future prosperity — if and when it does recover. The existence of a few bright spots does not mean that Spain’s economy is functional. 
In the past, life was full of vicissitudes. Farmers always had work to do, but droughts, collapsing prices, disease, floods could leave them destitute — no matter what they did or how hard they worked. Markets didn’t provide the insurance that would insulate them from these risks. 
As we moved from these primitive economies, the nature of risks changed. Now, it is individuals who face the prospect of no employment. 
Governments need to step in and provide the kind of social protection that people want and need. We can’t simply throw up our hands and say we accept a society in which the only people who get jobs are those with MBAs who speak five languages. 
When a few kids can’t get jobs, it’s not unreasonable to blame them:  They didn’t study hard enough, they chose the wrong subject, they haven’t searched hard enough for a job. 
When half of a country’s young people are unemployed, it’s no longer their fault. 
Let’s be clear. Spain’s economy is in terrible shape and the reckless and irresponsible path of austerity the government is pursuing — a kind of austerity that is especially hard on those who are down and out — is already leading to social and political tensions and constant strikes and demonstrations. After all these years, it is astonishing that the Partido Popular has not learned a thing.

Spain to wipeout Bankia's small investors

Having allowed Bankia to sell stock to small investors with little knowledge of finance, Spain is now taking the next step and effectively writing off their investment as part of recapitalizing Bankia.

Regular readers know that Bankia, which has about 10% of Spain's banking market, does not need to be bailed out and the small investors forced to lose virtually everything.

The reason that Bankia does not need to be bailed out is the combination of deposit insurance and access to central bank funding.  With deposit insurance, taxpayers have effectively become Bankia's silent equity partner while it is rebuilding its book capital from their current negative level.

Wiping out the small investors sends a really bad message.  The message is that the Spanish government cares more about protecting bank book capital levels and banker bonuses than it does about its citizens.

The bankers who mis-sold the stock were only forced to give back their bonuses for the year preceding the nationalization of Bankia.  The bankers got to keep their bonuses for the preceding years.

Fairness suggests that the bankers and members of the Board of Directors should have been required to return 100% of the bonuses and director fees they ever received from Bankia or its predecessor cajas.  It is bad enough that they get to keep their salary 'earned' while underwriting all the bad debt on Bankia's balance sheet.

As reported by Reuters,

Spanish lender Bankia will wipe out 350,000 shareholders, many of them small savers with little knowledge of financial markets, after it emerged it had a negative value of 4.2 billion euros ($5.6 billion). 
The measure, which will hit shareholders who were encouraged by aggressive marketing tactics to invest in the company, is seen as vital if the nationalised bank is to be refloated. 
A source close to the Bank of Spain said Bankia would receive 18 billion euros of European money by Friday and launch a capital increase in the first half of January when current shareholders will lose practically their entire investment. 
Under the European Union plan to prop up Spain's banking sector, shareholders must be the first in the queue to suffer losses. This has already been the case in Ireland where shareholders in Anglo Irish Bank were left with nothing. 
"Are we looking into leaving shareholders with something? Yes. How much? That's too soon to say. Will it be very little? For sure," said the source on condition of anonymity.
"But that will be purely symbolic. I can assure you they will lose up to the shirt on their back."...
Please note that under the European Union plan, unsecured debt holders are not second in the queue to suffer losses.

In fact, the unsecured debt holders, primarily banks in other parts of the eurozone, are protected from any losses.

Spain's government faced a choice between bailing out banks in other parts of the eurozone or protecting Spain's real economy and citizens.  Spain's government chose to bailout the banks and but the burden of the bad debt on the Spanish economy and taxpayers.

As shown by Ireland and Greece, this choice will only make the situation worse.
Another source with direct knowledge of the process said the final value of the shares would be close to nothing but that neither the Spanish government nor the bank wanted to send the message that Bankia's shareholders had lost it all. 
Hundreds of thousands of Spaniards, some retired people with no in-depth financial knowledge, invested their savings into Bankia shares when the bank was listed in July 2011. Shares have plummeted more than 80 percent since then. 
Some small savers, lured by aggressive marketing campaigns, also bought high-risk instruments, such as preference shares or subordinated debt, on which they will also suffer steep losses. 
Enrique Marquez, a 66-year-old retired technician, said he had invested 7,000 euros in shares and more than 70,000 euros in preference shares with Bankia. 
"The bank manager advised me to buy the shares. He told me it was interesting, that the staff were investing too and that it could be very profitable in the medium term," he said.
"It seems to be to have been managed extraordinarily badly. It is a total cock-up. I've been duped on the preference shares and I've been duped on the ordinary shares. It's been an abuse of trust."...
Your humble blogger predicted that Bankia would be unable to sell its shares in 2011 without providing ultra transparency and disclosing its current asset, liability and off-balance sheet exposure details.  I said this disclosure was necessary so that investors could assess the risk of Bankia.

