Saturday, October 3, 2009
A very good analysis
Hop down to zerohedge regularly to get high quality regular analysis - this particular piece is in my mind very much to the point.
Sunday, May 31, 2009
Thursday, May 7, 2009
The Inflation myth
Markets have rallied substantially of their previous lows. It appears that many market participants are rationalizing this with inflation expectations, which in the most extreme form turns out something like this:
The rationalization appears to be as follows: The FED has pumped Trillions into the financial system, so they must eventually pop up somewhere and produce inflation. Monetary expansion always fuels inflation does it not?
Well, basically, no.
The Fed has pumped trillions into the financial system. However, this is not effective monetary expansion but merely bank credit lines to pay for previous losses that have occurred due to last years repricing of risk in the credit markets. This pumping does not expand the money supply in the real economy, but merely buffers the shrinking of the money supply which is occurring due to financial system deleverage and writeoffs.
More precisely, the expansion of the FED balance sheet is largely due to the provision of "short term" liquidity to distressed financial institutions. Despite the concerted effort of the US government, the financial system remains severely stressed.
US consumers have been living off debt. Now it has been noted that this is unsustainable, credit lines are being cut: deflation, unless the FED effectively nationalizes the banking system by the backdoor to increase credit, which would be insane - not to mention illegal. The FED is stuck between a rock and a hard place, and is desperate to produce confidence so that defaults will not rise even more.
However, they appear to have forgotten that there is a relation between confidence and the real economy. The real economy remains unfixed. When the financial system delevers (which it must! - even Ben would have to agree on that), this is what you get:
Indeed, I agree that the current irrational exuberance is partly due to inflation expectations, and partly due to manipulation. Inflation expectations do to some extent drive effective inflation. However, in this case the inflation expectations are fighting an extreme crisis in the financial system, and a growing crisis in the real economy.
While layoffs continue, and people feel poorer whilst their credit lines are being cut, there is no driver for house prices to stabilize. Indeed, the premature confidence building is likely to cause greater difficulties down the road as people get poorer for being whiplashed twice in the stock exchange. I gather however that the treasury and the fed have decided that it is first necessary to recapitalize the financial system on the back of the sheeple (expect plenty of short prop trading in the summer or early autumn just as some "catalyst" causes markets to plummet again (this will be orchestrated via earnings, expensive oil, swine flu...).
Real inflation is impossible to produce whilst private and corporate credit lines are cut, especially in a consumption driven economy. The only driver for inflation will be the drop in the value of the dollar, however this will not bode well for indices as companies will suffer more in the aggregate given the bloated retail/consumption sector.
In case you need another example for what happens in a debt-deflation scenario:
The only real difference being that this time the problem is global, and there is no external growth area to export to.
In my analysis this is going to be brutal. So lots of Japan before we get anything close to Zimbabwe.
The rationalization appears to be as follows: The FED has pumped Trillions into the financial system, so they must eventually pop up somewhere and produce inflation. Monetary expansion always fuels inflation does it not?Well, basically, no.
The Fed has pumped trillions into the financial system. However, this is not effective monetary expansion but merely bank credit lines to pay for previous losses that have occurred due to last years repricing of risk in the credit markets. This pumping does not expand the money supply in the real economy, but merely buffers the shrinking of the money supply which is occurring due to financial system deleverage and writeoffs.
More precisely, the expansion of the FED balance sheet is largely due to the provision of "short term" liquidity to distressed financial institutions. Despite the concerted effort of the US government, the financial system remains severely stressed.
US consumers have been living off debt. Now it has been noted that this is unsustainable, credit lines are being cut: deflation, unless the FED effectively nationalizes the banking system by the backdoor to increase credit, which would be insane - not to mention illegal. The FED is stuck between a rock and a hard place, and is desperate to produce confidence so that defaults will not rise even more.
However, they appear to have forgotten that there is a relation between confidence and the real economy. The real economy remains unfixed. When the financial system delevers (which it must! - even Ben would have to agree on that), this is what you get:
Indeed, I agree that the current irrational exuberance is partly due to inflation expectations, and partly due to manipulation. Inflation expectations do to some extent drive effective inflation. However, in this case the inflation expectations are fighting an extreme crisis in the financial system, and a growing crisis in the real economy.While layoffs continue, and people feel poorer whilst their credit lines are being cut, there is no driver for house prices to stabilize. Indeed, the premature confidence building is likely to cause greater difficulties down the road as people get poorer for being whiplashed twice in the stock exchange. I gather however that the treasury and the fed have decided that it is first necessary to recapitalize the financial system on the back of the sheeple (expect plenty of short prop trading in the summer or early autumn just as some "catalyst" causes markets to plummet again (this will be orchestrated via earnings, expensive oil, swine flu...).
Real inflation is impossible to produce whilst private and corporate credit lines are cut, especially in a consumption driven economy. The only driver for inflation will be the drop in the value of the dollar, however this will not bode well for indices as companies will suffer more in the aggregate given the bloated retail/consumption sector.
In case you need another example for what happens in a debt-deflation scenario:
The only real difference being that this time the problem is global, and there is no external growth area to export to.
In my analysis this is going to be brutal. So lots of Japan before we get anything close to Zimbabwe.
Saturday, May 2, 2009
Government Lies
Governments lie.
Well maybe not every government all the time. But certain governments lie sometimes.
In case you need reminding/convincing, please look here, here and here (this list could of course be expanded on substantially).
Some lies may be good. Maybe it is best to downplay swine flu if its spread is inevitable. Personally, I do not adhere to the school of thought which appears to think that the people are too stupid, emotional or short sighted for the truth but I understand the argument. However, I can by no means bring myself to believe that the amount of lies and propaganda being produced regarding the current situation in the global economy will result in a beneficial outcome.
But first some lies:
'No one should be confused about what a bankruptcy process means. This is not a sign of weakness but rather one more step on a clearly charted path to Chrysler's revival.'
— President Obama (MW)
No real need to comment on this one it must be apparent that it is total nonsense.
"I remain confident that the economy will start to grow before the end of the year."
- Alistair Darling (Reuters)
The UK budget, and Darling's comment has been almost universally derided so I will merely provide a link.
This list could also go on and on, but I gather most people would get bored and may commence smoking some good ol' green shoots. So - enough propaganda nonsense. Let's look at a truism: "A depression is a self fulfilling prophecy".
Confidence is key in economics. If people think they are wealthy, they consume more, leading to more aggregate demand, leading to more aggregate supply, leading to economic growth, making people feel more wealthy...
This mantra has been repeated for many years now. Central Bankers have used this as the rationale for allowing ever more debt and leverage to dominate the economy, in turn bloating the financial sector and attracting ever more of the best and brightest to the global game of musical chairs with structured credit derivatives. This game has gone on and on, leading to where we are today with an amazingly intransparent derivatives bubble of nominal value of many times the size of the global economy.
Now that we have experienced a blip in this ponzi-esque system of ever increasing cross-leverage and debt bubbles, we should take a step back to reflect on what would be the best way to operate moving forward.
Currently, the approach being chosen to fix the bursting of the bubble is to reflate the global bubble. This was the path chosen when the Tech bubble burst - easy money then led to the real estate bubble. Maybe the next bubble will be in green technology equities? In order to maintain "con-fidence" in the system we are led to believe that everything is alright.
Everything is not alright. The financial system remains largely insolvent even though taxpayers have already bought trillions worth of inflated credit at significant premiums to what any rational investor is willing to pay and despite bankers taking bonuses of sizes that appear ludicrous to anybody who is not used to burning trillions worth of value that does not belong to them.
Despite the fact that the financial sector is too big for its own good, Governments have gone far beyond covering insured deposits and ensuring the flow of debt to important, producing firms. No, they have decided to take on the inflated debt of so-called risk takers in the economy so that other "risk takers" are not impaired on their "investments".
This although much of this exposure was only taken on in light of an expected government bailout, and some of the largest recipients of government bailouts claim to have been "fully hedged", in the knowledge that they had bought a nonsensical financial product in an unsustainable game of ever increasing debt.
We may be in a difficult time of chaos, but cushioning supposed "risk takers" from the consequences of their own actions makes no sense. The only rationale for bailing out institutions which do not hold private deposits and do not engage in direct lending activity could be that they are indeed too intensively linked to systemically fundamental financial institutions via derivative exposure that they are too large to fail.
Should this indeed be the case, the solution is not to pump trillions of taxpayer monies into exactly these entities, further increasing moral hazard and apparently encouraging the largest, and correspondingly most dangerous risk taking in the financial history of mankind.
Here I would like to mention Goldman Sachs, the systemically important "bank holding company" which is essentially a hedge fund with preferential access to federal reserve liquidity, which undertakes no direct real economy lending nor holds retail accounts and just got over 20 billion USD in TARP money due to apparently being insolvent, is now the no. 1 proprietary trader on the NYSE, larger than the next 14 institutions put together.
