Guest Post: “We Are in a Cabal… Five or Six Players … Own the Regulatory Apparatus. Everybody Is Afraid to Regulate Them”

Washington’s Blog

Harold Bradley – who oversees almost $2 billion in assets as chief investment officer at the Kauffman Foundation - told the Reuters Global Exchanges and Trading Summit in New York that a cabal is preventing swap derivatives from being forced onto clearing exchanges:

There is no incentive from the moneyed interests in either Washington or New York to change it…

I believe we are in a cabal. There are five or six players only who are engaged and dominant in this marketplace and apparently they own the regulatory apparatus. Everybody is afraid to regulate them.

Indeed, as I wrote last May:

In at least one area – one of the most important causes of the financial crisis – reform has already been defeated.

By way of background, the derivatives industry has volunteered (once again) to regulate itself.

As Newsweek noted April 10th, the big boys were using bailout money to aggressively lobby against the regulation of credit default swaps:

Major Wall Street players are digging in against fundamental changes. And while it clearly wants to install serious supervision, the Obama administration—along with other key authorities like the New York Fed—appears willing to stand back while Wall Street resurrects much of the ultracomplex global trading system that helped lead to the worst financial collapse since the Depression.At issue is whether trading in credit default swaps and other derivatives—and the giant, too-big-to-fail firms that traded them—will be allowed to dominate the financial landscape again once the crisis passes. As things look now, that is likely to happen. And the firms may soon be recapitalized and have a lot more sway in Washington—all of it courtesy of their supporters in the Obama administration…

The financial industry isn’t leaving anything to chance, however. One sign of a newly assertive Wall Street emerged recently when a bevy of bailed-out firms, including Citigroup, JPMorgan and Goldman Sachs, formed a new lobby calling itself the Coalition for Business Finance Reform. Its goal: to stand against heavy regulation of “over-the-counter” derivatives, in other words customized contracts that are traded off an exchange…

Geithner’s new rules would allow the over-the-counter market to boom again, orchestrated by global giants that will continue to be “too big to fail” (they may have to be rescued again someday, in other words). And most of it will still occur largely out of sight of regulated exchanges…

The old culture is reasserting itself with a vengeance. All of which runs up against the advice now being dispensed by many of the experts who were most prescient about the crash and its causes—the outsiders, in other words, as opposed to the insiders who are still running the show.

And today, Treasury gave the financial giants exactly what they wanted. As Bloomberg writes in an article entitled Wall Street Derivatives Proposals Adopted in Treasury Overhaul :

Wall Street’s largest banks are getting what they want in the U.S. Treasury’s plan to regulate over-the-counter derivatives by making all market participants adhere to the same capital requirements…

The banks appear to wish to maintain the intra-dealer market and raise barriers to new entrants to keep the OTC business as compartmentalized as possible and to protect their profitable market conditions,” said Brad Hintz, an analyst at Sanford C. Bernstein & Co. in New York. “The Street’s lobbyists appear to be asking for a ‘club’ structure in OTC trading.”…

The bank-written plan, titled “Outline of Potential OTC Derivatives Legislative Proposal” and dated Feb. 13, said the systemic regulator “shall promulgate rules” requiring “capital adequacy,” “regulatory and market transparency” and “counterparty collateral requirements.”

Hintz said Wall Street revenue from trading fixed-income, commodities and currency swaps in the over-the-counter market may be reduced by 15 percent under the Treasury’s changes. “Limiting potential competition” in the market “may not be an unreasonable position to take” by the banks due to the potential loss of income, he said

Investment banks fought regulation of OTC derivatives for more than a decade because the contracts provide a significant portion of bank earnings.

Do you get it?

Instead of “blowing up or burning” over-the-counter CDS – as nobel economist Myron Scholes urged – or making any other real changes which would help the economy and the consumer, the rule changes are mainly a p.r. effort by the derivatives industry itself (like the stress tests were a p.r stunt by the banking industry.) The “changes” will do virtually everything the derivatives industry asked for, including guaranteeing the big banks’ profits in selling CDS by keeping out smaller competitors.

Regulation of over the counter CDS has already failed.

And see this.

