How Long Will Europe Continue to Lie to Itself?

“Bank Seeks To Avoid Taking Loss On Bonds.”

So reads the headline for the New York Times article on the dilemma of the European Central Bank. (http://www.nytimes.com/2012/01/25/business/global/eu-officials-continue-to-press-for-a-quick-deal-on-greek-debt.html?_r=1&ref=business)

“European leaders have begun discussions with the European Central Bank on several options that might keep it from having to take a loss on its 55 billion-euro portfolio of Greek bonds.”

“The deal could address what has long been one of the more vexing questions in reaching a broad agreement on reducing Greece’s mountain of debt: how to get the central bank, the largest holder of Greek bonds, to participate in a debt restructuring without having to take a large loss that would have to be covered by European taxpayers, German ones in particular.

Private sector investors, including large European banks and hedge funds, have complained bitterly—and in some cases threatened legal action—over the central bank’s insistence that its 55 billion euros in Greek bonds were exempt from the loss that the private sector is facing, which some have estimated at 60 cents on the euro.”

The European Central Bank cries, “You can’t hold me responsible for my actions!”

There are articles all over the place on this issue. 

For example, on the front page of the Financial Times: “IMF urges ECB to take a hit on 40 billion-euros in Greek bond holdings.” (http://www.ft.com/intl/cms/s/0/74d2b31a-46b2-11e1-bc5f-00144feabdc0.html#axzz1kTbnc8Yy)

Greek debt will be written down…finally.

But, will people still be avoiding reality in some affected areas?

And, remember, this is all voluntary to avoid kicking off the credit default swaps outstanding…what a crock!

Still on the list of lies…Portugal…Spain…Italy…

Lies have a long life and can come back to haunt you in many…often, unfortunate…ways.  Just ask people up at Penn State these days. 

The resolution of a situation in which people cover up and try to avoid the truth never ends well.  The leaders (and I use this term lightly) of Europe that are perpetuating this comedy continue to draw it out as long as possible. 

The problem is that the European dilemma will continue to exist until it is dealt with.  For more on this see my blogpost “Credit Downgrades and Europe” posted on January 16, 2012 on my blogspot site (http://maseportfolio.blogspot.com/).  

How Do You Cover Up Your Failure: the Greek Case

I believe that Gretchen Morgenson of the New York Times has done investors a big favor in writing her piece for the Sunday morning paper of November 20.  This article reveals the extent that officials will go to try and avoid the consequences of when they royally “screw up”! (http://www.nytimes.com/2011/11/20/business/credit-default-swaps-as-a-scare-tactic-in-greece.html?_r=1&ref=business)

The situation: “the debt mess in Europe.”

The event: “bankers are pressing Greece’s bond holders to swallow big losses.”

The intended consequence: “Leading the charge is BNP Paribas, the big French bank, which has been hired by the Greed government to help persuade investors to accept a deal that would cut the value of their investments in half.”

The cover-up: “On paper, this restructuring would be voluntary!”

The reason for this behavior: the Credit Default Swaps that are supposed to cover the losses on a write down like this.  “If Greece stops paying after the restructuring (the swaps that investors bought as insurance on the Greek debt) are supposed to cover their losses, much the way homeowners’ insurance would cover a fire.” 

The effort: if the restructuring is declared voluntary then the “credit insurance may not pay off down the road, because after the restructuring is completed, the terms of the old debt might be changed.”

Who stands to gain: “BNP which stands to profit from the restructuring.”  BNP will “generate fees from the exchange” or is concerned about “its own exposure to Greece.  A question being discussed is whether or not “BNP Paribas has written a lot of insurance on Greek debt.  If so, getting people to unwind such swaps now would be less costly for BNP than having the insurance pay off.”

Most suspicious, an official of BNP Paribas, Belle Yang, is also on the “powerful” International Swaps and Derivatives Association (I.S.D.A.) “determinations committee” that will decide what constitutes a “credit event” both in Greece and elsewhere in Europe. 

When you don’t do your job, things happen.  And, when things happen and you deny that things are happening, things get worse.  And, when things get worse you sometimes do very stupid things in order to keep avoiding what you really have to do.

Just ask Penn State University officials about this!

Politicians in Europe created too much debt in trying to remain in office by paying off their constituents in order to get re-elected.  When financial markets started to complain about the excesses of debt created, European officials claimed that the problems were caused by speculators and other “greedy bastards” that were trying to disrupt things for their own gain.  When things got worse, officials claimed that there was a liquidity crisis at hand, not a solvency crisis.  And, because it was a liquidity crisis, bailouts could resolve the issue by giving governments enough time to get their budgets in order. 

This did not work and when these officials finally came to accept the fact that they might have to deal with the insolvency of their countries, they began working on a “new gimmick” that a default really was not a default…if it were voluntary.