Conspiracy theorists claim this is a concerted effort by GS and the US government to prop up the market to retain confidence. I gather that this is more likely a desperate attempt to make back losses in the credit markets to avoid insolvency. Whether it is one or the other, what is clear is this is being done by a firm that took government money, despite GS employees averaging more than 360'000$ of compensation (including janitorial staff!) in 2009.
Propping up markets with taxpayer money is maybe not illegal, but highly questionable. Bailing out private financial institutions and their equity and bondholders who made bad debts is ludicrous, and makes no sense whatsoever if you believe that markets are the best way to allocate resources, which is what these guys have been telling us at least for the last 20 years. The distributional consequences of these actions are horrendous, and show a complete disparity between government elites and people who actually have to do honest work for a living. Socialism for the rich is inexcusable, and makes no economic sense.
However, governments are taking the riskiest and most likely to fail approach possible: Whilst they preach confidence and green shoots, they are subsidizing reckless risk taking by those who need it least, truly destroying the last bit of equity or market control in the financial sector. The banks will not provide credit to companies given the macroeconomic outlook of deflation that they created themselves. Indeed, they will attempt to exploit the last days of the game to the absolute maximum whilst paying out as much compensation as they can get away with. This is going on with very little government control or oversight, especially in the United States.
Given this outlook, it the systematic creation of confidence in an already failed system on its last legs, which will inevitably sucker some fools into the financial markets is not just cynical and dangerous, but downright criminal. Not only will they fail to save the financial system, which, given it's current form, is actually a good thing, but it will also inflict long term damage on the prestige of the political system, making the rise of radical solutions all the more likely.
We must reform the financial system, and we must do it according to certain basic principles previously laid out here. Merely perpetuating the current inefficient, fundamentally unfair and wide open to abuse system is not an option.
The best way to fix the crisis would be to immediately separate the deposit-insured banking sector form the highly risky, speculative investment banking activity. The withdrawal of the Glass-Steagal acts was indeed a short sighted act.
Keep small business loans running, keep deposits insured, put aside some extra cash for large firms needing short term liquidity and THEN:
Let the market run it's course. Let the Investment banks who made bad, leveraged bets fail. The good guys can then start/get hired by hedge funds who CAN fail and who get capital in the market not from the FED or some other taxpayer funded corrupt gravy train. The other guys who don't get hired can then go to activities which actually bring a benefit to society unlike parasitical and useless overpaid musical chairs playing with structured credit derivatives.
This should have been done right from the beginning. Insuring GS speculative trades and bonuses with FED, TARP and FDIC cash is a scandal, and tantamount to daylight robbery. Eventually the moral hazard and failed incentives will lead to a greater crisis down the road. The bill to the taxpayer increases with every day the corrupt Geithner crew neglects true reform.
Too large to fail is too large to exist. We need smaller banks and more competition not enormous intransparent and immensely powerful state sponsored dinosaur banking behemoths.
Well maybe not every government all the time. But certain governments lie sometimes.
In case you need reminding/convincing, please look here, here and here (this list could of course be expanded on substantially).
Some lies may be good. Maybe it is best to downplay swine flu if its spread is inevitable. Personally, I do not adhere to the school of thought which appears to think that the people are too stupid, emotional or short sighted for the truth but I understand the argument. However, I can by no means bring myself to believe that the amount of lies and propaganda being produced regarding the current situation in the global economy will result in a beneficial outcome.
But first some lies:
'No one should be confused about what a bankruptcy process means. This is not a sign of weakness but rather one more step on a clearly charted path to Chrysler's revival.'
— President Obama (MW)
No real need to comment on this one it must be apparent that it is total nonsense.
"I remain confident that the economy will start to grow before the end of the year."
- Alistair Darling (Reuters)
The UK budget, and Darling's comment has been almost universally derided so I will merely provide a link.
This list could also go on and on, but I gather most people would get bored and may commence smoking some good ol' green shoots. So - enough propaganda nonsense. Let's look at a truism: "A depression is a self fulfilling prophecy".
Confidence is key in economics. If people think they are wealthy, they consume more, leading to more aggregate demand, leading to more aggregate supply, leading to economic growth, making people feel more wealthy...
This mantra has been repeated for many years now. Central Bankers have used this as the rationale for allowing ever more debt and leverage to dominate the economy, in turn bloating the financial sector and attracting ever more of the best and brightest to the global game of musical chairs with structured credit derivatives. This game has gone on and on, leading to where we are today with an amazingly intransparent derivatives bubble of nominal value of many times the size of the global economy.
Now that we have experienced a blip in this ponzi-esque system of ever increasing cross-leverage and debt bubbles, we should take a step back to reflect on what would be the best way to operate moving forward.
Currently, the approach being chosen to fix the bursting of the bubble is to reflate the global bubble. This was the path chosen when the Tech bubble burst - easy money then led to the real estate bubble. Maybe the next bubble will be in green technology equities? In order to maintain "con-fidence" in the system we are led to believe that everything is alright.
Everything is not alright. The financial system remains largely insolvent even though taxpayers have already bought trillions worth of inflated credit at significant premiums to what any rational investor is willing to pay and despite bankers taking bonuses of sizes that appear ludicrous to anybody who is not used to burning trillions worth of value that does not belong to them.
Despite the fact that the financial sector is too big for its own good, Governments have gone far beyond covering insured deposits and ensuring the flow of debt to important, producing firms. No, they have decided to take on the inflated debt of so-called risk takers in the economy so that other "risk takers" are not impaired on their "investments".
This although much of this exposure was only taken on in light of an expected government bailout, and some of the largest recipients of government bailouts claim to have been "fully hedged", in the knowledge that they had bought a nonsensical financial product in an unsustainable game of ever increasing debt.
We may be in a difficult time of chaos, but cushioning supposed "risk takers" from the consequences of their own actions makes no sense. The only rationale for bailing out institutions which do not hold private deposits and do not engage in direct lending activity could be that they are indeed too intensively linked to systemically fundamental financial institutions via derivative exposure that they are too large to fail.
Should this indeed be the case, the solution is not to pump trillions of taxpayer monies into exactly these entities, further increasing moral hazard and apparently encouraging the largest, and correspondingly most dangerous risk taking in the financial history of mankind.
Here I would like to mention Goldman Sachs, the systemically important "bank holding company" which is essentially a hedge fund with preferential access to federal reserve liquidity, which undertakes no direct real economy lending nor holds retail accounts and just got over 20 billion USD in TARP money due to apparently being insolvent, is now the no. 1 proprietary trader on the NYSE, larger than the next 14 institutions put together.Conspiracy theorists claim this is a concerted effort by GS and the US government to prop up the market to retain confidence. I gather that this is more likely a desperate attempt to make back losses in the credit markets to avoid insolvency. Whether it is one or the other, what is clear is this is being done by a firm that took government money, despite GS employees averaging more than 360'000$ of compensation (including janitorial staff!) in 2009.
Propping up markets with taxpayer money is maybe not illegal, but highly questionable. Bailing out private financial institutions and their equity and bondholders who made bad debts is ludicrous, and makes no sense whatsoever if you believe that markets are the best way to allocate resources, which is what these guys have been telling us at least for the last 20 years. The distributional consequences of these actions are horrendous, and show a complete disparity between government elites and people who actually have to do honest work for a living. Socialism for the rich is inexcusable, and makes no economic sense.
However, governments are taking the riskiest and most likely to fail approach possible: Whilst they preach confidence and green shoots, they are subsidizing reckless risk taking by those who need it least, truly destroying the last bit of equity or market control in the financial sector. The banks will not provide credit to companies given the macroeconomic outlook of deflation that they created themselves. Indeed, they will attempt to exploit the last days of the game to the absolute maximum whilst paying out as much compensation as they can get away with. This is going on with very little government control or oversight, especially in the United States.
Given this outlook, it the systematic creation of confidence in an already failed system on its last legs, which will inevitably sucker some fools into the financial markets is not just cynical and dangerous, but downright criminal. Not only will they fail to save the financial system, which, given it's current form, is actually a good thing, but it will also inflict long term damage on the prestige of the political system, making the rise of radical solutions all the more likely.
We must reform the financial system, and we must do it according to certain basic principles previously laid out here. Merely perpetuating the current inefficient, fundamentally unfair and wide open to abuse system is not an option.
The best way to fix the crisis would be to immediately separate the deposit-insured banking sector form the highly risky, speculative investment banking activity. The withdrawal of the Glass-Steagal acts was indeed a short sighted act.
Keep small business loans running, keep deposits insured, put aside some extra cash for large firms needing short term liquidity and THEN:
Let the market run it's course. Let the Investment banks who made bad, leveraged bets fail. The good guys can then start/get hired by hedge funds who CAN fail and who get capital in the market not from the FED or some other taxpayer funded corrupt gravy train. The other guys who don't get hired can then go to activities which actually bring a benefit to society unlike parasitical and useless overpaid musical chairs playing with structured credit derivatives.
