naked capitalism

By Edward Harrison of Credit Writedowns

Willem Buiter has just taken on a new role at Citi. The news of Willem Buiter’s role as Chief Economist at Citigroup comes via DealBook at the New York Times below. Afterward, I have some comments about Dubai contextualizing Yves’ recent post detailing a reluctance by the government to backstop Dubai World – something Buiter warns against.

Citigroup said on Monday that it has hired Willem Buiter, a professor at the London School of Economics, as its chief economist, effective January 2010.

Mr. Buiter will replace Lewis Alexander in Citi’s top economics post, in which he will head the firm’s economics research unit and join the management team of Citigroup’s Citi Investment Analysis and Research group.

“We are delighted that we have been able to attract a thought leader of Willem’s experience and track record to our global platform,” Andrew Pitt, the global head of Citi Investment Research & Analysis, said in a statement.

Currently a professor of political economy at the L.S.E., a well-known economics commentator and blogger and a consultant to Goldman Sachs, Mr. Buiter previously held posts at the European Bank for Reconstruction & Development and the Monetary Policy Committee of the Bank of New England.

“As one of the world’s most distinguished macroeconomists, Willem’s deep knowledge of global markets and economies, and emerging markets economies in particular, will be invaluable to our clients,” Hamid Biglari, Citi vice chairman, said in a statement.

I see this as a huge positive for Citi because it demonstrates that Citi is looking for fresh perspectives outside the mainstream. Buiter has been one of the finance bloggers most vocal in decrying the policies adopted before and during the panic in the global financial system.

Buiter correctly anticipated the potential for collapse in the Icelandic banking system. Since then he has warned other small open countries like Ireland and Dubai not to follow in Iceland’s footsteps in providing sweeping government backstops to bankrupt troubled institutions. This is what he terms the sovereign debt delusion (see “Too big to rescue” for more on this).

His most recent blog entry pointed out the relative insignificance of Dubai in the global system but it warns of the potential for sovereign default –especially in the Eurozone. He agrees with Credit Writedowns’ assertion that the US and the UK, as sovereigns that hold debt in their own currencies, are likely to try the inflationary route to mitigate the mounting debt burdens (see “Inflation: The strategy that dare not state its name”).

The massive build-up of sovereign debt as a result of the financial crisis and especially as a result of the severe contraction that followed the crisis, makes it all but inevitable that the final chapter of the crisis and its aftermath will involve sovereign default, perhaps dressed up as sovereign debt restructuring or even debt deferral. The Dubai World and Nakheel debt standstill and possible default is of systemic significance only because it may well be a harbinger of future sovereign financial distress, in Dubai and elsewhere.

From Dubai to Iceland, Ireland, Greece, Hungary, Italy, Portugal, Spain, Japan, France, the UK and the USA, the sovereign debt burdens have been at current levels during peacetime only on the way down from even higher public debt burdens incurred during wars.  Watching the public debt to GDP ratios rise to levels likely to reach or exceed 100 percent of GDP by 2014 is deeply worrying, especially with structural primary (non-interest) deficits as high as they are.  The political economy of fiscal burden sharing, inside nations and between nations, will be a major field of enquiry for economists and political scientists during the years to come. I am pessimistic in that regard about countries characterised by deep polarisation and political gridlock.  This includes nations as different as Greece and the USA.

It is clear that nations whose public debt is mainly denominated in domestic currency and whose central bank is either not very independent or can be make dependent by the government of the day are likely to choose inflation and exchange rate depreciation over default as a way out of fiscal-financial unsustainability.  That category would include the USA and, to a lesser extent, the UK.  Because the ECB faces 16 national governments and national ministries of finance, the power and independence of the ECB are much greater vis-a-vis any Euro Area member state than the power and independence of any central bank facing a single national government and Treasury.  That is regardless of the formal independence criteria laid down in laws, treaties or constitutions.

The practical implication of this is that the ECB will not monetise the government debt and deficits of small European Area member states.  Only Germany can really push the ECB around, partly for historical reasons, partly because it is the largest and most powerful Euro Area and EU member state and partly because of the geographic reality that the ECB is on its territory – in the final analysis the German government can order a siege of the Eurotower …

For small peripheral European nations, the threat of sovereign insolvency is therefore a real one, unless EU fiscal solidarity can be relied upon to bail them out.  When Ireland was about to be swept away by a wave of global financial mistrust triggered by the Irish government’s decision to guarantee effectively all liabilities of its banks, the then German Finance Minister Steinbruck made the amazing statement (which he obviously had not checked with his coalition partners, his Chancellor or his voters) that the Eurozone countries would not let one of their own go into default.

The year that has passed since then has made this implicit commitment to a Eurozone, let alone an EU cross-border sovereign bail-out rather less credible.  All EU sovereigns are, to varying degrees, in fiscal dire straits.  We may well see in the next few years the first sovereign default by an old EU15 country since Germany defaulted on its debt in 1948.  If the travails of Dubai wake us up to that possibility, they will have done some good.  Sovereign defaults are not acts of God.  They are the result of choices.  If we continue to play the political game in a business-as-usual mode, there could be quite widespread sovereign debt restructuring throughout the advanced industrial world.  If we grow up, we can avoid the worst.

I agree with Buiter’s sentiments. The best post I wrote on this topic was in February called “The European problem.” Despite asset market increases, the situation remains critical. Ireland, Greece, Spain, and Portugal are the clearest examples of countries which are storing up major trouble – and without the currency escape hatch – which makes these countries more akin to states like California, Michigan, or New York than the U.S. Sovereign credit ratings have been cut repeatedly in Ireland, Portugal and Greece.  Back in March, everyone was talking about this. But, somehow these concerns have faded from view as equity markets have risen. The exogenous shock in Dubai brought the reality back into the spotlight.

