Is the Fed still pursuing the Greenspan Doctrine?

In a biting post (hat tip NakedCapitalism), Dean Baker talks about 'Mr. Incompetent', Alan Greenspan, and looks at his track record including missing the housing bubble and championing the campaign to fix the debt.

His post stopped short though of asking the question of is the Fed still pursuing the Greenspan Doctrine.  Under this doctrine, bankers are free to seek profits however they want and if they blow up the economy the taxpayers will pay to clean up the mess.

There is strong reason to believe that the Fed is still pursuing this doctrine.

For example, Ben Bernanke is leading the charge in stressing how important it is to address the fiscal cliff by taking action that will reduce the size of the deficit.

No where does Mr. Bernanke suggest that the easiest way to reduce the size of the deficit is to have the banking system make a donation of its current holdings of US government debt to the US Treasury.  (Regular readers know that the donation reflects paying the true cost of deposit insurance and the debt that the US government has taken on as a result of cleaning up the mess made by the banks).

So we are lead to believe that Mr. Bernanke favors either a tax increase or spending cuts.

In a NakedCapitalism post, Bill Black explains how and why Econ 101 students are taught that cutting government spending in a recession makes the economy worse.  He cites as an example, the US adopting austerity during the Great Depression and the experience of Greece and Spain during the current financial crisis.

Since Mr. Bernanke is a Great Depression scholar, surely he knows that adopting austerity will trigger a slowdown in the economy.

So, unless the Fed is still pursuing the Greenspan Doctrine, what excuse is there for Mr. Bernanke leading the charge on the fiscal cliff?

Currency wars: yet another limitation of zero interest rate and quantitative easing monetary policies

Since the beginning of the financial crisis, it has been a frequent refrain that it is important to increase exports in order to help repay all the outstanding debt.

Regular readers know that this 'policy' is the direct 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.  If we weren't protecting bank book capital levels, the banks could recognize the losses on the excess debt in the economy and as a result, there would be no need to look for higher growth in exports than currently exists.

However, since we adopted the Japanese Model, the search for growth in exports is on.

One of the ways to grow exports is by engaging in monetary policies like zero interest rates and quantitative easing that devalue the currency.  If the other countries don't respond, the devaluation serves to make goods manufactured in the country with the devalued currency cheaper to buyers in the other countries.  The price drop encourages these buyers to consume more from the country with the devalued currency.

At the same time, the devaluation also makes goods manufactured in other countries more expensive to buyers in the country with the devalued currency.  The price increase encourages buyers to either buy from local manufacturers or to cut back on consumption.

The hope of currency devaluation is that the increase in both foreign and domestic demand spurs economic growth.

Sounds great, what could possibly go wrong?

The other countries respond.  After all, the economic growth experienced by the country that devalues its currency comes at the expense of the countries that don't devalue.

Currency wars occur when two or more countries engage in devaluation to protect their economies.

Unfortunately, not only do the conditions exist for a currency war, but we have at least 4 major economic areas already engaged in a currency war through pursuit of monetary policies that devalue their currency.

The 4 areas are Asia, the EU including the UK, Japan and the US.  Each has suffered a financial crisis and each has concluded that it is in its best interest to engage in a currency war.

Of course, when every country is engaged in a currency war, no country gains an economic advantage.  Yet another limitation to monetary policies like zero interest rates and quantitative easing and an example of why pursuing the Japanese Model will always fail.

The Wall Street Journal carried an article on Japan's latest efforts to insure that its central bank not only responds to the attempt by other countries to devalue their currency, but to try to be proactive in devaluing the yen faster than other countries can respond.

Japan's incoming prime minister fired a volley into increasingly tense global currency markets, saying the country must defend itself against attempts by other governments to devalue their currencies by ensuring the yen weakens as well. 

Shinzo Abe's call comes as others including Bank of England Gov. Mervyn King warn that the world's economic-policy makers risk becoming embroiled in currency spats that could heighten tensions among countries. 

France moving forward to separate investment and commercial banking

The Wall Street Journal reports that French bank reform is focusing on separating investment from retail and commercial banking.

France's banks are lobbying against this saying the separation will hurt economic growth.