This should have been done right from the beginning. Insuring GS speculative trades and bonuses with FED, TARP and FDIC cash is a scandal, and tantamount to daylight robbery. Eventually the moral hazard and failed incentives will lead to a greater crisis down the road. The bill to the taxpayer increases with every day the corrupt Geithner crew neglects true reform.
Too large to fail is too large to exist. We need smaller banks and more competition not enormous intransparent and immensely powerful state sponsored dinosaur banking behemoths.
Thursday, April 2, 2009
Peace in our time
"We have today therefore pledged to do whatever is necessary to:
· restore confidence, growth, and jobs;
· repair the financial system to restore lending;
· strengthen financial regulation to rebuild trust;
· fund and reform our international financial institutions to overcome this crisis and prevent future ones;
· promote global trade and investment and reject protectionism, to underpin prosperity; and
· build an inclusive, green, and sustainable recovery. " (full text here)
> Wow those guys certainly know how to build confidence! A new era of financial regulation and sustainable economics is born!
This is great! Or - it only it were true.
Indeed today showed some very worrying news for the sustainability of the financial system:
"The Financial Accounting Standards Board revised the rules to allow companies to use the judgment to a greater extent in determining the "fair value" of their assets. The board also made it easier for companies to avoid having to take impairment charges against earnings when they suffer losses on their investments." (WSJ)
Yes.
The guys who brought this mess upon us through incompetence or fraud are now allowed to value their "assets" themselves!
This will merely have the effect of decreasing transparency in the financial system, leading to more uncertainty and room for fraud, most likely prolonging the crisis and certainly not contributing to a sustainable solution.
Monday, March 30, 2009
Saturday, March 14, 2009
A coherent framework for Regulation
This financial crisis thing has been going on for quite a while now.
Many proposals have been made to solve the problems facing the financial system. Most of them have failed. This is a good thing, as the mainstream proposals were and remain uniformly poor.
Basically, most proposals have been designed to bring "bad" assets off bank balance sheets so that somebody else (first: other banks, now: the taxpayer) bears the cost of paying ridiculous compensation packages to bankers who made paper, ponzi profits by taking on risk without limit.
Of course we have to recapitalize the financial system. To not do so would be negligent. However, banks should offer something in return for getting using public wealth, and regulators should do something to impede this sort of thing from happening again (remember: savings and loan crisis happened in the '80's, and regulation was continuously eroded throughout the time since).
This should be the first point, obvious, but not respected in recent years:
> The regulator must be strong, independent and willing to regulate.
Throughout the western world, regulator positions have been filled by senior bankers. It doesn't work. If somebody has spent his life living for one system, he is unlikely to seriously criticize the system, especially as his social network will largely be among the regulated. Self regulation is also largely ineffective, for obvious reasons. Perversely, in places like the UK, the Financial Services Regulator was apparently pressured to adopt a "light touch" i.e. not to intervene in the free market! It is apparent that regulators need to take a step back and do some serious thinking about what their job actually is, and should be.
> If entities are systematically fundamental, they should not be private. If private entities are "too large to fail" they must be made smaller or nationalized.
In a system where companies are compensated from taking on too much risk, and know that the taxpayer will bail them out should the risk go bad, then the system bears a large incentive to abuse that position, and take on more risk than an entity would take on would they not have an implicit public insurance. The obvious answer to this appears clear: BREAK UP THE BANKS! Private risk taking, markets are great at allocating resources quite efficiently. They brought us everything from the Nintendo Wii to cruise ships to ... Therefore, any even semi capitalist system must retain a system where private risks can be taken and compensated accordingly. I think the area of private risk is currently adequately regulated: Investors can invest in stocks, bonds, alternative investment vehicles. If they make the wrong choices or trust the wrong people, the lose, and inversely, if they make the right choices, they win. The most important element is that the entities can lose and that bad investment choices are penalized. In a coherent framework for markets, the most important element is that there are no bailout, nor any need for bailouts. Private, non-state insured risk taking should therefore be encouraged.
Conversely, entities which hold insured deposits should not be allowed to take on excessive market risk. It appears obvious, but this is not the way things are being handled today. Large banks have taken on very large risks (RBS-ABN...) and when these risks have gone foul they have asked the state for help. Many have argued that the issue is with short term executive compensation. This may have contributed to excessive risk taking, but impeding this appears lees direct and more difficult to manage than impeding banks from taking on excessive risk in the first place.
What is excessive risk, and how to stop it? The easiest, naive way to stop excessive risk taking is with so called "capital adequacy ratios" whereby regulated banks are not able to take on more leverage/gearing than a particular amount. As a guideline, this should be closer to 3x than 30x. It should appear obvious, but apparently nothing is. Along the same lines, off balance sheet accounting which serves to hide risk from shareholders and regulators should be forbidden and recognized in law for the fraud that it is. Accounting rules should generally be revised to close loopholes and increase transparency.
Banks, and other risk takers should be given a choice: do they want to be systemically important small business lenders or do they want to be free to take on risk? I envisage a system whereby there is a regulated financial sector and an unregulated financial sector. In the regulated sector entities will have access to central bank liquidity and state capital guarantees. They will take deposits and may make loans to businesses at "market" rates, or invest in certain free market opportunities albeit in a highly regulated manner. Arguably these entities should be owned by the state due to their systemically fundamental nature and the strictly regulated way of operating. Another reason why these entities should not be freely owned is that they should not be subject to pressures to make short term profit by shareholders maximizing their short term wealth accumulation at the expense of future crisis. Basically, it would be difficult to make these regulated banks competitive with the free banks and therefore it may be best to exempt them from competition. It may be a good idea to have an artificial "market" whereby regulated bank executives have some of their compensation tied to their effectiveness in "competing" with the other regulated banks. This would however unlikely reach levels of star traders etc. in the free sector, except for cases of exceptional effectiveness or cost cutting in the regulated sector.
On the other hand, you will have the "free" unregulated financial system. "Banks" operating in this space will not be subject to regulation, will not have access to central bank liquidity and deposits will not be guaranteed by the state. It is very likely that deposits in the free sector will pay significantly higher interest thank insured deposits. This is desirable, as interest will reflect the higher risk taken on by free entities. Conversely, companies will face the choice of borrowing from the regulated or the non-regulated sector. This will be achieved by market mechanisms. Enterprises deemed to be less risky will be able to borrow from the regulated sector at lesser risk premia than risky enterprises forced to borrow from the free sector. Although the regulated sector will be compelled to take on some risk, this will be negligible compared to the risk taken on by the free sector.
The free sector will basically be characterized by funds (which can be called banks or investment vehicles or whatever). These will engage in lending, structuring, borrowing, trading, brokerage etc. These entities will be in competition with each other, will take on risk and compensate accountholders/investors according to their abilities in this highly competitive investment marketplace. The only role of the regulator in this market is one of atomization or the prevention of excessive consolidation. To impede the clout risk if entities becoming systemically important or "too large to fail" the regulator must break up entities or stop consolidation in the "free" financial sector. Although this is an obvious contradiction to the term "free", it appears the only way to impede the risky sector from consolidating risk and endangering public welfare. This also implies limits of financial technology - with the knowledge we have today, it appears clear that diversification is useful only on a single portfolio and not on a systemic level. Excesses such as "bond insurance" to generate cheap borrowing will not be attractive if insurance is sold at attractive premium. Rating agencies should be disenfranchised, or given some liability connected to ratings they give.
Implications to be noted:
Cheap liquidity caused the financial crisis. Private banks had such easy access to Central Bank liquidity that everybody with a business card could get "leverage" on their "diversified" investment products. This distorted risk premia, and basically rewarded short sightedness and led to the entire economy resembling a pyramid scheme. Should my suggestions be implemented, risk premia would no longer be distorted by excessively cheap liquidity, which in my eyes was the main factor contributing to the current malinvestment crisis.
This will make monetary policy less effective. This is a good thing, as recent history has shown that Central Bankers do not possess the foresight necessary to wield a tool as powerful pas determining financial system liquidity for any particular currency. This is an area where the market should be given more space, so that risk premia once again reflect risks taken.
What should be done right now:
Bankers want their firms to remain private so that they can continue to benefit from their privileged position in the financial system to syphon off public wealth for themselves. This is unacceptable.
The financial system is bust. For recapitalization to be durable, the financial system should once again reflect true values, and prices should not be determined in a political process (lest the financial sector mutate into an industry with soviet incentives with corruption, inefficiency and waste on an even higher scale than today). To achieve this, the entire system should be put into administration, and all liabilities laid bare to the regulator. Bankrupt firms should be identified, their equity and debt holders wiped out.
In the short term, operations could be consolidated into a mega bank which would then start organizing itself into free and regulated operations. Free operations would be sold off in small tranches to ensure competition and some upside for the taxpayer. Regulated operations organized as elaborated previously. Financial institutions which are not bust should generally be left alone, subject to the constraint that they would be required to remain smaller than "too large to fail". Certain deposit holding entities may elect to consolidate in the regulated sector.
