Quelle Surprise! Banks May Be Gaming ECB Liquidity Facility

The ECB has uncovered gambling in Casablanca. The central bank is shocked to learn that banks appear to be originating crappy assets solely for the purpose of dumping them in a liquidity facility intended to help them through a rough patch, not to provide an ongoing subsidy.

Regulators should know better. Indulgent parents generally wind up with spoiled kids who posses a sense of entitlement and react particularly badly when restrictions are imposed. In this case, the ECB took it as a point of pride that it accepted a broader range of collateral than other central banks, but its liberalmindedness appears to be working against it. Financial firms are first and foremost loyal to their own wallets. Any program that can be used to generate profit or other competitive advantage can and will be exploited.

From the Financial Times:

The European Central Bank yesterday voiced its "high concern" at growing evidence that banks are exploiting its efforts to unblock the frozen funding markets by using its liquidity scheme to offload more risky assets than it envisaged.

Yves Mersch, a governing council member, said the ECB was now "looking very hard at whether there is not a specific deterioration of collateral" which the central bank is accepting in return for funds.

He was speaking amid signs of some banks creating low-rated assets specifically so they can be traded for treasuries at the European Central Bank.....

Mr Mersch said the type of collateral now being accepted was: "A matter of high concern."....

Investment bankers who work in securitisation say that their main business is structuring bonds that are eligible for ECB liquidity operations. Some analysts have concerns about whether the bonds being created will ever be saleable if markets recover.

"There is moral hazard . . . and we are not in the business of taking over the market," Mr Mersch said. "That means there must be an exit strategy."

This shows the danger of the idea of the central bank as market maker of the last resort. It's too easy for it to become market maker of the only resort.

"Inflation here, there and everywhere"

Willem Buiter argues that the focus on oil and food price shocks, which economists view as relative price changes rather than inflation, is muddying the discussion about inflation. He sees considerable evidence of widespread inflation and it's central bankers' fault.

From Buiter:

Inflation is rising just about everywhere. Why is this and what can be done about it?

To get some basic concepts clear: inflation is a sustained rise in the general price level. Both the words ’sustained’ and ‘general price level’ are imprecise and in need of operationalisation. By general price level I mean a broad, representative index of consumer prices. That excludes the (headline) CPI in the UK....

I also exclude as unrepresentative various ‘core’ price indices, which exclude from the headline index such things as food, drink, energy and fuel. Among leading central banks, only the Fed has focused mainly on core inflation rather than on the headline index of consumer goods and services prices. Focusing on core inflation will be misleading unless either the relative price of core and non-core goods and services is expected to remain constant or Americans don’t eat , drink, drive cars and heat their houses or use air conditioning.

Until recently the Fed believed (a) that the best forecast of the future relative price of core and non-core goods and services was the current relative price of these sub-indices and (b) that the prices of non-core goods (mainly energy, fuel and agricultural commodities-based products) were more volatile than those of core goods and services. The volatility point was and remains empirically correct. The random walk or martingale hypothesis for the relative price of core and non-core goods was always a bad assumption empirically. In the most recent phase of globalisation, which has for much of this decade delivered a steady increase in the relative price of non-core goods to core goods and services, the assumption that it is OK to take this relative price as constant in the future is bad statistics and bad economics. Fortunately, the Fed is showing signs of kicking its core inflation habit, although painful withdrawal symptoms still are apparent from time to time. Admitting you have geen wrong is almost as difficult for central bankers as it is for politicians.

By ’sustained’ I mean,…uh, well, you know, something like ‘persistent’. And by ‘persistent’ I mean ’sustained’. Unsustained would be any one-off increase in the level of the price index that is not associated with expectations of further increases. I know this is vague and unsatisfactory, but welcome to the world of applied social science. For practical purposes, a representative price index that rises for more than two years would indicate inflation.

Who or what causes inflation?

This one is easy. In a fiat money world, central banks cause inflation, or, more precisely, only central banks are resposible for inflation. Other shocks, real and nominal, can influence the general price level if the central bank does not respond swiftly and determinedly, but these non-central bank-induced changes in the general price level can always can be offset by the central bank, given enough time, freedom to act and courage.

So, in the medium and long term (at horizons of two years and over, say) central banks choose the average rate of inflation. Not globalisation; not indirect taxes; not bad harvests; not OPEC and the price of oil; not the Chinese and their exchange rate management. There is no oil inflation, food inflation or cost-push inflation. There is just inflation. Inflation may be accompanied by changes in key relative prices - in the real prices of oil, of food, of oil and of labour for instance - if other relative demand and supply shocks accompany the inflationary impulses created by the central bank. Large increases in the real price of food will be bad news to food importers (including most urban households) and good news to rural food producers and exporters. But don’t confuse it with inflation.

Sometimes the central bank is the political captive of the fiscal authority. This is most clearly the case in countries with underdeveloped financial systems where seigniorage (the revenues appropriated by the central bank through the issuance of fiat money) is a significant source of government revenue and the central bank is not operationally independent. Sometimes the revenue needs of the government force a non-independent central bank to monetise the governments deficits. Zimbabwe is an example today. This is not a relevant consideration in today’s advanced industrial countries, as the revenue from seigniorage is tiny (around 0.25%-0.5% of GDP or less).

But with an operationally independent, sufficiently well capitalised central bank, the monetary authorities can, on average in the medium and long term, achieve the inflation rate they want. They are responsible, no-one else.

I assume, of course, that the exchange rate either floats or is set by the central bank. With a fixed exchange rate, or an exchange rate whose value is not set by the central bank, there is no substantive central bank independence. Given a floating exchange rate or a central-bank-set exchange rate, the central bank can make inflation in the medium and long term anything it wants it to be.

The central bank pursues its inflation objective by raising its policy rate (a short default-risk-free nominal interest rate) whenever inflation is expected to be above target over the horizon the central bank can influence it in a predictable way (starting between 6 and 12 months from the present), and by lowering the policy rate whenever inflation is expected to be below target. It’s simple, really. In financially repressed systems like India, the interest rate instrument (a) cannot be used freely because of political constraints and (b) has only a very small anvil to hit. So credit controls, including selective credit controls have so supplement the exchange rate as anti-inflationary instruments. It is clear that the Chinese authorities either don’t know the degree of monetary tightening (through credit controls, interest rate increases and yuan appreciation) that is required to bring inflation first under control and then down to a lower level, or that the economically necessary degree of monetary, credit and exchange rate tightening is noty yet politacally feasible.

Inflation is rising (almost) everywhere

The UK just got a nasty inflation shock. On the Bank of Englan’s official target, the CPI, year-on-year inflation in April came out at 3.0 percent, a full percent above the 2.0 percent target. Any higher and we would have had another Letter of St. Mervyn to the Tresorians. We are likely be see another couple of espistels again this year. The increase from 2.5 to3.0 percent was both large and larger than expected. It was preceded by a slew of data showing manufacturers costs and prices rising at alarming rates. The imminent interest rate cuts that had been anticipated by markets because the marked economic slowdown that is under way will reduce capacity utilisation and bring inflation down, are likely to be shelved for the time being. If the coming months confirm the pattern of higher than expected inflation, interest rate hikes must be on the cards for the UK, as even quite sharp increases in excess capacity may not be enough to bring inflation back to its target sufficiently quickly.