The same is true in the Baltics despite their sovereign currencies because of the Euro currency peg. Here too credit ratings are being cut. This is the reason I continue to be more concerned about Eastern Europe than I am about Dubai. Yes, there could be a butterfly effect with Dubai here but contagion risk is more acute in Eastern Europe where large banks have much greater exposure than in Dubai. I see Dubai as Buiter does – a tempest in a tea pot; the real action is in Europe.

So, hats off to Citigroup for getting Buiter onboard. His blog at the Financial Times, aptly titled Mavercon because of the unconventional ideas he often floats, demonstrates he will bring some critical new thinking to the organization.

Source

Citigroup Hires Buiter as New Chief Economist – DealBook

This is starting to get interesting. One of the problems of doing business in the Middle East is that the the boundary between the private business of the ruling families and state matters is often murky. Dubai World is forcing a some clarification, and the line is being drawn to cut off the real estate developer.

We had noted last night that the Abu Dhabi backstop was limited to banks, and thus appeared to exclude Dubai World. The Dubai action presumably reflects the stance of Abu Dhabi.

The implication is that other “commercial” developments that might have been assumed to be state backed will be seen in a different light.

From the Financial Times:

Dubai’s government will not guarantee the debts of Dubai World, the state-owned holding company struggling under the weight of $59bn in liabilities, arguing that lenders were mistaken to think that there was sovereign backing.

Abdulrahman al-Saleh, department of finance chief, said creditors were responsible for their own lending decisions and should differentiate between companies and the state.

“Creditors need to take part of the responsibility for their decision to lend to the companies. They think Dubai World is part of the government, which is not correct,” Mr Saleh said.

Mr Saleh’s comments underscored the government’s intention to cut Dubai World adrift and raised questions over whether it would distance itself from other parts of the emirate’s commercial empire.

Dubai World on Monday night unveiled details of how a restructuring of its debt might proceed.

“The total value of debt carried by the companies subject to the restructuring process amounts to approximately $26bn, of which approximately $6bn relates to the Nakheel sukuk [Islamic bonds from the property arm],” a company statement said.

“Initial discussions have commenced with the banks of Dubai World and are proceeding on a constructive basis,” it said. The efforts would not include other firms, which it said were financially stable, such as Infinity World Holding, Istithmar World and Ports Free Zone World, which includes DP World , Economic Zones World, P&O Ferries and Jebel Ali Free Zone, or JAFZA.

In a note to clients, RBC Capital Markets said Dubai World bondholders had “almost no legal legs to stand on” to recover the value of their investments from the government in the event of a default.

“We now have to look at each Dubai entity on its own merits and cash flows,” said one other banker. “The mood is really crummy, and it’s not just Dubai government risk, we have to be worried about healthy corporates with exposure to companies like Nakheel [Dubai World’s property arm] too.”…

Rachid Mohamed Rachid, Egypt’s trade and industry minister, warned that “the Dubai situation will have serious consequences for the region”…

Five-year credit default swaps for Dubai widened on Mr Saleh’s comments, after earlier tightening on UAE central bank intervention announced on Sunday.

Mr Saleh said creditors of Dubai World would be affected in the short term but claimed there would be long-term benefits as the government restructured the business.

Nakheel asked for all three of its sukuk worth $5.25bn to be suspended from trade, while Dubai World paid a coupon on another sukuk issued by the Jebel Ali Free Zone Authority, the industrial park next to Dubai’s largest port.

Ben Bernanke’s confirmation hearing before the Senate Banking Committee for his reappointment as Fed chairman is scheduled for this Thursday.

When CEOs preside over disasters, they are fired. Captains go down with their ships.

And Bernanke needs to be replaced.

He was a major architect of the policies that created the crisis.

He ignored signs of the severity of the developing crisis and failed to prepare for obvious dangers, like the collapse of an investment bank.

He has turned the Fed into an off-balance sheet funding vehicle of the Treasury to circumvent constitutionally-mandated budgetary procedures.

He has fought all efforts to examine the central bank’s conduct in the rescue operation.

Before, during, and after the crisis, he has put the interests of banks ahead of those of ordinary citizens.

He needs to go. Tell your Senator that this vote matters to you and he needs to vote no on Bernanke. Enlist the support of like-minded colleagues and friends to deliver the same message. Keep it simple and to the point. Bernanke has failed at his job. The US public deserves and needs better.

Please sign http://StopBailoutBen.com/

Be certain to concentrate your calls and e-mail messages on the members of the Senate Banking Committee, who are:

Christopher J. Dodd Chairman (D-CT)

Tim Johnson (D-SD)

Jack Reed (D-RI)

Charles E. Schumer (D-NY)

Evan Bayh (D-IN)

Robert Menendez (D-NJ)

Daniel K. Akaka (D-HI)

Sherrod Brown (D-OH)

Jon Tester (D-MT)

Herb Kohl (D-WI)

Mark Warner (D-VA)

Jeff Merkley (D-OR)

Michael Bennet (D-CO)

Richard C. Shelby Ranking Member (R-AL)

Robert F. Bennett (R-UT)

Jim Bunning (R-KY)

Mike Crapo (R-ID)

Bob Corker (R-TN)

Jim DeMint (R-SC)

David Vitter (R-LA)

Mike Johanns (R-NE)

Kay Bailey Hutchison (R-TX)

Judd Gregg (R-NH)

Among the most prophetic voices prior to the economic crash was UCLA economics professor Harold H. Somers, who warned in 1991 that revisions to the tax code would increase leverage, which could lead to economic disaster:

The result is to tilt the well-worn playing field even more in favor of leveraging, leading to the possibility of another leverage frenzy and debacle at some time in the future.

Professor Sommers explained:

The complete history of the causes of the junk bond debacle of 1989 and 1990 is yet to be written. But the tax incentive must have a prominent place in any comprehensive work. This comment applies to long-term debt where the interest deduction can be a major factor; short-term debt may be dominated by other considerations.

