naked capitalism

Truth be told, I hadn’t paid much attention to the implosion of MF Global, because so many hedge funds went under during the crisis that yet another levered trading firm death seems less than newsworthy unless it is big enough to constitute a possible systemic event. The collapse of MF Global didn’t seem all that unusual, save for the titilating angle that the firm was headed by former Goldman CEO and New Jersey state governor Jon Corzine (I’d treated the failure of hedge funds by other storied names, such as Jon Meriwether and Myron Scholes as comment-in-passing incidents).

But the picture changes considerably with the report that hundreds of millions of customer assets may be “missing”. If this is true, there are pretty much no savory explanations.
One possibility is the firm raided customer accounts to try to shore up its principal business. That’s a fraudulent use of customer assets, and one would think anyone associated with it (and that would include the managing partner) would be subject to fines and barred from the securities industry for at least a period of time. I’m not certain what level of abuse is considered to be criminal. Informed readers are encouraged to pipe up.

The Times does mention that the missing money may simply be really bad bookkeeping (or more likely, poor internal controls, particularly, sloppy validation of how employees marked trades in illiquid markets, allowing staff to game the system, either to boost their bonuses or to cover up losses they optimistically assumed they’d be able to reverse). But even so, that raises questions about the competence of the firm’s management, and whether past accounting “errors” led to profits being exaggerated.

From the New York Times:

The recognition that money was missing scuttled at the 11th hour an agreement to sell a major part of MF Global to a rival brokerage firm. MF Global had staked its survival on completing the deal. Instead, the New York-based firm filed for bankruptcy on Monday.

Regulators are examining whether MF Global diverted some customer funds to support its own trades as the firm teetered on the brink of collapse.

The discovery that money could not be located might simply reflect sloppy internal controls at MF Global. It is still unclear where the money went. At first, as much as $950 million was believed to be missing, but as the firm sorted through its bankruptcy, that figure fell to less than $700 million by late Monday, the people briefed on the matter said. Additional funds are expected to trickle in over the coming days.

But the investigation, which is in its earliest stages, may uncover something more intentional and troubling.

The trading strategy that blew up the firm appears to result from Corzine not adjusting his trading strategy to a smaller platform:

Mr. Corzine sought to bolster profits by increasing the number of bets the firm made using its own capital. It was a strategy born of his own experience at Goldman, where he rose through the ranks by building out the investment bank’s formidable United States government bond trading arm.

One of his hallmark traits, according to the 1999 book on Goldman, “Goldman Sachs: The Culture of Success,” by Lisa Endlich, was his willingness to tolerate losses if the theory behind the trades was well thought out.

He made a similar wager at MF Global in buying up big holdings of debt from Spain, Italy, Portugal, Belgium and Ireland at a discount. Once Europe had solved its fiscal problems, those bonds would be very profitable.

But when that bet came to light in a regulatory filing, it set off alarms on Wall Street. While the bonds themselves have lost little value and mature in less than a year, MF Global was seen as having taken on an enormous amount of risk with little room for error given its size.

First, readers of this blog are probably not all that sanguine that the Europe mess will be resolved in the way Corzine assumed. This seems an awful lot like betting that subprime would be “contained” as of May 2007.

Second, a basic rule of risk control is not to take excessive risks relative to your capital. As John Manyard Keynes is often cited as saying, “The market can remain irrational longer than you remain solvent.” The textbook case is LTCM, which took hugely levered bets that it was confident would eventually be proven right, but “eventually” turned out to take a little long. And a smaller firm has to be even more careful about its wagers for the very reason that brought MF Global down: counterparties will not cut you all that much slack, particularly if they don’t buy your investment thesis.

But if the customer monies really are gone, this will deservedly be a very ugly episode for Corzine. His investors and the authorities should rake him over the coals.

Update: I’ve corrected the post for my inaccurately describing MF Global as a “hedge fund”. The salient characteristic of a hedge fund is that it has raised third party funds pursuant to an investment agreement, which describes the fund’s investment strategy, among other things, and has typically steep performance based fees. Even though MF Global was using a highly levered trading strategy, it was a principal, using shareholder money, not funds in an asset management vehicle.

Daniel Kahneman: How cognitive illusions blind us to reason Guardian (hat tip reader WillamAshbless. See his comment to get the links to the underlying papers)

Stavins: The Promise and Problems of Pricing Carbon Mark Thoma

An ironic Qantas victory Business Spectator

The remorseless logic and profound disdain of Alan Joyce Crikey (hat tip reader Crocodile Chuck)

Japan Intervenes on Yen to Cap Sharp Rise Wall Street Journal

Thai ‘Credibility’ at Stake as Factories Soak Bloomberg

What saves the euro will kill the union Wolfgang Munchau, Financial Times

The two halves of the eurozone are locked in a broken marriage Ambrose Evans-Pritchard, Telegraph

Full Text: European Union letter to the G20 on the Euro crisis Ed Harrison

Is there a credit channel? A Fistful of Euros

Herman Cain Sexual Harassment Accusations: GOP Presidential Candidate Denies Politico Report Huffington Post (hat tip reader Carol B)

Occupy protests: There’s an app for that Danny Schechter, Aljazeera

Weekend edition: Firing Rosa Parks for not giving up her seat on the bus John Hempton

Why America is embracing protest Edward Luce, Financial Times

Wall Street by the Book Tom Engelhardt

Good old days when bonuses were paid from profits Financial Times

Slow-Paced Recovery Feels Like a Recession Wall Street Journal

The Latest Look At The REAL Mega-Bears Clusterstock

Bombs, Bridges and Jobs Paul Krugman, New York Times

The Multistate Settlement Lottery: Bupkis Adam Levitin, Credit Slips. Money quote:

It gives meaningless relief to a meaningless number of randomly or adversely selected homeowners. It doesn’t do justice, even by halves.

Antidote du jour:

Yves here. Note the comment at the end, that Sarkozy’s sales pitch to China on the levered up EFSF did not go so well. If the Chinese don’t relent, this greatly reduces of this scheme working, even in the short term. And further note that the flagging European growth is the result of the austerity hairshirt being imposed on highly indebted economies. Ambrose Evans-Pritchard has a pointed article on the consequences of the beggar-thy-neighbor German stance.

By Delusional Economics, who is horrified at the state of economic commentary in Australia and is determined to cleanse the daily flow of vested interests propaganda to produce a balanced counterpoint. Cross posted from MacroBusiness

Angela Merkel has been warning for quite some time that Europe’s economic woes will take up to a decade to fix and that it is time for Europe to rethink its economic strategy after years of living “beyond its means”. It seems fairly obvious from those statements that the rest of the world is going to have to get use to Europe moving into a slow growth phase while it attempts to adjust away from what it considers to be unsustainable debt.

In an attempt support the transition while keeping Europe together the European leaders have put together 3 part package to save Greece, re-capitalise the banks and provide a stability mechanism for countries that run into trouble. The problem is that once you understand the technicalities behind what they have come up with you come to realise that real economic growth is the only thing that actually matters. The latest news out of Europe for many of the 17 member nations is not good at all in that regard.

It became obvious that Belgium was in trouble when it was forced to nationalise Dexia, and over the weekend the Belgium central bank reported that economy is now stalling:

Belgium’s economy stalled in the third quarter as European leaders struggled to contain a worsening debt crisis and signs increased that the euro region is heading toward a recession.