The reporting of the increase in UK inflation has been abominable, even in papers that still credit their readers with IQs in double digits. The Financial Times contained a deeply misleading article headed “Familiar culprits drive surprise jump in bills”, with above it “7.2% food, 8.3% household energy,…., 18.7% fuel for transport…” etc. This is major-league disinformation as regards the drivers of inflation. There is indeed a familiar culprit for the increase in the cost of living - the Bank of England’s Monetary Policy Committee. The fact that this rise in inflation is accompanied by shocks that cause major changes in relative prices, including a nasty adverse terms of trade shock for the British consumer, is neither here nor there as regards the overall rate of inflation. If fuel for transport, food and household energy had not gone up at all, other prices would have gone up by more to produce pretty much the same overall rate of inflation.

I am willing to grant the old-Keynesians and new-Keynesians among us, the empirical regularity that at very high frequencies, the fact that most nominal commodity prices (and prices of non-core goods in general) are flexible (both ways), while most nominal core goods and services are sticky in the short run. So relative demand or supply shocks that cause the relative price of non-core goods to go up will tend to do so in the first instance through an increase in the nominal price of non-core goods rather than through a reduction in the nominal price of core goods and services; likewise relative demand or supply shocks that cause the relative price of non-core goods to do down will tend to do so in the first instance through a decline in the nominal price of non-core goods rather than through an increase in the nominal price of core goods and services.

So for a given stance of past, current and future monetary policy (as measured by the sequence of past, present and contingent future policy rates), relative demand and supply shocks that cause an increase in the relative price of non-core goods (the kind of shocks we are seeing globally today), will temporarily raise inflation above the level at which it would have been without these relative demand and supply shocks but with aggregate demand and supply at the same level. Such general price level blips work their way through the system quite swiftly; much of it is gone within a year, virtually all of it within two years. The do not ’cause inflation’.

In the Euro Area inflation has come down a little to 3.3 % year-on-year (on the inadequate HICP index, admittedly), from last month’s peak at 3.6%. For a central bank that aims at inflation in the medium term of below but close to 2 percent, this is not a great or even an acceptable performance. Unless the Euro Area level of activity slows down sharply, higher interest rates from the ECB cannot be ruled out.

Inflation in the US is running at 4.0 percent on the headline CPI inflation (which does include housing costs). This is way above what should be the Fed’s comfort zone. The die-hard core inflationists there will point out that core inflation is only 2.4%, but the only appropriate answer to that is: so what? Core inflation is of interest only to the extent that it is a superior predictor of future headline inflation. If it ever was, it has ceased to be so this millennium. The Fed has let inflation get away from it even more than the ECB and the Bank of England.

Even in Japan, inflation is positive again and rising.

In the BRICS, inflation is high and rising. China’s inflation rate just went up to 8.5 percent; and no, it’s not rice, chickens, pigs or energy, it’s inflation made by lax monetary policy in the short and medium term and a positive output gap in the short term. In fact, if we allow for inflation suppressed by price controls, the equivalent open inflation rate in China is probably above 10 percent. In Russia, inflation is well into double digits and rising. In India inflation is above 5 percent and rising. Only Brazil appears to have inflation reasonably steady at 4.73%, close to its target value.

Inflation is rising in countries that are tied to a weak currency, like the Gulf Cooperation Council States. Inflation is rising in countries tied to a strong currency. Latvia’s inflation rate came in at 17.8 percent. Inflation is rising in countries that have a floating exchange rate, like Iceland.

Central banks across the world have had it too easy for too long. It is time to bring inflation down to tolerable levels through appropriate restrictive policy. Fiscal tightening cannot reduce the short-run paid, but it can bias the composition of the necessary contraction in favour of the protection of investment. Unfortunaltely, both in the UK and in the US, discretionary stimuli instaed primarily support a still excessively buoy level of consumer demand.

As as regards those analysts and repporters who consider the inflation rate and inform you that, provided you exclude the bundles of goods and services whose prices have increased the most, the inflation rate of the rest is quite modest, cast them out, because they are not your friends.

Jim Hamilton Scolds Bernanke for Regulatory Neglect

Jim Hamilton must feel like a Cassandra. Last August, he warned that the GSEs were in danger of having the ambiguous status of their implied guarantee tested. That came in January, and was finessed with various new Fed facilities.

Hamilton has also warned repeatedly that the Fed needs to consider institutional reform, not merely bailing out the boat as it continues to founder. He continued on that theme today in Econbrowser in parsing Bernanke's remarks on Tuesday. Most observers focused on his comments on the continued rockiness of the markets; Hamilton worried about other oversights:

Bernanke concludes that it's the responsibility of the central bank to stop such self-fulfilling instability. But he neglects to discuss the key feature of a healthy financial system that is supposed to prevent such a problem from ever arising. Specifically, any institution that is in this position of borrowing short and lending long needs to ensure that a certain fraction of the funds it is lending came not from borrowers but instead from the owners of the institution itself, in the form of net equity. The goal is for the size of this net equity to be larger than the losses the institution would incur from selling its less-liquid assets at steep discounts. As long as it is, no creditors ever have reason to demand cash, and there would be no need for the central bank to step in to prevent a self-fulfilling breakdown.

And the core reason we are in the mess we are today is that these equity stakes were nowhere near sufficient for this purpose. Instead, financial institutions were allowed to take highly leveraged positions whose details are largely opaque to readers of publicly available financial statements. Exhibit A here might be Bear Stearns, whose 2007 10-K reported that Bear had outstanding derivative contracts whose notional value was $13.4 trillion. Much of these were credit-default swaps, in which the seller receives a fee in exchange for promising to pay any losses incurred by the buyer on some specified asset and time interval. If every such asset lost 100% of its value over the period, then maybe Bear is supposed to pay or receive $13.4 trillion. In practice, the actual price moves and net sum owed would be a small fraction of that notional total.

Now, there is nothing inherently wrong in making financial investments in the form of derivative contracts rather than outright loans. You're doing something similar whenever you buy or sell an option rather than the stock itself. But, if you were to sell an option through an organized exchange, the exchange would require you to satisfy a margin requirement, delivering for safekeeping good funds such that if the price of the underlying asset against which the derivative is written moves against you, you are able to make good on your commitment.

If anything like a reasonable margin requirement had been in effect, Bear Stearns could not possibly have gotten into contracts totaling $13.4 trillion notional. But these weren't traded on a regular exchange, so there was no margin requirement, and apparently no real limit on the size of the exposures that Bear Stearns could take on, or the size of what they could bring down with them if they fell.

And that raises the question, Why were counterparties willing to accept these trades with no margin to guarantee payment? To this I'm afraid the answer is, they figured Bear was too big for the Fed to allow it to fail. And on this, I'm afraid they proved to be exactly correct.

I would feel better if Bernanke were less focused on how to "provide liquidity" and more focused on how to get the system deleveraged and more transparent.