My prediction was wrong when it came to small investors, but right when it came to institutional investors.  Small investors bought and institutional investors stayed away.

I had not factored in that the Spanish government would let Bankia abuse its position of trust and sell these shares to small investors who relied on the bank to make honest representations about its financial condition.

I had also not factored in that the Spanish regulators would not communicate an honest assessment of the bank's financial condition.  If the Spanish regulators did communicate that the bank was solvent, then the Spanish government has a moral obligation to bailout the small investors as these investors were also trusting the government.

Wednesday, December 26, 2012

Germany: the next victim of the Japanese Model as plans for austerity made

As reported by Der Spiegel, the German government is making plans to adopt austerity as it is about to fall victim of the Japanese Model for handling a bank solvency led financial crisis.

Under the Japanese Model, bank book capital levels and banker bonuses are protected at all costs.

What this means in practical terms is that rather than banks recognizing the losses on the excess debt in the financial system, the burden of the excess debt is placed on the real economy.  This diverts capital that is needed for growth and reinvestment to debt service and shrinks the real economy.

The German government has aggressively pursued implementation of the Japanese Model throughout the eurozone following the beginning of the financial crisis in 2007.  It has done so to protect the German banks who hold a significant amount of this excess debt.

Unfortunately, this policy has now caught up to Germany.

Germany has an export oriented economy.  With the rest of the eurozone mired in a Japan-style economic slump from the forced adoption of the Japanese Model, there is less demand for German goods.  The result is a decline in the German economy.

A decline that the German government is planning on making worse by adopting austerity.  By design, austerity reduces government funded demand in the economy.  This should hasten the pace at which German slides into a recession.

Of course, all of this is easily avoidable by adopting the Swedish Model and requiring the banks to recognize upfront their losses on all the excess debt in the financial system.

The question that Germany's government faces is whether it should protect its citizens or continue to protect banker bonuses.
The German government and opposition are pledging higher benefits for pensioners, families and the long-term unemployed ahead of elections next year, but Finance Minister Wolfgang Schäuble is secretly planning cutbacks to prepare for a weakening economy and possible fallout from the euro crisis. 
German Finance Minister Wolfgang Schäuble has an inimitable way of misleading his listeners with a torrent of obfuscating words. 
This torrent of obfuscating words is a useful skill to have in politics as it allows the speaker to say something that implies support of one idea when it fact the speaker is in complete opposition to the idea.
When asked if the Greek bailout would cost more money, he responded: "Not necessarily," adding that there was merely "a greater financial requirement on the timeline."
Of course, Greece is going to require more funds. Its debt has not yet be written down to a level that it can afford.
It could soon be a similar story with yet another gem from Schäuble's repertoire of quotations. "Germany is clearly a gainer from the euro," as the minister likes to say. But if what his team has been writing over the past few weeks is true, Germans will soon find that their presumed winnings have transformed into losses. 
The government in Berlin is living in a dual reality. Strategists in the center-right coaliton parties are planning to enhance benefits for families, pensioners and the long-term unemployed in a bid to woo voters in the upcoming elections. 
By contrast, due to the economic slowdown, experts in Schäuble's ministry are anticipating an entirely different scenario: The next government -- no matter who will be chancellor and which parties will be in power -- won't be able to boost spending. Instead, it will have to impose rigorous spending restraint.
Austerity comes to Germany.
According to the recommendations made by Schäuble's team, in order to brace itself for the consequences of the euro crisis, Germany will have to drastically increase taxes and make painful cuts in social services over the coming years.
Why?  To protect the banks and banker bonuses.
These ideas don't fit with the current political climate in Germany, which has been characterized for months by a passionate debate about how additional money could be used to combat poverty among the elderly and improve life for low-wage earners. 
Schäuble nevertheless feels that his experts' forecasts are realistic. He has expressly approved their proposals and ordered them to continue to work on the cost-cutting program....
A cost cutting program that will undermine the social contract in Germany in the same way that the social contract is being undermined across the eurozone and US.
The Germans face a bitter déjà vu. It was only 10 years ago that then-Chancellor Gerhard Schröder of the center-left Social Democrats (SPD) and his conservative challenger Edmund Stoiber fought an election campaign that was primarily focused on social justice. After Schröder's victory, it became clear that Germany was strapped for cash. 
Subsequently, the chancellor introduced his radical -- and widely unpopular -- "Agenda 2010" reforms of the labor market and welfare system. This time, Schäuble's team has calculated that even deeper cuts may be needed.
No matter how deep the cuts are they will be insufficient.  The real economy is unable to support all of the excess debt and continue to grow.
What the Finance Ministry officials have listed under the seemingly innocuous title "Medium-Term Budget Goals of the Federal Government" is nothing less than the most comprehensive austerity program in postwar German history. In order to avoid forcing the government to incur additional debt, the officials are scrutinizing subsidies, entitlements and welfare benefits worth tens of billions of euros.
There are also plans to raise taxes. ... 
Schäuble's team wants to slash €10 billion from the federal government's contributions to the German health fund, which currently helps to stabilize premiums in the statutory health insurance system. ... 
The plan also calls for state pension funds to do their part. ...
It still won't be enough and look at how massively the social contract is being rewritten rather than have the banks absorb the losses and protect the real economy as they are designed to do.