What is involved is essentially the shield against income tax that is provided by corporate debt compared with the shields that are provided for equity by the income tax rules …

Former President of the St. Louis Federal reserve Bank – William Poole – agrees in a new paper:

A straightforward fix for excessive leverage can be achieved through the tax system. Companies borrow, in part, because they believe that debt capital is cheaper than equity capital. That is certainly the case under the U.S. corporate tax system because interest is a deductible business expense in calculating income subject to tax whereas dividends are not deductible.

Excessive leverage is highly destabilizing to the financial system (see this, for example). If a simple fix to the tax code could substantially reduce leverage, I’m all for it.

Poole recommends the gradual phasing-in of changes to the tax code to reduce leverage:

Interest deductibility could be phased out over the next 10 years. Next year, 90 percent of interest would be deductible; the following year, 80 percent would be deductible, and so forth, until interest would no longer be deductible at all. The same reform would apply to all business entities; partnerships, for example, should not be able to deduct interest if corporations cannot.With this simple change, the federal government would encourage businesses and households to become less leveraged. We have learned that leverage makes not only individual companies more vulnerable to failure but also the economy less stable. We use tax laws all the time to promote socially desirable behavior; eliminating the deductibility of interest would reduce the risk of failure of large companies—especially, large firms—and thereby reduce the collateral damage inflicted by such failures.

The man who smuggled himself into Auschwitz BBC (hat tip reader Jack)

Susan Boyle tops charts with fastest selling debut album Telegraph

DARPA Funds Nano-UAV Hummingbird h+ (hat tip reader Sugar Hush)

Tying pirates in knots The Engineer

An Empire at Risk Niall Ferguson, Newsweek

As Sales Vanish, Alligator Skins Stay on Gators New York Times

Unemployed Line Up To Reenact Job Loss Scenarios In Clooney Film IMB (hat tip reader John D)

History Lesson John Jansen. Congrats to Jansen on his joining TD Bank, but I am pretty certain this means the loss of his blog (big and even small financial institutions are not too comfortable with the concept).

Japanese Industrial Production Up, but Disappoints EconomPic Data

Harvard ignored warnings about investments Boston Globe (hat tip reader John D). The title is wrong. It should be “Summers ignored warnings about investments.” And it is not critical enough. For instance, one party rationalizes the losses by saying Harvard still earned 8.9% on its cash account. But Harvard committed to a long-term building program and ramped up other operating costs, yet kept putting the money at risk. If the university had invested more conservatively, it is less likely that it would have gone on a big spending campaign. I am hearing the budget cuts are large and wide-ranging, including no more hot breakfast for undergrads.

Holiday shoppers shunned credit cards: survey Reuters

Buyers Take a Pass on Some Failed Banks Wall Street Journal

Professor advises underwater homeowners to walk away from mortgages Los Angeles Times (hat tip reader LeeAnn)

The Jobs Imperative Paul Krugman

Best Buy, Krugman and the Carry Trade Bruce Krasting

Antidote du jour (hat tip reader Jack):

Of late, the Treasury, House, and Senate have put forward proposals for how to resolve large financial institutions. The problem is that none of them seem to deal with the elephant in the room, namely, how the responsible grownups are going to deal with particular creditors and counterparties. For better or worse, bankruptcy procedures are well established, even if they do not fit large complex financial firms very well. The key element is that either freezing counterparty positions or forcing them to take large haircuts could be highly disruptive, which is what a resolution process is supposed to avoid. The lack of attention to mechanics is troubling and suggests that these efforts in the end will amount to window-dressing.

But Dan Arondoff offers an appealing, streamlined alternative:

There was another way to resolve the collapse of Bear and AIG without having to bail out their bondholders. The impetus and justification for the intervention, recall, was to prevent a default on contracts to counter parties that might have a devastating systemic impact. But the very same funds that were injected into the firms as equity to be used by the firms to pay its counterparties, could have been made available directly to those same counterparties if the Fed or Treasury had announced a willingness to purchase the contracts directly from the counterparties. Let’s take AIG. The Fed purchased $85 billion of stock –for 80% of the equity -that was immediately used to pay off CDS counterparties like Goldman Sachs. Once having injected the funds, the Fed became an equity holder in AIG, with a claim junior to all bondholders, both secured and unsecured. If the Fed had paid Goldman directly for its CDS contract (assuming Goldman was interested in selling), then the Fed would have averted a possible collapse of Goldman and acquired a claim on AIG – the Goldman CDS contract -that was senior to the equity holders and possibly senior to some debt holders and equal to some others. The Fed would have achieved a superior collateral position. AIG could have then undergone a normal bankruptcy. The Fed could have reduced taxpayer exposure further by setting its purchase offer for AIG claims at lower than 100% face value if it deemed that a lower payout would not risk financial meltdown,,,,The same principle would have seen the Fed offer to purchase Repo contracts from Bears’ counterparties.

Government does not need resolution authority over investment banks or bank holding companies. All that is required is authority (if it does not already exist) to offer to purchase contracts from counterparties of failing banks. It can then pursue collection of its claims in a normal bankruptcy process. This will resolve much of the moral hazard issue, as equity holders and bondholders will not be bailed out. It will reduce taxpayer exposure and the policy is credible.

This is an interesting idea, and I’d offer a refinement: that the resolution authority would be required to buy the claims out at current market value, but could provide a total cash disbursement up to the face value of the instrument. The resolution authority could structure that overpayment to be either debt or equity.

Reader comments very much appreciated.

The United Arab Emirates offered a reassuring statement today after sending a bit more tough-minded message yesterday.

The markets will not doubt take heart from the cheery word today, but we need to remind ourselves that the fat lady hasn’t sung yet. Unlike the conduct of banking authorities in the US towards their wayward charges, it isn’t clear that the UAE is prepared to write blank checks to Dubai.