A minor quibble: we looked at the footnotes on Bear's derivatives positions when it was going down for good, and much of it looked to be more plain vanilla interest rate swaps. But the general point is well taken. Bear was a significant CDS writer, and its equity was insufficient given the size of its derivatives book.

How to Leash and Collar the Financiers? (Continued)

The fulminating over what to do about our miscreant socialized unrepentant and as yet unreconstituted financial services sector continues. Since massive subsidies have been extended in the form of help to the mortgage business and an alphabet soup of Federal Reserve facilities, with nary a demand made of the beneficiaries of this largess, it seems that the authorities have perilous little leverage over their wayward charges.

Of course, in reality that isn't so; a determined regulator can, if nothing else, harass a company into submission (the Japanese are masters of this technique) and they have more powerful tools at their disposal. But that presupposes the will to intervene, which despite the crisis, still appears to be sorely lacking.

The collective response resembles the storied boiled frog effect: the heat goes up, or in this case, the public outlays continue, yet legislators, regulators, and the public remain remarkably passive as the expenses continue to rise. Of course, it doesn't hurt that many of these costs are contingent liabilities, so the true damage will come to light only years later, when the perps have moved on to other roles.

But readers beware: the boiled frog is an urban legend. Real frogs have the good sense to hop out of hot water. But in a pot with high enough sides, even a frog that knows it is in trouble will be unable to escape.

The sightings today confirm the difficult of leashing and collaring a complex, sprawling, fast-moving industry. The Financial Times has a comment by Charles Dallara, the head of the Institute of International Finance, an international organization of financial institutions that verges on the sanctimonious. It confidently recites a list of four areas for action and asserts:

Thus, the debate is not about “self-regulation” versus “more regulation”. Instead, there is an emerging consensus on the benefits of reinforcing market-based corrections with improved regulatory incentives and structures.

A consensus among those who'd rather not be regulated, for sure.

Some regulators are getting mad enough to at least threaten action, but it isn't evident that they will be taken seriously. As the Telegraph reports in "EU to launch assault on bankers' bonuses":

A group of key EU finance ministers will today launch an assault on the rewards earned by bankers and top managers in a move that poses a potential threat to the City of London.

A confidential document prepared for the gathering in Brussels finds the "short-term" pay structure of modern capitalism has become deformed, causing firms to take on "excessive risk" without regard to the interests of stakeholders or society.

Note that these discussions do not include the UK.

Now one can correctly point out that this is silly; the main finance centers are not in Europe to begin with, and having the EU adopt even tougher rules will assure even less high powered finance take place there. But don't assume the EU is that naive. I suspect the credit crisis has at least another bad episode or two coming. The Fed has had to coordinate closely with the ECB on recent interventions. The EU may be trying to take intellectual leadership to force the US and the UK, which is also showing signs of financial distress, into taking more radical action. The EU may be taking a tough public posture while privately harboring more limited, realistic aims.

Ironically, the most sensible proposal comes from a US hedge fund manager. As reported by Ira Ross Sorkin in the New York Times:

Kenneth C. Griffin, who runs one of the biggest and most successful hedge fund firms, has a blunt assessment: “We, as an industry, dropped the ball.”

The breakdown happened, Mr. Griffin contends, when big investment banks gambled away money and jobs during the late great credit boom. The bosses let all those young gung-ho traders take far too many risks and now everyone is paying the price.

But the answer is simple, in his view. The entire industry needs to overhaul its thinking and, believe it or not, perhaps even accept greater regulation...

When you read that UBS did not even view parts of its mortgage portfolio as having market risk, it becomes very obvious that a number of firms were not dotting the i’s and crossing the t’s when it comes to risk management,” he said while on the panel [at the Milken Institute Global Conference] to a packed room.

How did it come to this?

A problem, he says, is youth and inexperience — and that’s coming from a former child prodigy.

“Walk across any of the trading floors — they are full of 29-year-old kids,” he said. “The capital markets of America are controlled by a bunch of right-out-of-business-school young guys who haven’t really seen that much. You have a real lack of wisdom.”

On top of that, many chief executives of big universal banks, the ones that combine all sorts of financial services under one roof, “only understand a small part of the business,” Mr. Griffin said, suggesting too many of them come from sales backgrounds. Put those two things together, the traders and the chiefs, and you have the making of an outright debacle.

The problem is compounded further by weak government oversight, he said. “The unwillingness of the Federal Reserve and the S.E.C. to require working capital” limits, he said, only exacerbates the risk-taking environment because the banks are playing the equivalent of no-limit poker. “The sad truth of the matter is it didn’t have to be this way,” he said.

But Mr. Griffin isn’t just a serial complainer. He has thought about solutions.

First, “the investment banks should either choose to be regulated as banks or should arrange to conduct their affairs to not require the stop-gap support of the Federal Reserve,” he says.

But that’s not all. He also wants new government oversight of the arcane world of credit default swaps, a business with a notional value and risk of $50 trillion. “Everyone is missing the elephant in the room,” he said.

It was the interlocking relationships between thousands of investors and banks over credit default swaps that pushed the Fed to help rescue Bear Stearns. In particular, Mr. Griffin wants the government to require the use of exchanges and clearing houses for credit default swaps and derivatives.

That way, instead of investment banks playing matchmaker between parties, an exchange will do it with strict rules in place, eliminating billions of dollars in exposure and creating more transparency.

“It’s not sexy, but it’s simple, it’s cost forward, its straightforward, and it’s what we should have done after 1998,” referring to the collapse of Long-Term Capital Management, a big hedge fund. He added that it “is a very sad commentary on where we are from a regulatory perspective” that such a move hasn’t happened already.

Of course, most big investment banks would hate such a plan, he acknowledged by telephone last week. “The investment banks and commercial banks benefit from the lack of transparency because they are the intermediary,” he said. (It also has the effect of making Mr. Griffin’s firm more money by cutting out the middleman.)

But he also wants to warn against going too far. “It may be a moment in time where there is quite a bit of fervor to put in place significant regulatory regimes that in my opinion could set this nation way back on the playing field,” he said.

He’s particularly nervous that excessive regulation could send more jobs overseas. “I see thousands and thousands of jobs at Canary Wharf and in downtown London, jobs that should have been in America in financial services. Derivatives really were developed in America and because of regulatory uncertainty left America.”

Note that, as readers have pointed out, moving CDS to exchanges isn't quite that simple. New contracts with different and more standardized features could be exchange traded; the current types don't lend themselves well to that. So the worrisome and potentially wobbly overhang of outstanding CDS would have to run itself off over time. Still, any progress on that front is welcome.

And to Griffin's point about regulatory arbitrage; that's where the EU's foray might prove useful. The idea of an international regulation, or failing that, greater international harmonization, is getting traction. But it will take a push, which may come in the form of another leg down in the credit crisis, for that to happen.

Microsoft Still Trying Evade the Rule of Law (EU Antitrust Edtion)

Someone needs to tell Microsoft to behave.