I can clearly see how it will hurt banker bonuses, but I fail to see the direct connection between separating the two businesses and hurting economic growth.  The reason I don't see a direct connection is that the two businesses still exist after they have been separated.

Regular readers know that your humble blogger sees reform efforts focused on separating investment from retail and commercial banking as a best a distraction and at worst a barrier to real reform of the financial system.

The starting point for real reform of the financial system is to require the banks to provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.

Not only does ultra transparency address the issue of reducing the riskiness of the investment and retail/commercial banks, but it also ushers in cultural change as sunlight is the best disinfectant for bad behavior.

The French government-planned reform of the banking industry, which seeks to separate speculative and highly risky activities from retail and commercial operations, is ill-timed, the head of the French Banking Federation said Saturday. 

Implementing the reform, which was an electoral pledge of socialist president Francois Hollande while the country is facing strong economic headwinds could further limit banks' profitability and ability to help foster growth, Jean-Paul Chifflet said in an interview with France Inter radio. 

In the U.S., banking reforms have been put on the back-burner because of the economic slowdown, Mr. Chifflet said.

Actually, in the US, bank reform was put on the back-burner by the Obama administration and the passage of the Dodd-Frank Act.  The administration didn't want to reform the banks and Dodd-Frank was written by and for the banks by their lobbyists.

The French government last week presented a bill forcing French banks to create specific units to house risky speculative operations, in a bid to address one of the causes of the financial and economic crisis that started in 2007 and to protect retail activities and customers' savings. 

The project, however, has been watered down from Mr. Hollande's original plan to split the banks into two and end the combined model of commercial and investment bank.

Gretchen Morgenson's guide to better business behavior

In her NY Times column, Gretchen Morgenson lists four ways to improve business behavior:

• Make it Sting;
• Wake up the Regulators;
• Solve the Rating Mess; and 
• Make Leaders Lead.

Waking up the regulators and solving the rating mess actually go together and Ms. Morgenson describes how to achieve both:

Why not ensure that investors get all the information they need to conduct extensive due diligence before agreeing to buy complex securities [like structured finance securities or bank bonds and stocks]? 

This may be the only way to blunt the [regulators' and] credit ratings agencies’ power or, better, make them disappear.

Please re-read the highlighted text as Ms. Morgenson has succinctly summarized what it takes to fix the financial system.

Libor rate fixing scandal reveals the rot at the heart of the financial system

In a must read Guardian column, Will Hutton looks at the Libor rate fixing scandal and concludes that real reform, rather than unsettling the global economy and financial system, is 'the platform on which a genuine economic recovery will be built'.

If the Libor rate fixing scandal teaches us anything, it is that the starting point for real reform is to bring transparency to all the opaque corners of the financial system as the Libor rate-fixing scandal could only have occurred because of the presence of opacity.

Libor interest rates are set by polling banks for an estimate of what they would pay rather than what they actually paid to borrow in the unsecured interbank lending market.  It was this opacity that allowed the bankers to engage in bad behavior by manipulating their estimates so that Libor moved in ways that were beneficial for their trading positions.

Real reform starts with transparency because our financial system is based on the FDR Framework which combines the philosophy of disclosure with the principle of caveat emptor (buyer beware).

The FDR Framework works on the simple notion that if market participants have access to all the useful, relevant information in an appropriate, timely manner, knowing they are responsible for all gains and losses, they will use this information to make an independent assessment and fully informed investment decisions.

Where there is opacity, like banks and structured finance securities, the FDR Framework doesn't work. Market participants do not have the information needed to make an independent assessment and fully informed investment decision.

Real reform starts with ensuring that the FDR Framework applies to all areas of the financial system.  This means bringing transparency to all the opaque corners of the financial system.

This is the year the consensus changed. Around the world, policy-makers, regulators and bankers recognised that the legacy of the 20-year credit boom up to 2008 is more corrosive than all but a few realised at the time. The bankers – and the theorists who justified their actions – made a millennial mistake. 

Navigating a way out of the mess was never likely to be easy, but it is made harder still by not recognising the magnitude of the disaster and the necessary radicalism involved if things are to be put right.

Your humble blogger a) realized how corrosive the build up of opacity was and b) that the starting point for navigating out of the mess is transparency.