This is an important point.  All of the rewriting of the social contract is being caused by government policy makers refusing to have banks perform as designed.

Banks are designed to continue operating and supporting the real economy even when they have low or negative book capital levels.  Banks are able to do this because of the combination of deposit insurance and access to central bank funding.

When banks have low or negative book capital levels, through deposit insurance the taxpayers effectively become the banks' silent equity partners.  It is the existence of the silent equity partners that allow the banks to continue operating.

Of course, if the banks recognize the losses on the excess debt, this means that banker cash bonuses will be reduced until such time as the banks have managed to rebuild their book capital levels.
Widows and widowers would also have to tighten their belts. Currently, the surviving spouse receives 55 percent of the deceased spouse's pension. The idea is to significantly reduce this level in the future. This initiative would annually save billions of euros for the state pension fund.
And someone in the German government thinks this is better than requiring the banks to recognize their losses.  Unbelievable!
Finance Ministry officials see additional cutbacks in social services as unavoidable if the state is to spend more money in other areas, for example, on repairing roads and improving the education system. These investments would "entail stronger limitations on consumptive expenditure," as it says in the draft paper. 
Of course, there would be plenty of money for both social services and repairing roads and improving the education system if needed capital were not be diverting from the real economy to support excess debt that the banks should absorb the losses on.
The proposals from Schäuble's ministry serve to tighten a regulation that has only been enshrined in the German constitution for the past few years: the so-called debt brake, which calls for the German federal government to "maintain a nearly balanced budget" starting in 2016. 
The government will still be able to take out loans to some extent. In 2016, for instance, it will be allowed to borrow some €10 billion. However, Schäuble and his staff say that Germany should not completely exhaust this scope for borrowing. They want a safety buffer. 
"It is absolutely necessary to maintain sufficient distance to the constitutional limit during budget planning to prepare for unexpected structural expenditure and revenue developments," it says in the paper.
The debt brake is a paid idea on par with pursuing the Japanese Model despite overwhelming evidence that it doesn't work (see Japan and its lost 2+ decades).

Since the Great Depression, government programs under the social contract have been designed to expand, think unemployment insurance payments, when economies have downturns.  By definition, governments will not be able to run a nearly balanced budget during a recession as at the time the government social programs are expanding the tax revenue will drop.
The experts also note that they intend to safeguard the national budget against a series of risks. 
One of the examples that they cite is "a sharp economic downturn." If the economy collapses, as it did in the wake of the financial crisis in 2009, experience has shown that public coffers come under considerable pressure. Tax revenues decline while expenditures, such as for the unemployed, massively increase. 
This can have a devastating impact on state finances. Following the most recent recession, government debt soared from 65 to nearly 83 percent of gross domestic product (GDP). 
Schäuble's experts say that the country cannot withstand another similar increase in public debt and conclude that it's time to take appropriate countermeasures. 
To make matters worse, Finance Ministry officials say that it's also possible that Berlin will have to absorb the costs of its bank bailouts. 
At the height of the financial crisis, the German government supported ailing financial institutions such as Hypo Real Estate, Commerzbank and WestLB with capital injections and guarantees amounting to nearly €180 billion. Large quantities of toxic assets were transferred to so-called "bad banks." 
But it's questionable whether these banks will ever be able to completely pay back this money. If that is the case, the federal government will have to waive its claims and permanently absorb the debt.
Again, the solution lies in having the banks absorb the losses on all the bad debt.
Schäuble's team foresees the possibility of a similar development with the euro rescue. 
Indeed, "irrevocable ESM payment defaults" is one of the reasons they list for their contingency plans. Behind the bureaucratic jargon lies the concern that Germany -- despite the government's solemn statements to the contrary -- will have to pay for the euro rescue. 
Germany is currently supporting the European Stability Mechanism (ESM) to the tune of at least €190 billion. A portion of these guarantees and loans could actually be lost if Greece's government creditors forgive some of the country's debt. The losses to German public coffers could then easily amount to tens of billions of euros.
Again, push the losses back on to the banks that are designed to absorb it without putting the burden for paying for these losses on the taxpayers.
Consequently, Finance Ministry officials contend that the government will have to make cutbacks elsewhere in the future. Now, in a scenario that euroskeptics have long been warning about, German Chancellor Angela Merkel's government has finally admitted, for the first time, that to balance out the impact of the monetary crisis it will have to reduce expenditure for pensioners and people taking early retirement.
So pursuit of the Japanese Model and protecting bank book capital levels and banker bonuses has finally come back to haunt the German taxpayer.
The paper by the Finance Ministry officials contains a further admission. The next finance minister will have to make up for what Schäuble has failed to accomplish. 
Merkel's most important minister forced half of Europe to submit to austerity measures while the Germans were spending money hand over fist at home....
Correct, Germany pursued the Japanese Model when it should have been pursuing the Swedish Model and requiring the banks to absorb their losses.