By way of background, in December 2004, Microsoft lost its final appeal on an EU antitrust case in which it was found guilty of tying its operating system to its media player, undermining competition and hurting consumer choice, and for failing to give rivals the information they needed to compete fairly in the market for server software, The Redmond company was fined a record $613 million.

To address the server complaint, Microsoft was ordered to license technical information to enable outside companies to design products that would run well on Windows (called API, the application program interface). Note that this isn't a particularly onerous request. Microsoft makes that sort of information available for free except in areas where it is trying to leverage its monopoly.

Microsoft acted in less than good faith through this entire exercise. It appeared to be delaying rather than complying. For example, Microsoft was asked to propose royalties for its API. Now consider Microsoft's response: up to 5.95% of revenues. The EU's technical expert, Neil Barrett, who was recommended by Microsoft, calculated that it would take software companies 7 years to recover their development costs. Now how many products last 7 years? And in particular, how many software products last for 7 years? Cost recovery looks like a fantasy. Barrett determined that even a 1% royalty would be too high, and 0% would be more appropriate.

In September 2007, the European Court of First Instance, in a starkly worded summary read to a courtroom of about 150 journalists and lawyers here, ordered Microsoft to obey a March 2004 commission order and upheld the €497.2 million, or $689.4 million, fine against the company.

In October, Microsoft negotiated a settlement of open items, giving every indication that it would submit to the court's ruling. As the Financial Times reported:

Microsoft finally admitted defeat in its three-year battle with the European Commission on Monday, as the US software giant agreed to comply with the regulator’s landmark finding that it was abusing its dominance of the market.

“I welcome the fact that Microsoft has finally undertaken concrete steps to ensure full compliance with the 2004 decision,” Neelie Kroes, competition commissioner, told a press conference in Brussels. “It is regrettable that Microsoft has only complied after a considerable delay, two court decisions and the imposition of daily penalty payments,” she said.

Under the deal reached between Ms Kroes and Steve Ballmer, the chief executive of Microsoft, early on Monday morning, the company will make it much easier for rivals to use its technology to develop their own programmes.

Microsoft also said it would not appeal the decisive September ruling by the European Court of First Instance, which upheld the Commission’s finding that Microsoft had broken EU competition rules. It ends three years of resistance that has cost €777.5m in fines.

Yet in February, the EU competition commission fined Microsoft $1.4 billion (€899m) for failing to adhere to the court decision:

The fine comes days after the world's biggest software group announced it would open parts of its software to rival companies in an attempt to assuage competition authorities.

But that move received a lukewarm reception in Brussels, where regulators have expressed scepticism about Microsoft's promise to make its Windows operating system and other big-selling software more open and transparent....

"The Commission has stuck to its guns," said John Pheasant, partner at Hogan & Hartson, an international law firm. "It also appears that the [European] Commission has not been swayed or deflected by the recent announcements by Microsoft."....

The Commission required Microsoft to offer such information on "reasonable terms," but subsequently complained that the royalty rates demanded by Microsoft over the next three years amounted to "unreasonable pricing". Microsoft fought the decision for several years but dropped its appeal after a top EU court ruled in favour of regulators last September

.
Now at the eleventh hour, right before the deadline for appeals is about to expire, Microsoft effectively repudiates the settlement and files an appeal. Yet incredibly, the press, even the usually reliable Financial Times, fails to note that this is a 180 degree change in its pretenses of being compliant. Again, from the Financial Times:

Microsoft said on Friday it would appeal against the record-breaking $1.4bn (€899m) fine imposed by Brussels two months ago because of the software group’s failure to comply with demands that it end anticompetitive business practices.

In a statement, the world’s biggest software group said that it was asking the European Court of First Instance to annul the European Commission’s February decision in which it imposed the penalty.

“We are filing this appeal in a constructive effort to seek clarity from the court,” Microsoft said in a statement....

Some independent competition specialists said openly that they believed there were grounds for an appeal – particularly since the Commission had never spelt out what it considered to be a reasonable charge for the patent licences. For example, Denis Waelbroeck, a partner at Ashurst, on Friday welcomed the move because he believed that there were “procedural inadequacies” in the approach taken by the Commission.

The Commission, however, responded on Friday by saying that it was “confident that the decision to impose the penalty was legally sound”.

The decision to file an appeal will also do nothing to ease the strained relations between the Commission and the company – which appear to have deteriorated again after failed efforts to reach some kind of “global settlement” late last year.

In January, the Commission announced that it was opening a fresh investigation into suspicions that Microsoft had abused market dominance of its Office software, and also whether it had illegally linked its Internet Explorer system to Windows. According to lawyers in Brussels, this probe is actively moving forward with information requests circulating.

It's too bad appeals courts can't increase fines. The one imposed on Microsoft was 60% of the maximum permitted; if I were a judge, I'd want to throw the book at them.

Why? The discussion about royalties is spurious; the Commission's expert said 1% was too high and zero might be appropriate. If Microsoft had had any good faith interest in putting this matter behind them, it would have proposed a royalty and put the onus on the EU to object.

I can't fathom what Microsoft thinks it will gain from this exercise, save delaying compliance with the EU's demands and annoying the regulator, which has issues far more important to Microsoft still before it. I am not a lawyer, but the issue of the level of royalties is not a basis for overturning the decision. The fine will stand and the interest will accrue. The most Microsoft can gain is to be able to charge a higher level within the 0% to 1% range. And this may be simply an artifact of the EU's drafting (the parameters were discussed in the trial, but the ruling itself indeed did not specify a level. Thus Microsoft at best will score a Phyrric victory.

Before readers assume Microsoft must have some advantage it can gain from this, consider: the coverage of Microsoft's antitrust trial in the US revealed that the company had an inept legal strategy. Some believed that Gates must have refused to listen to his advisors. Worse, the Redmond firm repeatedly showed its contempt for the court, repeatedly making statements that strained credulity.

Microsoft escaped tough penalties in the US only by a fluke. Judge Thomas Penfield Jackson was clearly disgusted by the Redmond's company's dissembling and was prepared to throw the book at them, but because he made the mistake of talking to the press substantively before the penalty phase was concluded, he was replaced by a cautious and clueless jurist, Colleen Kollar-Kotelly.

Microsoft just does not get it. The company seems not to understand that it is subject to the rule of law and has to comply when ordered to. Yes, Steve, there really are organizations out there that are bigger, tougher, and more determined than you are.

"Blame the Models"

One of our pet interests has been how the use of mathematics and models can unwittingly enable people to fool themselves. We see this regularly when working on deals. The model for the target business' performance somehow becomes more real than the company. When the numbers don't work, if you can come up with a good sounding rationale for tweaking them, presto! Suddenly everything in hunky dory. No wonder over 60% (some studies say as high as 75%) of all deals fail.

Our colleague Susan Webber, in an article about the corporate obsession with metrics, made some pertinent observations:

Metrics presuppose that situations are orderly, predictable, and rational. When that tenet collides with situations that are chaotic, nonlinear, and subject to the force of personalities, that faith—the belief in the sanctity of numbers—often trumps seemingly irrefutable facts. At that point, the addiction begins to have real-world consequences. Business managers must recognize the limitations of metrics.