Gross domestic product in Belgium, the sixth-largest economy in the euro area, was unchanged from the second quarter, when it grew a revised 0.4 percent, the National Bank of Belgium said today in a statement. That’s the worst performance since the country emerged from a recession in 2009.

Cyprus is looking far worse and as usual the IMF is calling for austerity:

The stagnant Cypriot economy — weakened by falling revenues, credit ratings and banks exposed to Greek debt woes — is in need of immediate measures, the IMF warned following an 11-day visit this month.

IMF’s Europe Department Assistant Director Erik Jan de Vrijer said the Fund considers the situation concerning.

“The fact that the government can not access capital markets is very serious and the risks to the banking sector compound that,” he said.

Amid fears that Cyprus may eventually need a bailout, de Vrijer said the first priority must be containing problems, chief among them, excessive public spending.

On top of that property prices continue to fall and the real estate industry is reported to be in meltdown as construction activity has fallen by over 40% this year.

Economic news from Portugal continues to be poor which is expected under the circumstances:

Portugal’s government said austerity measures contained in its 2012 budget, submitted to parliament Monday, will cause the economy to contract by a more than previously forecast 2.8 percent.

Finance Minister Vitor Gaspar told a press conference that the floundering world economy “will lead to a contraction of gross domestic product of 2.8 percent, following 1.9 percent this year,” in Portugal.

The government had previously envisaged the economy would shrink by 2.3 percent in 2012 and 1.8 percent this year. The Bank of Portugal had put the estimates at 2.2 percent and 1.9 percent, respectively.

And Spain‘s economy continues to deteriorate in the worst possible way:

The number of unemployed in Spain swelled to a record high of nearly 5 million in the third quarter, as a sputtering economy failed to create jobs amid mounting global financial uncertainty, according to government numbers released Friday.

The 4,978,300 unemployed amounted to a jobless rate of 21.5 percent, the highest since 1996 and up from 20.9 percent in the previous quarter. It remains the highest rate in the 17-nation eurozone.

Spain is struggling to recover economic growth after crawling out of nearly two years of recession prompted to a large extent by the collapse of a real estate bubble.

It now seems that France has little choice but to join the austerity budgeting brigade with Sarkozy warning his country of the coming budget cuts in a recent television broadcast:

“We will have to revise and adapt our budget plan to the new reality,” Mr. Sarkozy told an estimated 12 million viewers as he revealed that his government had lowered its forecast for next year’s gross domestic product growth to 1 percent from 1.75 percent. To compensate for an anticipated decline in 2012 tax revenues, he said that by mid-November he would announce a program of budget cuts of about $8.5 billion to $11.3 billion.

“It’s because of this debt crisis that we find ourselves in a situation of having to defend France’s triple-A” credit rating, Mr. Sarkozy said, noting that a rating downgrade would only increase the interest burden on the country’s public debt, already at more than $70 billion a year.

And then there is Europe’s economic engine, Germany, which on the back of the latest European PMI is now predicted to stall into the new year:

The German economy, Europe’s biggest, will fail to grow in the current quarter after expanding 0.4 percent in the previous three-month period, the DIW economic institute said.

With new reports suggesting that Sarkozy and Regling’s visits to China didn’t go as well as planned it would seem that Europe still has a long way to go before the end of this crisis and the rest of the world is going to have to get used to Europe in the slow-lane for a lot longer.

A key German finance leader is talking tough about financial reform. But will his peers follow?

Wolfgang Schäuble, in a Financial Times interview, called for a Tobin tax to discourage speculation. Schäuble urged the EU to proceed with the idea even if England balked.

That’s a sound move, since in too many markets, transaction costs have gotten to be so low that the ratio of real-economy related activity to mere opportunistic trading has gotten badly out of whack. The classic example is high frequency trading, where speculators add liquidity when it isn’t particularly needed, and withdraw it in a destabilizing manner at the first sign of trouble.

Readers may argue that banks will innovate around such a tax, but they miss crucial chokepoints that regulators have and have not yet used. All major banks that play in the Euro need direct access to payment facilities, and ultimately, payment systems controlled by the ECB. The big payments are almost all related to securities transactions; Perry Mehrling, in an interview, estimated the securities-related volumes as over 50X the real economy activity. A major bank can’t afford to go through correspondents; both the transaction costs and the detrimental impact as far as corporate customers are concerned would be too great (I looked into this issue over two decades ago for a major Japanese bank; these issues would be even more acute now given the much greater importance of capital markets related activities to all banks). And Mehrling claims (and I haven’t yet found any evidence to the contrary) that banks can’t innovate around the need for direct access to central bank payment facilities. Since any global bank worth its salt has to do business in the euro, the ECB could well impose global rules relating to activity in the euro, including a transaction tax. That is not how we have tended to think of regulatory reach, but recall how the Fed acted as the dollar dealer of the last resort by extending currency swap lines during the crisis. No banking authority should be in the position of backstopping activity or institutions (in the Feds’ case, Eurobanks) that it does not supervise.

I doubt the Schäuble proposal will go far; there are too many well placed bankers who will have their knives out. But I hope he and others push hard on this idea, particularly since the odds of a Euro-centered financial crisis are high. It is important to keep pushing proposals for serious reform so that they will have been debugged via having objections raised and dealt with, and will gain legitimacy through greater exposure. The most important ones are those that have the potential to change the architecture of the financial system, and a well-designed Tobin tax would force banks to redesign their institutions in a major way.

Yves here. Frieda makes a very important point in this Project Syndicate column, that of the role of the banking system in the European debt crisis. On one level, it may seem trivial to say that the sovereign debt crisis is the result of financial crisis. But the Eurozone leadership has not drilled into the next layer: how did this come about? The superficial explanation, that they all ate too much US subprime debt and got really sick, is superficial and shifts attention away from the real issues. European banks have huge balance sheets with a lot of low-return investments. I did some consulting work for some European banks over a decade ago (one of the remarkable things about banking is how little things change over time) and they tended to target commodity areas of banking in the US, not simply because that was where they could break in, but also because the returns were tolerable (although they did hope to move up the food chain into more lucrative business).

Frieda argues that merely having banks raise capital ratios to the 9% level stipulated in the current version of the Eurozone rescue is inadequate. Absent more aggressive measures, “no amount of capital will restore investors’ faith in eurozone banks.”

By Gene Frieda, a global strategist for Moore Europe Capital Management. Cross posted with author permission from Project Syndicate.

The good news for Europe is that it will not reenact the dramatic collapse of Lehman Brothers. The European Central Bank’s unlimited ability to provide liquidity ensures that. But European leaders have yet to recognize that old bank business models are obsolete, and that reliance on private-sector leverage for balance-sheet repair of both sovereigns and banks is doomed to failure.

Two years into the crisis, the authorities have correctly identified four crucial problems – sovereign debt, bank capital, the risk of a Greek default, and deficient growth. But they have yet to agree on cause and effect. Understanding the obsolescence of most European banks’ business models is absolutely crucial to sorting that out.