If there were any last doubts they were dispelled by the record $1.5bn fine paid by the Swiss bank UBS for "pervasive" and "epic" efforts to manipulate the benchmark rate of interest – Libor – at which the world's great banks lend to each other. 

The manipulation was at the behest of the traders who buy and sell "interest rate derivatives", whose price varies with Libor, so that cumulatively billions of pounds of profits could be made. Nor was UBS alone. 

What is now evident is that all the banks that made the daily market in global interest rates in 10 major currencies were doing the same to varying degrees. 

There was a complete disdain for the banks' customers, for the notion of custodianship of other people's money, that was industry wide. It is hard to believe this culture has evaporated with the imposition of a fine. 

No banker falsifying the actual interest rates at which he or she was borrowing or lending, or trader who requested that they did so, had any sense that there is something sacred about banking – that the many billions flowing through their hands are not their own. It was just anonymous Monopoly money that gave them the opportunity to become very rich. The UBS emails, which will be used to support criminal charges, could hardly be more revealing. This was about making money from money for vast personal gain....

One of the reasons for bringing transparency to the banks is that sunlight is the best disinfectant and as such is far more powerful as an agent for cultural change than a fine that is simply a cost of doing business.

The Libor scam is an object lesson in how finance taxes the rest of the economy. 

Plainly, the final buyers of the mispriced interest rate derivatives could not have been other banks, otherwise they would have lost money and we know that they all made profits. In any case, they were part of the scam. 

The final buyers of the mispriced derivatives were their customers. Some must have been large companies, but many were those – ranging from insurance companies and pension funds to hedge funds – who manage our savings on our behalf.... 

Bank managements are presented as ignorant dolts, fooled by rogue traders. They were no such thing. 

The interest rate derivative market is many times the scale than is warranted by genuine demand precisely because it represented such an effective way of looting the rest of us. 

The business model of modern finance – banks trading on their own account in rigged derivative markets, skimming investment funds and manipulating interbank lending, all to underlend to innovative enterprise while overlending on a stunning scale to private equity and property – is not the result of a mistake. 

It represents a series of choices made over 30 years in which finance has progressively resisted any sense it has a duty of custodianship to its clients or wider responsibilities to the economy. It was capitalism allegedly at its purest. We now understand it was capitalism at its most rotten. It needs wholesale reform....

Please re-read the highlighted text as it highlights the need for bringing transparency to all the opaque corners of the financial system as soon as possible.

Dutch housing market slump continues

The Wall Street Journal reported on how the Dutch housing market is continuing to slump.  The slump in housing combined with a decline in exports is leading to a slowdown in the Dutch economy.

While the decline in house prices is not as bad as in Ireland and Spain, there are reasons to think that the decline in Dutch house prices still has a long way to go.

House prices in the Netherlands continued to fall in November, suggesting that the slump in the housing market will continue to disrupt the country's struggling economy next year.
Prices of existing homes fell by an annual 6.8% in November, national statistics agency CBS said on Friday....

Since the peak of 2008, house prices in the Netherlands have tumbled more than 16%, according to CBS. The slump isn't nearly as bad as the busts that have engulfed Spain and Ireland, but it is weighing heavily on the euro zone's No. 5 economy. 

The news followed a string of poor economic data released earlier this week that reflected the economic weakness in the Netherlands. The country's jobless rate rose to 7% in November, hitting a 10-year high, and consumer sentiment is again nearing a historic low, CBS said on Thursday. For 2013 and beyond, the outlook is bleak. 

The Netherlands, seen as one of the "core" members of the euro zone, is facing a long period of economic contraction that will likely drag on until the second half of 2013, according to several official forecasts. 

For the third time since 2009, the Netherlands is about to fall back into recession and some analysts say the crisis in the euro zone will give it a final push. 

"Exports were the key driver for the Dutch economy in the past years," said Maarten Leen, an economist at ING Bank NV. "But exports are falling away too, now that the euro zone is in a recession and the global economy is weakening." 

Mr. Leen noted that private consumption is being squeezed by the weak housing market and government spending cuts, and that it has spread to other segments of the economy. 

"Domestic consumption continues to decline, mainly because of the situation on the housing market. Against this backdrop, companies will postpone new investments." 

