Tuesday, April 30, 2013

A toxic mix: Dodgy academic papers, agenda pushing press and politicians, and willing believers

In his Guardian column, Aditya Chakrabortty examines the lessons to be learned from trusting political solutions masquerading as economic laws.

Dodgy research pushed by publicity-happy academics. False claims burnished into golden truths by irresponsible newspapers, apparently trying their hardest to manufacture a panic. Finally, the repercussions: bad decisions and, years later, huge worries about the harm posed to the public.... 
Over the past fortnight, an academic paper regularly used by George Osborne to justify his cuts, public-sector redundancies and tax hikes has also been exposed as riddled with errors and dubious statistics.... 
there was Carmen Reinhart and Ken Rogoff, two Harvard economists of great renown – but hardly box-office. ... Reinhart and Rogoff are guilty of no such breaches and their book on banking crises, This Time Is Different, will be considered a classic. ... 
At the root of both sagas lies research, heavily contested then and now discredited, but given excessive credibility by outsiders in politics or the press – and used to push distinct agendas. ... Combined, we could call these lessons: how to flog a terrible idea. 
Lesson 1: Have a suspicious public 
For a terrible idea to take flight, the public must be in a receptive mood. ... The arguments over austerity followed on the great bust of 2007-8 – and hadn't then-prime minister Gordon Brown promised to abolish boom and bust? 
In both cases, the press had been gulled by the official expertise. Do you remember those spreads in the Daily Mail about the coming chaos at RBS? No, I don't either. 
Lesson 2: Bad ideas sound like common sense 
The press had trusted establishment scientists and the economic technocrats; by the time MMR and the banking bust came along there was a market for policies that sounded easy to understand. So David Cameron really could get away likening the British economy to a household that had maxed out its credit card. It was nonsense, of course, but it was easy to understand nonsense. Unlike Bloomsbury-style Keynesianism, which was much more sensible amid a slump but was treated as far-out science to do with money supplies and fiscal multipliers. ...
Lesson 3: Bad ideas need strong supporters 
That goes much more so for austerity, where the government here and the European troika used available research to push the cause of cuts and lay-offs. The Reinhart-Rogoff paper was published two years after Osborne had adopted austerity as his policy; academia provided justification, but they didn't change minds. And austerity has been fully cloaked in the language of morality: of debt being a bad thing, of southern Europeans being feckless. 
The final caveat is: pure science lays much more emphasis on reproducing tests to see if the results bear up; macroeconomists can't run big experiments on entire countries to see which policies work, meaning that fights in the dismal science are necessarily more ideological (however disguised) than methodological. 
Yet so many economists hanker after hard science status there's even a term for it: "physics envy". Indeed, that key finding from Reinhart-Rogoff – that countries with debt of more than 90% of their GDP experience sharply slower growth – sounds like something you'd hear at the back of a school lab. But it isn't a rule at all: high debt can mean slow growth, but obviously so too can slow growth produce high debt. 
Still, whether MMR or austerity, the bottom line in both is that plausible science can make bad decisions seem sensible. When the science no longer seems implausible, the game is up. Wakefield was rumbled; slowly but surely the same is happening to the austerity-mongers.

Monday, April 29, 2013

In place of austerity, what comes next?

In his Wall Street Journal Heard on the Street column, Simon Nixon looks at the question of "in place of austerity, what comes next?"

The simple answer to Mr. Nixon's question is the combination of the Swedish Model with fiscal stimulus and an end to monetary policies like zero interest rates and quantitative easing.

Regular readers know that a modern banking system is designed to absorb the losses on the excess debt in the financial system.  Under the Swedish Model, banks are required to perform the role for which they are designed.

Specifically, banks recognize upfront the losses on the excess debt.  Each borrower's debt is reduced to a level where the borrower can afford to make the debt service payments.  At the same time, the write-down is limited so that it does not create any equity for the borrower.

With the banks absorbing the losses on the excess debt, the burden of servicing this debt is removed from the real economy.  Capital that is needed for growth, reinvestment and supporting the social contract is no longer diverted to debt service.  As a result, the real economy begins to grow again.

To boost the recovery in the real economy, there should be some fiscal stimulus.

To further boost the recovery in the real economy, monetary policy must be changed to eliminate all the economic headwinds that it is currently creating.  These economic headwinds were triggered by reducing interest rates below Walter Bagehot's minimum threshold of 2% and include for example the Retirement Fund Death Spiral.

Collapse in trust that politicians and their experts can restore economy and living standards

It has taken almost 6 years, but we have finally arrived at the point where there has been a collapse in trust that the politicians and their experts can restore the economy and return people's living standards to  before the financial crisis.

This is a watershed moment as it sends the unambiguous message that the vast majority of people recognize the response to the financial crisis is a complete failure.

It is not surprising that the vast majority of people would feel this way as the response was designed to protect bank book capital levels and banker bonuses and shift the damage from excess debt in the financial system onto them.

As reported by the Guardian,

Most voters, but especially coalition supporters, have lost faith in the ability of swift government action to restore living standards to the levels seen before the banking crash. 
A belief in whether government has the power, let alone the policies, to restore living standards also appears to be one of the issues that most determines which party voters will back....

Such is the pessimism among poorer voters that one in three earning less than £20,000 a year do not believe a recovery would help their living standards, although that figure falls to a fifth among only a fifth of richer voters.... 
Gavin Kelly, chief executive of the Resolution Foundation, said: "Despite the stagnation of recent years, including in the period prior to the recession, the majority of people still think that with the right policies growth will translate into steadily rising living standards. 
"They want their share of the future gains from growth. However, a large minority appear to have lost faith in this belief, which is concerning, given that the legitimacy of our economy rests on it."

Sunday, April 28, 2013

Paul Krugman explains how academics from well-known universities effect policy response to financial crisis

In his NY Times blog, Professor Paul Krugman does a great job of explaining how academics from well-known universities have influenced the debate on how to end our current bank solvency led financial crisis.

Regular readers know that your humble blogger thinks their biggest contribution is to crowd out discussion of alternatives to end the financial crisis.

Professor Krugman explains how this crowding out mechanism works with Reinhart/Rogoff and austerity.

But before looking at his post, I would like readers to ask themselves one question: why were these or any academics listened to in the first place?

There are two reasons:
  1. The reputation of the institution that they work at; and
  2. The idea that a professor at one of these institutions in finance or economics would actually have some idea what they are talking about.
Between Reinhart/Rogoff's error filled paper supporting austerity and the finance and economics professions' failure to loudly warn let alone predict the financial crisis, it is clear that the idea finance or economics professors know what they are talking about isn't true.

Reinhart/Rogoff's paper confirmed that when it comes to peer reviewed papers in finance and economics there effectively is no minimum hurdle or standard they have to get over to get published.  So any fundamentally flawed idea can be published.

Regular readers first encountered this with Yale Professor Gary Gorton using bank demand deposits as an example to illustrate his concept of informationally insensitive debt (hint: deposit insurance is information as any 6-year old opening a bank account can tell you).

Reinhart/Rogoff's paper also confirmed Cullen Roche's observation that every single school of economics exists to promote a political agenda.  In this case, the authors were well paid shills for the austerity agenda.

One other point before I return to Professor Krugman's blog.  The reputation of the institutions acts to magnify the importance of what these professors say.  Do you think the austerity agenda would frequently cite the work of a junior college professor or a random blogger?

No!  Policymakers who are predisposed to these fundamentally flawed ideas want to wrap themselves in the mantle of the institution's reputation.  If a Harvard professor says its so, well then....