In general, the eurozone has outsized banks (assets equivalent to 325% of GDP) that are highly leveraged (the 15 largest banks’ leverage is 28.9 times their equity capital). They are also dependent on large quantities of wholesale debt – totaling €4.9 trillion (27% of total eurozone loans), with €660 billion maturing in the next two years – to fund low-yielding assets. According to Barclays Capital, the 15 largest banks increased their returns on equity by 58% between 1998 and 2007, with 90% of the gain coming from higher leverage. Returns have since collapsed.

This model’s viability depends on large amounts of cheap leverage, supported by implicit government backing. While leverage normally becomes scarce and expensive during recessions, this time declining confidence in sovereign debt also has increased the cost of capital. Government borrowing costs, which anchor banks’ own funding, normally fall during recessions. But, as “risk-free” rates have risen six-fold in the past two years, the cost of bank equity and debt has often surged to levels at which investors balk. No one should be surprised, then, that they are reluctant to recapitalize – or, indeed, lend – to eurozone banks.

Higher levels of capital are required for two main reasons. First, economic growth looks set to be much weaker than expected, meaning that capital buffers will need to be built. The European Banking Authority’s stress-test scenario from June looks more like the baseline scenario today. If traditional asset-quality considerations were the only problem buffeting eurozone banks, recapitalization would restore investor confidence, debt markets would reopen, and banks would find raising capital much cheaper than it is now. That isn’t happening, because the problem is growth.

Second, with the demise of sovereign-debt equality, eurozone banks will require higher capital-adequacy ratios to compensate for higher risk. Banks in emerging markets tend to carry higher capital buffers for a similar reason. Just as business and credit cycles there tend to be more frequent and extreme, the real possibility of de facto currency crises in the eurozone, owing to higher sovereign borrowing costs and slow adjustment to shocks under fixed exchange rates, renders massive balance sheets unsupportable and thus obsolete. Higher capital ratios are required today and, absent a credible sovereign safety net, in the future.

For example, French banks’ risk-weighted assets are €2.2 trillion, against a capital base of €167 billion – just above the 7.5% ratio established by the international Basel 2 rules. But, once risk weights are removed, assets balloon to €8.1 trillion (roughly 400% of GDP), and the equity-to-asset ratio plummets to 2%. Wholesale debt funds only 10% of these assets, but amounts to €841 billion, or 41% of French GDP.

In the event of a loss of market confidence, state guarantees for that much funding would further strain market perceptions of French creditworthiness, generating more pressure on French banks to shrink their balance sheets rapidly. And France is one of the stronger countries in the eurozone!

The latest agreement between European Union member states forces banks to raise core “Tier 1” capital levels to 9%, and will apparently require €108 billion of additional capital. But this figure is well below market expectations, as it is based on the Basel 2 rules, which have proven deficient in terms of risk weights and capital “quality” during the crisis.

With the sovereign ground quaking, reinforcing a 100-story skyscraper of leverage with an additional floor or two of concrete will not bring back wary tenants. Unless confidence in sovereign debt within the eurozone can be restored, Europe’s banking skyscrapers will need to be cut in half.

What is needed is a controlled deleveraging that recognizes that banks’ balance sheets have become too large to support, and that business models dependent on massive leverage are obsolete. Restoring confidence in eurozone sovereign debt requires not only bank recapitalization, but also a credible, publicly-funded financial safety net that is sufficient to protect the bloc’s larger states. Without that, no amount of capital will restore investors’ faith in eurozone banks.

Attempting to leverage with private money the new sovereign-debt bank known as the European Financial Stability Facility will fail for several reasons, but the simplest is that frightened private investors have already fled from European banks. After a massive private-sector boom-and-bust cycle, banks and households are deleveraging, and corporations are hoarding cash. These are the players being asked to fund the EFSF.

Once a leveraged EFSF fails, it should be clear that the eurozone will not last in its current form. The cause is excessive public and private indebtedness, coupled with the absence of an effective bailout mechanism; the effect is collapsing confidence in banks and sovereign debt.

The solution is either a broad and deep debt restructuring that imposes losses on the private sector, or an ever more expensive bailout by taxpayers. The latter would be credible only if carried out by the ECB, at the expense of its mandate. Until this choice is made, no amount of additional capital will assuage the private sectors’ fears.

By Satyajit Das, derivatives expert and the author of Extreme Money: The Masters of the Universe and the Cult of Risk Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives – Revised Edition (2006 and 2010)

This four part paper deals with a key element of derivative market reform – the CCP (Central Counter Party). The first part looked at the idea behind the CCP. This second part looked at the design of the CCP. The third part looks at the risk of the CCP itself and how that is managed.

The key element of derivative market reform is a central clearinghouse, the central counter party (“CCP”). The CCP is designed to reduce and help manage credit risk in derivative transactions – the risk that each participant takes on the other side to perform their obligations (known as “counterparty risk”). The CCP also simplifies and reduces the complex chains of risk that link market participants in derivative markets. However, the proposal relies on the ability of the CCP itself to manage risk.

Risque Matters …

The CCP holds the credit risk of cleared derivatives. All participants in the clearing system have exposure to the CCP, specifically its risk management systems.

The basic methodology is that used in exchange traded derivatives. The CCP receives an initial margin or deposit from all parties to a transaction that acts as surety or a security bond against performance. The contract is marked to market daily or more frequently, if market conditions dictate, to establish gains and losses. Parties must post margins to cover the losses on open positions. If a party fails to meet a margin call then the CCP closes out the position, replacing it in the market. The CCP will use the margin it is holding to cover the replacement cost.

The CCP is reliant on risk models and the ability to value contracts. There are significant issues in pricing and valuing contracts and, for some products, reliance on complex models.

The CCP risk management process assumes availability of market prices. In the OTC market, not all instruments trade with liquidity and reliable market prices may not be available. In 2009, Robert Pickel, then Chief Executive of the derivative industry body ISDA (International Swaps & Derivatives Association), told members of the U.S. House Agriculture Committee that some derivative contracts trade infrequently even if they have standardised economic terms.

Under the CCP, only a few instruments will be capable of being marked to market against actual prices. For some instruments, it will be mark-to-model based on inputs that may be validated from market prices. In other cases especially more complex products, it will be a case of mark-to-make-believe or mark-to-myself.

There are significant problems even with standard models for conventional derivatives. One interesting issue is the risk of counterparty credit risk and the extent to which this should be factored into the valuation.

Subsequent to and in response to the global financial crisis, there have been significant changes in the way cash flows are discounted back over time in derivative transactions. Prior to the crisis, it was commonplace to discount back cash flows at the swap rate, which provided a reasonable proxy for the cost of funding for major banks around the world active as derivative traders. The sharp and significant differences in the funding costs of individual banks during and following the crisis have resulted in changes in models. A complicating factor is the use of collateralisation arrangements to enhance the credit of counterparty.

The current trend is for dealers to discount future cash flows in uncollateralised trades at the rate at which each bank can borrow. For collateralised trades, cash flows are discounted at the relevant overnight index swap (OIS) rate. Unfortunately, there is no agreement between dealers on specific aspects of the models.

For example, a US dollar transaction that stipulates the posting of dollar cash collateral should be discounted using the federal funds rate. But this becomes complex where the trade is backed by a variety of different collateral, involving a variety of credit risks, currencies and trading liquidity. While dealers agree the discount rate should in theory be based on the cheapest-to-deliver collateral, it is near impossible to determine what specific security this might be over the entire life of the transaction. It is not clear how the CCP will resolve these issues in the absence of agreement amongst dealers.