And, if the default was just voluntary then contracts written to insure against a default could not really be collected upon!

That is, the legal contracts that were written to insure parties against default are really worthless!

“If investors think debt terms can be changed by fiat, they will flee the market.  Ditto, if they find that their insurance can be made worthless.” 

“The discussions with BNP Paribas confirm the view of some investors that credit default swaps are not insurance at all, but rather instruments that big banks use to benefit themselves.”

Hello, Occupy Wall Street!!!  

My prediction: “the debt mess in Europe” is not going to be cleared up until people stop lying to themselves and really start to address the issues that are outstanding.  The problem with this, as I have written about many times before, is that I see no leaders in Europe that are willing to stand up and really discuss the issues that are outstanding. (See my post: “In Europe the Issue is Leadership,” http://seekingalpha.com/article/280658-in-europe-the-issue-is-leadership.)  

The sovereign debt problems that Europe faces are problems of solvency.  How many times does someone have to say this!  Until the officials of Europe address this problem “head on” and really try to “get their hands around it” they will continue to come up with “screwball” ideas like the one that Morgenson writes about in the Sunday NYTimes.

Resolving solvency problems are not easy and I’m sure this is why many European officials “put off” going for a real solution.  Solving solvency problems are going to cause a lot of hurt and pain…and will take a lot of time to correct. 

Unfortunately, there was a lot of hubris connected with the conceit of many European governments, a conceit that these governments could engineer high rates of employment and a social infrastructure that took care of all ills within a world in which there would be no international repercussions for such excessive and undisciplined behavior.

Unfortunately, there are no “good” solutions to living beyond ones means for an extended period of time.  If you “screw up” you finally end up paying for it.  And, solving the problem can hurt many, many people.     

News From Italy: A Bargain is Struck?

The news out of Rome:

“Silvio Berlusconi has salvaged a compromise agreement on economic reforms with his coalition partners that commentators said lacks specifics and risks falling short of what eurozone leaders have demanded ahead of Wednesday’s summit in Brussels.” (http://www.ft.com/intl/cms/s/0/5945e250-ffba-11e0-89ce-00144feabdc0.html#axzz1bjQzVRpl)

The crucial point…the plan “lacks specifics and risks falling short”…

Prime minister Berlusconi and the head of his coalition partner, the Northern League, Umberto Bossi, negotiated the new compromise package to submit to other eurozone leaders.  Other than reaching some kind of agreement, the alternative is for Mr. Berlusconi to resign.

The prospects do not seem to be encouraging:

“Newspaper editorials on Wednesday said Mr. Berlusconi and Mr. Bossi may have staved off a collapse of their coalition for the time being, but at the risk of undermining a critical summit and failing to deliver the reforms Italy needs to lift an economy on the edge of a renewed recession.”

Mr. Bossi is not a fan of the European arrangement…a euro-skeptic.  Hence, his tradeoffs are substantially different from those of Berlusconi.  And, Mr. Berlusconi does not have much personal credibility…and little or no moral stature…to trade on.

In fact, Beppe Severginini in a Financial Post op-ed piece goes even further:

“How can the world’s eighth largest economy go on with a delusional prime minister, a weak government, an impotent opposition and its finances in disarray?” (http://www.ft.com/intl/cms/s/0/c78b1142-fe6e-11e0-bac4-00144feabdc0.html#axzz1bjQzVRpl)

How did someone like Berlusconi become prime minister in the first place?  Well, as one person commentated on my earlier post this week, Mr. Berlusconi became prime minister of Italy because everyone else running for the position was worse than he was.  Encouraging…

So where does that leave Europe?

Mr. Sarkozy and Ms. Merkel appeared to be applying the pressure to Mr. Berlusconi over the weekend.  This precipitated the efforts of the past two days. 

If the reports of the reform plan concocted by Berlusconi and his coalition are true and the plan really does fall short of what is necessary, the question becomes, will Sarkozy and Merkel “stick to their guns” and hold Italy’s “feet to the fire”?  Or, will the French and German officials back off and attempt to get by with something less than they stated was necessary. 

The crucial thing here, to me, is that the pressure on Italy was applied because several eurozone officials believed that the problems they faced were deep enough that an attempt needed to be made to “encircle” the major problems and not just work on individual nations on a case-by-case basis. (See my post “Italy is the Key to Solving the Euro Debt Crisis”, http://seekingalpha.com/article/301607-italy-is-the-key-to-solving-the-euro-debt-crisis.)  Whereas in the past, the European Union began with the smallest, weakest link in the chain and then moved up to the next, larger, crisis, the current move was to include the third largest economy in the EU along with the weakest, Greece, and this, then, would include all that was in-between, like Spain and Portugal. 