Let me return to Professor Krugman's blog, but let me show how the call for banks to hold more capital is simply a repeat of the call for austerity as it is based on a similarly ill-conceived idea.  
Robert Samuelson tries to minimize the significance of the Reinhart-Rogoff affair; and that, I realized, offers an interesting window into why, in fact, the affair matters so much. 
Samuelson starts by excusing R-R on the grounds that the economic crisis predates their blooper... 
But while R-R obviously had nothing to do with the start of the crisis, the question is how they played into the response. For the remarkable thing about this ongoing slump isn’t so much that we had a financial crisis as the fact that we responded to it, not by applying what macroeconomists thought they had learned, but by repeating all the policy errors of the 1930s....
The same argument could be made about bank capital.

Everyone knows that bank capital is an easily manipulated accounting construct.

Banks can manipulate it by how they reserve for bad debt.  Regulators can manipulate it through regulatory forbearance and allowing banks to use 'extend and pretend' to turn bad debt into zombie loans.  Politicians can manipulate it by pressuring accountants to suspend mark-to-market accounting for opaque, toxic structured finance securities.

Everyone knows that more capital does not mean a bank is safer.

What makes a bank more or less risky is the risk of its on and off balance sheet exposures.

Everyone knows that more capital does not mean a bank is solvent.

Since the beginning of the financial crisis, there have been numerous banks that have shown high capital ratios and been nationalized shortly after passing a solvency focused regulatory stress test.  A prime example of this being Dexia.

Finally, everyone knows that calling for more capital when the banks are hiding massive losses is counter-productive.  The banks need to recognize their losses upfront and then rebuild their book capital.  Recognizing losses first means that banks don't pay the bankers cash bonuses until the bank book capital levels are rebuilt.

By putting increasing book capital ahead of recognizing losses, not only do bankers get paid their cash bonuses, but increasing book capital levels takes precedent over recognizing losses on the bad debt.  The result of this is to repeat Japan's experience and end up with Japan-style economic malaise.
Still, R-R can’t have mattered here, says Samuelson, because politicians were going to do what they were going to do regardless....
Maybe politicians are going to do what they are going to do regardless, however, academics promoting fundamentally flawed ideas are giving them intellectual cover.

For example, let's look at who is championing the idea that banks need to hold more capital.  At the head of the cue we find former and current regulators.  Individuals who had a responsibility for acting before the financial crisis, but failed to take the steps necessary to prevent the financial crisis.
Standard academic obscurity? Reinhart-Rogoff instantly became famous. Reinhart gave star testimony to the Senate Budget Committee on Feb. 9, 2010; the paper was cited everywhere in the spring of 2010.
Sounds a lot like a book written on the need for banks to hold more capital.
OK, so what is the real story here? Austerity policies would probably have proceeded without Reinhart-Rogoff ... But the paper certainly helped sell the policies. 
And anyway, the important story isn’t about the sins of the economists; it’s about our warped economic discourse, in which important people seize on academic work that fits their preconceptions.
Please re-read the highlighted text as Professor Krugman makes an extremely important point about how these professors are warping the economic discourse.  I call this crowding out.

Had these professors not offered their fundamentally flawed ideas, the discussion could have focused on solutions that would have ended our current financial crisis (the Swedish Model) and prevented a future crisis (transparency).
Even if you don’t think Reinhart-Rogoff made much difference to actual policy, the meteoric rise and catastrophic fall of their reputation speaks volumes about why this slump goes on and on.
The slump goes on and on because the academic community continues to provide intellectual cover to policy makers' worse instincts. 

The difficulty in buying shares in any bank today

In a column discussing the possibility of the UK government selling its shares in RBS and Lloyds, the Guardian summarized why investors should not buy shares in any bank today.
But there are plenty of reasons to be cautious about buying bank shares – even when, compared with the value of banks' assets, they appear to be cheap. 
The market values banks at around half the value of their assets – and probably quite correctly, given that the regulators themselves are concerned about unexploded bombs on their balance sheets.
The Guardian focuses on the simple fact that investors do not know what exposures a bank has on or off its balance sheet.  

Without knowing what these exposures are, investing in a bank is nothing more than gambling on the contents of a 'black box'.

A not very attractive gamble as the regulators, who are in a position to evaluate the contents of the black box bank, "are concerned about unexploded bombs".

Saturday, April 27, 2013

One area where banks compete

Kipper Williams' Guardian cartoon on competition in the banking industry.


Icelanders questioning myth of post-crisis success

A Bloomberg article looks at Icelanders questioning the success of their policies for handling the financial crisis.  This dissatisfaction highlights the need to implement the Swedish Model correctly.

Regular readers will recall that Iceland adopted the Swedish Model and required its banks to recognize upfront the losses on the excess debt in the financial system.  These losses were determined by balancing what a borrower could afford to pay and ensuring that the debt write-down did not create equity for the borrower.

Initially, this implementation of the Swedish Model produced the desired results.  The real economy and social contract were protected.  This was shown in the resumption of economic growth.

However, there was one major flaw in Iceland's implementation of the Swedish Model.  This flaw was the failure to deal with the simple fact that the majority of Iceland's mortgages are linked to inflation.

On the one hand, government policy attempted to reduce the mortgages to what the borrowers could afford to pay.  On the other hand, inflation from devaluation of Iceland's currency made the mortgages unaffordable again.

Iceland is once again looking at making the banks take losses.

This time it needs to make all mortgages that are written-down fixed rate mortgages.

Friday, April 26, 2013

Brown-Vitter highlights failure of Dodd-Frank Act

Whether you approve or disapprove of the proposal by Senators Brown and Vitter to require big banks to hold more capital, this proposal offers confirmation that the Dodd-Frank Act has failed.

Dodd-Frank has failed because it is not seen outside of Washington DC and the financial regulatory community as actually making the US financial system safer.

Regular readers know that your humble blogger has been saying since Day 1 that there are only two elements of Dodd-Frank worth saving, the Consumer Financial Protection Bureau and the Volcker Rule.  The rest should be repealed.

Dodd-Frank is based on the fundamentally flawed premise of "we should give the financial regulators who failed to prevent the current financial crisis another chance to prevent a future financial crisis".

Why?  Especially since the financial regulators have already shown themselves by not preventing the current crisis to be up to the task.

The upside of giving the financial regulators another chance is that they succeed in preventing the next financial crisis.

The downside of giving the financial regulators another chance is that they fail.

If they fail, who pays for their failure?

Are the Senators and Congressmen who drafted and voted for Dodd-Frank first in line with all of their net worth to pay?  Is the President who signed Dodd-Frank into law first in line with all of his net worth to pay?  Are the financial regulators who are suppose to have prevented the financial crisis first in line with all of their net worth to pay?

No.  It is the taxpayers who pay when the financial regulators fail.  I say "when" because the financial regulators have already shown they are prone to failure.  It is only a question of time.

And it is the knowledge that the financial regulators will fail that drives individuals like Senators Brown and Vitter to propose legislation that attempts to protect the taxpayers from the failure of the financial regulators.

The Senators hope by putting more capital into the financial system this capital rather than the taxpayers' money will be used to pay for the losses incurred during the next financial crisis.

Of course, this won't work as financial regulators have already shown they will not use the banking system as it is designed and require banks to recognize upfront their losses on private and public debt that cannot be repaid.

Financial regulators don't require the banks to recognize losses upfront as the regulators perceive that any reduction in the reported level of capital signals a problem that threatens the safety and soundness of the financial system.

As regular readers know, this assumption is false as market participants already know the banks have experienced massive losses and undoubtedly have negative book capital levels if all their losses are realized.  What market participants don't know is just how negative book capital levels really should be.

While I think that the goal of Senators Brown and Vitter to try to protect the taxpayer from the failure of the financial regulators is correct, their effort to put more capital into the financial system won't achieve this outcome.

Taxpayers would be much better off if Senators Brown and Vitter championed enforcement of the Securities Act of 1933 and requiring the banks to provide ultra transparency.

Under the Act, the government is suppose to ensure that market participants have access to all the useful, relevant information in an appropriate, timely manner so they independently assess this information and make a fully informed investment decision.