Let’s first look at the somewhat tough talk of yesterday. From the Telegraph:

“We will look at Dubai’s commitments and approach them on a case-by-case basis. It does not mean that Abu Dhabi will underwrite all of their debts,” a senior Abu Dhabi official said.

Now consider the posture today, per Bloomberg:

The United Arab Emirates’ central bank eased credit for lenders and said it “stands behind” the country’s local and foreign banks as they face losses from Dubai World’s possible default….

U.A.E. banks are already facing rising loan losses stemming from the global recession as the economy slowed and two Saudi Arabian business groups defaulted on at least $15.7 billion of loans. Provisions for bad loans at U.A.E. banks rose to 2.76 percent of the total as of the end of October from 1.92 percent a year ago, according to central bank data.

The U.A.E.’s banking system is “more sound and liquid than a year ago” and local banks’ sale of medium-term notes and commercial paper in foreign markets has declined by 25 percent over the period, the central bank said. Foreign interbank deposits make up only 5 percent of the total, it said.

Dubai World, which owns property developer Nakheel PJSC, the builder of palm-tree shaped islands off the emirate’s coast, has $40 billion of debt, two bankers familiar with the company said Oct. 21, declining to be identified because the information is private. Some $18 billion of Dubai World’s debt is with companies such as port operator DP World Ltd. that have sufficient cashflow to service their loans, the bankers said. The remaining $22 billion is of greater concern, they said.

Yves here. So far, so good, but consider: the central bank support extends to banks, not to Dubai World. That means today’s statement is not necessarily a contradiction of the remarks yesterday. The restructuring of Dubai World still appears to be on, and that in turn appears to constitute a credit event on the credit default swaps that reference the relevant entities.

The Financial Times’ tone was more cautious than Bloomberg’s:

The UAE central bank set up an emergency liquidity facility to ease fears about its banking system, but investors remained nervous about the short-term impact on local markets as regional traders digested the global sell-off caused by the announcement that one of Dubai’s flagship entities – Dubai World – was seeking a standstill deal with creditors until May….

Meanwhile, Dubai World is preparing to persuade bondholders of Nakheel, its real estate unit, to roll over that maturity while the government is planning a charm offensive to repair damage caused by a standstill call that followed months of officials downplaying concerns over Dubai’s ability to meet obligations on its $80bn (£48bn) debt pile.

UAE authorities were in talks with Dubai officials over the weekend to formulate a response to investor fears and limit damage to the UAE economy.

Nakheel is due to pay $4bn on its Islamic bond next month, while the parent company has total liabilities of $59bn.

Bankers have been waiting to see if Abu Dhabi, the wealthy capital that bankrolls the central bank and is key to Dubai’s financial well-being, will intervene. But Abu Dhabi has always insisted that such issues have to be dealt with at a federal level….

Reaction to the central bank’s statement was mixed.

Marios Maratheftis, Gulf economist at Standard Chartered, said the move was positive, with the central bank acting proactively to send “a signal to banks and the world that they are behind the banks”.

Raj Madha, banking analyst at EFG-Hermes, welcomed it as a first step, but said the central bank might have to do more.

And there is a wild card in the mix. Lifted from a comment by RueTheDay in an earlier post:

There is an interesting angle here that isn’t being widely reported in the media, at least not yet.

These “bonds” are actually Sukuks, which are a type of Islamic Finance intended to get around the Islamic law that forbids the charging of interest on debt. They’ve only existed for around 7 years. It’s actually not a bond at all. They create an SPV for the issuing entity that owns all of its assets, the sukuks represent what appears to be an equity interest in the SPV backed by the underlying assets, and the payments are not “interest” but rather “rent” for the use of the assets. No idea what the courts will make of this in the event of a default.

So there is a possibility that this structure will be tested in the default and found to be wanting. And that could redound to all other debt like this. Remember when suddenly no one wanted anything to do with anything that might be tainted with subprime?

Independent of any rescue, a lot of investors and lenders will lose out on the collapse of the Dubai bubble. So the jury is still out on the ultimate costs.

Update 11:00 PM: Reuters, weighing in later, gave an even less positive reading:

But the move to inject liquidity into Dubai’s banks by the central bank of the Gulf Arab state, together with promises by neighboring city-state Abu Dhabi to provide selective support to Dubai companies was seen as by analysts as the bare minimum.

Siberian tiger in severe decline BBC

Is Global Warming Unstoppable? Science Daily

China takes a new look at Marxism Asia Times

Overcapacity in China: Causes, Impacts and Recommendations European Chamber of Commerce in China (hat tip reader Michael) and Dangers of an Overheated China Tyler Cowen, New York Times

Food Stamp Use Soars Across U.S., and Stigma Fades New York Times

Bernanke May Not Remember That the Fed Brought the Economy to the Brink of Collapse, but Reporters Should Dean Baker

Wallison: Timmy!’s Nose is Growing Streetwise Professor

Abu Dhabi rides in to rescue Dubai from debt crisis Times Online and Abu Dhabi will not race to Dubai’s rescue Telegraph. Notice the difference in headlines and emphasis with pretty much the same fact set. The Telegraph’s spin looks truer to the fact set. This suggests the rescue is going to be tougher to negotiate and less comprehensive than the US markets seemed to assume on Friday.

Antidote du jour. Reader Martine reports:

Attached is a picture I would entitle “True bears face a recession of their own”. Indeed, the cool and extremely wet summer we had here in Quebec has left the bushes almost devoid of berries. This bear came in my backyard a week ago, toppled over the garbage bin three times and – finally – ate apples form the appletrees on the edge of the forest…. 15 feet away from my back door.

And a bonus (hat tip reader Michael T), of sunset at the North Pole with the moon at its closest point.

By Thomas Adams, at Paykin Krieg and Adams, LLP, and a former managing director at Ambac and FGIC.

Many thanks for the thoughtful comments on my earlier post. If you can take a little more on the subject, I thought I would add some clarification to some of the issues raised.