Given that JP Morgan Chase, Bank of America, Goldman Sachs, Citigroup, and Morgan Stanley together held 80% of the country’s derivatives risk and 96% of the exposure to credit derivatives as of July 2009, those are probably the players to which Bradley is referring.

Why the fall in the savings rate means something

A post by Edward Harrison

Recently, I wrote a post which examined three different reasons the savings rate in the US could have been falling over the last year. Rebecca Wilder thinks this is a meaningless exercise:

Edward Harrison at Credit Writedowns is theorizing why the saving rate is falling when it should be rising, as households scram to deleverage their balance sheets. My reaction to this is twofold: first this is a meaningless exercise; but second, and worse yet, there’s likely something very "unhealthy" going on here.

Meaningless: The BEA conducts a comprehensive revision of the NIPA tables every five years. The saving rate is usually revised upward, and by a fair amount, as was the case for most of the 2000s.

So in "roughly" 5 years from 2009 (it’s not uniformly 5 years between each revision), you will see a higher saving rate than you do today. As I said in July, the

"BEA has "found" that households have been in fact saving roughly 1% more of their disposable income per quarter since 1995, 0.9% per quarter in 2008."

They will "find" it again.

The thing is that we are not looking at savings rate levels but changes in those levels.  I have seen the NIPA revisions and I even mentioned the fact that some pundits feel the savings rates will be revised upward:

Note that some pundits believe the data are inaccurate and that the decline has been nowhere as large as the data now indicate. Time will tell.

I reckon that when the revision do come in, regardless of whether they are revised higher, they will show that the savings rate did in fact still dip precipitously from mid-2009.  That IS indeed what we saw in the revisions in 2004 after interest rates were dropped as indicated in Wilder’s charts. The question is why.

Understanding why savings rates are dropping in the midst of a still severe economic shock, weak credit growth and sustained high levels of unemployment will tell you something about the durability of the policies used to goose GDP over the past three quarters. So, this is not meaningless in the least.

I have proffered three potential reasons why.  Wilder offers another: the black market for labour:

With an employment-to-population ratio a shocking 58.5% in February (it was 63.4% as recently as March 2007), there’s got to be a growing supply of labor that is "working under the table" just to get by. This non-market income would flow through the spending accounts but not the income accounts. Therefore, you have official consumption going up with official income (doesn’t include non-market income) stalling, which reduces the saving rate.

Implicitly, what Wilder is suggesting is that the savings rate actually is not dropping, that what we will see later is that a revised savings rate will be relatively flat from 2009 to 2010.  Obviously, I disagree. But as I stated above, time will tell.

However, more important in my analysis is the conclusions about stimulus one could reach. If I am right about asset prices being responsible for a downshift in the reported savings rate, we shall see that the withdrawal of stimulus leads to a fall in asset prices and a relapse into recession.

Moreover, in a post on the recent personal income data, I wrote:

The challenge the US faces is how to maintain consumption growth in the face of continuing pressure on income. Businesses are enjoying a huge resurgence in profit and this has contributed to their savings and low debt levels. Yet, households remain indebted. Moreover, after the 2009 stimulus shot in the arm, disposable personal income is not going anywhere.

Unless US policymakers solve this problem – the divergence in the benefits of economic policy for business and households, consumption growth will have to slow. If consumption does slow and asset prices stall, the US will be headed back into recession.

If you understand the financial sector balances approach, the increase in the government’s deficit must be balanced by a concomitant increase in the combined private sector and capital account surplus. Put simply, if the government goes into greater deficit, this increase must be balanced by an increased surplus of private sector savings or capital account inflows.

Clearly the aim of the deficits should be to increase household sector savings. But what I am stating rather clearly I believe is that this is NOT the aim of the deficits in the least.  Nor is it the aim of monetary policy. Instead we have:

an industrial economic policy in the US which is predicated simultaneously on suppression of domestic wage growth and on consumption growth in order to boost corporate profits and increase asset prices.

In fact, the Federal Reserve’s low interest rates discourages household sector savings and promotes the accumulation of debt.  The government may expand in order to induce an increase in net private sector savings, but fiscal expansion is a blunt instrument. The government cannot (in the short-term) determine where capital account or private sector surplus is directed or held. Right now, government deficit spending is increasing business savings and not household savings.