The current financial crisis has shown that the banks are "black boxes".  It is only when the banks disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details that market participants have the information that they need to make a fully informed investment decision.

ECB says ditching austerity would not help Eurozone

Reuters reports that ECB officials are saying that ditching austerity would not help the Eurozone economy very much.

Whether this is true or not, what would definitely help the Eurozone economy is if the Swedish Model was adopted and banks were required to recognize the losses on the excess private and public debt in the financial system.

This would lift the burden of servicing this excess debt from the real economy and end the diversion of capital needed for growth, reinvestment and supporting the social contract.  As a result, the downward spiral the Eurozone economy is experiencing, particularly in countries like Spain and Greece, would end.

ECB policymakers rebuffed suggestions that Europe should ease up on austerity and said that while the central bank has room to cut interest rates, such a move would not necessarily help the economy much. 
European Central Bank Vice-President Vitor Constancio said that seeking to stimulate economies by stopping measures aimed at cutting government debt could merely increase countries' borrowing costs rather than triggering growth.... 
With budget cuts blamed for a second straight year of recession in the euro zone, the EU's top economics official Olli Rehn indicated over the weekend that more flexibility on tough economic targets was needed. 
His boss, European Commission President Jose Manuel Barroso, said on Monday that austerity had reached its natural limits of popular support....

But ECB policymakers did not accept that weaker growth was a reason to change course on reform, insisting that more balanced budgets were essential to revive sustainable growth. 
"Economic adjustment, both internal and external, has been significant, has implied high costs in terms of unemployment and should not (be) put into risk of unraveling now," Constancio told the European Parliament. 
Joerg Asmussen, who sits on the ECB's Executive Board, also spoke of a risk of slipping back and warned against taking the current market calm for granted. 
"(A) sound fiscal condition is really a precondition for growth," he told the Financial Times. "If one postpones fiscal consolidation to a later day, that comes not without risks."

Thursday, April 25, 2013

Simon Johnson debunks notion TBTF can fail and refocuses debate on how do we prevent need for resolution

In a Project Syndicate column, Professor Simon Johnson debunks the notion that a Too Big to Fail bank can actually fail by cutting through all of the meaningless assurances by politicians and financial regulators and pointing out that a TBTF could not be resolved (bankruptcy for banks).

So the question becomes, "how do we prevent these banks from failing in the first place?"

The Obama administration's answer to this question was to double down and put the responsibility on the same financial regulators who failed to prevent our current financial crisis.

In case this wasn't a bad enough idea, the Administration and Congress turned over writing the new financial laws that these regulators are suppose to enforce to the bank lobbyists.  The result was the bank lobbyist full employment act, otherwise known as the Dodd-Frank Act.

Regular readers know that I think the Dodd-Frank Act should be repealed with the exception of the Consumer Financial Protection Bureau and the Volcker Rule.  Its sheer complexity reflects the absurdity of trying to replace market discipline with regulations.

Others have answered the question of how to prevent banks from failing by suggesting that the solution is to have them hold more capital. The logic behind this answer is if banks hold more capital it is harder for them to fail as they have more capital to lose.

This logic assumes that banks will not change their risk profile as a result of having to maintain a higher capital level.  But how will anyone know if they take on greater risk until ....

Which brings me to my preferred solution: transparency.

By making the banks disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details, transparency subjects the banks to market discipline.

For example, transparency achieves what the Volcker Rule tries to accomplish in ending banks taking proprietary bets.  As demonstrated by Jamie Dimon and JP Morgan's London Whale trade, banks fear that if their bets are known the market will trade against them.  Transparency makes this nightmare an everyday reality if they engage in proprietary bets.

For example, transparency restrains risk taking.  Market participants adjust the price of their exposures to a bank to reflect how risky it is.  This gives banks an incentive to reduce their risk.

But a great myth lurks at the heart of the financial industry’s argument that all is well. 
The FDIC’s resolution powers will not work for large, complex cross-border financial enterprises.  
The reason is simple: US law can create a resolution authority that works only within national boundaries. 
Addressing potential failure at a firm like Citigroup would require a cross-border agreement between governments and all responsible agencies.
On the fringes of the International Monetary Fund’s just-completed spring meetings in Washington, DC, I had the opportunity to talk with senior officials and their advisers from various countries, including from Europe. I asked all of them the same question: When will we have a binding framework for cross-border resolution?
The answers typically ranged from “not in our lifetimes” to “never.” 
Again, the reason is simple: countries do not want to compromise their sovereignty or tie their hands in any way. Governments want the ability to decide how best to protect their countries’ perceived national interests when a crisis strikes. No one is willing to sign a treaty or otherwise pre-commit in a binding way (least of all a majority of the US Senate, which must ratify such a treaty).
As Bill Dudley, the president of the New York Federal Reserve Bank, put it recently, using the delicate language of central bankers, “The impediments to an orderly cross-border resolution still need to be fully identified and dismantled. This is necessary to eliminate the so-called ‘too big to fail’ problem.”
Translation: Orderly resolution of global megabanks is an illusion. As long as we allow cross-border banks at or close to their current scale, our political leaders will be unable to tolerate their failure.

Wednesday, April 24, 2013

The Telegraph's Jeremy Warner's epiphany about banks and their regulators

The Telegraph's Jeremy Warner had an epiphany about banks and their regulators:  bankers run a pro cyclical business that is made even worse by their regulators.

The trouble with banks is that they are extraordinarily pro-cyclical beasts. 
During the good times they throw caution to the winds and lend with reckless abandon. 
During the bad times they do the opposite; in rebuilding capital to pay for the bad debts of the boom, they become highly risk averse. The priority is to reduce credit, rather than expand it, so that solvency can be re-established. 
This process is reinforced by regulators, who having been asleep on the job during the boom, then go violently into reverse and attempt to bullet proof the banks against all eventualities by insisting on much tougher capital and liquidity requirements. 
Only last month, Britain's Financial Policy Committee identified a further £25bn shortfall in UK banking capital, a deficit likely to be met by further shrinkage in bank balance sheets. 
A vicious cycle of credit destruction thus sets in. 
The madness of this regulatory over reaction is there for all to see the latest Basel III capital adequacy rules, which bizarrely require banks to hold much higher capital against corporate loans than mortgages. 
The inevitable consequence of such thinking is that the housing market is held up at silly valuations and the corporate market delevers even further. The impact on growth is terrible.
The only way to end this negative reinforcing cycle is by making the banks provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balane sheet exposure details.

With this information, market participants can assess and restrain bank risk taking.

As a result, we won't get the extremes on the upside in lending nor will we get the regulators kicking in policies that hurt lending on the downside.

Archbishop of Canterbury Justin Welby on long-term solution to financial crisis: "ancient virtue of transparency"

The Telegraph reports when asked what the long-term solution to the financial crisis is, the Archbishop of Canterbury and member of Parliament's commission on banking standards, Justin Welby, replied: the "ancient virtue of transparency".

Regular readers know your humble blogger strongly agrees.

He told the audience of Lords, MPs, bankers and businessmen that Britain was in the grip of a “failure of confidence” - rebuilding, he said, is “essentially an ethically based activity”....  
Having been asked by the Bible Society to come up with “long-term solutions to the financial crisis”, the Archbishop was practical. Sir Mervyn King told the Commission that a high proportion of bad loans in some of our major banks have not yet been recognised. 
The answer, said Archbishop Welby, was “the obvious and ancient virtue of transparency”: if banks are forced to recognise their losses, they will also have to recapitalise.... 
“Balance sheets that are not transparent, that do not recognise the full potential of loan losses, are not only bad in themselves but create a sense of fear and overhang in the markets.”
Please re-read Archbishop Welby's comments as he nicely summarizes why we need transparency to restore confidence and remove the sense of fear and overhang in the markets.