Now, this may not be achieved.  We wait to see how Mr. Sarkozy and Ms. Merkel respond to the new Italian proposal.

But, this is not all.  The banking situation in Europe still lingers. (http://seekingalpha.com/article/301369-europeans-facing-more-of-a-haircut-than-preciously-thought) European banks are balking over the proposed debt “haircuts” and the new proposed capital requirements. 

It would seem that if Sarkozy and Merkel “back off” any on the Italy effort, given the pressure put on Italy over the weekend, that the banks will smell the weakness and put up even more resistance to the effort to write down the debt issues under consideration as far as needed. 

This, of course, puts the eurozone in a more tenuous position because lack of cooperation by the banks on the write-downs has implications that relate to a “triggering event” which might set off “bankruptcy” questions leading to payoffs on Credit Default Swaps.  The possibility of this occurring raises the specter of contagion in the financial sector, ala’ the Lehman Brothers affair, something eurozone officials sincerely want to avoid.

It seems as if European officials are running out of choices.  Yet, as we have seen in the past, European officials are masters of the art of squirming out of difficult spots and postponing solutions for another time. 

The betting still seems to be on the conclusion that no real leaders will arise in Europe to resolve the problems that Europe faces.  We can only hope for a better outcome

Sovereign Recovery Swaps? What Are They?

 Sovereign recovery swaps are “bets on how much money will be retrieved in a default.”  The first trades took place last year.  (See “Default risks spark interest in recovery swaps trading,” http://www.ft.com/cms/s/0/0ab272c8-702e-11e0-bea7-00144feabdc0.html#axzz1KivknddC.)

Why did sovereign recovery swaps arise?

They arose as “European policymakers have moved to curb trading of credit default swaps, the established way to hedge against the risk of a debt restructuring.” 

These new tools are gaining more publicity as the eurozone moves back into a crisis mode concerning the sovereign debt of their troubled constituents.  This is especially coming to the fore as Greece struggles over its failure to achieve fiscal targets set to combat earlier financial market unease. 

Greek debt reached euro-era high interest rates yesterday…as did the interest cost of Ireland and Portugal debt. 

Calls are increasing for a restructure of the debt of Greece.

So, financial market participants want a way to protect themselves against unfavorable movements in debt prices…given the wisdom of “policymakers” to curb trading in other instruments that might do the same thing.

With recovery swaps, an investor can bet on the level of “haircut” that might take place on any restructuring. 

A credit default swap might have a fixed recovery rate in the case of a restructuring.  If the recovery rate is lower than this fixed rate, the investor makes up the shortfall through the purchase of the recovery swap. 

Of course, there are risks associated with these tools: the “credit event” that triggers the contract must be due to a failure of the nation to meet obligations…it must be an “official” default.

The point I want to emphasize, however, is how quickly financial markets respond to fill a need when restrictions or potential restrictions are devised to restrict or constrain other means of achieving the same objective. 

Policymakers just don’t get it! 

In their efforts to fight “past wars”, policymakers invent new rules or regulations to combat behavior the policymakers deem to be inappropriate or unacceptable.  In doing so, these policymakers just chase the participants in financial markets to move elsewhere or to create new financial innovations.

Two points here:

First, in this electronic age, there is little that regulators can do to establish the “control” that they want because it is so easy for one form of “information” to be transformed into another form;

And, second, once financial innovation is in place, there is no going back to an earlier time.

Policymakers just don’t seem to understand these two points.

Furthermore, another fear that the policymakers have is that these financial innovations can be used for “speculation”. 

For example, when the government of Greece announced its latest budget results, the cost of borrowing immediately went up and the price of credit default swaps and sovereign recovery swaps rose.  Some government officials claimed that unconscionable speculators betting against the government caused these movements. 

This, of course, is the basic visceral response of leaders faced by market movements unfavorable to the direction they are leading their organization.  I don’t know how many chairman I have known or worked for that have claimed that ‘the market just doesn’t understand us” and “speculators are hitting us just when we are down.”

I was less worried the other day when Standard & Poor’s said that the outlook for the debt of the United States was negative than I was about the response of President Obama saying that the bond markets were being impacted by speculators.  Oh, my!

Policymakers must eventually deal with the problems they have created.  Many governments in Europe have been dealing with the problems they have created for many months now, yet have not faced their real issues head-on. 

Policymakers must eventually realize that they cannot resolve these problems by changing the rules and regulations or by trying to buy time with “quick-fix” bandages.  The eurozone has been attempting to “get around” the solution to the problems of its members with short-term “fixes” and have not dealt with the fundamentals of the situation.

Policymakers must eventually understand that in the modern world information spreads and that governments cannot respond to crisis by pointing the finger in another direction, blaming “speculators” or “terrorists” or some other agent that is questioning their leadership.  The governments of the eurozone must ultimately take responsibility for their actions and do something about it.