Moreover, having low nominal rates skews investment toward payoffs with long lead times (think telecom infrastructure or tech in the 1990s and property in the 2000s). Longer-term, much of this shows up as malinvestment. You can’t expect an adequate long-term return on capital when average nominal rates across the business cycle are low.

What will happen instead is that firms like pension companies that have actuarial assumptions that are pegged to higher nominal returns will reach for return creating a misallocation of investment capital to riskier enterprises. Much of this will turn out to be a dead weight loss to the economy. You see this already with the returns in high yield bonds and the prevalence of payment-in-kind securities in leveraged finance deals to boost returns.

This is just an asset-based economic model predicated on ever-increasing asset prices. There is certainly something "unhealthy" going on here. Low rates are no panacea for slow economic growth. Nor is deficit spending in the absence of a purge of accumulated malinvestment. Trying to increase demand to meet excess supply simply doesn’t work, especially in an aging population.  Just ask the Japanese.

A reader tipped me off to a recent FT article by former Daiwa Securities Chief Economist Tadashi Nakamae, "How Japan could lead the way back to durable growth," which points to excess capacity as a reason for Japan’s continued malaise. He makes good points that I have made about malinvestment previously. I especially like it when Nakamae says:

demand-side fiscal and monetary policies have served only to delay the much-needed elimination of excess capacity.

That is exactly what I have been saying. However, I do have concerns that his ’solution’ of firing people en masse as he suggests leads to a deflationary spiral. More likely, it is better to allow marginal firms to fail.

As Wilder correctly states at the end of her piece, it is an increase in household income which will truly increase demand – sustainably. Wilder gives one example of how to increase income via a jobs program, something I have also broached and called unemployment insurance for the 21st century. See The consumption response to income changes from Vox for another take.

Also see Nakamae’s prescient remarks from January 2008 on the reluctance to write down debt in the banking crisis in the FT’s  Japan’s salutary tale in banking crises.


The saving rate paradox – Rebecca Wilder

Links 4/2/10

Wolves are being used to improve German business skills BBC

Rep. Hank Johnson: Guam could ‘tip over and capsize’ The Hill (hat tip reader John D). No, this is NOT a left over April Fool’s Day story.

Sarah Palin’s TV career hits early controversy Telegraph. What’s the Alaska version of “all hat, no cattle?”

Look Who’s Funding Climate Change Denial Seeing the Forest

Counting a billion: India begins new census Times of India. They want fingerprints and photos!

Iron ore price deal sparks steel fury Financial Times. Bye bye auto industry recovery once this cycles through to finished goods. As Crocodile Chuck remarked, “Mark my words-this shameless greed will backfire on the Australian producers…BIG TIME. I give it 4-6 months-until the NEXT downturn happens.”

Moves to Garnish Pay Rise as More Debtors Fall Behind New York Times

Financial Reform 101 Paul Krugman

Student debt keeps rising Rolfe Winkler

Gaming Uncle Sam’s Mortgage Modification Program Larry Doyle, Seeking Alpha

Behold China James Mann, The New Republic (hat tip reader Paul S)

Book Reviews: 13 Bankers, Econned Mike Konczal. Thanks Mike!

Dean Baker: Did We Make a Profit on Citigroup? Dean Baker, Huffington Post. Today’s must read.

Antidote du jour:


More Evidence of Lack of Competitiveness of Many Chinese Exporters

One argument we have made, which some readers find difficult to accept, is that China’s keeping its currency, the renminbi, at artificially cheap levels is tantamount to an across-the-board export subsidy (the proof that the RMB is artificially cheap comes via the fact that China has had to engage in massive dollar purchases to keep the RMB pegged at its target level. It’s hard to track Chinese purchase directly from monthly Treasury International Capital reports, since the Chinese execute many of their dollar purchases through London. And I would take the latest Goldman assertion on the value of the RMB with a fistful of salt. Goldman was also calling the euro a buy at 1.50).

Now one of the reason that export subsidies and tariffs are considered to be a Bad Thing among Respectable Economists is that they lead to inefficient producers, ones that are dependent on government protection and cannot compete without official support.

