naked capitalism

By George Washington of Washington’s Blog.

When a liberal labor leader and a conservative financial policy analyst unite against something, you know that something is really bad (actually, I don’t believe in the whole false left-right dichotomy; I think its Americans versus those trying to steal our wallets and our rights, but that’s another story).

Today, AFL-CIO president Richard Trumka has slammed the Fed and the proposed “Tarp on steroids” legislation in his testimony to Congress today. Here are the must-read parts of Trumka’s prepared remarks to the House Financial Services Committee:

We are deeply concerned that the Committee’s work thus far on the fundamental issues of regulating shadow financial markets and institutions will allow the very practices that led to the financial crisis to continue. The loopholes in the derivatives bill and the failure to require any public disclosures by hedge funds and private equity funds fundamentally will leave the shadow markets in the shadows. We urge the Committee to work with the leadership to strengthen these bills before they come to the House floor.

However, these powers must be given to a fully public body, and one that is able to
benefit from the information and perspective of the routine regulators of the financial system. We believe a new agency, with a board made up of a mixture of the heads of the routine regulators and direct Presidential appointees would be the best structure. However, if the Federal Reserve were made a fully public body, it would be an acceptable alternative.

But we cannot support the discussion draft made public earlier this week because it gives dramatic new powers to the Federal Reserve without reforming its governance so that the banks themselves are removed from the governance of the Federal Reserve System. Even more alarmingly, the discussion draft would appear to give power to the Federal Reserve to preempt a wide range of rules regulating the capital markets—power which could be used to gut investor and consumer protections. If this Committee wishes to give more power to the Federal Reserve, it must make clear this power is only to strengthen safety and soundness regulation and it must simultaneously reform the Federal Reserve’s governance. Reform cannot be put off until another day.

The Federal Reserve currently is the regulator for bank holding companies. In that
capacity, it was responsible throughout the period of the bubble for regulating the parent companies of the nation’s largest banks. While regulatory authority rests in the Board of Governors of the Federal Reserve in Washington, routine responsibility for regulatory oversight has been delegated by the Board of Governors to the regional Federal Reserve Banks. The Federal Reserve System’s regulatory expertise resides in these regional banks.

The problem is that these regional Federal Reserve Banks are actually controlled by their member banks—the very banks whose holding companies the Fed regulates. The member banks control the selection of the majority of the regional bank boards, and the boards pick the regional bank presidents, who are effectively the CEO’s of the regulatory staff.

These arrangements may explain why the Federal Reserve has never given any account of how it allowed bank holding companies like Citigroup and Bank of America to arrive at a point where they required tens of billions of dollars of direct equity infusions from the public purse to avoid bankruptcy.

Giving the Federal Reserve with its current governance control over which financial
institutions are bailed out in a crisis is effectively giving the banks the ability to raid the Treasury for their own benefit.

We are also deeply troubled by provisions in the discussion draft that would allow the Federal Reserve to use taxpayer funds to rescue failing banks, and then bill other nonfailing banks for the costs. The incentive structure created by this system seems likely to increase systemic risk.

We believe it would be more appropriate to require financial institutions to pay into an insurance fund on an ongoing basis. Financial institutions should be subject to progressively higher fee assessments, and stricter capital requirements, as they get larger. This would be a way of actually discouraging “too big to fail.”

In addition, language in the draft that appears to limit taxpayer bailouts of bank
stockholders actually does no such thing, rather it simply ensures that when stockholders are rescued with public funds, bondholders and other creditors are rescued with them…

Finally, and not least, the discussion draft appears to envision a process for identifying and regulating systemically significant institutions, and for resolving failing institutions, that is secretive and optional—in other words, the Federal Reserve could choose to take no steps to strengthen the safety and soundness regulation of systemically significant institutions. In these respects, the discussion draft appears to take the most problematic and unpopular aspects of the TARP and makes them the model for permanent legislation.

Instead of repeating and deepening the mistakes associated with the bank bailout,
Congress should be looking to create transparent, fully publicly accountable mechanisms for regulating systemic risk and for acting to protect our economy in any future financial crises.

Conservative Peter Wallison – financial policy study analyst at the American Enterprise Institute – largely agrees. In his prepared remarks to Congress, Wallison says:

The Discussion Draft of October 27 contains an extremely troubling set of proposals which, if adopted, will bring economic growth in this country to a standstill, essentially turn over the control of the financial system to the government, and seriously impair competition in all areas of finance.

Rather than ending too big to fail, the Draft makes it national policy. By designating certain companies for special prudential regulation, the Draft would signal to the markets that these companies are too big to fail, creating Fannies and Freddies in every sector of the economy where they are designated. This will impair competition by giving large companies funding and other advantages over small ones.

The idea that the designation of these companies will be kept secret is, with all due respect, absurd; securities laws alone will require them to disclose their special status; simple truthfulness will do the rest…

If this legislation is passed, every industry will be in Washington, asking for special treatment or exemption. Competition in the market will become competition before this committee or in the halls of the Fed, lobbyist-to-lobbyist and lawyer-to-lawyer…

This will not only create uncertainty and moral hazard, but it will give the large and powerful companies special advantages over small ones. Those that seem likely to be taken over by the government will have easier access to credit, at lower rates, than those likely to be sent to bankruptcy.