Like your humble blogger, the Archbishop calls for banks to recognize their losses today and then recapitalize over the next several years (the long-term) by rebuilding their book capital levels.  Book capital can be rebuilt through a combination of retention of 100% of pre-banker bonus earnings and stock issuance.

Tuesday, April 23, 2013

Neil Weinberg: Why the debate on TBTF is a distraction

In his American Banker column, Neil Weinberg, its editor in chief, explains why the debate about breaking up the Too Big to Fail, just like the debate about banks needing more capital, is a distraction from what would make our financial system safer and should be the true focus of reform.

In Mr. Weinberg's case, he suggests the true focus of reform should be:
The primary threat is that the system is so interconnected and complex that the failure of a bank big or small, or an institution that exists in the industry's shadow, can imperil everyone else with little or no warning.
Please re-read what Mr. Weinberg says because it nicely summarizes why transparency is the true focus of reform and why it must be brought to all the opaque corners of the financial system.

Regular readers know that our financial system is based on the FDR Framework.  The FDR Framework combines the philosophy of disclosure with the principle of caveat emptor (buyer beware).

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.

Under the FDR Framework, the principle of caveat emptor makes market participants responsible for all the losses on their investments.  This responsibility for loss gives market participants an incentive to use the disclosed information to assess the risk of their investments and to limit the size of any individual investment to what they can afford to lose given the risk.

The FDR Framework is designed to support the three step investment process:

  1. Independently assess the useful, relevant information so as to understand the risk of and value an investment.
  2. Solicit from Wall Street the price that the investment can be bought or sold for.
  3. Compare the investor's independently determined value with the price shown by Wall Street and make an investment decision, (buy, hold or sell), based on the difference between the independent valuation and Wall Street's price.

The issue of interconnectedness is not a problem under the FDR Framework as market participants limit their investments to what they can afford to lose.

The issue of interconnectedness becomes a problem when governments do not fulfill their responsibility under the FDR Framework and let large parts of the financial system become opaque (think banks and structured finance securities).

The opaque parts of the financial system are not investable because market participants cannot perform the first step of the investment process.  Market participants cannot perform this first step because they do not have access to all the useful, relevant information in an appropriate, timely manner so they can independently assess the risk and value an investment.

While the opaque parts of the financial system are not investable, market participants can gamble and buy opaque securities (think opaque, toxic subprime mortgage backed securities).

What led to our current level of interconnectedness is market participants gambled based on the recommendation of rating firms and government agencies.

Both the rating firms and government agencies represented they were in a position where they had access to all the useful, relevant information in an appropriate, timely manner and they were providing an accurate assessment of the risk.  Of course, this wasn't true.

Rating firms didn't have any information about structured finance securities that was not available to the investors and they were not in a position to accurately assess the risk and update their ratings in a timely manner.

Government agencies were limited in what they could say about the banks because of concerns about the safety and soundness of the financial system as well as lobbying by the banks.

Unfortunately, the result is more interconnectedness than would be the case if there was transparency and each market participant was held responsible for the losses on their exposures.

The solution for reducing interconnectedness is simple: bring transparency to the opaque corners of the financial system.

For banks, this means having them disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.

For structured finance securities, this means observable event based reporting under which all activities like a payment or delinquency involving the underlying collateral are reported to market participants before the beginning of the next business day.

With the restoration of transparency in the financial system comes the restoration of responsibility for losses.  The result is a dramatic increase in the robustness of the financial system and decline in the level of interconnectedness.

CFTC's Gary Gensler repeats call to base Libor on observable transactions

The CFTC's Gary Gensler keeps hammering home the point that the only way benchmark interest rates like Libor are both credible and not subject to manipulation is to base them on observable transactions.

Your humble blogger's question is when will regulators realize that the simple and only way to achieve this is to require the banks to provide ultra transparency and disclose on an on-going basis their current global asset, liability and off-balance sheet exposure details?

Ultra transparency both unfreezes and keeps unfrozen the unsecured interbank lending market.  It does this because it provides the banks with deposits to lend the information they need to assess the risk and solvency of the banks looking to borrow.

Ultra transparency also provides the data needed for calculating the benchmark interest rates.  Market participants can use all of the transactions in the unsecured interbank lending market or a subset of these transactions.

As reported by Reuters,

Two interest rate benchmarks that banks were fined for rigging should be scrapped and replaced by indicators based on market transactions, a top U.S. regulator said on Monday. 
The changes should also include benchmarks linked to gold, oil and other commodities, said Gary Gensler, chairman of the Commodity Futures Trading Commission said. 
Regulators from across the world are fleshing out changes to how two key interest rate benchmarks in particular, the London Interbank Offered Rate (Libor) and its continental European counterpart Euribor, are compiled.... 
"I believe Libor and Euribor are unsustainable in the long run. They threaten financial stability," Gensler said. 
Gensler co-chairs the group of regulators setting out principles on how benchmarks can be run and compiled to make them harder to manipulate....
What is so difficult about the principle that banks need to provide ultra transparency so the benchmarks can be based on actual transactions?
"The principles that we laid out are equally relevant to energy, metals, agriculture and financials - for any benchmark to be reliable and robust (it should) be anchored in observable transactions," Gensler later told reporters.
Users of contracts linked to all types of benchmarks should also have a "Plan B" if the transactions to compile them dry up, Gensler added.
Fortunately, with banks providing ultra transparency, transactions won't dry up as the banks with deposits to lend can continue to assess the risk and solvency of banks looking to borrow.

The interest rate paid by the borrowing bank might change, but that is what is suppose to happen in a functioning market.
He said Libor and Euribor fail to reflect wider market activity, noting how the cost of insuring one bank's bonds rose sharply during the Cyprus crisis while that bank's Libor submissions barely changed. 
"One might have thought the two would have had some relation to one another," Gensler said....
Transparency re-establishes this relationship.
The financial sector fears mayhem from a rapid switch to a new system for compiling benchmarks but Wheatley said changes would have to be phased in.
There should be absolutely no mayhem in the financial sector as ultra transparency is phased in.  Benchmark interest rates like Libor and Euribor will simply reflect the reality of what it costs the banks to borrow and not some bankers' bonus driven imagination of what it costs the banks to borrow.

Monday, April 22, 2013

NRA demonstrates that capture of lobbying organizations by manufacturers not limited to just Wall Street's sell-side

In his Sports Illustrated column, Peter King showed that the capture of lobbying organizations like the American Securitization Forum which claims to represent all participants in the structured finance market is not limited to just Wall Street's sell-side.
Read this by Augustus Busch IV, the Anheuser-Busch heir and, for years, one of the biggest National Rifle Association advocates. 
He resigned his "lifetime'' membership in the NRA last week in the wake of the Senatorial inaction, and he wrote this in his resignation letter, among other things, that the NRA was going against the will of its members by hand-grenading the background-check issue. 
He also wrote in his letter renouncing his NRA membership: "I am simply unable to comprehend how assault weapons and large capacity magazines have a role in your vision. 
The NRA I see today has undermined the values upon which it was established. 
Your current strategic focus clearly places priority on the needs of gun and ammunition manufacturers while disregarding the opinions of your four million individual members ... One only has to look at the makeup of the 75-member board of directors, dominated by manufacturing interests, to confirm my point. 
The NRA appears to have evolved into the lobby for gun and ammunition manufacturers rather than gun owners."

John Kay explains why next Keynes is unlikely to have a PhD in economics

In an interview in the Actuary, Professor John Kay explains why the next Keynes is unlikely to have a PhD in economics.

Kay is not the only critic of mainstream economists, and it would seem patently obvious that economics has failed as a predictive and explanatory tool. 
After all, it failed to predict our current financial crisis and it has failed to provide a policy solution that actually works.
Was the profession changing? 
Could there be an Einstein moment approaching, where the mainstream realises that the cranks were right? 
No, says Kay. Unlike subjects such as physics, you cannot definitively prove economics wrong. “The rewards structure of the economics profession is basically a common value system,” he says. 
Small marginal improvements are rewarded, critics are considered cranks and ignored.
In short, even though the economics profession has been thoroughly debunked, it is incapable of making the changes necessary to become relevant again.