Falling house prices have caused an erosion of household wealth and this in turn has led to consumers cutting back their spending. Dutch households are among the most indebted in Europe due to their large mortgage debt.

It appears that there is a negative feedback loop that has the potential for accelerating significantly.

So far, only a small number of households are behind on their mortgage payments, but this number could rise if the jobless rate shoots up. Around 700,000 homes are now worth less than the value of their mortgage, according to government estimates, which means homeowners could suffer a loss if they have to sell their property.

Greek banks confirm that bailouts are unnecessary

The Wall Street Journal carried an article on how Greek banks need at least $36 billion of new capital in order to meet international capital standards.

Please note two very important facts:

• Despite low or even negative book capital levels, the banks are continuing to operate and support the Greek economy; and

• The capital injection by the government simply reduces the amount of time until the banks meet international capital standards.

The fact that the banks can continue to operate while they have low or even negative book capital levels is the result of how a modern banking system is designed.  This occurs because the banks have access to the combination of deposit insurance and access to central bank funding.

With deposit insurance, the Greek taxpayers are the banks "silent" equity partner when they have low or negative book capital levels.

Without the bailout, the banks would have to retain 100% or their pre-banker bonus earnings until such time as they have rebuilt their book capital levels.

Since the banks are already operating, all the bailout does is reduce the amount of time until the banks meet international capital standards and banker bonuses can once more be paid.  The downside of bailing out the banks this way is that it consumes government funds that could be better used to stimulate the real economy.

Greece's four largest banks need a capital boost of €27.4 billion ($36.29) to overcome the impact of the country's sovereign debt write-down as they battle to stem growing losses in the rapidly shrinking domestic economy. 

A mammoth €200 billion debt restructuring completed by the country earlier this year wiped out the capital base of Greece's top lenders—National Bank of Greece SA, Eurobank Ergasias, Alpha Bank AS and Piraeus Bank SA —forcing them to appeal to the government for help.

Note despite the massive losses, the banks continue operating.

On Friday, NBG said it requires a capital boost of €9.7 billion while Alpha needs a capital injection of €4.6 billion. This comes after Eurobank and Piraeus Bank said Thursday they need €5.8 billion and €7.3 billion respectively. 

"The total number seems to be at the high end of expectations," said Panagiotis Kladis, an analyst at investment services company National P+K. 

"This is a lot of money and investor interest in these banks will be determined by economic conditions prevailing in coming months and the economy's broader outlook."

Actually, investor interest in these banks is going to be a function of the ability of investors to assess the risk of each bank.

Investors know that the Greek economy is spiraling down into a Depression.  The question investors have is what exposures do these banks have.

The only way to answer that question is for the banks to provide ultra transparency and disclose their current global asset, liability and off-balance sheet exposure details.

Without this information, investors are being asked to blindly bet on 'black boxes' whose contents are primarily exposed to a depressed economy.  Not exactly an attractive gamble.

As part of Greece's second €173 billion bailout package from international creditors, Athens has earmarked about €50 billion for a bank recapitalization plan. 

Under the terms of the plan, Greece's bank-rescue mechanism, the Hellenic Financial Stability Fund, will underwrite coming rights issues and effectively take control of the four big banks, which combined account for three-quarters of the banking system's assets. 

Greek banks will use a mixture of common shares and convertible bonds in order to meet international capital adequacy requirements....

Standards that neither depositors nor investors care about.  Recall that Dexia went bankrupt with one of the highest Tier 1 capital ratios in the EU.

With the country grinding through its fifth year of recession, NBG and Alpha reported growing losses on rising bad loans and falling income levels. 

NBG showed a nine-month loss of €2.45 billion, versus a €1.34 billion loss last year. Net interest income fell 11% on the year to €2.5 billion while loan provision charges jumped 43% to €1.87 billion. 

"Against this stressed environment, our efforts focused on fortifying our balance sheet by carrying out provisions of circa €1.9 billion in the nine months of the year…defending our key sources of liquidity, and curtailing operating costs," said NBG Chief Executive Alexandros Tourkolias in a statement. 

Alpha Bank said its loss for January to September hit €711.8 million, up from €566.7 million last year. Its net interest income dropped 16.4% on the year to €1.1 billion while loan loss provisions hit €1.17 billion, up 41.5% on the year.