That's about it for a short summary. I welcome debate on these issues, and look forward to any feedback anybody may have.
Many proposals have been made to solve the problems facing the financial system. Most of them have failed. This is a good thing, as the mainstream proposals were and remain uniformly poor.
Basically, most proposals have been designed to bring "bad" assets off bank balance sheets so that somebody else (first: other banks, now: the taxpayer) bears the cost of paying ridiculous compensation packages to bankers who made paper, ponzi profits by taking on risk without limit.
Of course we have to recapitalize the financial system. To not do so would be negligent. However, banks should offer something in return for getting using public wealth, and regulators should do something to impede this sort of thing from happening again (remember: savings and loan crisis happened in the '80's, and regulation was continuously eroded throughout the time since).
This should be the first point, obvious, but not respected in recent years:
> The regulator must be strong, independent and willing to regulate.
Throughout the western world, regulator positions have been filled by senior bankers. It doesn't work. If somebody has spent his life living for one system, he is unlikely to seriously criticize the system, especially as his social network will largely be among the regulated. Self regulation is also largely ineffective, for obvious reasons. Perversely, in places like the UK, the Financial Services Regulator was apparently pressured to adopt a "light touch" i.e. not to intervene in the free market! It is apparent that regulators need to take a step back and do some serious thinking about what their job actually is, and should be.
> If entities are systematically fundamental, they should not be private. If private entities are "too large to fail" they must be made smaller or nationalized.
In a system where companies are compensated from taking on too much risk, and know that the taxpayer will bail them out should the risk go bad, then the system bears a large incentive to abuse that position, and take on more risk than an entity would take on would they not have an implicit public insurance. The obvious answer to this appears clear: BREAK UP THE BANKS! Private risk taking, markets are great at allocating resources quite efficiently. They brought us everything from the Nintendo Wii to cruise ships to ... Therefore, any even semi capitalist system must retain a system where private risks can be taken and compensated accordingly. I think the area of private risk is currently adequately regulated: Investors can invest in stocks, bonds, alternative investment vehicles. If they make the wrong choices or trust the wrong people, the lose, and inversely, if they make the right choices, they win. The most important element is that the entities can lose and that bad investment choices are penalized. In a coherent framework for markets, the most important element is that there are no bailout, nor any need for bailouts. Private, non-state insured risk taking should therefore be encouraged.
Conversely, entities which hold insured deposits should not be allowed to take on excessive market risk. It appears obvious, but this is not the way things are being handled today. Large banks have taken on very large risks (RBS-ABN...) and when these risks have gone foul they have asked the state for help. Many have argued that the issue is with short term executive compensation. This may have contributed to excessive risk taking, but impeding this appears lees direct and more difficult to manage than impeding banks from taking on excessive risk in the first place.
What is excessive risk, and how to stop it? The easiest, naive way to stop excessive risk taking is with so called "capital adequacy ratios" whereby regulated banks are not able to take on more leverage/gearing than a particular amount. As a guideline, this should be closer to 3x than 30x. It should appear obvious, but apparently nothing is. Along the same lines, off balance sheet accounting which serves to hide risk from shareholders and regulators should be forbidden and recognized in law for the fraud that it is. Accounting rules should generally be revised to close loopholes and increase transparency.
Banks, and other risk takers should be given a choice: do they want to be systemically important small business lenders or do they want to be free to take on risk? I envisage a system whereby there is a regulated financial sector and an unregulated financial sector. In the regulated sector entities will have access to central bank liquidity and state capital guarantees. They will take deposits and may make loans to businesses at "market" rates, or invest in certain free market opportunities albeit in a highly regulated manner. Arguably these entities should be owned by the state due to their systemically fundamental nature and the strictly regulated way of operating. Another reason why these entities should not be freely owned is that they should not be subject to pressures to make short term profit by shareholders maximizing their short term wealth accumulation at the expense of future crisis. Basically, it would be difficult to make these regulated banks competitive with the free banks and therefore it may be best to exempt them from competition. It may be a good idea to have an artificial "market" whereby regulated bank executives have some of their compensation tied to their effectiveness in "competing" with the other regulated banks. This would however unlikely reach levels of star traders etc. in the free sector, except for cases of exceptional effectiveness or cost cutting in the regulated sector.
On the other hand, you will have the "free" unregulated financial system. "Banks" operating in this space will not be subject to regulation, will not have access to central bank liquidity and deposits will not be guaranteed by the state. It is very likely that deposits in the free sector will pay significantly higher interest thank insured deposits. This is desirable, as interest will reflect the higher risk taken on by free entities. Conversely, companies will face the choice of borrowing from the regulated or the non-regulated sector. This will be achieved by market mechanisms. Enterprises deemed to be less risky will be able to borrow from the regulated sector at lesser risk premia than risky enterprises forced to borrow from the free sector. Although the regulated sector will be compelled to take on some risk, this will be negligible compared to the risk taken on by the free sector.
The free sector will basically be characterized by funds (which can be called banks or investment vehicles or whatever). These will engage in lending, structuring, borrowing, trading, brokerage etc. These entities will be in competition with each other, will take on risk and compensate accountholders/investors according to their abilities in this highly competitive investment marketplace. The only role of the regulator in this market is one of atomization or the prevention of excessive consolidation. To impede the clout risk if entities becoming systemically important or "too large to fail" the regulator must break up entities or stop consolidation in the "free" financial sector. Although this is an obvious contradiction to the term "free", it appears the only way to impede the risky sector from consolidating risk and endangering public welfare. This also implies limits of financial technology - with the knowledge we have today, it appears clear that diversification is useful only on a single portfolio and not on a systemic level. Excesses such as "bond insurance" to generate cheap borrowing will not be attractive if insurance is sold at attractive premium. Rating agencies should be disenfranchised, or given some liability connected to ratings they give.
Implications to be noted:
Cheap liquidity caused the financial crisis. Private banks had such easy access to Central Bank liquidity that everybody with a business card could get "leverage" on their "diversified" investment products. This distorted risk premia, and basically rewarded short sightedness and led to the entire economy resembling a pyramid scheme. Should my suggestions be implemented, risk premia would no longer be distorted by excessively cheap liquidity, which in my eyes was the main factor contributing to the current malinvestment crisis.
This will make monetary policy less effective. This is a good thing, as recent history has shown that Central Bankers do not possess the foresight necessary to wield a tool as powerful pas determining financial system liquidity for any particular currency. This is an area where the market should be given more space, so that risk premia once again reflect risks taken.
What should be done right now:
Bankers want their firms to remain private so that they can continue to benefit from their privileged position in the financial system to syphon off public wealth for themselves. This is unacceptable.
The financial system is bust. For recapitalization to be durable, the financial system should once again reflect true values, and prices should not be determined in a political process (lest the financial sector mutate into an industry with soviet incentives with corruption, inefficiency and waste on an even higher scale than today). To achieve this, the entire system should be put into administration, and all liabilities laid bare to the regulator. Bankrupt firms should be identified, their equity and debt holders wiped out.
In the short term, operations could be consolidated into a mega bank which would then start organizing itself into free and regulated operations. Free operations would be sold off in small tranches to ensure competition and some upside for the taxpayer. Regulated operations organized as elaborated previously. Financial institutions which are not bust should generally be left alone, subject to the constraint that they would be required to remain smaller than "too large to fail". Certain deposit holding entities may elect to consolidate in the regulated sector.
That's about it for a short summary. I welcome debate on these issues, and look forward to any feedback anybody may have.
Monday, February 9, 2009
The case for war
We have come a long way in the past century. Despite many conflicts and the use gruesome technologies of mass destruction, the world is now more integrated than ever. The cold war was won by the west, defusing the main source of potential international conflict. Anyway, Globalization has caused economies to become more integrated, making world wars all but impossible.
Or is it really so?
During the pre- 1914 belle époque, the world was arguably even more economically integrated than today, with international trade as a percentage of gdp at all time highs in many nations. Given the horrors of WWI, and the resolution that the world had experienced the "war to end all wars" leading to the establishment of the league of nations to guarantee international security few would have thought that WWII was a mere two decades away.
There is a consensus among economic historians that WWII was to some extent caused by widespread poverty in the wake of the great depression, with national populations seeking strong men to solve their problems. It is also given that economic nationalism and protectionist policies exacerbated the global economic slowdown.
Today we are again confronted with economic difficulties of epic proportions. Again, politicians are seeking to solve their domestic issues by proponing measures designed to foster local economic growth over the most efficient method of production, leading to lower efficiency and increased costs. Again, these measures are sowing the seeds of international conflict. Although the magnitude as to what extent protectionist policies contributed to the great depression remains a topic of debate, the symbolic importance should not be neglected.
After all, we can learn certain things from the twentieth century. One of these lessons is that trade wars can lead to real wars.