Protecting bankers, Germany says "liability cascade" must prevail in bank bailouts

I keep wondering how many times bankers must be protected from the consequences of their actions until global policymakers realize that this protection does not a) result in banking systems that are fixed or b) economic growth.

In the latest round of protecting the bankers, Germany has called for rescuing the banks by enforcing a liability cascade that starts with shareholders and moves towards and includes depositors.

Regular readers know that based on how modern banks are designed the number one source for rescuing and recapitalizing banks is future bank earnings.

Please note the difference between recapitalizing banks using future earnings versus using deposits.
When future earnings are used, banker effectively "pay" for the damage they did to the bank because their cash bonuses are minimized until bank book capital has been rebuilt.

When deposits are used, bankers keep receiving their cash bonuses while the depositors and the real economy suffer the losses.

Plans in the euro area to allow the direct recapitalization of failing banks must stick to a hierarchy of responsibility that starts with the banks’ shareholders, the German Finance Ministry said. 
In its report for April, the ministry said a “liability cascade” must prevail in any attempt to save a bank, allowing the European Stability Mechanism to allocate resources on its main job of averting state insolvencies. 
“From the German government’s point of view, it’s important to limit the volume for direct recapitalization to allow the ESM to focus on its core task,” the ministry in Berlin said today. “It’s also important that the liability hierarchy is followed,” it said, echoing comments made by Finance Minister Wolfgang Schaeuble in Brussels this month.
All of Germany's stated goals are more easily achieved by tapping unlimited amounts of future bank earnings as a source for recapitalizing the banking system.

Sunday, April 21, 2013

Why the hurry to "fix" Slovenia's banking system when doing it right takes time?

A Reuters article on eurozone leaders pushing Slovenia to fix its banking raises an interesting question: why does it have to be done quickly when doing it right takes time?

Common sense says that there are three steps to fixing the banking system the right way:
  1. Require the banks to provide on-going transparency so that market participants can assess their global asset, liability and off-balance sheet exposure details.
  2. Based on this assessment, the true extent of the problem can be determined and the losses can be realized.
  3. Determine how to rebuild the banks' book capital levels over the next several years.
It is common sense that transparency is needed so that there is no doubt that all of the bad debt hidden on and off the banks' balance sheets is recognized.

As Ireland, Greece, Portugal and Spain have shown, so long as the banks remain "black boxes", market participants will never believe that all the hidden bad debt hidden been recognized.

So long as there is this doubt about what is lurking on or off bank balance sheets, the banking system has not been truly fixed.

Putting ultra transparency in place takes time.

It is common sense that before fixing the banks, the true extent of their bad debt needs to be known.  It is only when the size of the problem is known that the solution for fixing the banks that corresponds to the size of the problem can be chosen.

It will take time for market participants to assess the value of each of the banks' exposures.

Finally, it is common sense that the banks do not need to be recapitalized immediately.  Savers and SMEs, who represent the banks' core depositors, are using the banks today even though they know the banks probably have low or negative book capital levels when adjusted for all the hidden losses on and off their balance sheets.

Recognizing the hidden losses and putting the banks on a path towards recapitalization is not going to make the savers and SMEs stop using the banks.  If anything, it should make them more comfortable using the banks.

Recapitalizing the banks through retention of future bank earnings takes time.

So, why the hurry?

Five years later, policymakers finally searching for new economic rescue plan

As reported by Reuters, global policymakers are searching for a new economic rescue plan as it has become clear to all that the current set of policies isn't working.

What has been shown globally not to work to end a bank solvency led financial crisis can be summarized as either zero interest rates/quantitative easing with fiscal stimulus or zero interest rates/quantitative easing with austerity.

Your humble blogger predicted before these policies were implemented that they would not work.  I have explained in detail why they would not work and why they have not work.

Fortunately, there is a policy that has proven it ends a bank solvency led financial crisis and restores economic growth.  I call that policy the Swedish Model.

Under the Swedish Model, banks are required to recognize upfront the losses on all the excess debt in the financial system.  This protects the real economy and allows it to continue to grow.

Why does the Swedish Model work?

The Swedish Model protects the real economy by not diverting capital that is needed for reinvestment and growth to debt service.  Unlike the policies that have been adopted to date, the Swedish Model doesn't place the burden of servicing the excess debt on the real economy and then try to boost demand to offset this loss of capital through monetary and/or fiscal stimulus.

The Swedish Model also uses the banks as they are designed to be used.  Because of deposit guarantees and access to central bank funding, banks are capable of operating and supporting the real economy even when they have low or negative book capital levels.  Banks can do this because the deposit guarantee effectively makes the taxpayers the silent equity partner of the banks when they are in book capital rebuilding mode.

Where has the Swedish Model been used and shown to work?

In the US, the Swedish Model was implemented during the Great Depression beginning with the 1933 bank holiday.  As the NY Fed said, it broke the back of the Great Depression.

In Sweden, it was used during the 1990s.

Finally, it was used by Iceland at the beginning of our current financial crisis.

Given this track record, why hasn't the economic profession endorsed it?

Thanks to Nobel prize winning economist Joseph Stiglitz we know the answer.  Prior to the current financial crisis, economic models treated the banking system as simply moving money from one pocket to another.  Therefore, there was limited reason to study banks or include them in models used to predict economic performance.

If you are not studying the key element in the policy that has been shown to end bank solvency led financial crises, you are not very likely to endorse this policy.

Why should policymakers adopt the Swedish Model now?

Because it is clear to everyone that the economic policies adopted to date have failed.  If they had remotely worked, central bank balance sheets would be contracting rather than growing exponentially.

All the alternatives recommended by the economics profession have failed.

On top of this, the economics profession through Reinhart and Rogoff has been discredited as a serious science.  Economists have been revealed as simply biased story tellers whose stories are most likely based in pure fantasy.

As a result, politicians now have to take responsibility for the policies they pursue as economists no longer provide politicians with a fig leaf of intellectual cover.
More than three years after the end of the global recession, sluggish activity across rich and poor economies is confounding policymakers who expected more by now and raising concerns that options for kick-starting growth are increasingly limited. 
They face a sobering checklist: 
The U.S. economy remains shackled by a mountain of household debt and continues to whipsaw between periods of modest growth and next to none at all. 
The euro zone is mired in recession, lurching from crisis to crisis and now dealing with the latest trouble spot in Cyprus. 
And even such star performers as China and Brazil have run low on gas. China in 2012 posted its weakest year of growth since 1999. Brazil's economy slowed to a near standstill; at the same time, it faces a growing threat from inflation. 
Against this backdrop, the exasperation of finance ministers and central bankers attending last week's Group of 20 and International Monetary Fund meetings was palpable. 
The official communiques and sideline discussions reflected their frustration over the failure so far to deliver an effective mix of policies to finally get an upper hand on a long-lasting crisis that shows little sign of ending. 
"We cannot unmistakably declare that the worst is behind us," Brazilian Finance Minister Guido Mantega said on Friday. "There is a risk of a prolonged crisis, despite all our efforts in the G20 and other international forums." 
Central banks across the developed world have held interest rates at rock-bottom levels since 2008 while pumping more than $6 trillion into their banking systems through loans and asset-purchase operations known as quantitative easing, or "QE." The European Central Bank has helped lower borrowing costs for the governments of Spain and Italy. Ireland, Portugal and Greece have been bailed out. 
And yet a return to normalcy appears a distant dream....
Were the Swedish Model now adopted, we could be back to normal in 12 months.
"You're not going to have a perfectly optimal set of policies for everyone in the world," said Tharman Shanmugaratnam, chairman of the International Monetary and Financial Committee, which advises the IMF on the global monetary and financial system. 
Tharman said the trick was to find a mix of policies that would help economies grow without risking future bubbles. "We need a new framework," he said.
The new framework is simple: adopt the Swedish Model and bring transparency to all the opaque corners of the financial system.