Mind you, I’m not arguing that metrics and measurement are inherently bad things. To note just one example, a well-structured performance measurement system is essential to the well-being of large enterprises. But quantitative measures can be and frequently are used naively. It’s all too easy to abdicate judgment to the output of a model or scorecard.

Jon Danielsson at VoxEU takes this viewpoint further in an article that discusses a pervasive cognitive dissonance among trading operations and their regulators. They know that statistical models have major shortcomings, particularly in underestimating the odds of catastrophic losses, which is precisely what they are supposed to help avoid. While the conventional response has been to try to devise better models, Danielsson argues that that line of thinking is wrongheaded.

For Danielsson makes a fundamental point: what matters is management; the models are secondary. For reasons I cannot fathom (perhaps the rise of the PC and the ease of slicing and dicing data), qualitative assessments are seen as inferior to quantitative ones. But for a regulator to understand the robustness of a company's management practices requires more scrutiny than has been fashionable of late. And it also requires better regulators.

From VoxEU:

In response to financial turmoil, supervisors are demanding more risk calculations. But model-driven mispricing produced the crisis, and risk models don’t perform during crisis conditions. The belief that a really complicated statistical model must be right is merely foolish sophistication.

A well-known American economist, drafted during World War II to work in the US Army meteorological service in England, got a phone call from a general in May 1944 asking for the weather forecast for Normandy in early June. The economist replied that it was impossible to forecast weather that far into the future. The general wholeheartedly agreed but nevertheless needed the number now for planning purposes.

Similar logic lies at the heart of the current crisis

Statistical modelling increasingly drives decision-making in the financial system while at the same time significant questions remain about model reliability and whether market participants trust these models. If we ask practitioners, regulators, or academics what they think of the quality of the statistical models underpinning pricing and risk analysis, their response is frequently negative. At the same time, many of these same individuals have no qualms about an ever-increasing use of models, not only for internal risk control but especially for the assessment of systemic risk and therefore the regulation of financial institutions.1 To have numbers seems to be more important than whether the numbers are reliable. This is a paradox. How can we simultaneously mistrust models and advocate their use?.....

Underpinning this whole process is a view that sophistication implies quality: a really complicated statistical model must be right. That might be true if the laws of physics were akin to the statistical laws of finance. However finance is not physics, it is more complex, see e.g. Danielsson (2002).

In physics the phenomena being measured does not generally change with measurement. In the finance that is not true. Financial modelling changes the statistical laws governing the financial system in real-time. The reason is that market participants react to measurements and therefore change the underlying statistical processes. The modellers are always playing catch-up with each other. This becomes especially pronounced when the financial system gets into a crisis.
This is a phenomena we call endogenous risk, which emphasises the importance of interactions between institutions in determining market outcomes. Day-to-day, when everything is calm, we can ignore endogenous risk. In crisis, we cannot. And that is when the models fail.

This does not mean that models are without merits. On the contrary, they have a valuable use in the internal risk management processes of financial institutions, where the focus is on relatively frequent small events. The reliability of models designed for such purposes is readily assessed by a technique called backtesting, which is fundamental to the risk management process and is a key component in the Basel Accords.

Most models used to assess the probability of small frequent events can also be used to forecast the probability of large infrequent events. However, such extrapolation is inappropriate. Not only are the models calibrated and tested with particular events in mind, but it is impossible to tailor model quality to large infrequent events nor to assess the quality of such forecasts.

Taken to the extreme, I have seen banks required to calculate the risk of annual losses once every thousand years, the so-called 99.9% annual losses. However, the fact that we can get such numbers does not mean the numbers mean anything. The problem is that we cannot backtest at such extreme frequencies. Similar arguments apply to many other calculations such as expected shortfall or tail value-at-risk. Fundamental to the scientific process is verification, in our case backtesting. Neither the 99.9% models, nor most tail value-at-risk models can be backtested and therefore cannot be considered scientific.

We do however see increasing demands from supervisors for exactly the calculation of such numbers as a response to the crisis. Of course the underlying motivation is the worthwhile goal of trying to quantify financial stability and systemic risk. However, exploiting the banks’ internal models for this purpose is not the right way to do it. The internal models were not designed with this in mind and to do this calculation is a drain on the banks’ risk management resources. It is the lazy way out. If we don't understand how the system works, generating numbers may give us comfort. But the numbers do not imply understanding.

Indeed, the current crisis took everybody by surprise in spite of all the sophisticated models, all the stress testing, and all the numbers. I think the primary lesson from the crisis is that the financial institutions that had a good handle on liquidity risk management came out best. It was management and internal processes that mattered – not model quality. Indeed, the problem created by the conduits cannot be solved by models, but the problem could have been prevented by better management and especially better regulations.

With these facts increasingly understood, it is incomprehensible to me why supervisors are increasingly advocating the use of models in assessing the risk of individual institutions and financial stability. If model-driven mispricing enabled the crisis to happen, what makes us believe that the future models will be any better?

Therefore one of the most important lessons from the crisis has been the exposure of the unreliability of models and the importance of management. The view frequently expressed by supervisors that the solution to a problem like the subprime crisis is Basel II is not really true. The reason is that Basel II is based on modelling. What is missing is for the supervisors and the central banks to understand the products being traded in the markets and have an idea of the magnitude, potential for systemic risk, and interactions between institutions and endogenous risk, coupled with a willingness to act when necessary. In this crisis the key problem lies with bank supervision and central banking, as well as the banks themselves.

Martin Feldstein Calls a Downturn, Takes Issue With Government Statistics

Martin Feldstein, who as a Chairman of the Council of Economic Advisers under Reagan and an advocate of Social Security reform, has been a surprisingly open critic of the Fed's and Bush Administration's responses to our current economic woes. Feldstein has been regularly writing op eds opposed to some of the viewpoints and actions of those in the driver's seat. For instance, last month he wrote in the Wall Street Journal against further rate cuts, arguing they'd do little to stimulate growth but would be effective fuel for inflation. Feldstein, who now chairs the National Bureau of Economic Research, has said that the economy started into recession around the start of the year and expects it to last longer than the normal slowdown, a view which no doubt endears him to the officialdom in DC.

Today, in a comment in the Financial Times, "Misleading Growth Statistics Give False Comfort" (and a pointed contrast to Edward Lazear's whopper, that the 'data are clear" that the US is still in growth mode), Feldstein goes through the stats in more granular detail to demonstrate that the downturn is in progress (and gives a useful side lesson in how certain figures are derived).

He also urges more aggressive action and suggests an elegant-sounding solution: let borrowers refinance out of their mortgages into lower-interest, secured, but full recourse loans. The problem with this idea is that in most states, only purchase money mortgages are non-recourse. Refis (and half the subprimes were cash-out refis) are recourse loans. They are de facto non recourse because the costs of going after deadbeats are high (or higher) than recoveries, so pursing them isn't a very attractive economic proposition. Making new loans full recourse thus is an illusory improvement.