Had the German government done so, the real economy would have been protected and with it all of the social programs.
And, in keeping with his style, he is carefully preparing the Germans for hard times with his signature inscrutable Schäuble-speak: "We cannot allow ourselves to believe that the current positive situation is automatically secured for the future," he says. 
He goes on to say that sound public finances are "not a notion created by stubborn finance ministers, but rather the prerequisite for prosperity and social security." In plain language: Germany is going to start subjecting itself to some iron fiscal discipline.
In short, rather than admit the mistake of pursuing the Japanese Model and adopting the Swedish Model, the German government would rather rewrite the social contract to the detriment of Germany's citizens.

Portugal to hold fire-sale of state assets

Under intense pressure from Germany and the Troika (IMF, ECB and European Commission), Portugal is about to engage in a fire-sale of its assets.

Regular readers know that this fire-sale will accomplish nothing positive for the citizens of Portugal.

When dealing with a bank solvency led financial crisis, the critical first step is to require the banks to absorb upfront all of the losses on the excess debt in the financial system.

By taking the first step under the Swedish Model, the link between bank book capital levels and sovereign debt is severed.  

At the same time, the sovereign can continue to guarantee bank deposits.  This allows the banks that are capable of generating earnings before banker bonuses to continue in business and rebuild their book capital levels.  Banks that cannot generate earnings must be resolved or merged into banks that can.

Without taking this first step, countries are tempted to bailout their banks.  This links bank book capital levels.

Even worse, it places the debt service burden of this excess debt on the real economy.  This creates a drag in the real economy since capital that is needed for growth and reinvestment is now being used for debt payments.

Your humble blogger observed that a fire-sale of the state's assets would accomplish nothing positive because it is simply generating capital that will be consumed by the debt service burden of the excess debt.

As reported by the Guardian,
Portugal is to embark on a sweeping fire-sale of state companies over the coming months, possibly even privatising state broadcaster RTP, as it bends to the will of the troika of lenders that bailed it out 20 months ago. 
With the government of prime minister Pedro Passos Coelho hoping to persuade the troika of the European commission, the European Central Bank and the International Monetary Fund to treat it more leniently in 2013 by lowering interest rates on loans, the sell-off of national companies is seen as one way of winning support....
The lesson from Ireland is not to expect more lenient treatment.

The bailout exercise is all about extracting as much from the country and its taxpayers as possible so as to minimize bank losses and preserve banker bonuses.
The troika has told Portugal to sell €5bn of state companies as part of the deal which saw it receive a €78bn bailout in May 2011. But it looks set to beat that target thanks mainly to sell-offs in the electricity sector and in airports.... 
Under the bailout plans, Portugal is due to return to bond markets in 2013. Its borrowing costs have tumbled in recent months, with 10-year bond yields finally falling back to pre-bailout levels of below 7% shortly before Christmas. A successful return to the markets would be seen as a sign that the euro crisis was finally being solved.
The euro crisis is far from being solved.

For example, Portugal is mired in a deep recession.  Who would buy its debt when both the tax base and asset base is shrinking?
Passos Coelho's government hopes that the troika, which recently eased lending conditions to Greece, might do the same with Portugal – lowering interest payments and making it easier to cut the budget deficit. Portugal's debt is expected to reach 120% of GDP this year and it currently pays 3.6% interest on troika loans. 
Germany has already said it opposes a softening of the bailout loan terms, with its finance minister, Wolfgang Schäuble, saying that would look as though Portugal was unable to meet targets. "It would be a devastating signal and I would really advise them not to pursue this point any further," he said. 
The government should take this to heart and stop bailing out its banks and selling its state assets.