In other words, the Draft proposes nothing more or less than a permanent TARP, using government money to bail out the large or politically favored companies, and then taxes the remaining healthy companies to reimburse the government for its costs of competing with them…

The [proposed bill] would take control of the financial industry in the United States, stifle risk-taking and initiative, and change competitive conditions in every sector of the economy so that they favor large, government-backed, too big to fail enterprises…

The Draft … would now give the Fed authority to regulate any financial company that the Council determines should be subject to “heightened prudential standards,” even if there is no insured bank in the group…

The result is that the question becomes one of political clout, with industries fighting in Congress for the competitive result they want. Some industries want to invade others’ turf; the invaded industry uses the law to fend off the competition; consumers are the losers. Congress becomes the battleground. It’s not just unseemly; it’s a frightening example of what happens when the government starts picking winners…

Congress will be injecting itself into competitive fights between firms and industries, further politicizing what should be economic or financial decisions…

The Designated Companies are under the complete control of the Fed. They will not be able to initiate new activities without the Fed’s approval, or enter new competitive fields, or perhaps even open new offices in new places. This is a degree of political control of business that has never been attempted before. Not only will it place the dead hand of government on the activities of financial companies, but it will almost certainly drive many financial companies out of the United States before they submit to these restrictions.

The effect of these restrictions for the U.S. economy will be dire. First, Designated Companies will clearly have been labeled as too big to fail. In effect, the government has notified the capital markets that these firms will not be allowed to go into bankruptcy—they will be rescued in the ways I will describe below. This means they will be less risky borrowers than smaller companies that are not going to be controlled in the same way. As less risky borrowers, the Designated Companies will have lower costs of funding and will be able to drive smaller competitors from the markets they enter. Sound familiar? Yes, it’s Fannie Mae and Freddie Mac all over again. The existence of these Designated Companies will impair competition in every market they are allowed to enter, and will force the consolidation of competitors so that markets become dominated by government-backed giants like themselves….

[The bill assumes that] our entire financial system must be subjected, today, to far-reaching control by the Federal Reserve Board. With all due respect, this is absurd, and certainly disastrous for economic growth in the future.

The Draft also contains language that suggest some of the problems of identifying Designated Companies in advance—and thus creating the Fannie/Freddie too big to fail problem—can be avoided if the designation of these companies is not disclosed to the public. This, too, with all due respect, is absurd…

In addition, there is very little incentive for the government not to rescue failing Designated Companies, because the Draft provides that the surviving members of the financial industry larger than $10 billion in assets—whether Designated Companies or not—will be taxed to reimburse the government for its costs in the bailout…

As in the GM and Chrysler bailouts, preferences are going to go to favored groups, and disfavored groups will suffer disproportionate losses. It will be a political free for all, with important legislators pressing the FDIC to treat their constituents better than someone else’s constituents.

What we know is that no losses will be taken immediately by creditors. This is because the objective of the resolution authority is to prevent a “disorderly” failure, which actually means a failure in which creditors suffer immediate losses…

The proposals in the Draft reflect very bad policy—far more likely to be destructive of the financial system and damaging to the economy than an improvement on what exists today.

By George Washington of Washington’s Blog.

I have repeatedly pointed out that big banks are not more efficient than smaller banks.

For example, I previously noted that an article in Fortune concluded:

The largest banks often don’t show the greatest efficiency. This now seems unsurprising given the deep problems that the biggest institutions have faced over the past year.

“They actually experience diseconomies of scale,” [Celent analyst Bart] Narter wrote of the biggest banks. “There are so many large autonomous divisions of the bank that the complexity of connecting them overwhelms the advantage of size.”

Now, James Kwak has done some sleuthing and discovered that even Fed economists don’t buy the bigger-is-more-efficient argument. Kwak points out that New York Fed economist Kevin J. Stiroh found that most of the increase in efficiency during part of the time in which banks were consolidating was due to the increased use of information technologies:

His main explanation for the productivity growth is not consolidation, but information technology: “The finding of steady productivity growth, in particular, is important since it is consistent with the idea that the massive investment in new technology is working to improve the performance of the banking industry.” This is not proven in this paper, but Stiroh went on to write a bunch of other papers on the link between information technology and productivity. For example, this paper (on the entire economy, not just banking) concludes:

“IT-producing and IT-using industries account for virtually all of the productivity revival that is attributable to the direct contributions from specific industries, while industries that are relatively isolated from the IT revolution essentially made no contribution to the U.S. productivity revival. Thus, the U.S. productivity revival seems to be fundamentally linked to IT.”

Stiroh also wrote a paper on banks in Switzerland, concluding:

“We find evidence of economies of scale for small and mid-size banks, but little evidence that significant scale economies remain for the very largest banks. Finally, evidence on scope economies is weak for the largest banks that are involved in a wide variety of activities. These results suggest few obvious benefits from the trend toward larger universal banks.”

The kicker is that Stiroh is the main source cited by those claiming that bigger banks produce greater efficiencies.

The bottom line is that there is absolutely no reason not to break up the too big to fails.

By Edward Harrison of Credit Writedowns

I just came across a post on Zero Hedge called “An Overview Of The Fed’s Intervention In Equity Markets Via The Primary Dealer Credit Facility.” Now, that’s a mouthful. As far as I can discern, the post’s purpose is to expose alleged equities market manipulation by the Federal Reserve. However, I found the argument rather conspiratorial. And despite claims of an alleged smoking gun, there is no evidence in the post that that Federal Reserve is manipulating anything except interest rates. And the Fed made clear that that was what it intended to do.

Let me break down the argument made by Zero Hedge’s Tyler Durden and give a few remarks of my own on how I read the situation.

The junking of the Fed’s balance sheet

In March 2008, the Federal Reserve established the Primary Dealer Credit Facility (PDCF) to provide liquidity to the financial sector after Bear Stearns collapsed. Overnight funding had become a key source of liquidity for banks looking for cheap money (short-term rates are lower than long-term rates).

But when crisis hit, the liquidity in overnight interbank markets dried up leading to collapse at Northern Rock in October 2007 and then Bear Stearns in March 2008, institutions which were recklessly overexposed to overnight funding. This was a market failure. The Federal Reserve, therefore, stepped forward, effectively taking the entire wholesale banking market onto its balance sheet. That is what all of the Fed’s liquidity provisions are about.