That appears to be the case with a fair number of Chinese exporters, per the report of a state news agency. I only have a short Bloomberg report on the release, which came out on Xinhua; I was unable to find it on the English version of the paper.

From Bloomberg (hat tip reader Michael):

The profits of China’s makers of household appliances, automobiles and cell phones may plunge by between 30 percent and 50 percent if the Chinese currency were to strengthen by 3 percent, according to a state media report.

Small and medium-size exporters with low price-negotiating powers will face losses and may even go out of business, according to the Xinhua News Agency’s Economic Information Daily newspaper, citing the results of a “stress test.”

“The ultimate result of a currency that strengthens too quickly and by too much may be the irreversible damage to our economic structure, rather than improving our economic structure,” the report said.

Yves here. A 30% to 50% fall in profits on a mere 3% rise in the RMB (already an admission that they compete only on price), says their margins are unhealthy even with the benefit of a cheap RMB. Margins that thin will not support needed reinvestment in the business (nominal depreciation is often too low to cover needed reinvestment) nor allow the business to have much in the way of buffers for any kind of shocks.

So Why Isn’t the DoJ After JP Morgan and Goldman for Anti-Competitive Behavior? (Jefferson County Edition)

Even though I have read a number of accounts of the horrorshow of Jefferson County’s sewer financing fiasco, every time I go through a new one that it reasonably detailed, it still instills the same sense of rage. Rage not simply at the pervasive corruption – that’s bad enough – but that this predatory style of doing business is becoming increasingly acceptable (as witness the comments here that often defend it).

Municipal finance has long been a cesspool, but blatantly corrupt behavior was, not that long ago, for the most part limited to backwaters and bucket-shop operators. Now, it isn’t just Jefferson County, but pretty much every big-name financial firm is involved in multiple cases of stuffing local governments and their pensions funds, with derivatives that had all sorts of tricks and traps or toxic CDOs, sometimes with the liberal applications of bribes, sometimes merely with fast talk and omission of key details. Often, these government entities hired “experts” who simply sold them out for fat fees.

Matt Taibbi has a typical take-no-prisoners account of the fiasco, and one bit jumped out:

Given the shitload of money to be made on the refinancing deals, JP Morgan was prepared to pay whatever it took to buy off officials in Jefferson County. In 2002, during a conversation recorded in Nixonian fashion by JP Morgan itself, [JP Morgan banker Charles] LeCroy bragged that he had agreed to funnel payoff money to a pair of local companies to secure the votes of two county commissioners. “Look,” the commissioners told him, “if we support the synthetic refunding, you guys have to take care of our two firms.” LeCroy didn’t blink. “Whatever you want,” he told them. “If that’s what you need, that’s what you get. Just tell us how much.”

Just tell us how much. That sums up the approach that JP Morgan took a few months later, when [then county commissioner Larry] Langford announced that his good buddy Bill Blount would henceforth be involved with every financing transaction for Jefferson County. From JP Morgan’s point of view, the decision to pay off Blount was a no-brainer. But the bank had one small problem: Goldman Sachs had already crawled up Blount’s trouser leg, and the broker was advising Langford to pick them as Jefferson County’s investment bank.

The solution they came up with was an extraordinary one: JP Morgan cut a separate deal with Goldman, paying the bank $3 million to fuck off, with Blount taking a $300,000 cut of the side deal. Suddenly Goldman was out and JP Morgan was sitting in Langford’s lap. In another conversation caught on tape, LeCroy joked that the deal was his “philanthropic work,” since the payoff amounted to a “charitable donation to Goldman Sachs” in return for “taking no risk.”

That such a blatant violation of anti-trust laws took place and neither JP Morgan nor Goldman have been prosecuted for it is yet another mystery of the current financial crisis. “This is an open-and-shut case of anti-competitive behavior,” says Taylor, the former regulator.

Yves here. Now tell me, how come the other cops on the beat have swung into action but not the Department of Justice? Langford was found guilty on 60 counts and has been sentenced to 15 years in jail (despite being mayor of Birmingham at the time of his trial). Oh, and Langford is the fourth Jefferson County commissioner convicted on sewer-related charges. Blount was sentenced to 52 months (he testified against Langford). Jefferson County is suing JP Morgan, and the SEC has fined it $75 million and made it disgorge over $647 million of termination charges.