Keep your eye on markets and market innovations.  Don’t impose your own view on these market changes but dig as deeply as you need to in order to determine what the market is trying to tell you.  The markets may not always be right, but they do contain information we need to consider in making our own decisions.

The news today…there is going to have to be a debt restructuring within the eurozone.  Financial “band-aids”, government bailouts, and new rules and restrictions are not going to do the job.  Will it be Greece…or will it include Ireland?  Will it extend to Portugal…and then to Spain?  And, maybe others will be impacted as well?

The betting is getting hotter!

Will the Financial Industry Dance Alone?

Last Wednesday, February 23, I argued that “The Music’s Begun Again..” (http://seekingalpha.com/article/254474-the-music-s-begun-again-time-to-start-dancing), and I fully believe that to be the case.

The economy has been growing. Since its low point in the second quarter of 2009, real Gross Domestic Product (GDP) has risen by 4.4%. The compound rate of growth has been approximately 0.7% per quarter which works out to an annual rate of roughly 2.9% per year. So the economic recovery continues.

However, capacity utilization of the manufacturing industries remains low, at 76.1% in its latest reading, substantially below the previous peak of around 82%. Even this peak was the lowest peak since the 1960s when the series was originally constructed.

My calculation for under-employment still hovers above 20%, again a high for the period following the 1960s

And, this, of course, raises the fear of a period of economic “stagflation” for the United States. Although the economy is recovery, one certainly could not apply the term “robust” to describe it.

From the credit side…more and more evidence comes in every day that the credit inflation that began in the 1960s continues. Although the world is going through a massive re-structuring, our leaders in the government continue to cry…more of the same…more of the same.

As with the last fifty years, credit inflation begins with the Federal government. The national debt is set to more than double over the next ten years and none of our leaders seem to be really seriously concerned about it.

For the debt to double over the next ten years, government debt would need to increase at a compound rate of about 7.2% per year during this time period. This is not too different from the compound rate at which the gross federal debt increased annually over the fifty years which began in January 1961.

During this period of time, the United States saw the biggest buildup in private financial leverage in the history of the country and also saw the biggest spurt of financial innovation ever to take place in the world.

Aided by advancements in information technology, the world of finance seemed to take on a life
of its own, separate from what was going on in the real economy. Employment in finance rose to approach 50% of all employment in the country as the number of financial institutions and the number of financial instruments traded ballooned.

We were getting a glimpse of the future.

Thanks to our leaders in Washington, D. C., and elsewhere, the “music” is playing again and, as we read daily, people have begun to dance once again in earnest. We read that auto sales are up because the auto companies have gotten auto finance to step up to the dance floor.

But, sovereigns are also leading the charge. Check out a lead in the Financial Times, “Sovereigns Turn to Pre-crisis Financial Wizardry” (http://www.ft.com/cms/s/0/53b445a0-4045-11e0-9140-00144feabdc0.html#axzz1FMM69iWr). It seems as if Portugal, and others, are getting back to “structured finance technology” with the use of Credit Default Swaps (CDSs) and Collateralized Debt Obligations (CDOs) to help themselves climb their way out of the current crisis in the sovereign debt market.

What else?

Did I hear someone say that issues of mortgage-backed commercial real estate securities are back? They are, and in a fairly big way. (See http://dealbook.nytimes.com/2011/02/28/commercial-real-estate-breathes-life-into-a-moribund-market/?ref=business.) Morgan Stanley and Bank of America have recently completed a $1.55 billion deal while others have sold roughly $5 billion in mortgage-backed securities so far this year. And, more is on the way.

The quote I like…from Brian Lancaster, as securitization specialist at the Royal Bank of Scotland…”Things have going from vicious to virtuous.”

It seems that car loans and collateralized loan obligations “are showing signs of life.”

And, the trading platforms built on the latest technology are beginning to fight for “territory.” GFI, a London interdealer broker, launched a swaps trading platform in advance of what is being done in the United States. (See http://www.ft.com/cms/s/0/e107d684-4369-11e0-8f0d-00144feabdc0.html#axzz1FMM69iWr.) Whereas firms in the United States are having to wait on the Commodities Futures Trading Commission for the new rules and regulations forthcoming from the Dodd-Frank legislations, others are getting a head start on them.

Technology booms ahead…while the regulators scramble to catch up to 2008. The Financial Crisis Inquiry commission just released information that the Office of the Comptroller of the Currency questioned several aspects of how Citigroup valued certain troubled securities way back in February 2008: seems as if “weaknesses were noted.” The question concerns whether or not Citigroup should have reported this information in its public documents. (See http://www.ft.com/cms/s/0/3b673370-4399-11e0-b117-00144feabdc0.html#axzz1FMM69iWr.)