The problem most of us have with this and similar facilities is the PDCF’s collateral terms. In the past the Fed accepted treasuries. Now it was accepting a lot more (including some so-called toxic assets):

The PDCF will provide overnight funding to primary dealers in exchange for a specified range of collateral, including all collateral eligible for tri-party repurchase agreements arranged by the Federal Reserve Bank of New York, as well as all investment-grade corporate securities, municipal securities, mortgage-backed securities and asset-backed securities for which a price is available.

By April 2008, when David Einhorn questioned Lehman’s earnings report, people were asking if they were going the way of Bear Stearns (see my June 2008 post “Is Lehman the next Bear Stearns?”). When Lehman did collapse, acceptable collateral expanded. In some instances it included equities as well. The Fed’s press release expanding collateral said:

The collateral eligible to be pledged at the Primary Dealer Credit Facility (PDCF) has been broadened to closely match the types of collateral that can be pledged in the tri-party repo systems of the two major clearing banks. Previously, PDCF collateral had been limited to investment-grade debt securities. The collateral for the Term Securities Lending Facility (TSLF) also has been expanded; eligible collateral for Schedule 2 auctions will now include all investment-grade debt securities. Previously, only Treasury securities, agency securities, and AAA-rated mortgage-backed and asset-backed securities could be pledged.

You’ll notice nowhere in the press release does one see the term equities. This is obviously by design because the Fed was under fire for bloating its balance sheet with junk. This process – what I call qualitative easing – was meant to be opaque.

With the panic now over, things have settled down and these facilities are likely to end. The Fed is issuing its own research to give intellectual cover to these activities. But, outrage remains nonetheless. The Fed’s own Charles Plosser, the President of the Philadelphia Fed, has said he wants to see qualitative easing end sooner rather than later. And Bloomberg News is suing the Federal Reserve under the Freedom of Information Act to reveal who it is lending money to against this dubious collateral.

That sums things up in a nutshell.  The key to note here is that the PDCF is an overnight lending facility, the TSLF is a 28-day lending facility and another program, the TALF, is a third longer-term lending facility I haven’t discussed. (See more on the TALF here and why it is a bailout).

Tyler Durden’s beef: the Plunge Protection Team

Tyler’s history of events in his post is largely consistent with what I just presented. Where his history diverges from mine is when he goes into the section headed “Implications,” saying “the Federal Reserve has now managed to singlehandedly take over the entire capital market.” At some point, he goes as far as to say:

The bolded text is all you need to know to find the smoking gun for any and all allegations of "plunge protection" or however one wishes to frame the invisible market bid.

Those are pretty strong words and I believe these claims are unsubstantiated in the post.  Why not leave it at the lesser claim that the Federal Reserve is running a loose monetary policy that encourages excessive risk – something that, while subject to interpretation, is a valid criticism?

Posts like this are exactly why I expressed concern when Bloomberg fecklessly expunged a Tyler Durden interview in August amid media hoopla over his identity:

Zero Hedge is a site replete with copious information on finance and the economy and is often a necessary voice of scepticism in the blogosphere that keeps the mainstream media honest.  We need outlets like that.  And Tyler was on Bloomberg Radio in the first place because he has something to say that is different, interesting and adds value. However, the hyperbole, tone, anonymity and confusion as to which writer is using which pseudonym at Zero Hedge has long become a liability which reduces the credibility of the site.

The claim of equity market manipulation strikes me as hyperbole.  There is no smoking gun whatsoever. It is a theory that I don’t buy into and that is not substantiated by the evidence in the post. Otherwise, Tyler and I are on exactly the same page.

I do have a few other points of disagreement.

• Why talk about the Primary Dealer Credit Facility when it is an overnight facility? The haircut is usually reset daily. How much manipulating can the Federal Reserve really do with an overnight facility? As I see it, the real problem with the Fed’s balance sheet is the loans under longer-term facilities like the TALF.
• What about the haircut on other asset classes, namely investment-grade and non-investment grade asset-backed securities and collateralized debt obligations. Forget about the plunge protection team conspiracy. To my mind, this is the real story here. The Fed says it accepts only securities “for which a price is available” as collateral. Is that really true? I am sceptical, one reason I would like to see who is getting these loans and what kind of collateral they are using.

Somehow you get the feeling there is a reason these facilities are still around, namely that some institutions need them because their capital base is so impaired right now that they would fail without the Fed taking those toxic assets off their hands.

In the end, Charles Plosser, Tyler Durden and I all agree: the Fed needs to end these programs as soon as possible.

Expect more on this issue soon via Marshall Auerback. Don’t you lot get cute in the comments, claiming I am slagging Tyler off unfairly. I simply disagree – there is no evidence of a plunge protection team in that post.

Update: This phrase, “PDCF usage declined, reaching zero in mid-May 2009,” suggests the PDCF is not being used to goose equities. The quote comes from page seven of the following PDF document at the New York Fed from August: “The Federal Reserve’s Primary Dealer Credit Facility.”

A lot of investors I know lamented the loss of Gillian Tett. As the Financial Times’ capital markets editor in the runup to the crisis, she had provided very insightful commentary on some of the more arcane goings-on in the financial markets. I’ve had reason to look at her older commentary (circa 2004-2005) and some of it is freakishily prescient. But then she got promoted, she went to work on her book, and her writings were less frequent and just not as crisp.

Well, we may be getting the old Miss Tett back, and we all should be careful what we wished for. This article is very much like some pieces she wrote in January 2007…..and she says we’ll know better if the “reflate the economy by creating an asset bubble” strategy will work in 6 months.

Um, first we have the ugly 6 month parallel. The real break in the credit markets started in July 2007….6 months out from her January 2007 pieces.