So where is the Department of Justice on the little bribe JP Morgan paid to Goldman to get lost? Or does the DoJ inaction have more than a little bit to do with the fact that Obama raised more money from the financial services industry than any previous presidential candidate?

Update: Taibbi has more commentary on his blog.

Links 3/10/10

Researchers back cancer-fighting properties of papaya Associated Press

Sports Enhancement and Life Enhancement: Different Rules Apply h+ (hat tip reader David C)

Unionists make citizens’ arrest of insurance CEOs People’s World (hat tip reader John D)

Barney Eats Seconds – Or Blows Smoke – Or Both Bruce Krasting

Grayson Offers Medicare Buy-In Bill, Makes Impassioned Speech Huffington Post

Germany’s eurozone crisis nightmare Martin Wolf, Financial Times. One reader thinks the part of the article that discusses “the balance between income and expenditure in the private, government and foreign sectors must sum to zero” looks awfully similar to recent posts on NC, particularly one (here and here) by Rob Parenteau.

Alpert: Two years until we see market-clearing prices in housing market Ed Harrison

Econobloggers need their crisis back Ultimi Barbarorum. Whoops, this was on deck but didn’t make it into Links on a timely basis….still worth reading.

Why Is The Pentagon Worried About Consumer Protection? The Atlantic (hat tip reader John D). This post adopting a puzzled stance strike me as odd. It’s pretty well known that auto dealers get kickbacks, um, fees on loans they sell to car buyers. It is also a pretty good bet that most members of the armed forces are not very sophisticated financially, and hence could be steered into products that are not favorable to them. This isn’t the first time the Pentagon has intervened to protect its staff from predatory financial practices, see here for more background.

It looks like they might really ban naked CDS Eurointelligence

FDIC wants pension funds to prop up failed banks Raw Story

Goldman Sued for Overpaying Executives CBS (hat tip reader John D)

Also, per Lambert Strether, is running a poll on “ideas for change in America”. He points out, correctly, that single payer is on the list (as in, if you want to remind Team Obama that they blew it, this is one way to quickly register your unhappiness). The other one on the list I am keen about is “Move to Amend: Constitutional Rights for People, Not for Corporations – Abolish Corporate Personhood”. Vote here.

Antidote du jour:


A bonus, hat tip Richard Smith:

The Empire Continues to Strike Back: Team Obama Propaganda Campaign Reaches Fever Pitch

I’ve seldom seen so much rubbish written by people who ought to know better in a single day. Many able people have heaped the scorn and incredulity on three articles, one a piece on Rahm Emanuel slotted to run in the Sunday New York Times Magazine, another an artfully packed laudatory piece on Timothy Geithner by John Cassidy in the New Yorker and a more even handed looking one (I stress “looking”) in the Atlantic.

Ed Harrison has skillfully shredded parsed the Geithner pieces . Simon Johnson thrashed the New Yorker story. A key paragraph below:

The main feature of the plan, of course, was – following the stress tests – to communicate effectively that there was a government guarantee behind every major bank or quasi-bank in the United States. Of course this works in the short-term – investors like such guarantees. But there’s a good reason we usually don’t guarantee all financial institutions – or act happy when other countries do the same. Unconditional bailouts lead to trouble, encouraging reckless risk-taking and undermining responsible governance. You can’t run any form of reasonable market system when some big players hold “get out of bankruptcy free” cards.

Banking expert Chris Whalen was so disturbed by the numerous distortions in the New Yorker piece that he had already fired off a long letter to the editor by the time I pinged him, with these starting paragraphs:

Jack Cassidy tells us that “Timothy Geithner’s financial plan is working—and making him very unpopular.” Unfortunately this is completely wrong. Cassidy’s comment just illustrates why the New Yorker has fallen into such obscurity, namely because it is more Vanity Fair than its vivacious sibling and unable to perform critical journalism.