BoE's Robert Jenkins: plan to increase bank share price

In his speech to the ABI Annual Investor Conference, the Bank of England Financial Policy Committee member Robert Jenkins laid out a plan for what he thinks it will take to a) increase bank share prices and b) reduce risk in the financial system.

Naturally, the starting point for his plan is transparency of the risks that are on and off the bank balance sheet.

He presented the plan in a hypothetical speech by a bank CEO.

As you know we have weathered the crisis reasonably well. Loss-making quarters have been few. Earnings are recovering. Our balance sheet is stronger. By the standards of the industry we have much of which to be proud. There is only one not-so-small problem. Loyal shareholders – you, have made no money. 

Why have you made no money? Because the dividend was cut by us and bank share prices were cut by the market. 

Why did we cut the dividend? Because we wished to re-build capital. 

Why were bank share prices“cut?” Because the market fears that the capital we have built is insufficient. 

Why might our capital be insufficient? Well there is concern about the past and worries about the years to come. Investors fear that losses from the past will drag down earnings in the future. And in thinking about the future they are more conscious of the risks that financial firms take and the leverage with which they take them. 

Finally, there is uncertainty over the regulatory playing field on which banks will compete. 

Are these perceptions likely to change soon? Not unless we change. 

What must such change accomplish? It must lay to rest worries of vulnerability. It must remove to the extent possible the threat of surprise. It must clarify the earnings we hope to achieve and the risks we must take in order to achieve them. 

It must prove to prospective shareholders that management will do what is necessary to create shareholder value. And it must convince investors that such value will include a dependable dividend. 

So what is the plan? 

1) we will invite independent specialists to review our holdings and confirm our valuations. They will publish the results. 

2) we will increase provisions to the extent permissible; 

3) where the accounting standards do not permit prudent provisioning, we will ensure that in capital excess to regulatory requirements is there to absorb the losses...

Investors no longer strive for high short term returns unadjusted for risk. They strive for attractive relative risk-adjusted returns. 

The market will reward balance sheet strength, greater transparency, lower volatility and a predictable dividend - with a higher earnings multiple

Why invite a select few independent specialists to review each bank's holdings and the bank's valuation when the market is, by definition, the entity best equipped to review and value the holdings?  After all, the market includes all the specialists plus the rest of the valuation experts.

Why should anyone trust a few independent specialists?

If there is anything that has been learned from having accounting firms and specialists like BlackRock Solutions review banks in Ireland, Greece and Spain, it is that markets do not trust their results.

In theory, after the specialists have done their review, the facts are suppose to be disclosed to the market.  Then why hide the underlying data and not let the market independently confirm their assessments?

The bottom line of using independent specialists in place of the market is that you are raising a very large red flag and saying that the banks have something to hide.

Regular readers know that Step 1 of Mr. Jenkins' plan should be to provide ultra transparency.  Step 1 should be rewritten as follows:

1) We will disclose on an ongoing basis all of our current global asset, liability and off-balance sheet exposure details so that all market participants can confirm our valuations and our conservative management of risk and see that we have nothing to hide.

NRA response to reform after Newtown killings parallels big banks response to reform after financial crisis

The NRA's response to reform after Newtown killings bears a striking resemblance to the response to reform after the financial crisis by the big banks and their lobbyists.

In their column, Why does the NRA fear the truth of gun violence?, the Bloomberg editors look at how the NRA has successfully lobbied against transparency and shrouded needed information behind a veil of opacity. (Exactly what Wall Street and their lobbyists did before the financial crisis.)

A week after the gun massacre in Newtown, Connecticut, the National Rifle Association is speaking out. As well it should. If only the NRA believed in the right to free speech as fervently as it believes in the right to bear arms. 

Faced with government-funded research that contradicts NRA claims on gun safety, the gun lobby moved to defund the research and silence the researchers. 

When news reporters tried to learn which gun shops repeatedly supply violent criminals with firearms, the NRA lobbied to have gun-trace data exempted from the Freedom of Information Act. 

When advocates of transparency in campaign finance proposed the Disclose Act in Congress to require disclosure of top donors to political advertising campaigns, the NRA once again marched to the beat of its own 100-round drum: The organization obtained an exemption to keep its information secret. 

The list goes on. 