Or is it really so?
During the pre- 1914 belle époque, the world was arguably even more economically integrated than today, with international trade as a percentage of gdp at all time highs in many nations. Given the horrors of WWI, and the resolution that the world had experienced the "war to end all wars" leading to the establishment of the league of nations to guarantee international security few would have thought that WWII was a mere two decades away.
There is a consensus among economic historians that WWII was to some extent caused by widespread poverty in the wake of the great depression, with national populations seeking strong men to solve their problems. It is also given that economic nationalism and protectionist policies exacerbated the global economic slowdown.
Today we are again confronted with economic difficulties of epic proportions. Again, politicians are seeking to solve their domestic issues by proponing measures designed to foster local economic growth over the most efficient method of production, leading to lower efficiency and increased costs. Again, these measures are sowing the seeds of international conflict. Although the magnitude as to what extent protectionist policies contributed to the great depression remains a topic of debate, the symbolic importance should not be neglected.
After all, we can learn certain things from the twentieth century. One of these lessons is that trade wars can lead to real wars.
Tuesday, January 6, 2009
What to do about financial crisis
Although markets started the year with a cheer, the dire economic reality is currently taking precedent over wishful thinking that "the worst is over".
Deleveraging is ongoing. Sales are declining, contributing to an increase of deflationary pressures.
Credit remains tight, with banks reticent to lend despite unprecedented guarantees and liquidity facilities.
With interest rates approaching zero, certain renowned economists are calling a liquidity trap, the situation whereby credit remains tight despite liquidity being nominally cheap and available. The explanation for this phenomenon can be simplified substantially: Banks expects the economy to get worse, and are tightening credit conversely. By doing this, banks are reinforcing, indeed to some extent causing this trend.
Whereas Neoclassical economics suggests exiting this situation by giving money away, enhancing demand for goods, thereby supporting economic activity, Keynesian economics suggests government infrastructure projects to achieve the same aim.
Both these approaches have the potential to help us out of the current slump. Infrastructure projects would be more likely to produce long lasting benefits, whereas giving money away may
bring less value for money due to the fact that some of the stimulus would be saved.
The current issue with both these approaches remains not their theoretical soundness, but their political feasibility. Many politicians are still unaware of how dire the situation the economy is currently in really is, and remain skeptical towards stimulus operations which are nominally enormous such as the 800bn US$ pro0grma proposed by Barack Obama. Given the persistence of failed economic ideology, there is potential for this stimulus program to be downsized or stalled to the extent that it become insufficient and fails. In Europe, the situation is even more complicated, given the decentralized political process and perceived beggar-thy-neighbour effects of localized economic stimulus. This discussion is further complicated by the fact that governments are already in severe fiscal stress, arguably due to the competitive international pressure to reduce taxes below the level of comparable nations, to improve the attractivity of the economy for the productive factor capital. This in many cases worked as planned, with capital moving to the states where the least limits and costs were imposed on its use. Unfortunately, the expected fiscal benefit often remained scant, and major governments have been compelled to borrow from future generations to fund their operations. Even today, when any neutral analyst worthy of the label should be aware of the fact that unfunded tax decreases in large, open economies are most likely to result in state funding strains, and a corresponding decrease of the capability of the state to fund their operations than in economic growth, many are still calling for tax cuts, despite their realization that bailouts are necessary.
To summarize:
The economy is in trouble.
We should better fix it.
We will then have to pay for it.
Deleveraging is ongoing. Sales are declining, contributing to an increase of deflationary pressures.
Credit remains tight, with banks reticent to lend despite unprecedented guarantees and liquidity facilities.
With interest rates approaching zero, certain renowned economists are calling a liquidity trap, the situation whereby credit remains tight despite liquidity being nominally cheap and available. The explanation for this phenomenon can be simplified substantially: Banks expects the economy to get worse, and are tightening credit conversely. By doing this, banks are reinforcing, indeed to some extent causing this trend.
Whereas Neoclassical economics suggests exiting this situation by giving money away, enhancing demand for goods, thereby supporting economic activity, Keynesian economics suggests government infrastructure projects to achieve the same aim.
Both these approaches have the potential to help us out of the current slump. Infrastructure projects would be more likely to produce long lasting benefits, whereas giving money away may
bring less value for money due to the fact that some of the stimulus would be saved.
The current issue with both these approaches remains not their theoretical soundness, but their political feasibility. Many politicians are still unaware of how dire the situation the economy is currently in really is, and remain skeptical towards stimulus operations which are nominally enormous such as the 800bn US$ pro0grma proposed by Barack Obama. Given the persistence of failed economic ideology, there is potential for this stimulus program to be downsized or stalled to the extent that it become insufficient and fails. In Europe, the situation is even more complicated, given the decentralized political process and perceived beggar-thy-neighbour effects of localized economic stimulus. This discussion is further complicated by the fact that governments are already in severe fiscal stress, arguably due to the competitive international pressure to reduce taxes below the level of comparable nations, to improve the attractivity of the economy for the productive factor capital. This in many cases worked as planned, with capital moving to the states where the least limits and costs were imposed on its use. Unfortunately, the expected fiscal benefit often remained scant, and major governments have been compelled to borrow from future generations to fund their operations. Even today, when any neutral analyst worthy of the label should be aware of the fact that unfunded tax decreases in large, open economies are most likely to result in state funding strains, and a corresponding decrease of the capability of the state to fund their operations than in economic growth, many are still calling for tax cuts, despite their realization that bailouts are necessary.
To summarize:
The economy is in trouble.
We should better fix it.
We will then have to pay for it.
Monday, January 5, 2009
Monday, December 15, 2008
Is there no safe haven?
Hedge Fund ponzi schemes.
Where they are not fraudulent, they are just not very good at what they do. Alpha, in the case of the industry, if not in the case of certain managers, is apparently a myth.
Private Equity buyers strike.
Private Equity relies on committed capital which may be invested over significant time periods before they make money. As many investors are currently becoming reticent to throw good money after potentially bad money, this makes private equity problems a self-fulfilling prophecy, as young firms will not be getting the necessary cash to grow in to viable ones.
That mutual funds are crap is a well known fact.
Deflationary trends across the board. The credit crisis appears to be winning the battle with monetary authorities in the short term. If this goes on, we might end up in a rather unfortunate situation. Well, it's not as if recent history does not have a good example of what deflation looks like .
So, INflation or DEflation. Which will prevail?
In the long term, cheap money will lead to hyperinflation and a probable reflating of the credit bubble. The reason for this is that central bankers like inflation. Indeed, inflation is the only scenario they can deal with so they will always aim for it. In fact, so desperate are they to produce inflation that their efforts will likely lead to hyperinflation somewhere along the way.
Investing in an inflationary environment is quite easy. As prices will tend to go up, most investments are likely to yield positive returns relative to cash, the value of which is constantly eroded. Indeed, in an expected hyperinflationary environment it may be advisable to get a lot of debt and invest it, by for example buying real estate on margin (standard mortgage deal).
Deflation, on the other hand, is another beast altogether. Deflation of course means prices across asset classes trend down. Therefore, a wise investment is generally perceived to be cash "cash is king". Why buy a house today if I can live in this cardboard box for a bit longer and then get a nicer, bigger (not more expensive!) house tomorrow for what I would pay for an inferior property today?
Unfortunately, macroeconomic conditions are eroding substantially. Unwise policy decisions by central bankers and short sighted political systems have led to a credit bubble. This credit bubble is being brought on to the balance sheets of Central banks and governments due to short sighted bailout mentality. Some currencies are indeed starting to resemble Ponzi schemes themselves. Yes, I am talking about currencies backed by toxic credit. We used to be able to go to cash and let those private risk takers go poor. Nowadays, our immensely wise monetary authorities have decided to bail out the private risk takers, with potentially drastic effects for the economy as a whole (an interesting writeup from the inflationist camp here).
Therefore, in the short term, it may be advisable to hold a diversified basket of currencies, as it is not feasible that they will all fail simultaneously due to the fact that currency values are always relative to each other. When you feel that monetary authorities are winning the battle against deflation, go leveraged long.
After all, hyperinflation makes some investments appear fantastic (and they are relative to currency holders!).
Due to the negative value usually generated by stock picking, and the excessive fees paid for it, a broad based etf is probably a good option.
Where they are not fraudulent, they are just not very good at what they do. Alpha, in the case of the industry, if not in the case of certain managers, is apparently a myth.
Private Equity buyers strike.
Private Equity relies on committed capital which may be invested over significant time periods before they make money. As many investors are currently becoming reticent to throw good money after potentially bad money, this makes private equity problems a self-fulfilling prophecy, as young firms will not be getting the necessary cash to grow in to viable ones.
That mutual funds are crap is a well known fact.
Deflationary trends across the board. The credit crisis appears to be winning the battle with monetary authorities in the short term. If this goes on, we might end up in a rather unfortunate situation. Well, it's not as if recent history does not have a good example of what deflation looks like .