First, on the merits of a monoline vs. AIG bailout, consider a case of counterparty compare and contrast, using Goldman Sachs and Citigroup as examples.

The popular wisdom in the aftermath of the crisis is that Citigroup is the sick man of the banking world: they lacked sufficient controls to protect against unwise exposures to CDOs and other structures, they are still alive only due to massive government loans, etc. Goldman, in contrast, has been praised for their superior risk management and their shrewdness in avoiding the worst aspects of the crisis.

In light of the benefits Goldman received through the bailout of AIG, are these interpretations still accurate?

Citi had massive exposure to the monolines due, in part to their unique history together. Way back at the time of their first bailout around 1990, Citi owned two bond insurers: Ambac and Capmac. At the strong suggestion of the government, Citi unloaded Ambac and Capmac through initial public offerings in the companies. Capmac was subsequently acquired by MBIA. Though Citi sold off their interests in Ambac and Capmac, the companies have long been in bed with Citi. The senior management of both companies consisted of many former Citi executives. Both Ambac and MBIA were very active insurers for Citi’s asset backed commercial paper programs and for a variety of other structured finance assets.

Over the course of late 2007 and early 2008, as the bond insurers faced pressure and eventually downgrades due to their CDO exposures, the stock market would swing wildly around based on news of possible bond insurer bailouts. At times, these previously obscure companies seemed to hold the fate of the market in their hands. Despite widespread concerns about the impact monoline insolvency might have on counterparties, municipalities and investors, various commentators and bankers suggested that a bailout for the monolines would be inappropriate or might create the risk of moral hazard. Goldman Sachs, back in January of 2008, suggested that a bailout of the monolines would be ineffective and that putting the companies into run-off made more sense. As hedge fund manager Whitney Tilson (who was gleefully shorting the insurers) helpfully points out in the same article, a bailout of the monolines would have helped banks like Citi and Merrill who had been foolishly writing dozens of CDOs, but would not be in Goldman’s interest, since Goldman had avoided such risks. The monoline bailout never arrived.

It is strange then, after months of debate about the market-wide risk presented by monolines and the apparent government decision not to rescue them, that the Treasury and Fed suddenly discovered systemic risk when AIG faced a potential failure. This discovery coincided with AIG’s massive new collateral posting requirements after the company’s ratings were downgraded in September 2008. As it turned out, this posted collateral eventually flowed to the benefit of Goldman, among others. As it also turned out, the transactions for which Goldman received the collateral revealed that Goldman had not entirely been avoiding CDOs after all. They just had a different counterparty for their trades than Citi or Merrill.

Had the government bailed out the monolines, rather than AIG, Citi might have been in much better shape than they are now. The status of Citi’s huge off-balance sheet risk, some of which received enhancement from Ambac and MBIA, might be materially different. Today, Citi might be the bank being hailed for navigating the crisis successfully and paying impressive 2009 bonuses. In addition, had the Fed bailed out the monolines, no collateral posting would have been required and cash would not have flowed directly into Citi’s pockets.

Goldman, which had argued against a monoline bailout, was a major beneficiary of the bailout of AIG. In the absence of an AIG bailout, Goldman might now be the bank propped up by huge government loans. For this, Goldman can be credited for being a better political operator in a time of crisis than Citi. Or maybe they just managed to hide their bailout better.

Next, I would like to add a few clarifications.

AIG’s “regulatory capital trades” have been the subject of some confusion in the comments to my prior post and elsewhere. I believe that this phrase is just another name for “negative basis trades” which is just another way of describing collateralized debt obligations (CLOs) which were insured by AIG and the monolines via CDS. AIG had a massive portfolio of insured CLOs but, in aggregate, the monolines did as well. Some of the monolines who avoided real-estate related CDOS (such as FSA and Assured) had very large insured exposure to CLOs. In fact, all of the insurers had much bigger exposures to CLOs than to those CDOs.

As the crisis was emerging, the insurers sought to distinguish CDOs backed by subprime and mortgage collateral from CLOs backed by high yield corporate debt. However, these two asset classes were just offshoots of the same business. Like CDOs, the insurers would insure AAA rated bonds on a “secondary” basis by delivering credit default swaps to the protection buyer. Because both CDOs and CLOs were insured via CDS, they were both subject to mark to market accounting, whereas traditional insurance was not. In the wake of the financial crisis, the insurers experienced mark to market losses on both CDOs and CLOs.

However, by mid-2008, while no CDO had resulted in an actual claim yet, the insurers could no longer credibly argue that they would not incur real losses on the CDOs (though they tried). In contrast, CLOs, while suffering from impaired pricing, were still rated AAA and looked like they might survive without any losses. CLOs were still considered “safe” and therefore not a significant source of future insured losses. Thus, the impact from AIG’s and the monoline’s downgrades was much less for holders of insured CLOs. The regulatory arbitrage that the European banks had played with the CDS might be unwound, but the underlying bonds were still AAA, whereas the insured bonds in the many CDOs were worth pennies on the dollar.

With respect to questions regarding Goldman’s security in the collateral posted by AIG: this was no sure thing for Goldman. Had AIG gone bankrupt, the bankruptcy trustee could have tied the money up for years, as has happened in the UK to hedge funds exposed to Lehman. If Goldman had a pressing need for this cash, such a tie-up might have been a real problem. In addition, as the Skeptical CPA pointed out in a series of excellent posts some time ago (http://skepticaltexascpa.blogspot.com/2009/05/goldman-aig-and-18-usc-152.html,http://skepticaltexascpa.blogspot.com/2008/11/bust-outs-and-paulson-mob.html, andhttp://skepticaltexascpa.blogspot.com/2008/12/deprizio-doctrine-and-aig.html), the posted collateral could be subject to claw back, or worse, by a bankruptcy judge, depending on whether AIG was determined to be “insolvent” at the time of the posting. Had the deals that lead to AIG’s dire straits been examined in detail by a bankruptcy judge, Goldman might have faced questions about their own culpability in their AIG’s demise.