The NRA-backed Tiahrt Amendment requires the Justice Department to destroy records after gun-purchase background checks, making it harder to identify and catch straw buyers who work for criminals. 

As part of its war on information, the gun lobby has blocked efforts to put sales records into an integrated database, making the data more difficult for law enforcement officers to retrieve and organize, and complicating efforts to analyze gun trafficking patterns.... 

You might think, as we do, that the gun lobby’s aversion to information, and its success in securing congressional support for secrecy, poses a threat to public health and law enforcement (not to mention democracy). There is surely a case to be made to that effect. Yet it’s harder to document that argument thanks to the successful suppression of information. 

That, of course, is the point. In a study published in 1993 in the New England Journal of Medicine, researchers found that the presence of a gun in a home significantly increased the risks of homicide and suicide. (A finding seemingly borne out in the case of Nancy Lanza, the mother of the Newtown killer, who was murdered with her own gun.) The study was compelling, thought-provoking and attention-grabbing. Was it conclusive? 

Hardly. But rather than trust in scientific principle and a free marketplace of ideas to sort through the data, the gun lobby mobilized to snuff out such research altogether. 

The effort was remarkably successful....

This is exactly what the big banks and their lobbyists have been doing.  Rather than trust in a free marketplace to sort through the data and see what was on and off bank balance sheets and stuffed into securitizations, the big banks and their lobbyists mobilized to hide the data.

These are the results of the gun lobby’s storied political muscle. They are not, however, the actions of a political movement confident that history, data or reason itself can support its agenda. Truth doesn’t fear information.

The same applies to big banks and their lobbyists.

In response to the NRA's suggestion of putting an armed guard in every school, Mayor Michael Bloomberg made a few observations.

“Their press conference was a shameful evasion of the crisis facing our country,” Bloomberg said in an email to reporters. “Instead of offering solutions to a problem they have helped create, they offered a paranoid, dystopian vision....

In his response, Bloomberg said the NRA’s suggestion of armed security at schools shows the group “continue[s] to oppose the most basic and common sense steps we can take to save lives.”...

Sounds exactly like what the big banks and their lobbyists did after the financial crisis.

The most basic and common sense step we can take to prevent another crisis is to ensure that transparency is brought to all the opaque corners of the financial system including banks and structured finance securities.

The big banks and their lobbyists have aggressively fought this most basic and common sense step.

Joined by survivors of gun violence Monday, Bloomberg said he hoped the tragedy would be a turning point in the debate about gun control.

In the same way that taxpayers were hoping that the financial crisis would be a turning point in the debate over the Geithner Doctrine (nothing must be done that will hurt the profits or reputations of any bank that is pretty big and/or well-connected).

Beyond Bloomberg, other local politicians responded harshly to the first public statement from the nation’s most powerful gun-rights lobby.  

Rep. Chris Murphy, a Connecticut Democrat, posted a message on Twitter: “Walking out of another funeral and was handed the NRA transcript. The most revolting, tone deaf statement I’ve ever seen.”

Clearly hasn't been reading the statements by the big banks and their lobbyists.

China's equivalent of the CDO imploding and needs $1 trillion bailout

Reuters reports that the Chinese equivalent to opaque, toxic sub-prime mortgage-backed securities is in the process of imploding and is threatening to bring down its banking system unless the government injects upwards of $1 trillion.

The default of a Chinese investment plan has handed Beijing a tough choice: bail out investors and endorse moral hazard or let it fail and risk unnerving those who hold at least $1 trillion in so-called wealth management products.

China's bank regulators are debating what to do about the investment sold at a Hua Xia Bank branch near Shanghai, which failed to pay out on maturity late last month. 

The bank, a mid-sized lender partly owned by Deutsche Bank, says a Jiading district branch employee sold the product without authorization.... 

It's not yet clear how many, and to what extent, others have defaulted. But analysts say that if more flop and generate headlines like the Hua Xia case, a crisis in confidence could ensue, sparking a run on the wealth product market. 

"Some of these products won't be able to generate enough money to pay back investors," said BofA-Merrill Lynch China strategist David Cui. "The issue is, at a certain point, if it gets to a certain scale, you can no longer cover up the losses. Then we may have a systematic risk on our hands."