From the Financial Times:

Prepositions matter. The recent government report that US gross domestic product inc reased 0.6 per cent in the first quarter was very misleading. It implied that economic activity was rising in January, February and March. But the increase actually refers to the rise from the average level in the fourth quarter of 2007 to the average level in the first quarter. Monthly data since January indicate that economic activity and GDP have been declining since the start of this year.

Private sector payroll employment peaked last November and has fallen five months in a row, shedding more than 300,000 jobs. Industrial production was lower in March than in December and January. Real personal income net of taxes and transfers is also lower than in January. Real retail sales have fallen since the start of the year. Private housing starts are down 13 per cent in just the two months since January and 36 per cent from a year ago.

Although the government does not provide monthly estimates of GDP, Macroeconomic Advisers...estimates real GDP based on the price level of the year 2000. Its most recent estimates (revised figures to be published this month) show that real GDP rose from an annual $11,649bn last October to $11,701bn in December and $11,777bn in January but fell to $11,686bn in March, a decline of about $100bn in two months. Although GDP declined during the first quarter, the average of the monthly figures in the first quarter ($11,711bn) is higher than the average of the monthly figures for the final quarter of 2007 ($11,675bn).

The misstatement that the economy expanded in the first quarter creates an inappropriately sanguine view of the months ahead and therefore reduces the prospect of strong action to prevent the deep decline that may otherwise occur...

Although the tax rebates now under way may provide some temporary help, the combination of falling real incomes, declining household wealth and a dramatic drop in consumer confidence suggests further falls in consumer spending and GDP. But the most serious risk is that the rapid fall in house prices – down more than 12 per cent in the past year and falling at a 25 per cent rate in the past three months – will raise the number of negative-equity mortgages, leading to widespread defaults and foreclosures.

Because US mortgages are “no-recourse” loans (lenders have no recourse to the house’s owner beyond the value of the house), individuals with negative equity have an incentive to default. There are now an estimated 8m negative-equity mortgages – more than 15 per cent of all outstanding mortgages. Defaults are rising and foreclosures are now at twice the rate of a year ago. A downward spiral in house prices would cause a fall in household wealth and in the capital of financial institutions, potentially resulting in a deeper and longer recession than any seen in the past several decades.

Now is the time for policy action to forestall such a house price collapse. There is nothing more the Federal Reserve can do by lowering short-term interest rates or by creating new credit facilities. The Treasury proposal for voluntary negotiations between creditors and negative-equity homeowners has had relatively little success because a large share of mortgages have been securitised. Congressional proposals aim at helping homeowners with negative-equity mortgages and would at best help no more than 10 per cent of that group.

What is missing is action to prevent positive-equity mortgages from becoming negative-equity mortgages. The federal government could achieve that by providing low-interest loans with full recourse that would allow any homeowner to pay down a significant fraction of his mortgage. Homeowners would be in effect giving up the potential to default on their mortgage loans in exchange for lower interest costs.

Although political tensions make it difficult to achieve such a policy, a mistakenly benign view of first-quarter growth contributes to this stalemate. Policymakers must recognise the real economic condition and act quickly.

Brady Bonds Redux as Credit Crisis Remedy?

At VoxEU, Luigi Spaventa makes a forceful case that the remedies to the credit crisis are provisional at best and more work needs to be done:

The global financial system may be caught in a downward spiral as market and funding illiquidity reinforce each other...

Prolonged financial distress, which has now lasted for almost a year, is debilitating the financial system and risking a full-fledged crisis. Central bank interventions have thus far prevented worst-case outcomes, but they have alleviated symptoms rather than the underlying causes. Financial intermediaries are still in the process of shrinking their balance sheets, thus activating a channel of transmission of financial distress to the real economy...

The immediate problem is a spiral of forced deleveraging and illiquidity, as the link between market and funding illiquidity strains balance sheets. Proposed remedies are either insufficient or unsatisfactory...

The immediate problem is the disorderly reaction to the unprecedented growth of the financial system’s leverage and its exposure to risk. As demand for asset-backed securities has disappeared, prices have collapsed without finding a floor. Banks are reporting losses that strain their capital positions. The loss of market liquidity affecting all classes of debt securities directly or indirectly owned by intermediaries has translated into a sharp decline of funding liquidity, the more so because short-term debt issued on wholesale markets has become a major component of banks’ funding. The forced adjustment of banks' balance sheets could, in the worst case, result in a credit crunch with painful consequences on the real economy.

Can we break the link between the illiquidity of banks’ securitised assets, which prevents their orderly liquidation, and the shortage of funding liquidity, which is the driving force of the negative feedback originating from the process of deleveraging?
For funding liquidity, emergency liquidity support from central banks has helped lower the temperature in the worst moments, but it is not a long-term solution....Capital increases are also insufficient to break the spiral, as injections of capital may prove inadequate only a few weeks after their announcement.

For market liquidity, suggested remedies are equally inadequate. Mandated full disclosure of losses might reduce uncertainty, but unless market liquidity is instantly restored, full disclosure of the situation at time t offers no guarantee that it will be the same at time t+1. Similarly, retreating from marking financial products to market or model during this time of crisis would face a number of difficulties.

The feedback between market and funding liquidity problems demands more radical pre-emptive solutions. As long as “there is no immediate prospect that markets in mortgage-backed securities will operate normally”, “the situation will improve only if the overhang of illiquid assets on the banks’ balance sheets is dealt with” (Bank of England 2008). In creating its Special Liquidity Scheme, the Bank of England has moved to serve as the “market maker of last resort.”

The scheme allows banks and building societies to swap some of their illiquid assets, including debt securities rated no less than triple A, for specially issued Treasury Bills for up to three years. Eligible securities will be valued at market prices, if available, or, if not, at a price calculated by the Bank, with haircuts for private debt securities. Changes in market prices or in valuations will require re-margining. The credit risk will remain with the banks, so that there will be a loss for the lender only if the borrower defaults and the value of the collateral falls below that of the bills originally acquired in the operation.

Is the initiative bold enough? The scheme does not set a floor for assets’ market prices and uses market prices to value collateral, despite the fact that during a negative bubble they do not reflect fundamentals. Downward instability may moreover occur if haircut discounted collateral values trigger a convergence process for market prices requiring repeated re-margining.

In CEPR Policy Insight 22, I recommend the creation of a publicly sponsored entity that could issue guaranteed bonds to banks in exchange for illiquid assets, drawing on US Treasury Secretary Nicholas Brady’s solution to the Latin American sovereign debt crisis in 1989. This new entity, preferably multilateral, would value assets based on discounted cash flows and default probabilities rather than crisis-condition market prices.

As a firm floor is set to valuation and illiquid assets otherwise running to waste are replaced by eminently liquid Brady-style bonds, funding difficulties and, at the same time, the market liquidity problems besetting the banks’ balance sheets would be removed. Shielding the banks’ assets from the vagaries of disorderly markets is a necessary condition to dispel the uncertainty that prevents a proper working of credit markets.

I'm curious to get reader reactions, but I suspect that this model breaks down under further examination. First, a fair bit of paper that banks hold is sufficiently arcane that valuing it for the purposes of going into this entity is problematic. How do you value a CDO (I'm not suggesting they can't be valued, but I suspect that valuation ranges using reasonable assumptions would be very wide). Does this mean going back to the repudiated credit models of the rating agencies?