Second, she indicates that most observers recognize the rally is not the result of fundamentals (duh!) but the result of excessive liquidity chasing assets. She adds this:

Now, some western policymakers like to argue – or hope – that this striking rally could be beneficial, in a way, even if it is not initially based on fundamentals. After all, the argument goes, if markets rebound sharply, that should boost animal spirits in a way that could eventually seep through to the “real” economy….

Yet, what worries me is that it is still very unclear that that pile of damp wood – aka the real economy – truly will catch fire, in a sustainable way.

Tett is being way too cautious. Someone tried this very experiment once and it was a complete disaster.

In 1985, the US bilateral trade deficit with Japan had gotten so bad that even the “free markets” oriented Reagan administration felt it had to do something about it. The result was the Plaza accord, a coordinated currency intervention to push down the greenback.

It was narrowly too successful and broadly a failure. The dollar fell further than anyone wanted it to, over 50% versus the yen. In fact, two years later, another coordinated intervention, the Louvre accord, was implemented to drive the dollar back up.

Even though US imports from Japan fell, US exports to Japan barely budged. The trade barriers were structural. But the Japanese now had a very pricey currency, and their exports to other countries fell also.

So the authorities figured they’d try to stimulate consumer spending via asset appreciation. Notice how Japan’s problem then is analogous to China’s now: an economy that depends on exports with insufficient consumer spending (of course, one problem in Japan that everyone seems to forget is the small size of their homes. How can you consume a lot if you have restricted living and storage space?). The idea was that the wealth effect would lead people to spend more and raise the level of domestic growth, offsetting the fall in exports.

We know how that movie ended.

Asset bubbles beget more bubbles unless the authorities shrink the financial sector. Tett’s colleague Wolfgang Munchau wrote earlier in the week:

This is exactly what the economist Hyman Minsky predicted in his financial instability hypothesis.** He postulated that a world with a large financial sector and an excessive emphasis on the production of investment goods creates instability both in terms of output and prices.

While, according to Minsky, these are the deep causes of instability, the mechanism through which instability comes about is the way governments and central banks respond to crises. The state has potent means to end a recession, but the policies it uses give rise to the next phase of instabiliy….The world has witnessed a proliferation of financial bubbles and extreme economic instability that cannot be explained by any of the established macroeconomic models. Minsky is about all we have.

His policy conclusions are disturbing, especially if contrasted with what is actually happening. In their crisis response, world leaders have focused on bonuses and other irrelevant side-issues. But they have failed to address the financial sector’s overall size. So if Minsky is right, instability should continue and get worse.

From Tett:

Earlier this month, I received a sobering e-mail from a senior, recently-retired banker. This particular man, a veteran of the credit world, had just chatted with ex-colleagues who are still in the markets – and was feeling deeply shocked.

“Forget about the events of the past 12 months … the punters are back punting as aggressively as ever,” he wrote. “Highly leveraged short-term trades are back in vogue as players … jostle to load up on everything from Reits [real estate investment trusts] and commercial property, commodities, emerging markets and regular stocks and bonds.

“Oh, I am sure the banks’ public relations people will talk about the subdued atmosphere in banking, but don’t you believe it,” he continued bitterly, noting that when money is virtually free – or, at least, at 0.5 per cent – traders feel stupid if they don’t leverage up.

“Any sense of control is being chucked out of the window. After the dotcom boom and bust it took a good few years for the market to get its collective mojo back [but] this time it has taken just a few months,” he added. He finished with a despairing question: “Was October 2008 just a dress rehearsal for the crash when this latest bubble bursts?”

I daresay this missive reflects some element of hyperbole. But I have quoted it at length because the question is becoming more critical. Six months ago, the financial system was in deep distress, reeling from a meltdown. Now despair and panic have been replaced not simply by relief – but, in some quarters, euphoria. Never mind the high-profile rally that has occurred in the equity markets; what is perhaps most stunning is the less visible rebound in debt and derivatives markets, as risk assets have displayed what Barclays describes as a “stellar performance”

The New York Times has a good update on the progress, or more accurately, lack thereof, in the efforts to return to normalcy in the credit markets. The story highlights the fact that the securitization markets, to the extent they are operating, are heavily dependent on government intervention and it does not appear likely that they will function at their present level if support were withdrawn:

The continued disarray in debt-securitization markets, which in recent years were the source of roughly 60 percent of all credit in the United States, is making loans scarce and threatening to slow the economic recovery. Many of these markets are operating only because the government is propping them up.

But now the Federal Reserve has put these markets on notice that it plans to withdraw its support for them. Policy makers hope private investors will return to the markets, which imploded during the financial crisis….

“Given the imperative for securitization markets to fuel bank lending, we won’t have meaningful economic growth until securitization markets are re-established,” said Joseph R. Mason, a professor of banking at Louisiana State University…

Enormous swaths of this so-called shadow banking system remain paralyzed. Depending on the type of loan, certain securitization markets have fallen 40 to 100 percent.

A once-thriving private market in securities backed by home mortgages has collapsed, from $744 billion in 2005, at the peak of the housing boom, to $8 billion during the first half of this year.

The market for securities backed by commercial real estate loans is in worse shape. No new securities of this type have been issued in two years.

“The securitization markets are dead,” said Robert J. Shiller, the Yale University economist and housing expert who predicted the subprime collapse. The government is supporting them, he said, but it’s unclear what will happen when it extricates itself. “We’re stuck,” he said.

What is intriguing about these comments is the tacit assumption that we have to go back to status quo ante, of having a significant amount of loans on-sold into credit markets rather than retained on bank balance sheets. Yet we have seen the superficial appeal of that system comes at considerable cost. Securitization allows for more “efficient” banking, in the sense that banks can operate with far less equity than if they conducted banking the old-fashioned way, by holding the loans they originate.