My point is that we are still re-hashing what went on or what went wrong two or more years ago. The world has moved on since then. Information technology has moved on since then.

Note the headline in the New York Times: “For South Korea, Internet at Blazing Speeds is Still Not Fast Enough.” (http://www.nytimes.com/2011/02/22/technology/22iht-broadband22.html?scp=1&sq=for%20south%20korea,%20internet%20at%20blazing%20speeds%20is%20still%20not%20fast%20enough&st=cse) South Korea is seeking to have every home in the country connected with speeds of one gigabit per second. And, this is for homes.

One should also read about the changes that are coming to banking for individuals and families in places like India and Africa! This, while American banking is constrained by archaic restrictions that is causing it to lag behind much of the rest of the world in terms of customer delivery.

And, if all this is happening for the consumer, what is taking place in the biggest, most sophisticated financial institutions? Anyone for some science fiction? And, we are just worried about “flash trading”?

Regulation always lags behind the private sector. In the credit inflation of the last fifty years, the gap widened considerably. But, in re-fighting the last war will Congress and the regulators drive more business “off shore”?

The music has begun to play again. Credit inflation is underway. Further financial innovation is right on its heals. The economic recovery is underway…but, I fear, finance is going to go its own way again.

Regulation on the Move: the Swaps Market

Glimpses of the regulatory process are starting to hit the news. Gary Gensler, Chairman of the Commodity Futures Trading Commission offered some insight into the process as he spoke of the evolving discussions surrounding the swaps market.

It is estimated that the swap market has over $600 trillion in contracts outstanding. (The Gross Domestic Product of the United States, in current dollars, is a little less than $15 trillion.) There are now 16 regulated futures exchanges that could handle swap transactions. Gensler expects that there may be 20 to 30 more organizations that will register as Swap-execution facilities (SEFs), organizations that would match buyers and sellers and provide more transparent pricing and information to the world.

One of the known unknowns about the swaps market is the volume of trades that will take place. Currently, swaps are created privately and are traded privately. The trading volume is not very substantial given the dollar-volume of the swaps market.

The chief executive of the International Swaps and Derivatives Association (ISDA) states that fewer than 2,000 standardized swaps, on average, are traded daily. The most active, the 10-year dollar swaps, only trade about 200 times a day.

One might expect that as this market develops and more transparency and openness come to the market that volumes will increase. This is the experience of other derivative markets as they have moved to more formal and standardized formats.

Gensler guesses that maybe up to 200 organizations may want to become “swap dealers.” These organizations would have to “register” under the new setup and meet regulatory qualifications for being classified as such.

Of interest is the fact that of these 200 or so organizations that might move in this direction about 75 banks could be considered to be swap dealers. This total, Gensler stated, consists of 25 global banks, 25 non-US banks that do some trading in the United States, and a further 25 US banks that are not global in scope.

“The rules could require these 75 banks to set up separate entities, with their own capital, that would be registered to trade derivatives including commodity, equity, and some credit default swaps.” (See http://www.ft.com/cms/s/0/44491a9a-c1e3-11df-9d90-00144feab49a.html.)

The new rules and regulations are supposed to be in place by July 2011. Gensler told CNBC that he has enough staff to develop the rules. The problem is that he will need at least 400 more employees to enforce them. (See http://professional.wsj.com/article/SB10001424052748704394704575495723231513104.html?mod=ITP_moneyandinvesting_2&mg=reno-wsj.)

It is very, very difficult to write new rules and regulations for financial markets that were previously just “over-the-counter” markets. Even going back historically to the “standardization” of relatively simple instruments, like interest rate futures and so forth, shows how difficult it is to capture all the nuances and quirks that relate to a specific type.

The new standardized, formal markets will be forthcoming. They will be heavily used and trading volume will increase substantially as information becomes more public.

Perhaps the ultimate, bottom line conclusion to the developments described above is that the swap market will grow and prosper, including the sector relating to credit default swaps. The hysteria connected with the financial crisis has subsided and financial innovation continues on. The populist outcry against the greedy bastards that developed the derivatives industry is fading into the shadows.

So, financial innovation is alive and well. It is impossible to know what form it will take next.

Ho-hum, the Financial Reform Bill is Going to be Passed

Perhaps the most benign statement about the passage of the United States financial reform bill passed by the House of Representatives last week and whose passage is pending in the Senate comes from Richard Bove, banking analyst at Rochdale Securities: The bill, he states, “doesn’t seem to be terribly onerous.” (See “JPMorgan Brushes Aside Bill Concerns,” http://www.ft.com/cms/s/0/24bcbc8c-8858-11df-aade-00144feabdc0.html.)

In terms of the regulation of swaps, especially credit default swaps, “The once-feared swap provision has become toothless.”