So, INflation or DEflation. Which will prevail?
In the long term, cheap money will lead to hyperinflation and a probable reflating of the credit bubble. The reason for this is that central bankers like inflation. Indeed, inflation is the only scenario they can deal with so they will always aim for it. In fact, so desperate are they to produce inflation that their efforts will likely lead to hyperinflation somewhere along the way.
Investing in an inflationary environment is quite easy. As prices will tend to go up, most investments are likely to yield positive returns relative to cash, the value of which is constantly eroded. Indeed, in an expected hyperinflationary environment it may be advisable to get a lot of debt and invest it, by for example buying real estate on margin (standard mortgage deal).
Deflation, on the other hand, is another beast altogether. Deflation of course means prices across asset classes trend down. Therefore, a wise investment is generally perceived to be cash "cash is king". Why buy a house today if I can live in this cardboard box for a bit longer and then get a nicer, bigger (not more expensive!) house tomorrow for what I would pay for an inferior property today?
Unfortunately, macroeconomic conditions are eroding substantially. Unwise policy decisions by central bankers and short sighted political systems have led to a credit bubble. This credit bubble is being brought on to the balance sheets of Central banks and governments due to short sighted bailout mentality. Some currencies are indeed starting to resemble Ponzi schemes themselves. Yes, I am talking about currencies backed by toxic credit. We used to be able to go to cash and let those private risk takers go poor. Nowadays, our immensely wise monetary authorities have decided to bail out the private risk takers, with potentially drastic effects for the economy as a whole (an interesting writeup from the inflationist camp here).
Therefore, in the short term, it may be advisable to hold a diversified basket of currencies, as it is not feasible that they will all fail simultaneously due to the fact that currency values are always relative to each other. When you feel that monetary authorities are winning the battle against deflation, go leveraged long.
After all, hyperinflation makes some investments appear fantastic (and they are relative to currency holders!).
Due to the negative value usually generated by stock picking, and the excessive fees paid for it, a broad based etf is probably a good option.
Friday, December 5, 2008
Sources of financial system Leverage
This will be a post in work. I am looking to list all sources of financial system leverage and hope your comments will contribute to the oeuvre!
- fractional reserve banking:
- national fiat currencies
- insurance system leverage
- leverage in the shadow financial system
- off-balance sheet accounting
- double gearing
- derivatives clearing houses
- unfunded government obligations: Medicare, pension liabilities.
- special drawing rights?
- uncollateralized interbank lending
[insert 2008 12 15:
- fraudulent leverage in Ponzi schemes (apparently substantial as witnessed in the Madoff case)]
[insert 2009 04 03:
- Mark to Optimism leverage due to FAS 157 amendment]
- GSE leverage, trust funds for S.S. and Medicare, for example (thanks to JP):
Can anyone think of more, or, more importantly, direct me to sources where this leverage is quantified? Or would anyone argue that certain concepts should not be in the list, or are counted more than once under different names?
- fractional reserve banking:
- national fiat currencies
- insurance system leverage
- leverage in the shadow financial system
- off-balance sheet accounting
- double gearing
- derivatives clearing houses
- unfunded government obligations: Medicare, pension liabilities.
- special drawing rights?
- uncollateralized interbank lending
[insert 2008 12 15:
- fraudulent leverage in Ponzi schemes (apparently substantial as witnessed in the Madoff case)]
[insert 2009 04 03:
- Mark to Optimism leverage due to FAS 157 amendment]
- GSE leverage, trust funds for S.S. and Medicare, for example (thanks to JP):
Can anyone think of more, or, more importantly, direct me to sources where this leverage is quantified? Or would anyone argue that certain concepts should not be in the list, or are counted more than once under different names?
Tuesday, November 25, 2008
Money for nothing
Citi has been bailed out. Again.
I will not delve into a discussion of the exact modalities of the deal, as it has been done here. I will however elaborate on why I think that the deal is wrong, very wrong and misguided.
Here's why:
1) It is expensive.
A 27bn equity investment. And then guarantees on a further 306bn. The size of the TARP so far, for only one firm!
2) It may be insufficient to turn the market - or - don't throw good money after bad.
Citi has over $2 trillion in assets and a further several hundred billions of dollars in off-balance sheet liabilities. Earlier capital injections have not been enough, so what makes this one different? In fact, it seems rather ill advised to put a ceiling on the size of the bailout at all, especially if the real commitment is meager relative to the size of the problem.
3) It has excessive distributional consequences.
Joe Sixpack is now paying for the Armani shirts of Jack the banker. Simple as that. It's not that Joe Sixpack is aware of it, or would even want the shirts, he would however need the money. Amazingly, the US government no longer appears to find it necessary to disguise the direct subsidy nature of this program. After all, the approach adopted to buy troubled assets over equity stakes is widely discredited, and the prospect of the government buying equity stakes at ~3x the prevalent market price is an affront to both socialists and capitalists. Indeed, it seems more like theft to me.
4) We're not being duped, so it won't work.
This crisis is about confidence. All measures currently adopted have been about shoring up confidence. After all, that is why they have to be so hastily put together and not scrutinized properly, as confidence is key (still trying to get my head round this one).
However, it does not appear to be working. The reason for this is largely point (2), but there is another, altogether more worrying element.
The US cannot really afford it.
Given US twin deficits and the already enormous debt and liability overhangs the US government is fighting with, US debt will most likely never be repaid without extremely inflationary policies on the part of the FED, which will bring with it new problems, most relevantly a crisis of confidence in the US dollar.
To put it simply, shoring up confidence in financial institutions is bringing to the fore a much more problematic issue: a potential crisis of confidence in the US Dollar, which remains the global reserve currency of choice.
Again, unfortunately, Switzerland is an example of a country which has chosen a similar route. Although Switzerland was in fact in a relatively healthy financial position, the UBS deal also mainly chose the path of buying up overvalued toxic assets to recapitalize the bank. The main difference is the size of the Swiss banking system relative to the size of the economy. Indeed, the balance sheets of UBS and Credit Suisse alone equate to several times the Swiss annual GDP. The UBS deal, which may prove to be insufficient to solve the problems of the bank, has taken up almost half of the balance sheet of the Swiss National Bank. It remains to be seen what the Swiss National Bank would do should the ~70bn CHF already provided prove to be insufficient, given that they already used up most of their conventional firepower.
This shoring up of confidence in theoretically private institutions at the expense of the confidence in currencies may prove to be a poor tradeoff by national monetary authorities.
I will not delve into a discussion of the exact modalities of the deal, as it has been done here. I will however elaborate on why I think that the deal is wrong, very wrong and misguided.
Here's why:
1) It is expensive.
A 27bn equity investment. And then guarantees on a further 306bn. The size of the TARP so far, for only one firm!
2) It may be insufficient to turn the market - or - don't throw good money after bad.
Citi has over $2 trillion in assets and a further several hundred billions of dollars in off-balance sheet liabilities. Earlier capital injections have not been enough, so what makes this one different? In fact, it seems rather ill advised to put a ceiling on the size of the bailout at all, especially if the real commitment is meager relative to the size of the problem.
3) It has excessive distributional consequences.
Joe Sixpack is now paying for the Armani shirts of Jack the banker. Simple as that. It's not that Joe Sixpack is aware of it, or would even want the shirts, he would however need the money. Amazingly, the US government no longer appears to find it necessary to disguise the direct subsidy nature of this program. After all, the approach adopted to buy troubled assets over equity stakes is widely discredited, and the prospect of the government buying equity stakes at ~3x the prevalent market price is an affront to both socialists and capitalists. Indeed, it seems more like theft to me.
4) We're not being duped, so it won't work.
This crisis is about confidence. All measures currently adopted have been about shoring up confidence. After all, that is why they have to be so hastily put together and not scrutinized properly, as confidence is key (still trying to get my head round this one).
However, it does not appear to be working. The reason for this is largely point (2), but there is another, altogether more worrying element.
The US cannot really afford it.
Given US twin deficits and the already enormous debt and liability overhangs the US government is fighting with, US debt will most likely never be repaid without extremely inflationary policies on the part of the FED, which will bring with it new problems, most relevantly a crisis of confidence in the US dollar.
To put it simply, shoring up confidence in financial institutions is bringing to the fore a much more problematic issue: a potential crisis of confidence in the US Dollar, which remains the global reserve currency of choice.
Again, unfortunately, Switzerland is an example of a country which has chosen a similar route. Although Switzerland was in fact in a relatively healthy financial position, the UBS deal also mainly chose the path of buying up overvalued toxic assets to recapitalize the bank. The main difference is the size of the Swiss banking system relative to the size of the economy. Indeed, the balance sheets of UBS and Credit Suisse alone equate to several times the Swiss annual GDP. The UBS deal, which may prove to be insufficient to solve the problems of the bank, has taken up almost half of the balance sheet of the Swiss National Bank. It remains to be seen what the Swiss National Bank would do should the ~70bn CHF already provided prove to be insufficient, given that they already used up most of their conventional firepower.