In fact, the banking system is continuing to sink under bad loans and even worse securities losses. Telling the public that the banks are “fixed” is irresponsible. Unfortunately this false perception is widespread, including among major media such as CNBC and also with a number of my clients in the hedge fund world.

And from Marshall Auerback, who had a ringside view of the aftermath of the Japanese bubble:

Cassidy’s article brings to mind a retort by Chou En Lai when he was asked about the success of the French Revolution. He said, “It’s too early to tell”. Yet here we have John Cassidy from the New Yorker and Joshua Green from The Atlantic both making the assumption that the Geithner plan “worked”. This whole line about “taxpayers to recover bailout money” is based on an accounting fraud, because accounting abuses are the primary means by which TARP recipients have repaid bailout money — putting us at greater risk. That may seem paradoxical, but the rush to repay is driven by a desire to have unrestrained executive bonuses (a very bad thing associated with far greater accounting fraud and failures — requiring future, larger taxpayer bailouts) and accounting abuses produce the (fictional) ability to repay the United States (primarily by failing to recognize existing losses). The TARP recipients weakened their financial condition, and increased moral hazard, when they rushed to repay the TARP funds. Both factors increase the risk of making more expensive future bailouts more likely.

Yves here. The reason that people who can discern clearly what is afoot are so deeply disturbed is simple, and all the comments touch on it. The campaign to defend Geithner and Emanuel, both architects of the administration’s finance friendly policies has gone beyond what most people would see as spin into such an aggressive effort to manipulate popular perceptions that it is not a stretch to call it propaganda.

This strategy, of relying on propaganda to mask their true intent, has become inevitable, given the strategic corner the Obama Adminstration has painted itself in. And this campaign has become increasingly desperate as the inconsistency between the Adminsitration’s “product positioning” and observable reality become increasingly evident.

Recall how we got here. Early in 2009, the banking industry was on the ropes. Both the stock and the credit default swaps markets said that many of the big players were at serious risk of failure. Commentators debated whether to nationalize Citibank, Bank of America, and other large, floundering institutions.

The case for bold action was sound. The history of financial crises showed that the least costly approach is to resolve mortally wounded organizations, install new management, set strict guidelines, and separate out the bad loans and investments in order to restructure and sell them. An IMF study of 124 banking crises concluded that regulatory forbearance, the term of art for letting impaired banks soldier on, found:

The typical result of forbearance is a deeper hole in the net worth of banks, crippling tax burdens to finance bank bailouts, and even more severe credit supply contraction and economic decline than would have occurred…

Shuttering sick banks is hardly a radical idea; the FDIC does it on a routine basis. So the difference here was not in the nature of the exercise, but its operational complexity.

This juncture was a crucial window of opportunity. The financial services industry had become systematically predatory. Its victims now extended well beyond precarious, clueless, and sometimes undisciplined consumers who took on too much debt via credit cards with gotcha features that successfully enticed into a treadmill of chronic debt, or now infamous subprime and option-ARM mortgages.

Over twenty years of malfeasance, from the savings and loan crisis (where fraud was a leading cause of bank failures) to a catastrophic set of blow-ups in over the counter derivatives in 1994, which produced total losses of $1.5 trillion, the biggest wipeout since the 1929 crash, through a 1990s subprime meltdown, dot com chicanery, Enron and other accounting scandals, and now the global financial crisis, the industry each time had been able to beat neuter meaningful reform. But this time, the scale of the damage was so great that it extended beyond investors to hapless bystanders, ordinary citizens who were also paying via their taxes and job losses. And unlike the past, where news of financial blow-ups was largely confined to the business section, the public could not miss the scale of the damage and how it came about, and was outraged.

The widespread, vocal opposition to the TARP was evidence that a once complacent populace had been roused. Reform, if proposed with energy and confidence, wasn’t a risk; not only was it badly needed, it was just what voters wanted.

But incoming president Obama failed to act. Whether he failed to see the opportunity, didn’t understand it, or was simply not interested is moot. Rather than bring vested banking interests to heel, the Obama administration instead chose to reconstitute, as much as possible, the very same industry whose reckless pursuit of profit had thrown the world economy off the cliff. There would be no Nixon goes to China moment from the architects of the policies that created the crisis, namely Treasury Secretary Timothy Geithner, Federal Reserve Chairman Ben Bernanke, and Director of the National Economic Council Larry Summers.