Goldman has made it clear that they are upset and concerned about all of the media attention on their role in the bailout. In my view, they should really turn their gaze inward and be angry at the people who put them in a position of massive exposure to AIG. Instead, they (and their friends such as John Paulson) boasted about how much smarter they were than everyone else by profiting from the market downturn and having superior risk management. As we know now, some of these claims turned out to be an exaggeration.

In a sign that the Federal Reserve is circling the wagons, chairman Ben Bernanke has an op-ed in the Washington Post that attempts to defend the central bank’s role. What is interesting is how much the tables have turned. The Obama effort to make the Fed into the uber bank regulator has become a rout, with decent odds that the Fed will have its powers reduced, and an increasing possibility that Bernanke might not be reconfirmed (which is frankly the right outcome, no CEO who presided over a similar disaster would still be in charge).

This piece has so many artful finesses that I must limit myself to the most salient points. From Bernanke:

As a nation, our challenge is to design a system of financial oversight that will embody the lessons of the past two years and provide a robust framework for preventing future crises and the economic damage they cause.

Yves here. He’s only one paragraph into the article and he is already discrediting himself. If he is looking only to last two years for lessons, he is looking in the wrong place. This crisis was at a minimum a decade in the making, and I’d say more like 30 years. Where are the post-mortems? There is absolutely no evidence that the Fed sees its own policies, namely the Greenspan and then Bernanke puts, and the extreme laissez-faire attitude towards bank regulation, as major culprits.

For instance, the Fed was the architect of the “let a thousand flowers bloom” policy towards derivatives, and made inadequate (one might say no) effort to understand new financial technology. Bernanke himself rationalized burgeoning consumer debt, claiming that consumer balance sheets were in good shape. Hun? This is Japan circa 1989 thinking. The measure of whether a borrower can handle his debt load is primarily his debt coverage ratios (income versus debt service costs). And by those measures, consumer creditworthiness had been deteriorating (admittedly, the data series aren’t great here, but merely looking at zero consumer saving rates would tell anyone with an operating brain cell that things were out of whack). And why do we want to encourage consumer borrowing? Unlike businesses, consumers are not funding in productive investments (and before you offer student loans as an example, one reader has done an analysis and had concluded the returns are lousy). Balance sheets are relevant only in a distress or liquidation scenario. If you need to revert to a conversation about balance sheets to defend debt levels, it should be obvious you are on shaky ground.

Similarly, I had a chat with a Fed official in the early stages of the subprime crisis, and the Fed was absolutely unwilling to see the banks as having any culpability for the disaster.

This is hardly a complete list of pre-crisis failures; I’m sure readers can make numerous additions. Back to Bernanke:

I am concerned, however, that a number of the legislative proposals being circulated would significantly reduce the capacity of the Federal Reserve to perform its core functions. Notably, some leading proposals in the Senate would strip the Fed of all its bank regulatory powers. And a House committee recently voted to repeal a 1978 provision that was intended to protect monetary policy from short-term political influence. These measures are very much out of step with the global consensus on the appropriate role of central banks, and they would seriously impair the prospects for economic and financial stability in the United States. The Fed played a major part in arresting the crisis, and we should be seeking to preserve, not degrade, the institution’s ability to foster financial stability and to promote economic recovery without inflation.

Yves here. Notice how Bernanke invokes a “global consensus,” which is wonderfully vague and ignores the fact that the pre-crisis “global consensus” of minimally regulated markets and financial institutions, is precisely what caused the crisis. Moreover, even if the Fed’s mandate in theory was appropriate, its governance structure is not. The Bank of England and the ECB are not peculiar largely private institutions, accountable to almost no one, as the Fed now is. The Fed’s insistence on secrecy regarding many of its emergency operations is unwarranted and deeply troubling. And “the Fed played a major role in arresting the crisis” ignores the fact that the Fed played a major role in creating it, namely, via negative real interest rates for a protracted period. And he is declaring the Fed’s policies to be successful when the jury is still out.

Back to Bernanke:

The proposed measures are at least in part the product of public anger over the financial crisis and the government’s response, particularly the rescues of some individual financial firms. The government’s actions to avoid financial collapse last fall — as distasteful and unfair as some undoubtedly were — were unfortunately necessary to prevent a global economic catastrophe that could have rivaled the Great Depression in length and severity, with profound consequences for our economy and society. (I know something about this, having spent my career prior to public service studying these issues.) My colleagues at the Federal Reserve and I were determined not to allow that to happen.

Yves here. This is actually very arrogant once you translate it: “What we did was correct, but the public is on a witch hunt and is incorrectly taking it out on the Fed. And I do know better because I am an expert on the Depression.” First, if we are going to get into dueling experts, Anna Schwartz has been enormously critical of the Fed’s conduct, both pre-crisis and in seeing providing liquidity as the primary solution. She also warned explicitly against drawing comparisons between the gold standard era Depression and now. Second, Bernanke’s reading of the Depression (which is pretty conventional, that the Fed blew it by not providing more liquidity) is contradicted by other evidence. As Paul Krugman has pointed out repeatedly, the monetary base, which is what the Fed controls, grew in 1930. But the money supply collapsed. Third, the vast majority of economists tend to look for single factor explanations of why the Depression ended, and within those, tend to focus on the ones that are the easiest policy levers, namely monetary or fiscal stimulus. But the Depression also saw considerable institutional reform, as well as a protracted period of debt reduction, via restructuring (via the Home Owners Loan Corporation) and defaults. Drawing simple conclusions from a complex phenomenon strikes me as misleading and misguided.