And even if you exclude the more complex structures, coming up with a cash-flow-based value when there is still a high deal of uncertainty in the trajectory of the housing market (particularly in markets like Florida with massive inventory) involves a great deal of artwork. Moreover, the sovereign loans that were restructured in the early 1980s were pretty homogeneous, as far as terms were concerned. The mortgage assets are far more diverse, and the underlying collateral is very heterogeneous, which makes for a difficult valuation process.

As I understand it, the original Brady bond process arrived at structure and pricing via negotiation, not via one side putting out an offer based on its valuation (which seems to be the process here) and seeing who shows up to submit colllateral is asking for adverse selection: you'll get offered paper when you are offering too much.

Nevertheless, this is an interesting idea, and if there was a better finesse for the valuation issue, this could be a useful remedy.

So Why Did MBIA Raise $1.1 Billion? To Pay Executives, Apparently

MBIA has brazenly advanced its own interests at the expense of investors and policyholders. A partial list:

Issuing a disappointing earnings release in the middle of the night in the hopes that it would garner less attention that way

Asserting it needed no more capital while the Dinallo-led "save the monolines" effort was still underway. CEO Gary Dunton's claim was so patently bogus that it stirred the normally circumspect S&P to issue a swift rebuke

Telling the one major rating agency that has the guts to give the bond insurer the less-than-AAA it deserves to take a hike (fortunately, Fitch is ignoring that directive)

Admittedly, some of these unsavory actions took place on ousted CEO Gary Dunton's watch; we now have Jay Brown in charge. However, old habits die hard.

The latest stunner is that the money raised in MBIA's last, hugely dilutive equity sale is being held at the parent company. For those who have not followed the monoline saga, that's scandalous.

The whole purpose of the fundraising was for the parent to then downstream the proceeds to the insurance subsidiaries. That's where the insurance is written, that's where the capital shortfall is.

So why is MBIA hoarding cash at the parent level? Well, executives (along with other corporate charges) are paid out of the parent company's books. The subsidiaries can dividend cash up only if the are profitable OR get permission from their regulator.

The big bond guarantors have been notably loss-making of late. Eric Dinallo says that both MBIA and Ambac may need to raise more capital. The monolines' business model is toast. The structured finance business involves bona-fide risk transfer, and the bond guarantors' capital bases (equity is less than 1% of assets) is far too thin to allow for that, particularly when an AAA rating is essential for conducting business; the nearly risk free ratings arbitrage in the muni finance business is going the way of the dodo bird (and with local government budgets under stress, even that old supposedly cosmetic credit enhancement may wind up leading to some unanticipated losses).

So how does the hoarding of cash fit into this picture? Well, Bill Ackman, the hedge fund manager who was leading the campaign against the monolines, argued that they should be put in runoff mode, with the investors at the parent level sacrificed to preserve the claims-paying ability of the subs. That's a course of action the regulators would almost certainly arrive at on their own if they thought the bond insurers were in peril.

So what does the holding of so much cash at the parent level mean? Aside from being a shameless case of duplicity, it says one of two things, neither pretty. First, they expect losses for the foreseeable future, and expect the regulators to prohibit dividend payments too. But withholding the entire $1.1 billion is an admission of how bad they expect things to get. Or second, they expect the regulators to put MBIA into runoff mode, and are keeping their cash to support the parent level empire that would otherwise be starved out of existence. But if so, the representations made by management about the soundness of the company are false.

No matter how you slice it, the sequestering of funds is wildly inconsistent with management's position that MBIA has a good future, or indeed any future at all.

From Bloomberg:

MBIA Inc. has yet to pass on $1.1 billion of capital to its insurance subsidiary, three months after raising the money to defend the unit's AAA credit rating.

The cash, raised in a February stock sale, is being held at the parent company while Armonk, New York-based MBIA develops a plan for the company's legal and operating structure, MBIA Chief Executive Officer Jay Brown said in a letter to shareholders released yesterday.

``Given the more than adequate liquidity in both our insurance and asset management businesses, there is no compelling reason to move this cash at this point,'' Brown said.

MBIA was criticized by Fitch Ratings, which said on April 4 the decision raised the risk that the cash may not end up as capital for the insurance unit as MBIA had promised. While Fitch downgraded MBIA to AA from AAA, Moody's Investors Service and Standard & Poor's cited the capital raising as a reason for keeping the insurance unit at AAA.

Regulators are waiting for MBIA to contribute the funds, according to New York State Insurance Department Deputy Superintendent for Property and Capital Markets Michael Moriarty.

``It was never our expectation that the funds raised would go anywhere other than to the insurance subsidiary,'' Moriarty said. MBIA spokesman Jim McCarthy declined to comment.....

``S&P and Moody's are being a bit disingenuous by affirming the AAA on the insurance company based on their ability to raise capital, even though the capital isn't there,'' said Joshua Rosner, managing director at New York-based research firm Graham Fisher & Co. ``The rating seems unjustifiable.''

MBIA said in a February statement that it would ``contribute most of the proceeds of the offering to the surplus of its subsidiary, MBIA Insurance Corporation, to support its business plan.''

Moody's assigned a negative outlook to MBIA's rating in part because the money wasn't transferred to the insurance unit, Stanislas Rouyer, an analyst in Moody's financial guarantor group, said in an e-mailed statement.

``The proceeds from the capital raise remaining at the holding company is one of the factors considered in our negative outlook,'' Rouyer said.

Fitch, a unit of Paris-based Fimalac, said MBIA's insurance unit needs $3.8 billion, in addition to capital already raised, to warrant a AAA. MBIA in March asked Fitch to stop rating its debt because of disagreements over the model Fitch uses to estimate losses. Fitch relies on other ratings companies for data and its analysis is limited, MBIA said.

``Since a significant portion of the capital that was recently raised by MBIA Inc. still resides at the holding company level, the insurance company's capital position could become pressured in the future by possible liquidity demands at the holding company,'' Fitch analyst Thomas Abruzzo said in a report.

Note that S&P, unlike Fitch ad Moody's, is not upset that the cash has not been downstreamed.

Hoisted From Comments: Greater Liquidity Produces Instability

Below is a provocative line of thought from an anonymous reader. It supports a gut feeling that I have been unable to prove, namely, that lowering of boundaries between markets (ranging from the large number of global macro hedge funds to the large number of retail currency speculators in Japan) is destabilizing. I've found the occasional supporting bit of empirical evidence (for instance, Kenneth Rogoff's and Carmen Reinhart's recent paper on financial crises, which found that greater financial integration was correlated with crises) but no theories. Conventional economic wisdom would tell you arbitrage is always and ever good (it supposedly improves price formation which leads to better allocation of capital), and inefficiencies are bad. However, complex systems theory provides a very different perspective:

Perhaps a lesson to be learned here is that liquidity acts as an efficient conductor of risk. It doesn't make risk go away, but moves it more quickly from one investment sector to another.