The recent debate in Congress over the financial reform bill: A lot of “sound and fury signifying nothing.”

This legislation, the most comprehensive reform of the financial system since the 1930s, seems be passing into the history books with very little fanfare.

Sure, the financial institutions “huffed and puffed” and spent tons of money to fight Congress “every inch of the way.” But, what else did you expect. Perhaps you need to read a good economics book on “Game Theory”.

And, now?

Can’t you hear the executives at the big banks say, under their breath, “Well, the bill is passed, now we need to get back to business. Sure we spent a lot of money that could have gone elsewhere, but that is now history. In terms of where we are going to focus in the future, we just continue doing what we have been doing, finding the best way to do business and to make money. The bill, itself, will cause some inconvenience in some areas, hurt the smaller institutions more than the larger ones, but will not basically change what we are going to be doing.”

The article cited above states it all. JPMorgan acquired a large energy and metals trader last week. How will the financial reform bill impact this deal? After all, “Commodities are among a handful of derivatives still targeted…” by the bill.

The author of the article writes: “Blythe Masters, head of commodities at JPMorgan, said the bank already traded most energy through an affiliate and the law would ‘not substantially’ affect business.”

I have been arguing for months that the large banks had already moved beyond the reach of the regulations being discussed in Congress and that anything enacted by the legislators would be DOA, “dead on arrival.” The large banks started to reform and restructure themselves soon after the fall of 2008 when the financial crisis was at its peak! By the spring of 2009 these banks were well on the way to the future.

Congress, on the other hand, was mired in the past.

JPMorgan, to my mind, is one of the organizations leading us into the future. See, for example, my blog post “Follow the Dimon,” (http://seekingalpha.com/article/212236-follow-the-dimon). But, there are many others that are also out there pushing finance into the future.

Similar discussion are taking place in all areas of the finance field. Just this morning, the Wall Street Journal contained the article “What’s a ‘Prop’ Trader Now?” relating to the proprietary trading that many of the largest financial institutions engage in. (See, http://online.wsj.com/article/SB10001424052748703620604575349161970563670.html?mod=ITP_moneyandinvesting_0&mg=com-wsj.) The article addresses issues like, “What are ‘Prop’ traders?” and “How are banks redefining ‘Prop’ traders?” and “Where are ‘Prop’ traders located within the organization?”

The answers to these questions will help the larger financial institutions “churn out” billions of dollars in profits. Thus, the banks are willing to spend millions of dollars in hiring “the best and the brightest” lawyers and financial experts to come up with the answers. Congress is just not capable of matching the resources available to these publically-traded firms and so will lag behind what is going on in the private sector. To me, the information “gap” between the public sector and the private sector has never been larger.

The problem is that Congress is attempting to achieve “outcomes”. They want to keep banks from becoming “too big to fail” and to keep banks from taking on too much risk. Historically, we see that laws and regulations that seek “outcomes” are bound to fail because, specifying “outcomes” tells those being regulated what they have to “get around”, what they have to “evade.”

In this Age of Information, it has become exceedingly easy to “get around” laws and regulations and “evade” the restrictions imposed by the legislators and regulators. (See the series of posts I began on January 25, 2010, “Financial Regulation in the Information Age”: http://seekingalpha.com/article/184153-financial-regulation-in-the-information-age-part-a.)

Laws and regulations work better when they are aimed at processes, the way that the regulated firms do business. These kinds of rules and regulations have to do with information flow (corporate disclosure and transparency), how trades are made, how trades are constructed, margin requirements, and so forth. One can see successful examples of “process” oversight in the creation of the Financial Futures Market and the Options Market in the latter part of the 20th century.

A proposal for overseeing the assumption of risk by financial institutions has been put forward by Oliver Hart, an economics professor at Harvard, and Luigi Zingales, an economics professor at the University of Chicago, in the Spring 2010 copy of National Affairs, titled “Curbing Risk on Wall Street,” (http://www.nationalaffairs.com/publications/detail/curbing-risk-on-wall-street). I have threatened several times to present a critique of this proposal in one of my posts. Hopefully, I will accomplish this soon for the Hart/Zingales proposal, I believe, offers a lot for people to consider.

So, the world goes on. The financial reform package will be passed. Banking and finance will continue to thrive. Big banks will get bigger and there will be fewer and fewer small banks. Hedge funds and venture capital funds will, in general, continue to do what they do well. And, sometime in the future there will be another financial crisis.

Things are not different.

End note: for a “good read” check the lead article in the business section of the New York Times on Sunday about Ken Rogoff and Carman Reinhart and their book “This Time Is Different”: http://www.nytimes.com/2010/07/04/business/economy/04econ.html?_r=1&scp=1&sq=ken%20rogoff%20and%20carmen%20reinhart&st=cse.