Defenders of the administration no doubt will content that the public was not ready for measures like the putting large banks like Citigroup into receivership. Even if that were true (and the current widespread outrage against banks says otherwise), that view assumes that the executive branch is a mere spectator, when it has the most powerful bully pulpit in the nation. Other leaders have taken unpopular moves and still maintained public support.

Obama’s repudiation of his campaign promise of change, by turning his back on meaningful reform of the financial services industry, in turn locked his Administration into a course of action. The new administration would have no choice other that working fist in glove with the banksters, supporting and amplifying their own, well established, propaganda efforts.

Thus Obama’s incentives are to come up with “solutions” that paper over problems, avoid meaningful conflict with the industry, minimize complaints, and restore the old practice of using leverage and investment gains to cover up stagnation in worker incomes. Potemkin reforms dovetail with the financial service industry’s goal of forestalling any measures that would interfere with its looting. So the only problem with this picture was how to fool the now-impoverished public into thinking a program of Mussolini-style corporatism represented progress.

How did the Administration and financial services message control teams work together?

The first was the refusal to consider investigations of any kind. Obama is widely reported to have studied the early days of Franklin Delano Roosevelt’s administration for inspiration; it would be impossible for him to miss the dramatic steps FDR took, including supporting the continuation of a Senate Banking Committee investigation into the misdeeds of the Roaring Twenties, the Pecora Commission. The Pecora Commission not only kept the bankers on the defensive, but it also did the forensic work into the abuses. It was critical to bring the nefarious practices to light to devise durable and lasting reforms.

Why were there no inquiries into how the firms that needed bailouts got themselves into a mess? This was an obvious and comparatively easy avenue of inquiry which would make a great deal of useful background accessible and identified issues for further examination. For instance, after the rescue of UBS, the Swiss Federal Banking Commission required UBS to provide an extensive report of what went wrong, and also had the bank make considerable portions of that information public, via a special report to its shareholders. Yet no US firm has been asked to make any explanation of how it managed its affairs so badly as to require extensive public support to keep from failing.

The choice here was obvious. A refusal to investigate was tantamount to a refusal to reform. A good understanding of what had happened was essential, not merely to develop sound new rules, but also to keep the industry from muddying the waters, which would be easy to do, given how complex and opaque many of the products are

More compelling evidence of the Administration’s lack of interest in reining in the money-changers came via Treasury Secretary Timothy Geithner’s first presentation on his reform plan, which was more accurately a plan to have a plan. It was widely criticized for its sketchiness, but most observers missed the true significance. Had the Obama transition team done any serious thinking about the financial crisis? Obviously not, because you don’t need to think too hard if the game plan is to go back to business as usual to the extent possible. Geither’s presentation came nearly three weeks after Obama was sworn in, and all its initiatives were Bush/Paulson wine in new bottles: a new go at the failed idea of having the government overpay for bad bank assets; “stress tests” to put more discipline around the process of handing out TARP funds to the needy; and a mortgage modification program which pretended to be able to square the circle of saving borrowers without taking on investors in mortgage securitizations.

Geithner’s not-much-of-a-plan exemplified the second tool in the Obama campaign to sell doing as little as possible to the financiers: the Theory of Positive Thinking.
That notion has a proud tradition in America and was much in evidence in the run-up to the crisis. It promises that the economy will be fine as long as everyone thinks happy thoughts about it. For instance, I noted in a March 2007 blog post that while the tone of the Financial Times as of March 2007 had become generally grim, the US had become a Tinkerbell market, where valuations are held aloft by faith, and participants conspire to stoke true belief. And as the crisis wore on, other magical personages intervened. As a hedge fund manager who writes as Augustus Melmotte noted,

The market responded with enthusiasm to reports that the Tooth Fairy has agreed to acquire Lehman. The purchase price has not yet been determined and will be set by Dick Fuld wishing upon a star, clicking his heels three times, and being transported back to that magical place where Lehman still sells for over $70 per share….. Meanwhile, the SEC has announced an investigation of mean, evil, bad short-seller David Einhorn. …. Einhorn reportedly suggested that the Tooth Fairy does not exist and that wishing upon a star is not a wholly reliable price discovery mechanism. Christopher Cox, chairman of the SEC, said, “Vicious rumors attacking the Tooth Fairy will not be tolerated. Our entire financial system and indeed the American way of life depend on the Tooth Fairy and wishing upon a star…” The SEC is reportedly planning to set up re-education camps for short-sellers.

