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.
Monday, February 9, 2009
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?
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