But this prized efficiency comes at high social cost. First, the idea that these loans were really off balance sheet in many cases was spurious. For some types of conduits, like credit card trusts and SIVs, banks did intervene when the supposed off balance sheet vehicles got in trouble. Indeed, credit card receivables could not have been off-loaded absent parent support. So the supposed efficiency gain was phony; the banks were simply using off balance sheet vehicles as a way to run with less equity than they actually should have had, but the regulators accepted the charade and looked the other way.

Second, as we know, securitization reduces the incentives to do proper borrower assessment and even worse, means no one is monitoring the borrower on an ongoing basis. There is no good substitute for traditional credit screening. The idea that simple metrics are an adequate proxy for credit assessment and local knowledge is utter rubbish. A banker who is a member of the community can factor in qualitiative considerations in (how stable is the employer for whom the prospective borrower is working? Is the local economy improving or weakening?) that get lost in simple minded scoring systems. And for corporate borrowers, the lender is the only party in a position to obtain non-public information that will allow for a better assessment of the lending risk. That is not to say these procedures are perfect; they aren’t, but they are better than what we have experimented with over the last 20 years.

As a result of the first two failings, we have the third problem: the public covertly and overtly has provided greater backstops to securitized credit than the traditional sort. We had Fannie and Freddie and Ginnie making the first wave of mortgage securitizations possible, and after those became well accepted, banks pushed into private (meaning non-government-backstopped) securitizations. But when a fair portion of them ran into trouble, the loans could not be restructured (increasing the social cost) and the banks that were exposed (by holding securitized mortgages, or warehoused mortgages due to be securitized) wound up being rescued. So the now greater level of support to the banking system is not a mere unfortunate side effect of the credit bubble, but a direct result of securitization, a process that leads to an undercapitalized banking system and a degradation of the lending process.

It is also noteworthy that the article fails to mention the fix proposed by the Obama administration, of having the originator retain 5% of the deals they on-sell. That is simply too low a percentage to change behavior. And a hold-back high enough to make a difference (probably at least 25%) will mean banks will have to hold more capital and will thus undermine the efficiency gains that are the raison d’etre of securitization.

Before the contraction entered the near-meltdown phase (fall 2008), central bankers appeared to have some willingness to have banks go back to a more old-fashioned model, even though it implied financial firms would have to raise massive amount of equity. Dizard depicted this line of thinking as wildly unrealistic, but it is noteworthy that is was the tacit plan until the wheels started coming off the financial system:

Think of the main US banks and dealers, along with their regulators, as the Iraqi government – though without the same unity, purpose or long-term planning….

The US banks and dealers are through the first quarter [of 2008], and are backstopped by a Federal Reserve that has gone from vestal virgin to camp follower…

It is not fair to say the Fed does not have a plan. It does. The plan is for the banking system to recapitalise for a new on-balance sheet world by raising a minimum of $200bn in a short period of time, not longer than two quarters. That way, there is no credit crunch, according to the model. A credit crunch, in Fed chairman Ben Bernanke’s own language, is: “A significant leftward shift in the supply curve for bank loans, holding constant both the safe real interest rate and the quality of potential borrowers.” ( The Credit Crunch , Brookings Institution, 1991) That means you can have a decline in the demand for credit as part of a business cycle without a “crunch”.

Let us put the Fed’s plan in the context of the world of the capital markets. Consider Washington Mutual’s $7bn recapitalisation of last week. We would have to have a Washington Mutual recap a week for the next six months to get the Fed’s plan done. All the uncommitted capital available to the private equity funds could be dedicated to this purpose.

All of it? I do not think so. The private equity people have other ideas. To raise anything like the bank capital the Fed and the other authorities such as the Treasury want, it would be necessary to have a series of road shows for the investing public that would be the size of theme parks. That could be done with difficulty and with great dilution for shareholders and, more seriously, career damage for senior management. The Fed itself would have to be a co-sponsor in some form.

Quietly arranged deals, first with sovereign wealth funds, then with private equity partnerships, are not enough. It is a bit like attacking militias in Basra without adequate forces or preparation. Some investors might throw down their arms and defect to the short-selling side.

Another way large banks are de-leveraging is to hive off assets, such as the $12bn of leveraged financing commitments Citibank laid off on a group of private equity funds, at a discount to the original price. The problem there is that while Citi is providing what a distressed homeowner would call “seller financing”, it is a lot less than the leverage available if the commitments were to be funded on Citi’s own books, or on the books of other banks. Multiply that $12bn by a raft of other deal announcements and you have the “leftward shift” Mr Bernanke referred to. Maybe more than one shift, come to think of it.

Readers no doubt also remember that that $7 billion recapitalization of WaMu was a very unhappy experience for the private equity investors who ponied up the money.

But now that we are only (according to the IMF) 60% of the way through the losses that US banks will realize thanks to the crisis, it will be hard simply to bring the banks back to a dim resemblance of pre-crisis levels of equity after the writeoffs are factored in. The additional capital needed for on-balance sheet lending seems an impossible goal. Yet there seems to be no realistic plan for bringing back the securitization markets, which is what has to happen for a restoration of status quo ante. And some question the wisdom of that goal. From Marshall Auerback:

….the history of banking crises suggest that the regulatory focus on the liability side of the banks’ balance sheets is faulty. There is much discussion of counter-cyclical capital requirements, but the reality is that capital standards and leverage ratios for financial institutions almost never work. They are always set so low that they allow leverage that would have been viewed as extreme as recently as 30 years ago. They are easy to scam through accounting fraud. When times get tough, the financial services industry demands (and usually receives) regulatory dispensation on flaky accounting, legalizing what would otherwise be blatant securities fraud.