Back to Bernanke:

Moreover, looking to the future, we strongly support measures — including the development of a special bankruptcy regime for financial firms whose disorderly failure would threaten the integrity of the financial system — to ensure that ad hoc interventions of the type we were forced to use last fall never happen again. Adopting such a resolution regime, together with tougher oversight of large, complex financial firms, would make clear that no institution is “too big to fail” — while ensuring that the costs of failure are borne by owners, managers, creditors and the financial services industry, not by taxpayers.

Yves here. This is way oversold. First, financial firms decay catastrophically, as we saw with Bear and Lehman. No one has a template for how to resolve a big capital markets trading firm, save a subsidized gunshot wedding. This is like pretending you know how to build a nuclear weapon in 1935. What do you do about counterparty exposures? No one wants to be at risk of having his positions frozen. And if you have the government backstop a firm while it continues trading, you get into another huge can of worms. And layer the political problems, that to resolve a big financial firm, you need a very large check. Congress is not about to cede that kind of spending authority to the Treasury, and there do not appear to be any proposals on the table to come up with emergency approval processes (as in some pre-set frameworks and ground rules). But even so, there are massive thorny issues that Bernanke is pretending are solved, when they have not even been addressed. What do you do with Citibank’s $500 billion of foreign deposits, for instance, a fair chunk of which are presumably uninsured? How do you justify having US taxpayers bail out foreign depositors? What responsibility (if any) does the US have for trading operations in other countries? This is thorny because trading books are passed across time zones, again putting operational issues in conflict with legal jurisdiction. And it isn’t clear that a US desire for a resolution regime will dovetail well, or at all, with the bankruptcy regimes in various countries (bankruptcy is handled where the legal entities are domiciled, the Fed’s fond wishes for a US-driven process to the contrary). I have not seen anything to indicate that anyone in authority has grappled with the complexity of the issues, which means statements like this are mere empty sloganeering.

Back to Bernanke:

Working with other agencies, we have toughened our rules and oversight. We will be requiring banks to hold more capital and liquidity and to structure compensation packages in ways that limit excessive risk-taking. We are taking more explicit account of risks to the financial system as a whole.

Huh? Toughening oversight? We’ve seen the reverse, massive regulatory forbearance. Yes, I am told the Fed is now making all the banks disclose their derivatives positions to them, but the Fed lacks the analytical capacity to do much with this information (and I am further told the Fed staff understands that too). So that does not fit my notion of “tougher oversight.” And the rest is just empty promises. Back to the op-ed:

We are also supplementing bank examination staffs with teams of economists, financial market specialists and other experts. This combination of expertise, a unique strength of the Fed, helped bring credibility and clarity to the “stress tests” of the banking system conducted in the spring. These tests were led by the Fed and marked a turning point in public confidence in the banking system.

Yves here. The worst is the folks at the Fed clearly believe the bogus stress tests were a meaningful exercise. That alone should disqualify them from getting a bigger role in bank supervision. And if you read their pronouncements, they plan to continue to use them, and have the process run by….monetary economists! Pray tell, what do they know about bank operations? Help me! And some of the help the Fed has enlisted in the stress test exercise includes the consulting firm McKinsey, which has the biggest banking practice in the consulting industry. Think McKinsey is going to devise anything that might be rough on its biggest meal tickets? Bernanke also conveniently ignores the fact that the rally might also have a wee bit to do with the fact that he threw a bit over $1 trillion at the markets, as announced in mid-March.

I could go on, but you get the picture. The Fed seems to believe its own PR.

For the record, zero is a very impressive achievement, so we have to give the Treasury department credit where credit is due. From Bloomberg:

More than 650,994 loan revisions had been started through the Obama administration’s Home Affordable Modification Program as of last month, from about 487,081 as of September, according to the Treasury. None of the trial modifications through October had been converted to permanent repayment plans, the Treasury data showed. That failure is getting the administration’s attention.

Treasury was clearly trying to blunt criticism of this program by having some new measures ready to go, as discussed in the New York Times yesterday. But the goose egg results, per Bloomberg today, are, even by the low expectations for this effort, a remarkably poor showing. And give the complete failure of the Bush, then Obama Administration efforts to get more mortgage mods within the considerable confines of current practice, why should we expect a different outcome?

The mortgage mod program is yet another ill-conceived effort to solve the problems borne of faulty technology, namely securitization. The FASB came out with a memo in 2004 that warned that warned about subprime loans and the current head of the FASB has questioned the entire premise of securitizing risky mortgages. In a 2008 roundtable, FASB chairman Robert Herz remarked:

In securitization accounting, there’s been in place, as part of the rules, a device called a qualified special-purpose entity (QSPE). It basically was a notion that if assets were placed into a trust, a vehicle, and then interests were issued out of that vehicle to various forms of security holders, what are called beneficial interest holders; basically the form of that vehicle, that trust, was to collect the proceeds on the assets and then remit them to various security holders. They were fairly passive, and the rules talked about how the powers would be very limited-entirely specified up front–and I think that worked for a fair amount of time.

But 1 think what we’ve learned in the last three to five years is in residential mortgages (also to a certain extent in commercial mortgage space and some other assets) that these assets are not passive in nature. Certainly, the subprime assets that were put into these vehicles called “Q’s,” with a lot of hindsight, because they took a lot of management when they went bad in terms of the servicing or having to restructure the loans, modify them, do all sorts of workouts. That clearly was not intended. I think the lesson learned here is that they were not actually “Q-able.”

Yves here. Now there may be remedies to prevent this sort of problem from occurring in the future, but that does nothing to solve the wee mess we have now. Residential real estate prices are sufficiently under water in a most markets that for a viable borrower (meaning one who still has a steady source of income), a deep mod can be a win/win. And before readers get moralistic, this isn’t charity, it’s practicality. In real estate downturns in the stone ages when banks held mortgages on their balance sheets, banks routinely did mods. And even in our current environment of more highly levered consumers, this practice has some empirical support. Wilbur Ross, vulture investor (ie, not predisposed to be a friend of the little guy) is an advocate of deep principal reductions based on his success with them as the owner of the biggest third-party mortgage servicer.