For exotic products, the risk of inaccurate market prices is significant. There may no agreement on pricing models and inputs further complicating valuation. David Goldman, a former credit strategist, described quotes for credit default swap (“CDS”) prices in the following terms: “The business looks like the window of a Brezhnev-era Soviet butcher shop. Mouldy scraps hanging in the window. Old women lining up at 4am to try and buy credit protection on General Motors. What are reported as trades are really ways to establish prices to satisfy the auditors.”

CCP risk management relies on models that are variants of the Value at Risk (“VAR”) to establish the level of initial margin consistent with risk. The models are based on historical data and also assume price behaviour of assets inconsistent with actual performance under conditions of stress. These are the same class of models that proved problematic in the GFC.

Some products present special modelling challenges. Small changes in market prices may have large valuation effects; for example, in knock-in and knock-out options or digital options. Similarly, CDS contracts are triggered by defaults. Unexpected and rapid deterioration in the credit condition of an entity can trigger large changes in value – known as “jump to default” risk. Such rapid changes in value are difficult to model and capture in risk management systems.

These problems mean that initial margins may be too low, increasing the risk that the CCP is inadequately protected against counterparty default. Alternatively, the initial margin may be set too high creating disincentives for legitimate risk management activity.

Where a margin is not paid, the mechanics of close-out assume the ability to replace the defaulted contract with a new counterparty at current market prices. This assumes an active market with liquid trading. In the aftermath of the Lehman Brothers’ bankruptcy filing, market liquidity diminished sharply and price volatility increased. It was practically difficult to replace contracts. Market prices and valuations were significantly different from model valuations. It is not clear how these risks will be managed by the CCP.

The CCP will, it is assumed, aggregate all positions across instruments and asset classes for each clearing party. Margins will be based on netting and cross margining across the portfolio of trades. The CCP risk models will need to incorporate correlation between different asset classes and products.

There are important differences between different products and asset classes. For example, a CDS is different from an equity option. The CDS, a form of credit insurance, provides a binary outcome conditional upon default of the reference entity. In contrast, equity prices and the behaviour of equity options more closely approximate a continuous distribution of outcomes.

These differences create modelling problems for formal relationships between asset classes, products and price distributions. Relationships are also likely to be highly unstable. Tractable correlations developed under benign and stable conditions may prove misleading under conditions of stress. These risks may undermine, perhaps severely, the ability of the CCP to manage its risks. Lack of liquid markets in many OTC products may distort prices and compound the problem.

The CCP also requires high quality operational systems to manage its trading, payments, collateral management and risk oversight. All market participants subject to clearing will also need commensurate operational capabilities to manage liquidity demands and the collateral management processes.

Gross and Net of It…

There are two possible clearing models, with different risks. In the first, all participants deal with the CCP directly lodging, margins with the designated clearing entity (“gross clearing”). The second entails non-clearing participants dealing via a CCP clearing member (also known as a clearing broker or in the US a futures clearing merchant) (“net clearing”). In net clearing, non-clearing members have no direct relationship with the CCP when trading. They lodge margins with the clearing member who deals with and is accountable to the CCP for payments and contract performance.

The CCP sets standards for and regulates clearing members. In a net margin arrangement, the relationship between clearing members and clients is entirely negotiated. Key elements agreed include the level of margins, the form of collateral permitted, netting of positions, the timing for meeting margin calls and the clearing fees. Clearing members may also provide credit facilities, funding margin calls on behalf of clients, enabling trading without credit enhancement.

Commercial negotiations focus on the margin levels and type of permitted collateral, including haircuts on securities. Clearing members may cover some or all the margin requirements on a client’s behalf, based on its own internal offsets with the CCP. It may also rely on offsets with the client, cross margining other transactions such as futures, bilateral trades and prime brokerage business. It may also rely on revenues from other business with the client, pricing the clearing function on a holistic basis. Competition between clearing members may reduce risk management standards, reducing the effectiveness of the CCP.

A net margin arrangement creates complex inter-relationships between cleared and uncleared trades as well as different margining and netting models. Assume a transaction involving a cleared OTC derivative and a related uncleared non-standard derivative over it. The cleared derivative requires a CCP margin. Where the two transactions are transacted through a dealer who also acts as a clearing member, the dealer may not require collateral on the uncleared derivative using it own risk model to offset the two positions. This does not result in a lower margin requirement on a client’s cleared transaction, but cuts the total margin paid across cleared and uncleared trades.

Most existing futures exchanges use net clearing. This reflects the administrative and operational complexity of gross clearing. Dealers also favour net clearing, as it creates a profitable business for them clearing non-member trades. In existing exchange traded markets, most of the profits from futures broking comes from not from execution but clearing, including crucial access to client funds that can be reinvested at a profit.

Dealers will push aggressively for net clearing, enabling them to develop a significant business clearing OTC derivatives trades for non-clearing parties. They will argue that this is essential to offset the losses from moving OTC derivatives trading to the CCP.

Net clearing means that the CCP structure will resemble that set out in the Diagram 3 below. In practice, this means that there will be two separate layers of risk – at the level of the CCP and one at the level of the clearing members.

Given that most inter-dealer OTC derivative trading is already collateralised to a substantial degree, the CPP arrangement only formalises these arrangements. For other OTC derivative participants that trade through clearing members, the risk remains with these entities. Given the dominant position of a few firms in OTC derivatives trading and eventually in clearing, this may not reduce risk concentrations significantly as sought.

Diagram 3 – CCP Structure with Net Clearing

Risk Taming …

ISDA’s case against the CCP is based on the fact that OTC products are difficult if not impossible to clear. ISDA argues that the CCP’s ability to clear contracts is conditional upon liquidity and availability of market prices. Pickel on behalf of ISDA testified that this made “it difficult for [the CCP] to calculate collateral requirements consistent with prudent risk management.”

The U.K. Financial Services Authority (“FSA”) also argues that some OTC derivatives may not be capable of clearing. In its December 2009 report Reforming OTC Derivative Markets: A UK Perspective, the FSA did not support mandatory clearing because “the clearing of all standardised derivatives could lead to a situation where a …CCP… is required to clear a product it is not able to risk manage adequately, with the potential for serious difficulties in the event of a default.”

The CCP’s ability to manage risk effectively is questionable, at least for all products. This reflects the lack of availability of prices, limitations of market liquidity and inherent product attributes that may be difficult to model and mitigate. Rejecting the trading of CDS on the futures exchanges, Howard Simons, a Chicago exchange trader, identified the problems of risk management of certain OTC derivatives: “The clearing members of the CME [Chicago Mercantile Exchange] think trading this stuff is the stupidest idea in the world. I didn’t work my whole life so some investment bank can take all our capital. Do I look like Hank Paulson?”

Where products can be cleared, commercial, CCPs may undercut each other on margins and initial deposit requirements to gain market share, in the process undermining the stability of the system itself. Riccardo Rebonato, an experienced risk manager at Royal Bank of Scotland, noted: “In a world where CCPs are competing for an undifferentiated product – clearing – the main differentiating factor for an outsider is going to be the margin and some CCPs may be tempted to compete on margin. But margin must be compatible both with the systemic resilience of the new hub-and-spoke system and with considerations of commercial viability. LCH.Clearnet chief executive Roger Liddell recently criticised newer US rival International Derivatives Clearinghouse for “reckless” behaviour in setting low margin to win business.