Instead, the government should require its banks to take the first step towards ending the financial crisis and recognize their losses.
Portugal's economy shrank by 3% this year and the country has lost almost 6% of GDP since the credit crunch of 2007.

Quantifying the harm done by quantitative easing

In an interesting Business Insider article, Mike Norman quantifies the harm done by quantitative easing by comparing the net increase in salaries since 2008 to the private sector's lost interest income since 2008.  He finds the loss of interest income is greater than the gain in salaries.

This finding is not surprising.

As their interest income declines, savers offset this decline by cutting back on current consumption.  As current consumption declines, demand declines.  As demand declines, businesses cut back on hiring and salary increases.

The Fed, having locked itself into the pursuit of quantitative easing, continues to purchase interest bearing securities.  This puts more cash into the financial system and further reduces private sector interest earnings.

In turn, savers offset this decline by cutting back on current consumption...

Of course, the Fed could stop pursuing destructive monetary policies like zero interest rates and quantitative easing.  This would imply that the Fed was capable of following Walter Bagehot's rule to never lower interest rates below 2%.  Mr. Bagehot is an authority on modern central banking having invented it in the 1870s.

Every time the Fed announces another round of QE we hear the "know-nothings" in the media, on Wall Street and in the mainstream economics community tell us that we're getting more stimulus....
For as the chart below clearly shows, the Fed actions have removed an enormous amount of interest income from the economy. In fact, it has removed over $100 bln more in interest income than the total net gain in private wages and salaries since it began undertaking these extraordinary measures.... 
So while the net change in wages and salaries since 2008 has been an increase of $317 bln, personal interest income dropped by $425 bln. That's not a stimulus by any means. It's mind boggling that the mainstream economics community and the Fed itself, doesn't understand this when they incessantly call for more "stimulus."

Tuesday, December 25, 2012

Nassim Taleb's anti-fragile system is the FDR Framework

In his NY Times editorial, Nassim Taleb calls for
an antifragile system — one in which mistakes don’t ricochet throughout the economy, but can instead be used to fuel growth. The key elements to such a system are decentralization of decision making and ensuring that all economic and political actors have some “skin in the game.”
Regular readers know that the FDR Framework is an anti-fragile system.

The FDR Framework combines the philosophy of disclosure with the principle of caveat emptor (buyer beware).  This combination promotes decentralized decision making and ensures that market participants have 'skin in the game'.

How does the FDR Framework do this?

Please recall the under the FDR Framework, governments are responsible for ensuring that market participants have access to all the useful, relevant information in an appropriate, timely manner so they can independently assess this information and make a fully informed investment decision.

Each market participant under the principle of caveat emptor has an incentive to assess the disclosed information as they have skin in the game because they are responsible for all gains and losses on their exposures.

This skin in the game builds robustness into the system as each market participant restricts their exposures to what they can afford to lose given the risk of each exposure.

Back to Mr. Taleb.

First, in a decentralized system, errors are by nature smaller....
It’s a myth that centralization and size bring “efficiency.” Centralized states are deficit-prone precisely because they tend to be gamed by lobbyists and large corporations, which increase their size in order to get the protection of bailouts. No large company should ever be bailed out; it creates a moral hazard. 
Consider the difference between Silicon Valley entrepreneurs, who are taught to “fail early and often,” and large corporations that leech off governments and demand bailouts when they’re in trouble on the pretext that they are too big to fail. Entrepreneurs don’t ask for bailouts, and their failures do not destabilize the economy as a whole. 
Second, there must be skin in the game across the board, so that nobody can inflict harm on others without first harming himself. Bankers got rich — and are still rich — from transferring risk to taxpayers (and we still haven’t seen clawbacks of executive pay at companies that were bailed out). 
Likewise, Washington bureaucrats haven’t been exposed to punishment for their errors, whereas officials at the municipal level often have to face the wrath of voters (and neighbors) who are affected by their mistakes. 
If we want our economy not to be merely resilient, but to flourish, we must strive for antifragility. It is the difference between something that breaks severely after a policy error, and something that thrives from such mistakes. Since we cannot stop making mistakes and prediction errors, let us make sure their impact is limited and localized, and can in the long term help ensure our prosperity and growth.
In short, we need to adhere to the FDR Framework and ensure that transparency is brought to all the opaque corners of the financial system.