U. S. banks are public/private partnerships, established for the public purpose of providing loans based on credit analysis. Supporting this type of lending on an ongoing, stable basis demands a source of funding that is not market dependent. All regulation, then, should proceed from a ‘public purpose’ standpoint and the regulatory focus should be on the asset side of the balance sheet. Banks should only be allowed to lend directly to borrowers, and then service and keep those loans on their own balance sheets. There is no further public purpose served by selling loans or other financial assets to third parties, but there are substantial real costs to government regarding the regulation and supervision of those activities. And there are severe consequences for failure to adequately regulate and supervise those secondary market activities as well.

Unfortunately, ideas like this are simply unacceptable right now. The path of least resistance is to find a way to declare victory, which in this case will be to continue to prop up the securitization markets while somehow claiming they are operating on their own.

I read my first management book at the age of 11, not because it was a management book, but a best seller at the time, And it may have been imprinted by it more than I realized. The Peter Principle says that managers are promoted until they reach their level of incompetence. The classic example is promoting the best salesman to be a sales manager. The joke (all too true) is that you both lose your best salesman and gain a lousy supervisor.

That pattern says that organizations as a whole are not very capable (if they recognize this danger, they should try to manage against it, but the popularity of The Peter Principle did not change corporate practice one jot, at least as far as I can tell). And of course, it explains why there are so many crappy managers and executives.

John Kay of the Financial Times applies this idea to financial firms, arguing that they diversify their way into incompetence:

Financial institutions diversify into their level of incompetence. They extend their scope into activities they understand less…

The principle of diversification into incompetence applies from the largest financial institution to the smallest. AIG was America’s leading insurance company. The company did not just undertake credit insurance, but was the largest trader in the credit default swap market. That is how its financial products group, employing 120 people in London, brought about the collapse of a business that employed 120,000.

Yves here. Citigroup is another example. It isn’t so much that Citi made a disastrous acquisition as it dedicated itself to massive reach as a corporate imperative: be as global and be in every conceivable product niche. That is a prescription for being unable to manage yourself, which is the essence of the big bank’s problems. Back to Kay:

The boredom factor is important. Much of traditional banking is quite boring. The desire to find new challenges is an admirable human trait. It is, however, very expensive for shareholders to allow their chief executives to indulge it.

Public sector bodies are usually constrained in their activities, so deregulation is often a trigger for expensive experimentation. In Britain, many of the efficiency gains from privatisation were squandered in diversification: I watched senior managers spending 80 per cent of their time on activities that generated 1 per cent of turnover and minus 10 per cent of profit. But it is more fun to go on jollies to Buenos Aires than to fix leaking pipes.

To win an auction when you don’t know what you are bidding for is often to lose. This winner’s curse is often behind bad acquisitions because the successful purchaser is the bidder most willing to pay too much. Hence the contest between Royal Bank of Scotland and Barclays as to which bank would court bankruptcy by buying ABN Amro. Ignorance of products may also be a problem. When you are the newcomer and know little, the business that gravitates to you will be the business no one else wants.

But the driving factor is hubris. Jim Collins’s well-timed study of How the Mighty Fall applies to every business I have mentioned. The financial services industry is particularly vulnerable to hubris because sections of it are not very competitive, and randomness plays a large role in the outcome of speculative transactions. It is therefore particularly easy for those who work in financial institutions to make the mistake of believing that their success is the result of exceptional skill rather than good fortune. What more natural to believe than that extraordinary talent will find pots of gold under other rainbows? Until vanity is vanquished, I anticipate that diversification to the level of incompetence will continue to be a powerful element in business behaviour.

With all due respect, I think Kay has the essence of this wrong. First, deals are engrossing and sexy. They are very intense, the top executives are the focus of Big Decisions, and they have a horde of high priced talent catering to them (well actually, leading them by the nose, but they are usually so adept at it that the client often does not realize he is no longer in control).

But the big driver is that bank CEO pay is correlated with the size of the institution. And it is much easier to get big fast by acquisition than organically. Big deals are a wallet-lining activity, and the advisors understand that very well.

Nicholas Nassim Taleb and Mark Spitznagel have a provocative comment up at the Financial Time today, In some ways, it is isn’t surprising for those familiar with his work on risk and uncertainty. On the other hand, it is an eye opener to see what an internally consistent, reasonably comprehensive solution to our mess looks like,

Taleb and Spitznagel, unlike most others, include real economy fragility in their calculus. The dependence on sophisticated computers networks and advanced communications creates more points of failure. Integrates supply chains and interdependence due to trade also creates more complexity. For the life of me, I never understood the vogue for outsourcing and offshoring, Every study ever done says the majority of companies are disappointed with the results. It seems to represent hope over experience. And from what little I have seen in the way of hard numbers says it does not yield impressive results. One IBM project, to send some work to China, showed that the labor cost savings were substantial, something like a 75% to 80% reducution. Yet the all-in cost savings projected were a mere 15% to 20%. And most projects do not live up to expectations. The gap between the two figures says the additonal coordination costs and delays were considerable.

That is a tremendous amount of rigidity and risk to introduce into one’s operations for not much gain. Yet everyone went merrily down that path because it was what all right-minded modern companies were supposed to do.

The other big message of this piece is trying to prop up asset prices via more debt is a bad idea. He recommends restructuring via large-scale debt to equity conversions, plus arrangements that allow for partial equity conversions if borrowers go into arrears. A clever concept, but too hard to administer.

As much as Taleb and Spitznagel’s message about the dangers of debt, and the need for a surgical remedy is clear, the odds of the right sort of action are zero unless things get much worse in short order.

From the Financial Times:

The core of the problem, the unavoidable truth, is that our economic system is laden with debt, about triple the amount relative to gross domestic product that we had in the 1980s….government policies worldwide are causing more instability rather than curing the trouble in the system. The only solution is the immediate, forcible and systematic conversion of debt to equity….