On 12 May 2010, the Basel-headquartered Committee on Payment and Settlement Systems (“CPSS”) and the Madrid-based International Organization of Securities Commissions (“IOSCO”) published 15 recommendations for CCPs. The guidelines were vague on risk management issues, only stating the need “more complex models and methodologies” to calculate risk exposure and margin requirements and requiring methodologies to “be reviewed periodically by a qualified, independent internal group or third party”.

CCP risk management may be based on the attributes identified by poet e. e. cummings: “all ignorance toboggans into know and trudges up to ignorance again.”

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Earlier versions of this piece have been published as “Tranquillizer Solutions Part I: A CCP Idea” and “Tranquilizer Solutions: Part 2 – CCP Risk Taming” in Wilmott Magazine (May and July 2010)

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Qantas Fleet Grounded for Second Day New York Times

The Solipsists at Obama for America David Atkins, Hullabaloo. Per reader Carol B:

Atkins doesn’t get that Obama isn’t a Democrat or a Republican: he’s just for himself. The Democrat “thing” was a Chicago political necessity.

Kirby: Beware: Romney’s flat tax no different than Mormon tithing Salt Lake Tribune (hat tip reader Buba R)

Perry’s Flat Tax and other “bold reform” ideas in context of the richer 1% Linda Beale, Angry Bear (hat tip reader Aquifer)

400% Rise in Anti-Depressant Pill Use: Americans Are Disempowered — Can the OWS Uprising Shake Us Out of Our Depression? Alternet (hat tip reader Aquifer). Hhm, this is really quite a conceit….

Denver Police Move Into Protest Encampment Associated Press

Occupy Oakland Protestors Square Off With Police ABC (hat tip reader Deontos)

Oakland has become epicenter of Occupy movement Mercury News (hat tip reader Deontos)

Occupy Oakland Solidarity in Egypt Boing Boing (hat tip reader Deontos)

How the 99 Percent Really Lost Out – in Far Greater Ways Than the Occupy Protesters Imagine Truthout (hat tip reader Aquifer)

Meet the 0.01 Percent: War Profiteers Alternet (hat tip reader furzy mouse)

Exclusive: Cover-up at St Paul’s Independent (hat tip reader Stevie B)

Did You Hear the One About the Bankers? Thomas Friedman, New York Times. I quibble with Friedman over his comparison of Citi and Goldman. Goldman is simply more careful about legal liability. That does not make their intent any better.

MOVE YOUR MONEY – Bank Of America Branch Manager Begs Customer Not To Close Accounts Daily Bail (hat tip reader 1SK). You must read the conversation with the branch manager.

Antidote du jour:

There have been so many rumors about the so-called 50 state attorney general settlement (which now is more like a 43 state settlement) being on the verge of having a deal that we’ve discounted them. We’ve said from the beginning that this was a cash for release deal. Basically, because the Federal regulators and state AGs, by design, had done no meaningful investigations, they didn’t have any threats to bring the banks to heel. So they’d have to offer a bribe, and the bribe has always been a “get out of jail free” card.

Put it more simply: The banks got bailed out, and the rest of us got left out. Yet all levels of government are actively trying to find a way to release from wrong doing for the banks, when everyone knows that they violated a host of laws every step of the way in the mortgage business.

We said the only way a deal would get done is if the state AGs capitulated completely. There have been enough leaks about state AGs being uncomfortable with a broad release, plus the banks greatly overplaying their hand, that it looked like no deal would happen. Tom Miller, the Iowa AG who is the lead negotiator for the states, has been saying a deal is imminent since last January, so his credibility is pretty thin. But the Obama administration is moving heaven and earth to get a deal done, since they seem to think the public can be snookered into thinking motion is progress.

Nevertheless, the negotiations appear to be grinding forward. And it isn’t the banks that are giving ground. Gretchen Morgenson tells us at the New York Times what an utter joke the settlement has become.

The $25 billion being bandied about is about as solid as AIG’s credit default swaps. Of that total, only $3.5 to $5 billion would be paid in cash. That’s spread across 12 or more companies, with Bank of America presumably paying the most. So how do you get to $25 billion? Smoke and mirrors, natch. Per Morgenson:

The rest — an estimated $20 billion — would consist of credits to banks that agree to reduce a predetermined dollar amount of principal owed on mortgages that they own or service for private investors. How many credits would accrue to a bank is unclear, but the amount would be based on a formula agreed to by the negotiators. A bank that writes down a second lien, for example, would receive a different amount from one that writes down a first lien.

I hope you can see how insulting this is. How many mortgage modification programs have we had so far? And what has the result been? In every case, the number of mods done has fallen well short of the target and the banks have gamed the programs massively. And the Treasury Department has seemed remarkably unembarrassed by their glaring failures. Even if everyone involved knew that these programs were merely to placate the public, the banks were not supposed to make it so bloody obvious. But the Treasury hasn’t bothered to pretend either. For instance, one of the few things it could do under its limp wristed voluntary HAMP program is claw back incentive payments. Has it bothered? No.

Morgenson highlights another feature of the plan:

One of the oddest terms is that the banks would give $1,500 to any borrower who lost his or her home to foreclosure since September 2008. For people whose foreclosures were done properly, this would be a windfall. For those wrongfully evicted, it would be pathetic. Roughly $1.5 billion in cash is expected to go into this pot.

“Pathetic” isn’t strong enough. Let’s look at the damages sought by Nevada attorney general Catherine Masto in her second amended complaint against Bank of America: civil penalties of $5000 per violation, or $12,000 for elderly or disabled borrowers. An individual loan can, and likely does, have multiple violations. The suit also seeks restitution, costs for wrongful foreclosures, plus the cost of damage to municipalities and homeowners from unnecessary vacancies. Note that an AG victory on the issue of wrongful foreclosure would pave the way for private lawsuits, and here the damages would be massive, particularly if state law or precedent allows for penalties (as we’ve noted, Alabama has statutory tripe damages for wrongful foreclosure, and recent rulings have had applied penalties in excess of nine times).

And what did Masto get from a different servicer, Morgan Stanley’s Saxon? The settlement is estimated to average somewhere between $30,000 and $57,000 per borrower. And the basis of action wasn’t erroneous or fraudulent foreclosures, but deceptive practices in mortgage lending and securitization.

Look at the MERS compplaint filed by Delaware AG Beau Biden. He’s suing MERS over deceptive practices, at $10,000 per violation. It’s quite possible that he may find more than one violation per mortgage. And I would imagine that success against MERS would pave the way for actions against servicers who relied on MERS in the face of knowledge of its deficiencies.

In other words, the suits filed by two AGs alone make a mockery of these negotiations. We discussed that the $25 to $30 billion settlement figure which the AGs have become fixated upon was derived from a bogus analysis performed by the CFPB for Tom Miller in February:

The critical part comes on the third page, “Calibrating the Size of Potential Penalties”. You’ll note it assumes that the cost of special servicing of delinquent loans would have cost 75 basis points a year more than actual costs incurred. That drives the entire analysis…

Now….is this “75 basis points a year” a knowable figure, ex doing a lot of real nitty gritty work, which certainly has not taken place? We can debate whether this is the right figure, and whether the CFPB has also captured the actual costs correctly…Our Tom Adams has estimated that servicing now costs 125 basis points versus the banks’ typical fees of 50 basis points, plus another 30 to 50 basis points in late and junk fees.