Wealth management products have taken off in the past five years, with Chinese looking for investment choices other than real estate, betting on the country's roller-coaster stock markets or parking money in bank accounts that offer state-set deposit rates. 

The majority of the products are short-term savings vehicles often created by third parties and issued through banks. The products mostly invest in stocks and money market instruments, promising returns of 4-5 percent. 

But a sizeable amount have funneled money into riskier investments, offering double-digit gains by financing anything from property and infrastructure projects, to car dealerships, pop concerts and even the sale of ham. 

The products are part of China's "shadow banking" system - or credit given to borrowers outside formal lending channels. 

Barclays estimates the shadow banking industry has nearly doubled in the past two years to 25.6 trillion yuan ($4.11 trillion), or more than a third of total lending.

To recap, the wealth management product invests in assets that the buyer cannot see and independently assess the risk of and in return the buyer gets a fixed rate of return.

This sounds like blindly betting with lousy odds.

Beijing has not forced Hua Xia Bank to pay back the estimated 500 investors hit by the default. 

China International Capital Corp (CICC), a prominent Chinese investment bank, urged regulators in a December 4 note to allow such products to fail. Most are not guaranteed by banks, analysts say. 

"If we don't take this opportunity to let a relatively small-scale contract be broken, it will only reinforce the attitude that these products have a rigid return and a limitless guarantee," CICC said. Forcing Hua Xia to stand behind these products would cause "no end of trouble", it added..... 

Wealth management products shot to prominence after China's stock markets sank during the 2008 global financial crisis. As China pumped up its economy and inflation surged past official interest rates, investors sought higher returns elsewhere rather than effectively lose money in bank deposits.... 

China's wealth products have been likened to the U.S.-invented collateralized debt obligation (CDO). That product pooled together loans, mostly American mortgages, and sold them to hedge funds. When home owners defaulted, and hedge funds stopped buying CDOs, banks were left with packaged loans they couldn't sell. That helped cause the 2008 financial crisis. 

Beijing has tolerated wealth products because they offered alternative investment opportunities and channeled credit to industries in need.

The CBRC put the total outstanding at 6.7 trillion yuan ($1.08 trillion) as of September, nearly double the year before. Fitch Ratings predicts total sales will hit 13 trillion yuan by the year-end, or more than 16 percent of total bank deposits....

Working out how many need to default before they threaten China's financial system is impossible to tell because the real threat is investor psychology, he said. 

If Chinese investors stop buying wealth products en masse, that would likely cause a liquidity crunch, and force Beijing to react, according to Werner. 

"The government will step in if social stability is at risk," Werner said. 

Cui from BofA-Merrill Lynch said any loss of confidence in wealth management products would have wider consequences. 

"This can be self-reinforcing. Once people stop buying (them) for fear of potential defaults, in addition to the solvency risk, the market will face liquidity risk as well," he said. 

Analysts suspect a lot of lenders are using new money to pay old customers that have invested in wealth products.... 

A "Ponzi scheme" is what Xiao Gang, chairman of Bank of China, the country's number 4 lender, called certain wealth products in a newspaper editorial in October. A Ponzi scheme collapses when new money no longer comes in, and old investors cannot be paid.

Around 70 percent of wealth products are tied to bond and money markets. Where the rest goes is less clear. The government has said principal guaranteed products offered by banks must be counted on a lender's balance sheet. 

That means banks are on the hook for the roughly 15 percent of products in circulation they have guaranteed. 

Analysts agree that if a host of wealth products went bust, it would cause a liquidity crunch. At the very least, banks would be expected to cover losses and pay investors principal plus interest on products that had been guaranteed....

May Yan, head of Asia bank research at Barclays, said the market needed failure to educate domestic investors about taking excessive financial risks. At the same time, the government needed to be aware of the pressure that would fall on banks should customers demand repayment. 

She predicted the banking regulator and the central bank would tighten up on wealth products and shadow banking in 2013. 

"If the product fails, it is a big step forward for risk awareness in China," Yan said. "If banks need to bail everyone out, the implications would be very negative."

The lesson to be learned is not to blindly gamble and that financial products need to provide disclosure so that market participants have access to all the useful, relevant information in an appropriate, timely manner so they can independently assess an investment and make a fully informed investment decision.