Good for the global economy, good for society and bad for banker cash bonuses.

Saturday, April 20, 2013

Paul Krugman: reasons current policies to end financial crisis has failed are obvious

On his NY Times blog, Paul Krugman attempts to explain why it was predictable that the policies applied to end the bank solvency led financial crisis would not succeed and why it is no mystery what must be done to end the crisis.

Regular readers know that the Nobel-prize winning economics professor is on the right track when he says it was predictable before the policies were implemented that they would fail [your humble blogger predicted it] and why it it is no mystery what must be done to end the crisis [your humble blogger has been saying it publicly since the beginning of the crisis].

However, like all economists, he fails to consider, or maybe it is understand, that there is an X-factor that explains why the policies implemented would fail and why his choice of policies to end the financial crisis would have failed also.

The X-factor is the banking system and the excess debt in the financial system it is designed to absorb the losses on.

It is a very bold statement to say economists fail to consider or maybe understand the role of the banks and why they are an X-factor.

Why do I make it?

No less an authority on economics than Nobel-prize winning economist Joseph Stiglitz observed that prior to the financial crisis economic models left out the banking system in its entirety.  The banking system was seen as moving money from your left to right pocket and therefore could be ignored.

The conclusion from this statement is if the policies you recommend when the banking system is ignored are the same policies you recommend after we discover that the banking system cannot be ignored, there is little reason to believe your policies are right.

Chris Giles of the FT reports that central bankers are worried that they are “flying blind”; he quotes Lorenzo Bibi-Smaghi, formerly of the ECB governing board, saying “We don’t fully understand what is happening in advanced economies.” 
Um, guys, that’s because you don’t want to understand.
Professor Krugman makes an excellent point about the desire of central bankers, policy makers and economists not wanting to understand what is happening.

I have explored on this blog a number of different reasons they might not want to understand or worse, understand, but chose to adopt policies that don't reflect this understanding.
Nothing about our current situation, except maybe the absence of outright deflation, is at all surprising or mysterious. 
We had a huge financial crisis, and the combination of a housing bust (on both sides of the Atlantic) and an overhang of household debt (also on both sides) has acted as a drag on private demand.
Here is where a discussion of the banks and how they are suppose to absorb the losses on the excess debt in the financial system is suppose to come in.
Monetary policy quickly found itself up against the zero lower bound, while fiscal policy, after providing some stimulus, soon turned strongly contractionary....
Here is where Professor Krugman pushes his solution of more fiscal stimulus needed.

Unfortunately, by not dealing with the excess debt in the financial system, this additional fiscal stimulus would also not solve the problem.  Put simply, the fiscal stimulus would be swallowed by the debt burden that the excess debt places on the real economy.

We saw this with the original fiscal stimulus at the beginning of the Obama administration and we have seen this repeatedly in Japan.
But many central bankers and other officials chose to ignore all that and place their faith in the confidence fairy instead. 
So now that it has all gone wrong, they throw up their hands and say that it’s a mystery — how could this happen? 
No mystery, guys; you messed up.
The same conclusion would hold had Professor Krugman's solution been followed in the absence of requiring the banks to absorb the losses on the excess debt in the financial system.

However, if the banks were required to fulfill the function that they are designed for, which is absorbing the losses on the excess debt in the financial system, then Professor Krugman's solution would in fact see the results he anticipates.

Kaggle answers the question of "can and will market participants use transparency"

One of economists' and Wall Street lobbyists' favorite objections to requiring the banks to provide ultra transparency is that market participants won't know what to do with this much data and it will confuse them.

After all, your humble blogger is talking about having each bank disclose on an ongoing basis its current global asset, liability and off-balance sheet exposure details.

Since these details are tracked by information systems, what we are talking about with this disclosure is what I call the "Mother of All Financial Databases".

Is this database large?  Yes, but not so large that we are talking about orders of magnitude bigger than Walmart's database.

Will market participants use this database?  Of course, there is money to be made.

Can market participants use this database?

Rather than rely on your humble blogger's "yes" response, I will let Kaggle answer "yes" for me.

For those readers who are not familiar with Kaggle, an article in The Atlantic describes it as
an on-line platform for data-mining and predictive-modeling competitions. A company arranges with Kaggle to post a dump of data with a proposed problem, and the site's community of computer scientists and mathematicians -- known these days as data scientists -- take on the task, posting proposed solutions. 
Importantly, competitors don't just get one crack at the problem; they can revise their submissions until a deadline, driving themselves and the community towards better solutions. 
"The level of accuracy increases, and they all tend to converge on the same solution," explains Anthony Goldbloom, Kaggle's co-founder and CEO.
Is there any reason to believe that market participants will use a Kaggle to analyze the Mother of All Financial Databases?
Companies as varied as MasterCard, Pfizer, Allstate, and Facebook (not to mention NASA) have all created competitions. 
GE sponsored a contest to give airline pilots tools to make more efficient flight plans en route. 
Health technology company Practice Fusion funded another challenge to identify patients with Type 2 diabetes based on de-identified medical records. 
Prizes for the winning solution have ranged from $3,000 to $250,000. A $3 million prize, offered by the Heritage Provider Network for the best prediction of which patients will be admitted to a hospital within the next year, based on historical claims data, closed last week, and the winner will be announced in June at the Health Datapalooza.
Do you think a hedge fund would be willing to pay say $10 million to the winner of a Kaggle competition if the hedge fund makes $1 billion?

But how do we know that Kaggle is up to the challenge of assessing the Mother of All Financial Databases?
The key to Kaggle is the community: 85,000 data scientists (who knew there were that many data scientists in the world!) have entered competitions, and each is ranked according to their skill and results in competitions. 
Xavier Conort, a French actuary living in Singapore, holds the Number One spot (he's won 6 prizes and come in the top 10 percent a dozen times). 
As I'm writing this, Joshua Moskowitz, an American who joined 9 minutes ago, is at the other end of the pecking order. Just wait till Joshua starts competing, though; he could be a challenge Xavier in a matter of months. 
That everyone-has-a-chance ethos means that any competitor, no matter how isolated they may be, can judge their talents against the top rank of their field. 
What's more, in the company's forums competitors can swap techniques and hone their skills. Goldbloom says that a good programmer can work their way up the ladder fairly quickly, by scoring well in two or three competitions.
In short, there are no barriers to entry by a data scientist to see if they can win a Kaggle competition and collect the prize money from the hedge fund.

Friday, April 19, 2013

Is the Federal Reserve insane? No. It only has one tool and it uses it to try to solve all problems.

In a must read Bloomberg editorial, Matthew Klein asks if the Federal Reserve is insane because its response to every economic problem it to try to solve it with a bigger economic bubble.

I would not argue that the economists who run the Fed are insane.  I would say they are a product of their training.  In the course of studying for their PhDs, they have learned a particular way of looking at the world.

It is this rigidity in thinking and the desire to defend the PhD theses that resulted that prevents them from implementing alternative responses to solving an economic problem.

My case in point would be our current financial crisis.  It is well known that we are dealing with a bank solvency led financial crisis.  Yet, the Fed continues to treat it as if it were a bank liquidity crisis.

Your humble blogger is not the first to make this observation that the Fed is treating a bank solvency problem as a liquidity problem.

The loudest voice on this was Anna Schwartz, Milton Friedman's co-author and an authority on the Great Depression and monetary policy before Ben Bernanke began his studies.  In a Wall Street Journal interview, she debunked the Fed's response, which is a reflection of what Mr. Bernanke argued should have been done at the time of the Great Depression, to our current crisis.

Ms. Schwartz made the case for bringing transparency to all the opaque corners of the financial system, including banks and structured finance securities.