If you take this analysis at face value, the biggest question is what standard of servicing is implied by “effective special servicing of delinquent loans”? If they mean loan modification, that’s the same as a new underwriting of a mortgage. That cannot be done through the current platform and would require new staff with different skill sets and software/systems support. So any estimates are at best finger in the air exercises. And given that some servicers are far more abusive with junk fees than others, Tom Adam’s comment above suggests that a one-size-fits-all estimate is misleading too.

But arguing over a pretty much made-up figure misses the critical point: the money the servicers saved is not even remotely the right basis for thinking about the appropriate settlement level. Settlements are based on potential liability. For instance, in 1998 the tobacco settlement, the tobacco companies agreed to pay a minimum of $206 billion over 25 years to be released from liability on Medicare lawsuits on health care costs plus private tort liability.

The saved costs bear no relationship to the banks’ legal liability for servicer-driven foreclosures, nor to the damage they have done to homeowners or broader society through their actions. It’s like basing the penalties in a robbery on the unpaid parking fees and rental costs of the car used to make the heist.

But all is not lost. First, Morgenson tells us a lot of mortgages are excluded from this deal, in particular, Fannie and Freddie mortgages. Second, her story says nothing about the terms of the release. The objective of the negotiations now seems to be to get the true economic value of the deal to be so small that the banks will agree to a relatively narrow release. I would not bet on that.

It’s important to keep the pressure up, particularly on state AGs who might walk from a too bank friendly deal. States whose AGs might decamp include Oregon, Washington, Arizona, and Colorado. It’s also key to let the AGs in states who have left the talks and are under pressure to return that voters are watching and will be unhappy if they reverse themselves. Those states are New York, Delaware, Massachusetts, Kentucky, Nevada, Minnesota, and of course, California. You can find their phone numbers here.

Police pointing “non-lethal weapons” at protesters and media:

Rubber bullet wounds:

Batons:

Pepper spray:

There are reports – just as in Oakland – of police attacking people while they were trying to help the injured:

Man being SHOT w/ riotgun while assisting injured persons

The problem is militarization of police departments and the use of anti-terror laws to crush dissent.

Meet my fantastic family of foxes: Pensioner who shares her home with bushy-tailed ‘Minette’, ‘Chico’ and ‘Billy’ Daily Mail (hat tip reader May S)

Beer & Bullets to Go: Ancient ‘Takeout’ Window Discovered Live Science (hat tip reader Aquifer)

Obesity Fuels Custody Fights Wall Street Journal

Are American workers in a race against the machine? The Lookout (hat tip reader Aquifer)

The women who have to sleep with their husbands’ brothers: Shortage of girls forces families into wife-sharing Daily Mail (hat tip reader May S).

Directors’ pay rose 50% in past year, says IDS report BBC (hat tip reader appointmetotheboard)

Cameron slams fat cat bosses as it is revealed they have awarded themselves a massive 49 per cent pay hike Daily Mail (hat tip reader 1SK)

Outside the Law Foreign Policy (hat tip reader May S). On the Nato operation in Libya.

Greece Will Eventually Leave Euro, Rogoff Says Bloomberg (hat tip reader Jim Haygood)

National Day Parades Turn into Protests with Eggs, Yogurts and Black Flags (pcts, videos) Keep Talking Greece (hat tip reader Jay)

Furious Greeks lampoon German ‘overlords’ as Nazis with picture of Merkel dressed as an SS guard Daily Mail (hat tip reader 1SK)

Euro Bailout Failure 5 ducats (hat tip reader john newman). Be sure to read his final comment.

Italy gives EU a post-party hangover Financial Times

How historians will look back on Euroland’s demise Norman Davies, Financial Times

Qantas Grounds All Flights World-Wide Wall Street Journal

Perry’s Flat Tax Proposal Linda Beale (hat tip reader Aquifer). I wish she’d put more eye-catching titles on these devastating posts.

Occupy Oakland Protesters Remain in Legal Limbo After Release From Jail Truthout (hat tip reader Deontos)

Obama Has Even Lost The ‘Occupy Wall Street’ Crowd Business Insider. Um, he never had them. If you’ve been paying attention, this is no surprise.

Audit Notes: The Occupy-Rwanda Connection, Reckless Blame, Jarvis For Dummies Columbia Journalism Review. The OWS part is brazen.

Occupy the No-Spin Zone Slate (hat tip reader Jeremy B)

US consumer spending rise outpaces income Financial Times. I usually don’t comment on GDP releases since so many other sites do, but quite a few astute commentators questioned whether this “not big enough to make a real dent in unemployment” growth rate could be sustained.

Savings Rate Is Dropping, and Experts Are Puzzled New York Times

Confidence Rises in Sign U.S. Will Keep Recovery Intact Bloomberg. This seems to reflect the degree to which the powers that be have indoctrinated the public to believe the stock market is a barometer of the state of the economy.

Goldman sued for $1.07 billion over Timberwolf CDO Reuters

Bank of America Rethinking Debit Card Fee New York Times

Congresswoman Waters Renews Her Call for Mortgage Servicer Accountability RealEstateRama. Bernanke and Walsh are blowing off her servicer information request.

What the Costumes Reveal Joe Nocera, New York Times. Saw this only now. Holy moley.

Antidote du jour:

By Sell on News, a global macro equities analyst. Cross posted from MacroBusiness

Having just watched the second episode of All Watched Over By Machines of Loving Grace by my favourite documentary maker Adam Curtis, in which he tells the “story of how our modern scientific idea of nature, as a self-regulating ecosystem, is actually a machine fantasy”, I am once again struck by what an absurd body of ideas, or more accurately, self delusions, much of modern economic prejudice-masquerading-as-theory is.

Curtis, in this episode, shows that the idea that there was a balance of nature was always flimsy, never supported by the empirical evidence, and based on extreme, self proving over simplifications. Ecological thought is about on the same level as economic thought, it seems. Nature is not in balance at all. Consequently all those ideas about self correcting systems — you know, Adam Smith’s so called invisible hand — also turn out to be a fantasy. The neo-liberal assumption that markets are like an ecology, a natural system that will self correct provided it is left alone, is also looking rocky. If, indeed, markets are natural systems — and they are not, they are created systems — then they will not self correct. The vegetative metaphor is extremely unpersuasive.

Curtis does not explore the implications for economics, his interest lies more in how we have given up the power to act because we have allowed machine driven systems to take us over. But what he traces is extremely damaging for General Equilibrium theory, a central plank of much economic “theory” and the basis of micro-economics. General Equilibrium theory basically borrows the vegetative metaphor, that there is a “balance of nature” and applies it to markets. This was always a nonsense move, because markets are not natural, they are artificial. As Curtis shows, it is double nonsense, because even if the metaphor holds, it leads to the opposite conclusion. That markets will probably not incline towards equilibrium at all. Quelle surprise.

In one sense, the assumption that there will eventually move towards equilibrium is typical of the kind of circular arguments of which economists are so fond. Balance is implied in the transactional structures. Balance sheets have to, well, balance; assets must match liabilities. Prices must reflect some sort of balance between supply and demand. That is what a price is. Debts must be repaid from income. And so on. In the artificial rules of finance, equilibrium is implicit.