Now it was pretty obvious that the Obama mortgage mod effort would not produce much in the way of results. First, it provided subsidies to servicers, but much less than they would make from foreclosing. That means the banks have every reason to use the Treasury initiative to amass a track record that mods do not succeed (independent of whether they might succeed, as Wilbur Ross has shown they can).

Second, the program offered only a five year payment reduction program, with the lender then able to step up the interest payments to the fixed rates in effect at the time the sorta-mod was entered into. That does not do enough for the borrower. the redefault rate on mortgage mods that do not have significant principal reduction in the first six months now is high. When the initiative was announced, he New York Times reports that payment reductions are expected to be “hundreds of dollars” a month. Is that really going to make a difference with most borrowers, particularly since the interest portion is tax deductible and these mortgages are recent (ie, the interest component is a high proportion of the total payment).

Moreover, if a homeowner has negative equity, he still faces a big bill when he sells the house. What incentive does he have to work to keep current on the mortgage, or to invest in the house?

Now most people have focused on lack of servicer incentives, infrastructure, and experience to do mods, but we have another impediment, which the Treasury interest-only modification program clearly tried to work around. Losses are distributed differently in a mod than in a foreclosure. For a foreclosure, the losses go against the lowest tranches first, and then proceed to higher tranches. However, with a principal reduction, all tranches, including the AAA (or more accurately, what was once AAA) layer.

The interesting bit here, however, is the complete goose egg in the way of results. Most banks do own some mortgages they originated, and they should be able to renegotiate those freely. The failure to do so suggests either that they are concerned that modifying delinquent mortgages might require them to write down similar paper and/or they simply aren’t set up to do mods and are not really interested in creating the infrastructure to do so (and again note that what Treasury tried to create was a “mass mods” template, to reduce the work required by the lender).

The Administration did not throw its weight behind the only idea so far that could have cut this Gordian knot, which was to allow for the modification of mortgages in bankruptcy (the concept, which is well established in commercial bankruptcies, is to write the mortgage down to the current value of the collateral, and treat any remaining mortgage balance as unsecured credit). So now that this voluntary program is turning out to be an embarrassment, what will Team Obama do next? Back to Bloomberg:

“We are taking additional steps to enhance servicer transparency and accountability as part of a broader focus on maximizing conversion rates to permanent modifications,” Treasury spokeswoman Meg Reilly said in an e-mail yesterday. The Obama administration plans to announce additional steps tomorrow, including new private-public partnerships and resources for borrowers.

Given that “public private partnerships” has meant “large subsidies to banks that produce perilous little in the way of results,” I would not hold my breath. And the measures suggested in the Times verged on laughable:

“The banks are not doing a good enough job,” Michael S. Barr, Treasury’s assistant secretary for financial institutions, said in an interview Friday. “Some of the firms ought to be embarrassed, and they will be.”

Even as lenders have in recent months accelerated the pace at which they are reducing mortgage payments for borrowers, a vast majority of loans modified through the program remain in a trial stage lasting up to five months, and only a tiny fraction have been made permanent…

“They’re not getting a penny from the federal government until they move forward,” Mr. Barr said

Shaming bankers? What planet is Barr from? The industry is systematically predatory. If they had any concern about public opinion, they’d have used the Bush and Obama efforts as cover to try pushing back against investors in securitization vehicles. Before some of you go on about sanctity of contract, the father of mortgage backed securities, Lew Ranieri, seemed genuinely shocked in the Milken conference in 2008 when other participants said mods were restricted or prohibited in many securitization contracts. Ranieri said they did them routinely. Not only has the industry done anything more than go through the motions, one has to wonder whether they influenced Treasury in the design of the program so as to assure it would not be effective.

Hat tip reader Mark:

Brain scanner can tell a Dali from a Picasso New Scientist (hat tip reader John D)

Horse deaths prompt racing ban in Australian state BBC

“It’s the Cop’s….Run!” Cassandra

Yen intervention: maybe, maybe not FT Alphaville

A Good Old-Fashioned Panic Macro Man

Shoppers hit Black Friday sales with pared budgets Reuters

Antidote du jour:

We have a bonus antidote, courtesy Megan. When you get to the site, if you click on the image, you get a new one. It’s a slide show of sorts.

For the record, I actually do NOT like it when markets fall apart, even when I anticipate it and am correctly positioned for it (2007 and 2008). It’s very upsetting to watch.

Every savvy investor I know has been expecting a mild to meaningful correction. So independent of its seriousness, the Dubai World frisson could take a bit of the air out of a market that was starting to look pretty bubbly.

Futures are now saying that the US will open nearly 3% down and even everyone’s new favorite store of value, gold, has taken a 2.5% hit. Treasuries have rallied. So many assumed that dollar is a one-way trade, to the degree that even a modest reversal could lead to a short-covering rally. This may not be the reversal of the dollar carry trade that Roubini has predicted, but if when we get real news out of Dubai (probably not till next week) it gives little relief, we might get a mini preview of the Big One. The timing of this is either world class inept or says something not pretty is indeed up. Why did they announce prior to a four-day religious holiday AND a major US holiday? Why would they think a move like this prior to a news black hole would be a plus?

I seem to have some very weird personal karma at work. I got my book deal March 1. The big rally kicks in almost immediately thereafter. While we had a lot of interesting (and frankly depressing) political shenanigans, and I felt bad about not being as on top of the markets and news as I normally am, it wasn’t as if there were world shaking market events to chronicle.

My page proofs have to go in on Saturday. After that, my only additional contact with the manuscript prior to publication is that I get two days to look at them right before Christmas to make sure the changes I indicated went in. So basically I am about to be free of the book.

And the markets obligingly stayed bullish virtually the entire time I was working on it. Go figure.