A Time for Crybabies

The headlines of the day: “European Leaders Call for Crackdown on Derivatives” (http://www.nytimes.com/2010/03/10/business/global/10swaps.html?hpw) and “Call for Action on Speculation Rules” (http://www.ft.com/cms/s/0/7a22b968-2bad-11df-a5c7-00144feabdc0.html).

Alternative headlines to these are “Financial Markets Call for Crackdown on Undisciplined and Irresponsible Government Budget Behavior” or “Call for Action on Fiscal Policy Biases.”

This is the time for cry-babies and the leaders of many nations in the world are not letting us down.

Their basic theme is “All our problems can be laid at the feet of the financial community, its innovations, and its speculative behavior. We need better and tougher regulation and we need stricter laws and rules about what can be done. Doing this will make everything better!”

This, however, is getting “cause and effect” turned around!

My question is, “Who created the inflationary environment of the last fifty or sixty years that resulted in the financial innovation and speculation that resulted? Who promoted almost perpetual government budget deficits, in recessions as well as booms, and who underwrote this deficit spending with supportive monetary policies that encouraged the expansions but fought the contractions? Who is responsible for the 85% decline in the purchasing power of the United
States dollar since January 1961?”

The stage was set in the United States in 1946 when Congress passed the “Full Employment Act of 1946.” In 1961, an administration took over the presidency that was devoted to the Keynesian full employment policy. In 1971, President Nixon in an effort to stimulate the economy to get himself re-elected claimed that “We are all Keynesians now!” In this effort to get re-elected, Nixon appointed Arthur Burns as the Chairman of the Board of Governors of the Federal Reserve System. Monetary policy supported the effort to achieve the economic goals Nixon believed he needed to have in order to get re-elected. Then in 1978, Congress enacted the “Full Employment and Balanced Growth Act”, often referred to as the “Humphrey-Hawkins Full Employment Act.”

The true test of government monetary and fiscal policy, as written into the law of the land was full employment and high levels of economic growth. And, explicitly or implicitly, countries throughout the free world followed this pattern in the post World War II world.

And, what resulted from this policy bias?

Well, by the last half of 1968 we had high-grade corporate bond rates in the 6.5% range. These yields had not really gotten much above 4% until late 1959 into 1960, and did not cross 5% until the middle of the latter decade. It was during the late 1960s that researchers started discussing the presence of “inflationary expectations” in interest rates, a concern that vanished toward the end of the 1920s.

In the 1960s we also saw the first real post-World War II financial innovation take place. The primary source of business credit at that time was the commercial banks. As the presence of inflation spread and in order to expand their capacity to lend and to compete against banks worldwide, United States commercial banks developed the negotiable Certificate of Deposit, the Euro dollar, and the use of Commercial Paper to raise funds through bank holding companies. Large banks ceased to have funding limits on their ability to raise money to lend. This was an omen for the future.

In August 1971, President Nixon froze wages and prices and took the United States off of the gold standard. Inflation had obviously reached a point where it had become a concern of the nation.

The bid to get Nixon re-elected re-ignited inflationary pressures and his predecessor Gerald Ford attempted to Whip Inflation Now! (The WIN campaign) By the middle of 1979 inflation had become so bad in the United States that President Jimmy Carter had to appoint someone of the prestige of Paul Volcker to take over at the Fed and “get serious” about the high levels of inflation existing in the country.

In the 1980s financial innovation was rampant. One only needs to go to the Michael Lewis book, “Liar’s Poker” to get an idea of how much financial innovation had taken over Wall Street by the middle of the decade. Increasing tensions between the Reagan administration and Volcker resulted in Volcker resigning in August 1987. Someone much more conciliatory, Alan Greenspan, got appointed Fed Chairman.

All one needs to be said about Greenspan is that the term the “Greenspan put” was created during his tenure. Greenspan supported economic expansion, but protected financial markets on the downside. In the 1990s the United States experienced credit bubbles, the best known being the dot-com boom…and bust. The 2000s saw bubbles in both the housing market and the stock market. And, during the credit inflation of the 1990s and the 2000s financial innovation exploded!

And, I haven’t touched on the governmental deficits created since the 1980s that the Federal
Reserve was helping to underwrite. But, enough said about the United States.

Leaders throughout the free world behaved in this manner through much of the last fifty years. There were, of course, earlier periods in which the cry-babies came out. This occurred numerous times, but the blame then was placed on those “shadowy people” known as “the international bankers.” Government deficits and loose monetary policy resulted in a sell-off of the currency of the country. This sell-off continued until the government made some efforts to bring on fiscal discipline and give some independence to its central bank. But, again, the governments assumed little of the blame; it was always the fault of “the bankers”.