But of course that is not what happens, especially when you allow markets to be “free”, and especially when you allow financial markets to be “free” to make up their own rules. They are not self organising systems that incline towards balance. They become out of control exercises in chaos that move towards anything but equilibrium. I cite the GFC, the Great Depression, the Latin American debt crisis, Japan’s asset bubble, the Asian financial crisis and ever so much more, even back to Tulipmania.

Accordingly, what needs to happen, in financial markets in particular, is that equilibrium is ENFORCED, and continually at that. I recognise that such enforcement is difficult in today’s global markets, but the idea that if things are left free, the system will self correct — which was Alan Greenspan’s now exploded assumption — is just plain wrong. It is a system of rules. When traders are left to make up their own rules, the system of rules will be weakened and may collapse. Ergo, continually enforce the rules to ensure that the necessary balances are maintained.

Curtis goes on to show how the vegetative metaphor was used to justify the networking of machines, especially the internet and social media. That is exactly the type of shift that has occurred in finance, with machines being used increasingly to unleash the forces of financial “freedom” (derivatives, algorithmic trading, the mechanisation of risk models, etc.) that is supposed to lead to a self correcting system but which actually leads to its exact opposite. It must, quite frankly, be stopped before it does more harm to our system of money. Not that I see much hope of that happening.

It is always fascinating how bad ideas become so poular. No-one is better than Curtis at showing how it happens, although he does not really explain why it happens. Perhaps it is simply mysterious. Perhaps it is what Chesterton meant when he said that when people give up older beliefs they do not then believe in nothing, they believe in anything. Perhaps it is just that metaphors are powerful, we must have them, and we have become susceptible to very bad ones.

I don’t know. What I do know is that it is about time to jettison the assumption that markets, left free, will be self correcting and incline towards equilbrium. The opposite is the case. And human beings need to be put at the centre of human systems, not pushed to the side as just components in a “system” (how that is happening now is beautifully documented by Curtis). That, in turn, means putting the consideration of morality (an equilibrium that actually makes some sense) back into the consideration of economics.

Tomas Sedlacek’s book, The Economics of Good and Evil: The Quest for Economic Meaning from Gilgamesh to Wall Street, might be a good place to start to reconstruct the entire discipline from the ground up. This is what he had to say in a recent interview:

So, “Does the system behave the way we want it to behave?” is ultimately a moral question, one that we are banned from asking. In economics, this is exactly the sort of a question we’re not allowed to ask, because economics is supposed to be a positive science, not a normative science. The difference is clear: positive statements should describe things as they are (“facts only, baby”), whereas a normative statement describes things the way we want them to be.

Let’s take Milton Friedman, who was, of course, the biggest proponent of positive economics. He wrote the famous essay “Economics as a Positive Science.” In that essay, on the first page, you will find the following sentence: “Economics should be a positive science.” Now, please tell me if that is a positive or a normative statement. [Laughter]

The New York City General Assembly website has a section for a recently-formed Alternative Banking group, which has started meeting on Sundays from 3:00 to 5:00 PM. You can read the notes from last week’s session here.

Despite the title, this is NOT about moving your money. An alternative economics committee had already started on that effort and the alternative banking committee agreed to let them run with that ball. Although this group is still in the process of deciding what it is about, it appears to be moving towards making fundamental, wide-ranging critiques and proposals.

Anyone is welcome, and the group would particularly benefit from the input of people with capital markets, regulatory, and wholesale banking expertise. The group already has some members with relevant experience (SEC, major hedge fund, investment banking) but more depth would be of great benefit.

Please sign up at the NYCAG webpage to find the meeting location. There is also a dial in number if you are not in NYC and would still like to take part.

The risks of believing that the Mayan calendar ends December 21, 2012! Carl Johan Calleman (hat tip Richard Smith). The Mayan end of the world is really today! Hope you are prepared.

Conservatives Are More Squeamish than Liberals LiveScience (hat tip reader Aquifer)

The Most Anal CEO Ever Gawker

How a Jellyfish Protein Transformed Science LiveScience (hat tip reader Aquifer)

Astronomers discover complex organic matter in the universe e! Science News (hat tip reader peak oil not)

Decreasing Inequality Under Latin America’s “Social Democratic” and “Populist” Governments: Is the Difference Real? CEPR (hat tip reader Thomas R)

China spoils the party MacroBusiness

CDOs on the brink of collapse: report BusinessSpectator (hat tip reader Crocodile Chuck). The impact of the seizure of US mortgage insurer PMI hits Australian investors.

Art world thumbs its nose in Paris at economic crisis DailyStar (hat tip reader 1SK)

Roger Bootle on the European Crisis Deal: Get Austere or Die Trying Credit Writedowns

The Path Not Taken Paul Krugman, New York Times. On Iceland.

$6.6 billion in lost Iraq cash now accounted for, inspector says The Envoy (hat tip reader Aquifer). Hhhm, a story on CNBC on at least $40 billion being handled in a lax manner, and suddenly we are told everything is hunky dory.

Obama Backers Tied to Lobbies Raise Millions New York Times (hat tip Joe Costello). Quelle surprise! Obama lied!

House Passes the “Even Obama Supported” Non-Jobs Jobs Act Dave Dayen, FireDogLake

On Occupy Oakland and Policing in America Abigail Field. Money quote:

…. consider what a Marine said: “I was involved in a RIOT in Rutbah, Iraq 2004 and we did NOT treat the Iraqi citizens like they are treating the unarmed civilians in our OWN Country. No one was brutalized because our mission was to ‘WIN the hearts and minds.’ why should I expect anything less in my OWN Country.”

Occupying Struggle Street MacroBusiness (hat tip reader Aquifer)

Occupy Phoenix’s most devoted protesters Salon

Mayor Quan Left #OccupyOakland’s GA Rather Than Wait Turn to Speak. But Veterans Showed Up! [Video] Daily Kos (hat tip reader Deontos)

NYPD Union Warns of Lawsuits Against ‘Occupy’ Supporters Wall Street Journal. You cannot make this stuff up. The police union is threatening to sue any organization associated with OWS if cops are hurt.

The big questions raised by anti-capitalist protests Martin Wolf, Financial Times. More support for OWS.

It’s Time for Debt Forgiveness, American-Style William Greider, The Nation

Mr. Hoenig Goes to Washington Simon Johnson (hat tip reader Carol B)

Senators press Obama for swifter REO strategy Housing Wire (hat tip Lisa Epstein)

How Ed DeMarco finally cried fraud Moe Tkacik, Reuters

Rakoff queries Citi’s settlement with SEC Financial Times. I love Judge Rakoff. And one of his questions (I read the claim) was one we raised: what were the losses? The SEC only provided the low end of a range! He also, as before, wants individuals to be punished.

How gross and net CDS notionals really work Lisa Pollack, FT Alphaville (hat tip Richard Smith).

The NYT Touts the Fact That GDP Data Show the World Did Not End Dean Baker

Antidote du jour:

I suppose there is no point in being part of the 1% unless you can throw your weight around.