The Fed, as Mr. Klein observes, is not interested in bringing transparency to all the opaque corners of the financial system.  Instead, the Fed is only interested in implementing what Mr. Klein describes as the Fed bubbles only policy:

Back in the 2000s, however, most people just wanted to get out of the funk associated with the aftermath of the tech boom. 
There was also a widespread belief that bubbles aren't dangerous as long as the central bank is around to "clean up" the mess when they burst. This view was best articulated by Ben Bernanke in 1999. 
As a result, many monetary policymakers were untroubled by the prospect of creating a new bubble to replace the old one. 
Transcripts of the Fed's internal meetings make it clear that this was their conscious plan. 
On March 16, 2004, Donald Kohn, a longtime Fed staffer who later became the Fed's vice chairman, said that the credit bubble was "deliberate and a desirable effect of the stance of policy." 
According to Kohn, the Fed's strategy was: "boost asset prices in order to stimulate demand." 
That appeared to work for a short time, but it ended badly. We're still struggling to emerge from the wreckage despite, yet again, incredibly low real interest rates and very large government budget deficits. 
Clearly, cleaning up after bubbles is harder than it's made out to be. 
One might think that the Fed has learned something from this experience.  A recent speech from Nayarana Kocherlakota, the president of the Minneapolis Federal Reserve Bank, suggests otherwise. 
He said that the Fed "will only be able to achieve its congressionally mandated objectives by following policies that result in signs of financial market instability." 
In other words, he wants to repeat the exact same formula that Donald Kohn endorsed in the 2000s.
Please note that there is nothing in the Fed's blow bubbles strategy that directly addresses bank insolvency.  So what are the chances it will be successful in ending a bank solvency led financial crisis?

Rallying to defense of TBTF, Treasury questions existence of big bank subsidy

Confirming its commitment to implementing the Geithner Doctrine (Yves Smith:  don't do anything that will hurt the profits or reputation of a big and/or politically connected bank), the US Treasury questioned the existence of any big bank funding subsidy based on the idea these banks will be bailed out by the government.

By questioning the existence of this funding subsidy for Too Big to Fail banks, the US Treasury is casting doubt on the core argument used to support breaking these banks up.

Regular readers know that your humble blogger sees the argument for breaking up the Too Big to Fail and the argument for banks holding more capital as distractions that crowd out discussion of the most important reform:  transparency.

I say that transparency under which the banks disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details is the most important reform because with this level of transparency we get a number of benefits including the TBTF breaking themselves up and banks holding more capital.

This is a bold statement.

Fortunately, it is supported by the facts.

First, transparency has already been shown to shrink a TBTF institution.  All we have to do is look at Jamie Dimon and the JP Morgan London Whale trade.

His first response was to hide the trade so that the market wouldn't find out about it and trade against JPM.  Senator Levin's committee documents cutting off information to regulators for fear of leaks.  His second response was to exit trade as soon as possible.

Please note, simply ending proprietary betting is a step in breaking up the TBTF.

What else might be ended and be a step in breaking up the TBTF as a result of transparency?

How will the market react when it gets to see what is really happening with all of those subsidiaries that are designed to arbitrage regulations and taxes?  Will the market pressure the TBTF to close these subsidiaries?

Second, transparency has already been shown to exert discipline on a bank so it holds more capital.  For confirmation, all we have to do is look at the level of capital that banks held back in the early 1900s when providing exposure detail disclosure was the norm and seen as a sign of a bank that could stand on its own two feet.

As reported by Reuters,

 A Treasury Department official on Thursday rebuffed recent arguments that giant banks enjoy cheaper borrowing because markets think the government would bail them out in a crisis. 
Mary Miller, Treasury's undersecretary for domestic finance, said in prepared remarks for a speech at an economic conference in New York that it is not necessarily true that the biggest banks borrow more cheaply than smaller competitors can. 
And even if they do enjoy such a subsidy, she said, it may not be because markets believe they are "too big to fail." 
"In the wake of the financial crisis, the largest banks' borrowing costs have not only increased more than those of some regional bank competitors, but have also increased to higher absolute levels," Miller said.... 
Many politicians and some regulators argue some banks are still so big that the government would support them, as was done during the 2007-2009 crisis, rather than let their failure threaten the stability of the financial system. 
Because markets also believe the government would step in, these critics say, the biggest banks have the unfair advantage that they can issue debt more cheaply than smaller banks can.... 
Even if big banks do have lower funding costs, that could be explained by other factors, she said. For example, financial giants may have greater liquidity and a bigger pool of potential investors than smaller competitors. 
"Research shows that large non-financial corporations enjoy a similar funding advantage over their smaller and less-diversified peers," Miller said.

Thursday, April 18, 2013

More on why the Swedish Model works to end a bank solvency led financial crisis

The Washington Post reports on a paper that looks at the impact that underwater mortgages had on the economy.

The paper concludes that the benefit to the economy to be gained from writing down the mortgage debt more than offsets the cost to the creditor from realizing the loss.

Regular readers will recall that under the Swedish Model banks are required to recognize upfront the losses on the excess debt in the financial system.  An example of the loss that could be realized is the difference between the outstanding mortgage balance and the value of the house.

A recently revised paper by Atif Mian of Princeton, Amir Sufi of the University of Chicago Booth School of Business and Kamalesh Rao of MasterCard Advisers suggests that underwater mortgages have played a significant role in holding back the recovery. 
The paper, “Household Balance Sheets, Consumption and the Economic Slump,” was first released several years ago, but it has been revised to include an important new calculation. 
It is widely recognized that the fall in housing prices had a “wealth effect” that led homeowners across the country to cut back on spending. 
In the updated paper, Mian, Sufi and Rao measured how much more underwater borrowers probably cut back on spending compared to borrowers without an overhang of mortgage debt. (More precisely, they measured how much homeowners cut back on auto spending for each dollar loss of housing wealth. But that’s important; the decline in auto sales was a significant part of the economic contraction.) 
The authors found that being underwater makes a big difference. .... 
In an e-mail interview, Sufi says he and his co-authors believe the paper is the first to show that borrowers with very high leverage – which would include people who are underwater – are likely to cut back significantly on spending in a housing decline....

Sufi says the findings underscore the notion that principal reductions – reducing the overhang of mortgage debt left by the financial crisis – should have been more widely embraced as part of the policy response to the housing bust. 
“Facilitating mortgage debt write­-downs would have softened the blow to household spending. A dollar lost by a creditor has less of a negative effect on consumption than the positive effect on consumption from a dollar gained by an underwater homeowner,” he says. 

Risk manager explains why transparency and not complex regulations needed

In a ProPublica article, Jesse Eisinger lets a former Wall Street senior risk manager explain why transparency and not complex regulation is needed.

I've been talking to him periodically over the years about how giant financial institutions should manage the aggressive traders slinging giant sums around the world in ever more complex transactions. 
After the Senate issued a report last month on JPMorgan Chase's multibillion-dollar "London Whale" trading loss, an incident where the mathematical modeling went seriously wrong, I reached out to him again. 
That debacle encapsulates much of what is wrong about how banks manage their risk and how the regulators oversee those efforts. 
At JPMorgan Chase, the risk models hid — and were used to hide — risks from the traders and top executives. 
Too many measures and too many numbers undid the risk managers.....
Please note the reliance on models which can be manipulated to hide the risk of a trade as oppose to actually looking at the trade details.
Early in his career, Mr. Breit figured out that models for markets aren't like those for physics. They don't come from nature. It was necessary to know the math, if only so that he couldn't be intimidated by the quantitative analysts. 
But the numbers more often disguise risk than reveal it. "I went down the statistical path," he said. He built one of the first value-at-risk models, or VaR, a mathematical formula that is supposed to distill how much risk a firm is running at any given point. 
The only thing from capital markets math he came to embrace was this immutable law of nature: Investors make money by taking risk. "If it's profitable and seems riskless, it's a business you don't understand," he told me....
One of the benefits of requiring banks to provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details is that it lets competitor banks flag for the regulators the risks that each bank is taking.