First, debt and leverage cause fragility; they leave less room for errors as the economic system loses its ability to withstand extreme variations in the prices of securities and goods. Equity, by contrast, is robust: the collapse of the technology bubble in 2000 did not have significant consequences because internet companies, while able to raise large amounts of equity, had no access to credit markets.

Second, the complexity created by globalisation and the internet causes economic and business values (such as company revenues, commodity prices or unemployment) to experience more extreme variations than ever before. Add to that the proliferation of systems that run more smoothly than before, but experience rare, but violent blow-ups.

Our ability to forecast suffers due to this complexity and the occurrence of the occasional extreme event, or “black swan”. Such degradation in predictability should have made companies more conservative in their capital structure, not more aggressive – yet private equity, homeowners and others have been recklessly amassing debt. Such non-linearity makes the mathematics used by economists rather useless. Our research shows that economic papers that rely on mathematics are not scientifically valid. Not only do they underestimate the possibility of “black swans” but they are unaware that we do not have any ability to deal with the mathematics of extreme events. The same flaw found in risk models that helped cause the financial meltdown is present in economic models invoked by “experts”. Anyone relying on these models for conclusions is deluded.

Third, debt has a nasty property: it is highly treacherous. A loan hides volatility as it does not vary outside of default, while an equity investment has volatility but its risks are visible. Yet both have similar risks. Thus debt is the province of both the overconfident borrower who underestimates large deviations, and of the investor who wants to be deluded by hiding risks. Then there are products such as complex derivatives, which in the name of “modern finance” make the system even more fragile.

Against this background, we have two options. The first is to deflate debt, the other is to inflate assets (or counter their deflation with a collection of stimulus packages.)

We believe that stimulus packages, in all their forms, make the same mistakes that got us here. They will lead to extreme overshooting or extreme undershooting. They lead to more borrowing, by socialising private debt. But running a government deficit is dangerous, as it is vulnerable to errors in projections of economic growth. These errors will be larger in the future, so central bank money creation will lead not to inflation but to hyper-inflation, as the system is set for bigger deviations than ever before.

Relying on standard models to build policies makes us all fragile and overconfident. Asking the economics establishment for guidance (particularly after its failure to see the risk in the economy) is akin to asking to be led by the blind – instead we need to rebuild the world to make it resistant to the economist’s mystifications.

Invoking the pre-internet Great Depression as guidance for current events is irresponsible: errors in fiscal policy will be magnified by this kind of thinking. Monetary policy has always been dangerous…. Bubbles and fads are part of cultural life. We need to do the opposite to what Mr Greenspan did: make the economy’s structure more robust to bubbles.

The only solution is to transform debt into equity across all sectors, in an organised and systematic way. Instead of sending hate mail to near-insolvent homeowners, banks should reach out to borrowers and offer lower interest payments in exchange for equity. Instead of debt becoming “binary” – in default or not – it could take smoothly-varying prices and banks would not need to wait for foreclosures to take action. Banks would turn from “hopers”, hiding risks from themselves, into agents more engaged in economic activity. Hidden risks become visible; hopers become doers.

It is sad to see that those who failed to spot the problem (or helped to cause it) are now in charge of the remedy. Just as the impending crisis was obvious to those of us who specialise in complexity and extreme deviations, the solution is plain to see. We need an aggressive, systematic debt-for-equity conversion. We cannot afford to wait a day.

What is going on?

We noted on June 12 that the World Bank has lowered its growth forecast for 2009 from a negative 1.7% to close to negative 3%. World Bank Group President announced this prior to the G8 meeting and stressed the global contraction would have particularly grim consequences for poor countries.

Today we have this Bloomberg headline, “Stocks, Copper Retreat on World Bank Forecast; Dollar, Yen Rise“:
Stocks and commodities fell while the yen, the dollar and Treasuries rose after the World Bank said the global economy will

shrink 2.9 percent this year, a deeper recession than it predicted in March.

The Dow Jones Stoxx 600 Index of European shares slid 1.3 percent at 1:20 p.m. in London, while Standard & Poor’s 500 Index futures slipped 0.9 percent. The yen strengthened 0.9 percent against the euro and the dollar rose 0.6 percent. The yield on the benchmark 10-year Treasury dropped six basis points to 3.72 percent.

A flight of capital from developing nations will increase the numbers of the poor and the unemployed, the Washington-based World Bank said in a report today. The projection for a deeper slump than the 1.7 percent contraction forecast in March follows a three-month, 44 percent rally that drove the price-earnings ratio on the MSCI World Index to the highest level in four years.

“The green-shoots story is largely priced in,” Lena Komileva, an economist in London at Tullett Prebon Plc, wrote in a note today. “Judging by the general commentary in recent days focus has started to shift from the overall positive direction of the economic surveys,” she said. That’s “consistent with weak demand, pressured producer profit margins, high unemployment and weaker labor wages,” Komileva wrote…

The World Bank said that while a global recovery may begin this year, impoverished economies will lag behind rich nations. Global growth will be 2 percent next year, down from a 2.3 percent prediction in March, the bank said.

We did note at the time that it was puzzling that the media took so little note of the marked change in the World Bank forecast, since it is usually an above-the-fold news item. And looking at the World Bank site, I do not see a new press release (the older one was dated June 11).

As of this writing, the DAX is down 1.9%, the Footsie is down 1.5% and the CAC is down 2.0%. S&P 500 futures down 9.7 points.

This is probably just the usual “markets will fluctuate” story with Bloomberg searching for explanations, but this one is quite a stretch.

Yesterday, we highlighted yet another indication that one of two parts of the infamous Public Private Investment Partnership, the so called Legacy Loans Program, was being delayed, possibly on a permanent basis (or more likely, it will be launched eventually to save bureaucratic face and have weak to non-existent take-up). Its evil twin, the program for securities, was to have been operational as of May 1. The target start date has been pushed back to July.