Governmental leaders just don’t get it. Inflation becomes the music that everyone has to dance to. As long as inflation continues the dance goes on. As Charles “Chuck” Prince III, the former CEO of Citigroup famously said, “As long as the music continues to play, you must keep dancing.” And people and governments kept borrowing, bankers and other financial geniuses continued to craft new financial innovations, and bonuses continued to rise. And the music went on and on…

One of the difficulties of economics is that in most situations it takes time for things to work themselves out. That is, there can sometimes be a long lapse of time between the cause of something and the effect that the action brings about.

A classic example given is the long run impact of rent controls. Rent controls are great for renters in the short run. But, if low rents result in landlords reducing the amount of maintenance applied to the rent-controlled properties, the properties deteriorate in quality. Blame is then assessed against the greedy landlords and not against the rent controls.

We see a similar situation in the case of the financial speculation the governmental leaders are crying out against. Blame is assessed against the “bankers” and not against those that created the inflationary environment that produced the financial innovation and subsequent financial transactions. Unfortunately, a lot of people, those that can’t really defend themselves, get hurt in the process.

Whereas the renters got hurt in the previous example; workers, the people that were being helped by the governmental policies, are the ones that end up suffering when the music ends and people stop dancing. See “Irish Take Bitter Medicine to Survive Age of Red Ink”: http://online.wsj.com/article/SB20001424052748704486504575097672075207734.html#mod=todays_us_page_one.

Financial Indicators of the Deteriorating Real Economy

More and more we see concern being expressed about the deteriorating real economy and less emphasis being placed on the crises within the financial sector. The concern about the growing weakness in the real economy points to a longer and deeper recession than had been anticipated.

The current recession, as defined by the NBER, is in its 12th month and trails two other recessions which lasted 16 months as the longest post-World War II downturns on record. As economists revise their forecasts, most seem to believe that the 16 month period will be exceeded and many are saying that the current recession will reach the 20-24 month time span.

Economists only have to point to the daily release of employee layoff announcements to support their increasing pessimism. Companies are restructuring and these efforts are accompanied by reductions in workforce by 5,000 and 10,000 and more, per firm. AT&T announced today that they are going to lay off 12,000 employees and are taking a $600 million charge in the fourth quarter to cover severance payments. And, given recent experience, there will be two or three other companies announcing layoffs today. There will be more tomorrow…and Monday…and…

Then these layoffs must work their way through the rest of the economy. Lower spending…credit card defaults…additional decline in sales…more layoffs…and so on and so on. The effects are cumulative.

The policy problem is how to stop the cumulative contraction so that the downward spiral is broken.

The potential effects of this downward spiral in the real economy are being translated into the financial markets and the warnings are rather severe. For example, take the article in the Financial Times, titled “Record number of companies at risk of default”: http://www.ft.com/cms/s/0/490a8668-c154-11dd-831e-000077b07658.html. This article focuses on the Markit iTraxx Crossover index which measures the cost of protecting junk-grade companies against default. This index rose above 1,000 basis points for the first time ever indicating that “a record number of companies are on the verge of default because of deepening financial problems.”

The authors also write that “Some of the world’s leading investment-grade companies look in danger of default, according to CDS prices.” The point being that the future shows nothing but dark clouds now. As these firms continue to restructure to avoid default on their debt the situation, at least in the short run, can only worsen because the layoffs lead to lower incomes which results in lower spending which results more restructuring and so on.

This deterioration in the real economy is also being transmitted to the government sector. There are two concerns being expressed in terms of the government securities. First, at local and regional levels…state and local governments…there is a restructuring gong on as government revenues drop and attempts are made to bring government budgets into balance…or at least into manageable level of deficit.

Second, governments at the national level are attempting to protect financial markets and combat the deterioration in their real economies. As a consequence, national deficits are ballooning and concern is being raised over the possibility of default on the part of sovereign nations. Another article in the Financial Times speaks to this concern: “Sovereign CDS prices soar as debt mounts”: http://www.ft.com/cms/s/0/c441907a-c1a3-11dd-831e-000077b07658.html. “Credit default swaps, which insure against bond defaults, rose to all-time highs on the US, UK, France, Spain, Italy and Germany yesterday…The dramatic rise is due to investor concerns over the amount of bonds the government will have to issue to bail out the banks and stimulate the economy.” The concern relates not only to the current economic and financial difficulties but also to the possibility that these governments will not be able to stem the downswing and will have to issue more and more bonds in the future.

Retail sales figures for November have just been release and the story reads that November retail sales are amongst the weakest in many years.

The difficulty that any government faces in attempting to compose a monetary or fiscal policy that can turn this situation around is that it is in the best interests of most economic units in the economy, individual, family, business, or non-profit, to get back to basics, to restructure what they do, to cut back their living standard, and to reduce debt. Consequently, government efforts are like “pushing on a string”…there is nothing to push against.