It is a lot easier for a regulator to figure out that there is a problem if a bank says a trade is risk-less and its competitors see it as being risky.
All the while, he was on the lookout for bad trades. Most traders who get into trouble, he thinks, aren't bad guys. The bad ones, who try to cover up improper trades, are relatively easy to detect. 
The real threat, he said, comes from the "crazy ones" who really believe they've found ways to spin flax into gold. They can blow up a firm with the best of intentions.
Please note that with transparency, market participants have an incentive to scan for these trades that could blow up a bank and bring everyone's attention to them.
They don't do it suddenly. "I hate the whole Black Swan concept," he said, referring to the notion, popularized by Nassim Nicholas Taleb, that the true risks lie in unforeseeable events that occur with much more frequency than the mathematical models suggest. "It takes years of concerted effort to lose a lot." 
Yes, a big market move might reveal a fatally flawed trade, but that volatility is not the root cause of an oversize loss.
The root cause is misunderstanding the risk or a trade where the risk is hidden for a period of time (think investing in subprime mortgage-backed securities).
The problem, as Mr. Breit sees it, is that this has nothing to do with how risk management is practiced today, or what the regulators encourage. 
Regulators have reduced risk managers to box checkers, making sure they take every measure of risk and report it dutifully on extensive forms. "It just consumes more and more staff, turning them into accountants and rotting brains." 
Take VaR. In Mr. Breit's view, Wall Street firms, encouraged by regulators, are on a fool's mission to enhance their models to more reliably detect risky trades. 
Mr. Breit finds VaR, a commonly used measure, useful only as a contrary indicator. If VaR isn't flashing a warning signal for a profitable trade, that may well mean there is a hidden bomb.
Recall that VaR can be manipulated by manipulating the risk models.  Just ask JP Morgan how this played out in the London Whale trade.
He despises the concept of "risk-weighted assets," where banks put up capital based on the perceived riskiness of the assets. 
Inevitably, he argues, banks will "pile into" the same types of supposedly safe investments, creating bubbles that make the risks far more severe than the initial perceptions. 
Paradoxically, risk-weighting can leave banks setting aside the least capital to cover the biggest dangers.
Say sovereign debt having a zero risk weight.
"I could not be more disappointed," he said. "The cynic in me thinks this is all in the interests of senior management and regulators to avoid blame. They may not think they can prevent the next crisis, but they then can blame the statistics."
It is an exercise in both covering the regulators' backside when the next crisis happens and also preserving opacity so that bankers can continue to bet with taxpayer money.
Instead, Mr. Breit believes that regulators should encourage firms when they reach different conclusions on what is risky and what is safe. That creates a diverse ecosystem, more resilient to any one pestilence.
Please re-read Mr. Breit's comment because he nicely summarizes a major benefit of requiring the banks to provide transparency.  Each bank can reach its own conclusions on what is risky and what is safe and adjust their exposure to the other banks based on its own conclusions.

Reinhart/Rogoff: a symptom of more serious problem with economic profession

In a must read column in the Guardian, Heidi Moore lays out the serious problem with economics: it is unreliable as a policy tool yet central banks and the technocratic parts of government focused on fiscal policy are run by economic PhDs, i.e. true believers in the truth provided by economics.

This point cannot be repeated enough times.

It was not by chance that the global economics profession, with a small handful of exceptions, failed to predict our current financial crisis.

It was not by chance that the policies pushed forth by the global economics profession have failed to end our current financial crisis.
Economics is an inexact science, as any honest economist will tell you. 
It is based on unreliable numbers that measure relatively small swaths of the population. Whatever the number – unemployment, inflation, wages – it is almost always wrong the first time the government publishes them, and then it is revised later: once, twice, three times or more. The errors are usually large.
If it is not an exact science, what is economics?

A nice set of theories by which to express one's political biases without have to disclose these biases.

Reinhart and Rogoff demonstrated this.
Many Americans know that Washington lawmakers have been engaged in a two-year battle to the death over the federal deficit. ... 
This philosophical debate is not actually about philosophy. It has been, to a certain extent, about two activist economists who spent years preaching that high debt would destroy America's economy in the future, pitching us into certain recession. 
Here's how it happened: 
In 2011 Congress was engaged in a bitter battle over the direction of the US economy; a group of them seemed ready to default on the nation's debt and shut down the government, if necessary, to win their point: that the growing federal deficit would endanger America's economy for generations to come. Others were unconvinced. The stalemate brought Washington to a standstill on the issue. 
During this tense period, there was an important meeting. Nearly 40 Senators sat in neat rows to hear a presentation on debt from Carmen Reinhart and Ken Rogoff, two economists with faultless reputations and keen academic credentials. 
They were not just economists that day, however, bolstered by years of research and a 900-pound book full of graphs and complex economic data, Reinhart and Rogoff were also activists against debt. Their goal was to convince the assembled lawmakers to cut the amount of money the government owed....
Reinhart and Rogoff also demonstrated that faultless reputations and keen academic credentials are worthless when talked about in the context of economists.  

Had their article gone through the peer review process that exists for serious academic disciplines like the hard sciences or business operations, it would not have been published as the findings of their research had no statistical significance after fixing their Excel error and omission of relevant data.  

At the end of the day, regardless of their reputation or academic credentials, economists are simply shills for their political biases.
The travails of Rogoff and Reinhart show one thing conclusively: we put too much trust in economics to tell us how to run the country. 
Economics cannot actually bear this burden. It is largely a science of educated guesses. Economics is a useful science, but it is not an infallible one. 
It is, in particular, an unreliable policy tool.
Which brings us to central banks who have been pursuing zero interest rate policies and quantitative easing since the beginning of the financial crisis.

Bernanke and his colleagues have been coming up with new, innovative ways to stimulate the US economy. 
The Federal Reserve did things it had never done before: it lent money directly to certain kinds of banks, it increased access to cheap loans when banks wouldn't lend to each other, and it bought billions of dollars in Treasury bonds and mortgage-backed securities to take them off the market so banks would buy other kinds of bonds. 
How does the Fed, which has an encyclopedic command of every kind of economic indicator, know all of this is working? 
Spoiler: it doesn't. 
Bernanke has repeatedly said in press conferences that he believes this stimulus – known as quantitative easing – is working, but also implied that is hard to measure whether the Fed's stimulus moves are making enough of a difference in major economic indicators
As your humble blogger mentioned at the start of this blog, we have true believers taking action that influences the real economy and society based on their belief in an unreliable policy tool.

Does that sound like a recipe for success in ending the financial crisis?

Sounds to me more like Mr. Bernanke is adopting policies in defense of his PhD thesis and subsequent academic career.

No less an authority on the Great Depression and monetary policy than Anna Schwartz, Milton Friedman's co-author, said Mr. Bernanke learned the wrong lessons and adopted the wrong policies for our current financial crisis.  She identified our current financial crisis as a bank solvency led financial crisis.

There is one and only one proven way to end a bank solvency led financial crisis: adoption of the Swedish Model.  Under the Swedish Model, banks are required to recognize upfront their losses on the excess private and public debt in the financial system.

It is common sense why the Swedish Model works.  It does not require the real economy to divert capital it needs to support growth, reinvestment and the social contract to making debt service payments on the excess debt.

The drawback to the Swedish Model is it crushes banker cash bonuses for the next several years.

The Swedish Model originated in the US during the Great Depression (FDR implemented during the 1933 bank holiday and, according to the NY Fed, broke the back of the depression), was successfully used by Sweden to handle its 1990s crisis and was most recently successfully used by Iceland at the beginning of our current financial crisis.

I am not an economist.  Hence, I have a bias to adopting policies that have been proven to end a bank solvency led financial crisis.