From a complex systems theory standpoint, this is exactly what you would do if you wanted to take a stable system and destabilize it.

One of the things that helps to enable non-linear behavior in a complex system is promiscuity of information (i.e., feedback loops but in a more generalized sense) across a wide scope of the system.

One way you can attempt to stabilize a complex system through suppressing its non-linear behavior is to divide it up into little boxes and use them to compartmentalize information so signals cannot easily propagate quickly across the entire system.

This principle has been recognized in the design of software systems for several decades now, and is also a design principle recognizable in many other systems both natural and artificial (c.f. biology, architecture) which are very robust with regard to exogenous shocks. Stable systems tend to be built from structural heirarchies which do not share much information across structural boundaries, either laterally or vertically. That is why you don't die from a heart attack when you stub your toe, your house doesn't collapse when you break a window, and if your computer crashes it doesn't take down the entire internet with it.

Glass-Steagall is a good example of this idea put into practice. If you use regulatory firewalls to define distinct investment sectors and impose significant transaction costs at their boundary that will help to reduce the speed and amplitude of signals which will propagate from one sector to another, so a collapse in one of them will be less likely casue severe problems in the others.

It worries me that we’ve torn down most of these barriers in the last several decades in the name of arbitrage, forgetting that the price we paid for them in inefficiency was a form of insurance against the risk of systemic collapse. This is exactly what I would do if I wanted to take a more or less stable, semi-complex system and drive it in the direction of greater non-linearity.

I think this was to some degree inevitable - it is a symptom of the decay and loss of trans-generational memories from our last great systemic shock in the 1930s. I suspect that something like this is bound to happen every 3-4 generations as we unlearn the lessons our grandparents and great-grandparents learned to their cost.

"Seven habits finance regulators must acquire"

I get worried when the Financial Times' Martin Wolf starts adopting Stephen Covey-esque sloganeering, particularly when he goes so far as to call his financial services reform proposal "the seven Cs." Eeek.

Earth to UK: one of the big hidden advantages you have is that the lingua franca is your language. That cloying business jargon so popular in America that we have managed to export is not an innovation, it is a debasement. Anyone who can speak and write in an unvarnished manner can trounce those who traffic in gobbledegook.

To be frank, this isn't one of Wolf's best columns, but that may be in large measure due to the near impossibility of setting forth how to fix the global financial system in his word budget. And I have omitted the liveliest part, namely, the set-up, in which he review Paul Volcker's recent speech at the Economic Club of New York, simply because it has been covered elsewhere.

Nevertheless, US readers are likely to find his recommendations to be thin gruel, but remember, there's a valid reason. The UK is a principles based system, so general, high level statements are more meaningful in that system than in ours, where sadly, the devil is in the details. But even giving that allowance, Wolf at points ducks questions he could have addressed. For instance, he mentions the problem of rating agencies, yet fails to mention any solutions. Several are on offer; surely Wolf could have given a thumbs up to one he likes.

Similarly, he sees the main problem in the "originate-to-distribute" model as bad incentives which can be solved by having the originators hold some of the riskiest tranches. Um, don't underestimate their ability to jigger the structures so as to still leave other parties holding the bag. The real problem with the originate to distribute model may be that it is seeking to create a free lunch by reducing the equity that needs to be held against loans. What if that in the end is a false economy? My sources with good regulator contacts tell me they expect to see a good deal more old-fashioned, on-balance-sheet intermediation. Mind you, that it not a view that is convenient for them to have; it implies that banks need to raise not only enough capital to cover their recent losses, but even more to allow for bigger balance sheets. Their view may be pragmatic, in that they see the market for securitized assets as sufficiently burned that it will not come back to its former size for quite some time. That degree of investor repudiation in turn suggests greater changes may be required.

Nevertheless, the advantage of a simple catchy list is that it provides a useful frame of reference.

From the Financial Times:

So here are seven principles of regulation. I call them the seven “Cs”.

First, coverage. Perhaps the most obvious lesson is the dangers of regulatory arbitrage: if the rules required certain capital requirements, institutions shifted activities into off-balance-sheet vehicles; if rules operated restrictively in one jurisdiction, activities were shifted elsewhere; and if certain institutions were more tightly regulated, then activities shifted to others. Regulatory coverage must be complete. All leveraged institutions above a certain size must be inside the net.

Second, cushions. Equity capital is the most important cushion in the financial system. Also helpful is subordinated debt. If Bear Stearns had had larger equity capital, the authorities might not have needed to rescue it. Capital requirements must be the same across the entire financial system, against any given class of risks. But there must also be greater attention to the adequacy of that other cushion: liquidity.

Third, commitment. The originate-and-distribute model has, it is now clear, a huge drawback: originators do not care sufficiently about the quality of loans they plan to offload on to others. They do not, in Warren Buffett’s phrase, have “skin in the game”. That makes for sloppy, if not irresponsible or even fraudulent lending. Originators should be required, therefore, to hold equity portions of securitised loans.

Fourth, cyclicality. Existing rules are pro-cyclical. Capital evaporates in bad times, as a result of write-offs, thereby forcing contraction of lending, worsening the economic slowdown and further impairing assets. Mark-to-market accounting, though inherently desirable, has a similar effect. One solution could be to differentiate between target levels of capital and a lower minimum level. Institutions that have minimum capital in bad times would only be required to aim for the higher target level over an extended period.

Fifth, clarity. Lack of information, asymmetric information and uncertainty are inherent in financial activities. These are why they are vulnerable to swings in collective mood. The transactions-orientated financial system is particularly vulnerable, because information has to flow freely across arms-length markets. So a big challenge is to generate as much clarity as is possible. One issue is the calamitous recent role of the rating agencies and the conflicts of interest under which they operate.

Sixth, complexity. Excessive complexity is a significant source of lack of clarity. It is particularly damaging, as we have seen, to the originate-and-distribute model, because markets in complex securitised products may, at times, seize up, forcing central banks to become “market makers of last resort”, with all the difficulties this entails. One possibility then is to insist that all derivatives be traded on exchanges.

Seventh, compensation. On this I can do no better than quote Mr Volcker: “In the name of properly aligning incentives, there are enormous rewards for successful trades and for loan originators. The mantra of aligning incentives seems to be lost in the failure to impose symmetrical losses – or frequently any loss at all – when failures ensue.” Whether regulators can do anything effective is unclear. That this is a challenge is not.

John Maynard Keynes wrote of an eighth “c”. He argued that “when the capital development of a country becomes a byproduct of the activities of a casino, the job is likely to be ill done”. He had a point. Features of a casino will always be present in a financial system that performs the essential functions of guarding people’s savings and allocating them where they can do most good.

Regulation will always be highly imperfect. But an effort must still be made to improve it.

Media, Congress Waking Up to Freddie and Fannie Default Risk

It's amazing how a problem isn't a problem until it's presented as one on television or a respected print outlet. Never mind the fact that the cognoscenti have been worried about the possibility that the two big mortgage guarantors, Fannie Mae and Freddie Mac, were too thinly capitalized relative to their massive balance sheets. Never mind that well respected economists have told the Fed it should be worried to its face, as