This shoring up of confidence in theoretically private institutions at the expense of the confidence in currencies may prove to be a poor tradeoff by national monetary authorities.
Friday, November 21, 2008
Bankruptcies are good!
US car companies are currently lining up for crisis cash. Whether they get it or not is largely up to the political process. Whether or not doling out cash to failed enterprises is a good thing for the economy is within the scope of this blog.
I will attempt to make it simple:
-The big three failing means massive layoffs and an immense cost to society.
-The big three not failing means keeping employees employed in structures which, despite having had ample warning and time to adapt, were unable to meet the challenges of the market. We should also not forget that bailing out these enormous cash burners would come at an immense ongoing cost to society. Note that GM is currently rumored to be burning about 2bn US$ every month.
So whatever way we choose to go, there will be an immense cost to society. Given that consumers have already voted down the product range, the question remains: Do we, as a society, want these companies? Do they produce positive externalities for society?
The answer, for me, is no. Car manufacturers exist to produce cars. If they fail, they can no longer produce cars. Equity and to a large extent debt holders get punished for investing in a bad company. End of story?
Not quite. Many proponents of bailouts or not letting companies fail argue with the employees. That companies should be maintained due to the fact that their highly specialized workforce would encounter difficulties in finding new jobs and therefore their jobs should be maintained, subsidized with public wealth.
Nothing could be more far from the truth. Indeed, society has already taken these peoples jobs away by not buying the cars. To keep people in jobs to NOT build cars would not only be a waste of money, but also a waste of talent. Auto engineers with time freed up from keeping their seats warm in Detroit could go out and start designing the kind of car / electro-mobile / apparatus that people actually want to buy and use, thus becoming efficient participants in the economy. I for one am certainly unwilling to believe that all US auto engineers were designing the products they actually wanted to.
Of course, many auto workers will not be able to find work in their industry of choice, and will have to adapt. This is also a good thing. After all, laid off auto workers could become teachers, laborers, financial institution liquidators or a multitude of other things that the economy of today requires.
In general terms, the same logic applies to financial institutions. Let's take the example of Citigroup.
Citigroup is about to fail. Maybe, probably. The stock market appears to be reacting to the announcement that they would be firing up to 75'000 employees, or a quarter of their workforce. I must admit this comes as little surprise to me, as I gather that they have been effectively bankrupt for quite some time now. After all-even CITI must be hard pressed to liquidate non-core assets to the tune of half a trillion in this market.
What strikes me is that although they have been obviously extremely distressed for quite some time now, they have been kept on a lifeline by 25bn of TARP funding via sales of preferred stock. Now that the Tarp is no longer buying up distressed assets (which could have relieved the CITI balance sheet to the tune of 79bn$, according to some analysts) the company is being forced to recognize its dire straits.
Well - good that the mess is now being cleaned up, pity about the 25bn investment which may now be largely worthless?
The US treasury can invest in financial institutions, allowing for more savvy investors to exit their positions at more attractive prices, but it appears that this time they cannot compensate for the immense value destruction which is the bursting of the credit bubble without putting themselves at risk. Furthermore, there are gaping moral hazard and socialization of losses issues. After all, the bailout money does not come from nowhere, it comes from the state. This is money which, rather than bailing out investors who made poor decisions, could go to repairing the pisspoor US infrastructure, or to education, or to medicare...
There are similar examples everywhere. As I am based in Switzerland, I will go into the example of UBS. With UBS stock going down the drain (now trading around CHF 11 down from over 80 just over a year ago) it appears that they may be challenged to shore up confidence, despite the Swiss taxpayer committing to buy up "assets" to the tune of around 60 billion CHF alongside an equity investment of about 6bn. Despite guarantees and subsidies by the Swiss taxpayer equating to almost 9000 CHF (~7500 US$) per PERSON IN SWITZERLAND the markets, and particularly UBS board members appear to have little confidence in the firm.
From my perspective as a taxpayer in Switzerland, I feel ripped off , and would prefer to have not had my currency backed with debt bought from US credit Ponzi schemes, thank you very much (and I hold UBS restricted stock in an amount which used to have quite significant value)!
But what about the systemic implications?
Admittedly, systemic issues are critical. The uncontrolled failure of Lehman Brothers wrought havoc in Financial Markets, with banks unwilling to lend to each other. This is due to the fact that other banks know what kind of assets their peers hold. Assets which were bought and priced at values which were based on assumptions of inflation which are now turning out to be false.
So the banks are bankrupt. Well not all, but a lot of them.
The solution adopted so far is to recapitalize the banks (for more detail see Wednesdays post). This would be an ok approach if we were merely experiencing a temporary glitch which can be compensated by short term liquidity provisions. This is not the case. The banks are not insolvent but bankrupt. It appears very unlikely that credit markets will recover to a point where most leveraged banks who participated in US credit musical chairs will be able to recover their investments.
Given these constraints, the questions beckons regarding financial institution recapitalizations is: Will it be enough? Where will we draw the line? From the point of view of somebody who has worked for many a financial institution, let me just note that honesty is not a virtue they are known for.
From a macroeconomic perspective, the issue is becoming is it already too late? Do countries, and especially the US, even have the cash necessary to undertake such immensely deficitary exercises just as their tax base is shrinking?
I will attempt to make it simple:
-The big three failing means massive layoffs and an immense cost to society.
-The big three not failing means keeping employees employed in structures which, despite having had ample warning and time to adapt, were unable to meet the challenges of the market. We should also not forget that bailing out these enormous cash burners would come at an immense ongoing cost to society. Note that GM is currently rumored to be burning about 2bn US$ every month.
So whatever way we choose to go, there will be an immense cost to society. Given that consumers have already voted down the product range, the question remains: Do we, as a society, want these companies? Do they produce positive externalities for society?
The answer, for me, is no. Car manufacturers exist to produce cars. If they fail, they can no longer produce cars. Equity and to a large extent debt holders get punished for investing in a bad company. End of story?
Not quite. Many proponents of bailouts or not letting companies fail argue with the employees. That companies should be maintained due to the fact that their highly specialized workforce would encounter difficulties in finding new jobs and therefore their jobs should be maintained, subsidized with public wealth.
Nothing could be more far from the truth. Indeed, society has already taken these peoples jobs away by not buying the cars. To keep people in jobs to NOT build cars would not only be a waste of money, but also a waste of talent. Auto engineers with time freed up from keeping their seats warm in Detroit could go out and start designing the kind of car / electro-mobile / apparatus that people actually want to buy and use, thus becoming efficient participants in the economy. I for one am certainly unwilling to believe that all US auto engineers were designing the products they actually wanted to.
Of course, many auto workers will not be able to find work in their industry of choice, and will have to adapt. This is also a good thing. After all, laid off auto workers could become teachers, laborers, financial institution liquidators or a multitude of other things that the economy of today requires.
In general terms, the same logic applies to financial institutions. Let's take the example of Citigroup.
Citigroup is about to fail. Maybe, probably. The stock market appears to be reacting to the announcement that they would be firing up to 75'000 employees, or a quarter of their workforce. I must admit this comes as little surprise to me, as I gather that they have been effectively bankrupt for quite some time now. After all-even CITI must be hard pressed to liquidate non-core assets to the tune of half a trillion in this market.
What strikes me is that although they have been obviously extremely distressed for quite some time now, they have been kept on a lifeline by 25bn of TARP funding via sales of preferred stock. Now that the Tarp is no longer buying up distressed assets (which could have relieved the CITI balance sheet to the tune of 79bn$, according to some analysts) the company is being forced to recognize its dire straits.
Well - good that the mess is now being cleaned up, pity about the 25bn investment which may now be largely worthless?
The US treasury can invest in financial institutions, allowing for more savvy investors to exit their positions at more attractive prices, but it appears that this time they cannot compensate for the immense value destruction which is the bursting of the credit bubble without putting themselves at risk. Furthermore, there are gaping moral hazard and socialization of losses issues. After all, the bailout money does not come from nowhere, it comes from the state. This is money which, rather than bailing out investors who made poor decisions, could go to repairing the pisspoor US infrastructure, or to education, or to medicare...
There are similar examples everywhere. As I am based in Switzerland, I will go into the example of UBS. With UBS stock going down the drain (now trading around CHF 11 down from over 80 just over a year ago) it appears that they may be challenged to shore up confidence, despite the Swiss taxpayer committing to buy up "assets" to the tune of around 60 billion CHF alongside an equity investment of about 6bn. Despite guarantees and subsidies by the Swiss taxpayer equating to almost 9000 CHF (~7500 US$) per PERSON IN SWITZERLAND the markets, and particularly UBS board members appear to have little confidence in the firm.
From my perspective as a taxpayer in Switzerland, I feel ripped off , and would prefer to have not had my currency backed with debt bought from US credit Ponzi schemes, thank you very much (and I hold UBS restricted stock in an amount which used to have quite significant value)!