Greg Palast writes in the Guardian of how Goldman took a wee bit of revenge on Occupy Wall Street via the itty bitty credit union ($30 million in assets) that OWS chose for its bank account, Peoples Bank. Peoples has “a unique Federal charter”. It focuses on low income customers, meaning families with less than $38,000 in income (to get to how far that goes in the rest of the US ex maybe San Francisco, reduce that amount by at least 30%).

Goldman had donated $5,000 as a sponsor of a 25th anniversary party for the bank. So far, so good, until someone at Goldman gets wind of the fact that the invitations include its name along with that of other donors, as well as the honoree: Occupy Wall Street. Now to Palast:

When a Goldman exec saw its gilded name next to Occupy Wall Street, the financial giant expressed much displeasure. In fact, my sources say, Goldman threatened legal action unless the credit union gave up the $5,000 and reprinted the invite sans the Sachs moniker. Goldman Sachs did not respond to our requests for comment on the affair.

So far, it’s a cute story: tiny bank uses Goldman’s money to fete some tent-dwellers who are denouncing Sachs as the Giant Vampire Squid.

But there’s a lot more at stake in this battle than a $5,000 donation gone wrong. Underneath, it’s a battle royal for control of tens of billions of dollars in government mandated “community reinvestment” funds.

Yves here. Yes, sports fans. When Goldman became a bank during the crisis, it became subject to CRA. Back to Palast:

Problem: Goldman has, it seems, no low-income customers, nor a “community”. Goldman was directed to find poor people and a community and hand over some cash.

So Goldman looked down from its riverfront tower in lower Manhattan and discovered Peoples. Over 80% of Peoples member-owners have low incomes. At least 65% are Latino.

Yves again. So Goldman got a twofer with Peoples. At least prior to the OWS association, it thought it was satisfying some pesky regulatory requirements and buying some cheap PR. Back to the article:

Goldman did draw the line. And other bankers are stepping back across it, too. Capital One also pulled its name off the dinner invites.

Goldman has so far only passed out its legally-required CRA funds with an eye-dropper: the $5,000 for Peoples (now withdrawn), and a few other dabs here and there. The big cash investments from the Goldman fund are dangling, hoping to lure only those community banks and low-income funds that will dance to Goldman’s tune. My sources told me that Goldman’s “Urban Investment Group” representative had stated in a phone conversation that Occupy’s credit union will never get another dime from any big bank, but, again, Goldman refused to speak with me to confirm or deny this.

Peoples’ [Chairman} Del Rio dismisses such threats, but I don’t. These Community Reinvestment funds ultimately come from public pockets, so why should the titans of Wall Street be allowed to bully community credit unions, which are answerable to their members, not Goldman’s partners?

This low grade thuggish behavior over a mere $5,000 illustrates how deeply narcissistic Wall Street has become. Anything that threatens their image, no matter how small, must be beaten back. Goldman could have been punitive (by threatening never to do anything for the bank ever again) without going to the ridiculous step of threatening litigation over a charitable contribution. How charitable is it, exactly, when you try to attach retroactive conditions?

Unfortunately, I doubt this heavy-handed move will backfire to the degree that its efforts to shut down the website Goldman666 did. But they deserve ample ridicule over this boneheaded and abusive ploy.

This site has had plenty of company in expressing doubts about the latest episode in the continuing “save the banks, devil take the hindmost” Eurodrama. The same issues came up over and over: too small size of rescue fund, heavy reliance on smoke and gimmickry to get it even to that size, insufficient relief to the Greek economy (the haircuts will apply to only a portion of the bonds), no assurance that enough banks will go along with the “voluntary” rescue, and way way too many details left to be sorted out.

But it is a particularly bad sign to see disagreement within the officialdom about the just-annnounced deal. The Telegraph (hat tip reader Jim Haygood) reports that the Bundesbank, which has considerable influence on the ECB, is trash talking a critical part of the pact:

Hours after an all-night summit of euro governments ended, flaws began to emerge in a package that was billed as a “grand and comprehensive” solution to the European debt crisis.

The concerns were led by Germany’s powerful central bank, which expressed fears that a plan to leverage a €440 billion eurozone rescue fund to amass a “fire power” of €1 trillion, or £880 billion, resembled the risky finance methods that triggered the crisis in 2008.

EU leaders are expected to sanction the establishment of a so-called special purpose investment vehicle, or SPIV, to be set up in the coming weeks. It is aimed at attracting investment from countries such as China and Brazil.

Jens Weidmann, the president of the Bundesbank and a member of the European Central Bank, sounded the alarm over the plan to “leverage” the fund by a factor of four to five times without putting any new money into the pot.

We’ve pointed out the only way this scheme might work is if it attracts enough new money, which as the Telegraph indicates, is presumed to be the BRICS (I gather the sovereign wealth funds are too smart for this sort of thing, and even if they went along, their aggregate contribution would not be big enough). The Financial Times reports that China is being courted, but wants “assurances”:

China could be willing to contribute between $50bn and $100bn to the EFSF or a new fund set up under its auspices in collaboration with the IMF, according to one person familiar with the thinking of the Chinese leadership.

“If conditions are right then something a bit above $100bn is not inconceivable,” this person said….

One condition China might ask for is that its contribution be at least partly denominated in renminbi, which would protect its investment against currency fluctuations. China would buy euro-denominated bonds but repayments would compensate for any changes in the value of the renminbi, which has appreciated nearly 20 per cent against the euro in the past three years…

Beijing’s main concern is how any contribution to a European bailout will be viewed domestically by an increasingly informed and critical populace.

“Any mis-steps in helping Europe could cause problems with domestic public opinion – the Chinese people will watch very carefully what their own government does,” Prof Yu said. “European leaders also must have a clear plan of what to do and they must show China they have the political will as well as the support of their own people; if we see protests and chaos all the time, then China won’t have confidence in Europe’s political ability.”

If the Chinese think the Europeans can provide meaningful foreign exchange guarantees, they are smoking something very strong. The austerity programs being put in place will put Europe on a deflationary path. The only way to deleverage the private and government sectors at the same time and not see GDP contraction is to run a large trade surplus. And that means the Eurozone as a whole, not Germany within Europe. To do that, the currency needs to be much lower. The Financial Times’ Wolfgang Munchau has argued the euro will need to fall to between .6 and .8 to the dollar, roughly a 50% depreciation from current levels.

This guarantee is a classic wrong way risk. China is asking Europe to make promises it won’t be able to honor if its policies result in a cheaper currency or other bad results for China. And in general, China’s expectations are unreasonable. Its currency is undervalued. Even ex the undervaluation, the normal state of affairs for a maturing economy is to see its value rise. Any foreign currency investment can be expected to show large foreign exchange losses. And just because you shift your risk on the other party does not mean they can perform. As the example of AIG and the monolines showed, underpriced insurance has this nasty way of blowing up.

Japan was the dumb money in its bubble era. But at least they had an excuse: they yen was super high so everything looked cheap. At least the foreign exchange part of the equation worked in their favor, but they had insufficient knowledge of foreign investments to make good picks. The Chinese may be shrewder about their targets, but they seem woefully in denial on the magnitude and inevitability of foreign exchange risk on some of their plays. So they may rescue the Europeans and continue to resent funding their trade partners, just at the Germans do.

He warned that the scheme could be hit by market turbulence with taxpayers left holding the bill for risky investments in Italian and Spanish bonds.