Another program, the TALF, or Term Asset Backed Securities Lending Program, may also be in the process of being curtailed. The TALF was envisioned as a way to restart the securitization market by letting investors borrow on a non-recourse basis against newly issued AAA asset backed securities, from asset pools consisting of credit card receivables, student loan, auto loans, SBA loans. The TALF was expanded from its original $200 billion size to $1 trillion, and would include certain types of commercial mortgage paper. The Fed also flagged residential mortgage securities as “an area of possible expansion.”.

Since then, a couple of things have happened. First, the Fed appears to be pulling back on the residential mortgage idea. From Bloomberg (hat tip DoctoRx):

The Federal Reserve may not start lending against residential mortgage-backed securities under its Term Asset-Backed Securities Loan Facility, Federal Reserve Bank of New York President William Dudley indicated.

“We’re still in the process of assessing whether a legacy RMBS program is feasible, and if it were feasible, whether it would be significant enough to make a major impact,” Dudley said….

His comments add to signs that Treasury Secretary Timothy Geithner’s Public-Private Investment Program to boost debt prices and rid banks of devalued assets to expand lending is stalling, after helping to spark a rally in stocks and bonds….

Responding to questions after a speech at the conference, Dudley said each home-loan security is different and must be separately evaluated for the size of the haircut that should be applied, so “there’s a huge administrative hurdle” to expanding the TALF to the bonds….

Last month, the Fed’s program to finance commercial- mortgage bonds was potentially hampered by Standard & Poor’s saying it may downgrade many AAA securities, rendering them ineligible under the central bank’s rules. As much as 90 percent of so-called super senior commercial-mortgage bonds sold in 2007 may be affected as the ratings firm changes how it assesses the debt, New York-based S&P said…..

The TALF and PPIP plans contributed to a rally among many types of home-loan bonds. Typical prices for the most-senior prime-jumbo securities jumped to about 83 cents on the dollar on May 14, from about 63 cents March 19, before steadying, according to Barclays Capital. Similar bonds backed by Alt-A loans with a few years of fixed rates rose to 45 cents, from 35 cents, according to the bank’s reports. Alt-A mortgages fall between prime and subprime in terms of expected defaults.

“Just the announcement of legacy RMBS being included in TALF has already had a major impact,” Roger Lavan, a portfolio manager in New York at Stone Harbor Investment Partners LLP, a fixed-income asset manager, said in an e-mail today. “Not including legacy RMBS in TALF would be a big mistake.”

Another factoid that Bloomberg failed to mention: participation to date is underwhelming, with only $30 billion uptake so far.

Many commentators chose to focus on Dudley’s speech, in which he defended the use of AAA ratings as the basis for determining eligibility for the program (the argument being that it is safe). But as insulting to the intelligence as it is to hear him say that, this has been the program’s design from the get-go.

Submitted by Rolfe Winkler, publisher of OptionARMageddon

In an interview with Charlie Rose on Tuesday, Tim Geithner admitted the bubble was caused by Greenspan’s easy money policy. Unfortunately, Charlie didn’t ask the obvious follow-up: “why will this time be different? Why will Bernanke’s easy money policy lead to different results?” Here was the crucial exchange:

Rose: “Looking back, what are the mistakes and what should you have done more of? Where were your instincts right, but you didn’t go far enough?”

…

Geithner: “…I would say there were three types of broad errors of policy and policy both here and around the world. One was that monetary policy around the world was too loose too long. And that created this just huge boom in asset prices, money chasing risk. People trying to get a higher return. That was just overwhelmingly powerful.”

Rose: “It was too easy.”

Geithner: “It was too easy, yes….

What makes Geithner’s admission so frustrating is that the government is engaged in the same disastrous policy today, to fight the same bogeyman: deflation.

As Geithner makes plain, a huge side effect was that investors seeking meaningful returns inflated the bubble taking flyers on overpriced, risky securities. Toxic structured products are the obvious example. Credit rating agencies get lots of blame as enablers, rating trash “AAA.” But fixed-income investors wanted an excuse to invest in riskier stuff that carried slightly higher yields; hell, artificially low interest rates meant many needed an excuse.*

Truly low risk securities like Treasurys and money market instruments were yielding so little, they were of no use to portfolio managers trying to match assets with liabilities.

But what happens when low-risk fixed-income securities yield 0% or close to that? Asset managers are more or less forced to seek higher interest rates through riskier investments.

So what are the results of our latest experiment with rock-bottom rates? Investors are piling back into risky investments across the board. Taking just one example, FT noted this week that high-yield debt is skyrocketing. The “experts” cited in the article claim this is proof that we’ve come through the worst of the recession. In their brains, markets operate efficiently, so running bulls must reflect improving fundamentals.

First of all, efficient market theory doesn’t apply to asset markets the way it applies to goods markets. But even if it did, how can folks pretend that any market with fixed prices is operating efficiently? With their stranglehold on interest rates via open market ops, central banks everywhere are engaged in a massive price fixing scheme that distorts investor incentives across all asset markets.

Geithner admits such a policy was a disaster before, that the “overwhelmingly powerful” force of low rates inflated the bubble. So how can he/Bernanke justify the same approach this time ’round? No doubt they’d argue they’ve no other choice: a ponzi system “relying on credit” needs credit to flow or else it will collapse. It doesn’t occur to these guys that the system itself is flawed, that we need a gut renovation, not just another layer of paint.

No doubt de-leveraging would be quite violent if the Fed left rates higher. But de-leveraging is the only solution to the crisis. God forbid Bernanke’s easy money policy actually “works;” God forbid he “rescues” the economy by reflating the credit bubble. De-leveraging is coming, whether we want it to or not. Better to rip the band-aid off quickly…

[The guest writer's blog can be viewed here.]

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*Not that CRAs are blameless. They deserve every ounce of criticism they’ve received.