But what about the systemic implications?
Admittedly, systemic issues are critical. The uncontrolled failure of Lehman Brothers wrought havoc in Financial Markets, with banks unwilling to lend to each other. This is due to the fact that other banks know what kind of assets their peers hold. Assets which were bought and priced at values which were based on assumptions of inflation which are now turning out to be false.
So the banks are bankrupt. Well not all, but a lot of them.
The solution adopted so far is to recapitalize the banks (for more detail see Wednesdays post). This would be an ok approach if we were merely experiencing a temporary glitch which can be compensated by short term liquidity provisions. This is not the case. The banks are not insolvent but bankrupt. It appears very unlikely that credit markets will recover to a point where most leveraged banks who participated in US credit musical chairs will be able to recover their investments.
Given these constraints, the questions beckons regarding financial institution recapitalizations is: Will it be enough? Where will we draw the line? From the point of view of somebody who has worked for many a financial institution, let me just note that honesty is not a virtue they are known for.
From a macroeconomic perspective, the issue is becoming is it already too late? Do countries, and especially the US, even have the cash necessary to undertake such immensely deficitary exercises just as their tax base is shrinking?
Wednesday, November 19, 2008
Some thoughts on the financial crisis
This being the first post in my new blog, I would like to outline what in my mind is the fundamental issue with efforts currently being undertaken as a response to the current financial crisis, and conclude with an outline of what a more attractive solution might entail.
Financial Crisis
The financial crisis has been going on for quite some time now, despite repeated claims to the contrary by the Paulson - Bernanke fire brigade, and several other bureaucrats in the initial stages of the crisis.
Given that the US administration is soon to to change, it is interesting to note the differing agenda of the current administration, who remain focused on "shoring up confidence" while implementing incoherent and hastily stitched together programs to stop the crisis from worsening, from that of the incoming administration, who appear to be talking up the crisis. Paul Volker's speech at Lombard Street research certainly does little to foster confidence: "What this crisis reveals is a broken financial system like no other in my lifetime". It should be noted that Paul Volcker was alive and kicking during the Great Depression. Whether this is a warning by Volcker to go out and buy canned food or whether this is merely an attempt to pre-empt partisan attacks when the Obama administration proves incapable of solving the mess left by the current incumbents is unclear to me at this time.
However, I do generally appreciate a bit of straight talking regarding this crisis as I tend to get rather worried when I see Central Bank Board members, Professors with substantial reputations, turn in to cheerleaders for the financial system, as experienced at this event. The point being of course that the crisis must be really bad if a member of the Governing Board of the SNB is unwilling to tell you that it is, in fact, really bad.
It appears clear to me as it has for some time now that the current financial crisis is indeed going to be the major historical economic crisis of our time. Deflation appears to be increasing, causing enormous wealth destruction across the globe. The extremely expensive programs to buy up toxic assets and recapitalize the degenerate financial system appear to be largely futile, as banks remain unwilling to provide capital to the real economy. Therefore, it appears inevitable that the situation will get worse before it gets better.
What to do about it?
Problem: The highly overleveraged financial system has produced paper liabilities (to itself) that are so enormous that they can no longer be borne by the financial system.
So far, two main paths have been chosen to solve this problem:
Solution 1: Liabilities will be transferred to the public (Switzerland mostly, initial TARP) so the financial institutions can continue as if the crisis never happened, in the knowledge that the state will always bail them out.
Solution 2: The public invests in financial institutions via equity participation, thus recapitalizing banks and subjecting banks to increased oversight and control by the state. Once the banking system works again, state equity participation will be sold.
To me, solution 1 is certainly the most irresponsible, short term solution imaginable, and signals excessive coziness between Central Banks and the Private Financial system. Indeed, without severe penalties to the financial institutions who seek public capital to operate, the moral hazard involved in this operation is extreme. Solution 2 is far more attractive, as it goes some way to align interests and also control between the investor (the public, i.e. you) and the entity invested in. Banks do not want to be controlled by the state so they will endeavor to become self-sufficient once again as soon as it is feasible, and then try and make sure that they remain independent from state interference.
However, the main problem with both of these approaches is that they do not address the main problem, namely, unsustainable levels of risk taking in the financial system. Both approaches have the aim of financial institution recapitalization, and do so by injecting public capital into supposedly private enterprises, with the implicit goal of reflating the credit bubble so that we can all continue as we have so far. It is widely accepted that levels of leverage prevalent in the system were excessive prior to the crisis. For this reason, attempts to maintain previous levels of credit such as directives to financial institutions in the UK and US to maintain or even expand levels of mortgage lending will not only be extremely expensive, but largely futile. Indeed, such measures will merely postpone the inevitable.
The long term solution will have to focus on maintaining the economy in a state of relative balance by eliminating the excesses which led to the current crisis. It will have to address issues such as the role of state in the markets, moral hazard, government sponsored entities or the problem of being "too large to fail" and most fundamentally, public vs. private risk raking.
I realize that this is quite an undertaking, However, if you decide to follow this blog then maybe I may find the time to attempt an outline of a real, sustainable solution to the problem, one that will hopefully minimize the exposure of the public to financial system excesses.
Financial Crisis
The financial crisis has been going on for quite some time now, despite repeated claims to the contrary by the Paulson - Bernanke fire brigade, and several other bureaucrats in the initial stages of the crisis.
Given that the US administration is soon to to change, it is interesting to note the differing agenda of the current administration, who remain focused on "shoring up confidence" while implementing incoherent and hastily stitched together programs to stop the crisis from worsening, from that of the incoming administration, who appear to be talking up the crisis. Paul Volker's speech at Lombard Street research certainly does little to foster confidence: "What this crisis reveals is a broken financial system like no other in my lifetime". It should be noted that Paul Volcker was alive and kicking during the Great Depression. Whether this is a warning by Volcker to go out and buy canned food or whether this is merely an attempt to pre-empt partisan attacks when the Obama administration proves incapable of solving the mess left by the current incumbents is unclear to me at this time.
However, I do generally appreciate a bit of straight talking regarding this crisis as I tend to get rather worried when I see Central Bank Board members, Professors with substantial reputations, turn in to cheerleaders for the financial system, as experienced at this event. The point being of course that the crisis must be really bad if a member of the Governing Board of the SNB is unwilling to tell you that it is, in fact, really bad.
It appears clear to me as it has for some time now that the current financial crisis is indeed going to be the major historical economic crisis of our time. Deflation appears to be increasing, causing enormous wealth destruction across the globe. The extremely expensive programs to buy up toxic assets and recapitalize the degenerate financial system appear to be largely futile, as banks remain unwilling to provide capital to the real economy. Therefore, it appears inevitable that the situation will get worse before it gets better.
What to do about it?
Problem: The highly overleveraged financial system has produced paper liabilities (to itself) that are so enormous that they can no longer be borne by the financial system.
So far, two main paths have been chosen to solve this problem:
Solution 1: Liabilities will be transferred to the public (Switzerland mostly, initial TARP) so the financial institutions can continue as if the crisis never happened, in the knowledge that the state will always bail them out.
Solution 2: The public invests in financial institutions via equity participation, thus recapitalizing banks and subjecting banks to increased oversight and control by the state. Once the banking system works again, state equity participation will be sold.
To me, solution 1 is certainly the most irresponsible, short term solution imaginable, and signals excessive coziness between Central Banks and the Private Financial system. Indeed, without severe penalties to the financial institutions who seek public capital to operate, the moral hazard involved in this operation is extreme. Solution 2 is far more attractive, as it goes some way to align interests and also control between the investor (the public, i.e. you) and the entity invested in. Banks do not want to be controlled by the state so they will endeavor to become self-sufficient once again as soon as it is feasible, and then try and make sure that they remain independent from state interference.
However, the main problem with both of these approaches is that they do not address the main problem, namely, unsustainable levels of risk taking in the financial system. Both approaches have the aim of financial institution recapitalization, and do so by injecting public capital into supposedly private enterprises, with the implicit goal of reflating the credit bubble so that we can all continue as we have so far. It is widely accepted that levels of leverage prevalent in the system were excessive prior to the crisis. For this reason, attempts to maintain previous levels of credit such as directives to financial institutions in the UK and US to maintain or even expand levels of mortgage lending will not only be extremely expensive, but largely futile. Indeed, such measures will merely postpone the inevitable.
The long term solution will have to focus on maintaining the economy in a state of relative balance by eliminating the excesses which led to the current crisis. It will have to address issues such as the role of state in the markets, moral hazard, government sponsored entities or the problem of being "too large to fail" and most fundamentally, public vs. private risk raking.
I realize that this is quite an undertaking, However, if you decide to follow this blog then maybe I may find the time to attempt an outline of a real, sustainable solution to the problem, one that will hopefully minimize the exposure of the public to financial system excesses.
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