Remember that the US has an entire cable channel devoted to the Theory of Positive Thinking, namely CNBC, and a goodly portion of the financial media falls into CNBC-style cheerleading with more than occasional abandon.

Now it is true that this idea has a kernel of truth. John Maynard Keynes attributed the Depression to a change in investor “liquidity preferences,” which meant they had suddenly become very risk averse and preferred to hold cash until they felt conditions had improved, with devastating consequences for economic activity. Uncertainty can morph into a self-reinforcing downcycle. But it is one thing to use confidence boosting as a tool, quite another to regard it as a magic bullet. Merely clapping our hands all together will not cure the long-standing ailments in the economy.

Moreover, the Theory of Positive Thinking has been used, upon occasion, to suggest that conditions will only deteriorate if the public examines the financial services industry critically. It isn’t hard to see whose interests benefit from that posture.

Now it is hard to prove in a tidy way that the tone of financial press coverage had shifted suddenly, and decisively, to optimism as of early March. But many professional investors in my circle started regularly talking of cheerleading. Two Wall Street veterans, Sandy Lewis and William Cohan, weighed in on this pattern at the New York Times:

Whether at a fund-raising dinner for wealthy supporters in Beverly Hills, or at an Air Force base in Nevada, or at Charlie Rose’s table in New York City, President Obama is conducting an all-out campaign to try to make us feel a whole lot better about the economy as quickly as possible… We’re concerned that nothing has really been fixed. We’re doubly concerned that people appear to feel the worst of the storm is over — and in this, they are aided and abetted by a hugely popular and charismatic president and by the fact that the Dow has increased by 35 percent or so since Mr. Obama started to lay out his economic plans in March.

This result relied on more than mere dint of personality. A Pew Research Center study found that roughly government and businesses originated over half the economics-related news after the crisis. Obama himself “dominated” the key images and ideas. The reporting had a clear arc. The early coverage focused on the struggles over the stimulus plan and the banking industry plans, and as those faded, so did coverage of the crisis in any form. The tacit assumption was that the crisis was over, and the performance of the supposedly forward looking stock market was proof. But as anyone with a modicum of detachment could see, the market was a false positive, treating an aversion of utter disaster as an imminent return to normalcy.

The stock market has rallied over 60% from its early March lows, enabling the wounded banks to sell new equity to the public and avoid further contentious taxpayer-funded rescue measures. But the justification for the soft glove treatment of the banking classes, that what was good for them would prove to be good for everyone else, has proven to be wildly false. When the Dow levitated over 10,000, mainstream news outlets celebrated the event, with nary a mention of the continued train wreck in the real economy. As Matt Taibbi observed, “the dichotomy between the economic health of ordinary people and the traditional ‘market indicators’ is not merely a non-story, it is a sort of taboo — unmentionable in major news coverage.”

But banking boosterism has succeeded all too well, allowing Team Obama to fantasize that it can get away with creating Potemkin prosperity in lieu of waging the pitched battles needed to lay the groundwork for the real thing.

Indeed, the adoption of the Theory of Positive Thinking has virtually guaranteed that nothing will change, unless there is sufficient deterioration in the real economy or the financial markets to provide compelling counter-evidence. One example is the “paying back the TARP” charade. As the banks continued to post improved earnings, no matter how phony they were, they argued that they were now healthy and should be allowed to pay back the TARP funding that had been crucial to their survival. The reason they were so keenly motivated to do should have been reason enough to deny their request: namely, that they wanted to escape restraints on executive compensation, virtually the only demand that the government had made. But overpaying staff and keeping too little in the way of risk reserves was precisely the behavior that led to the near collapse of the financial system. Going back to business as usual would virtually guarantee more looting of major financial firm and another series of collapses.

But the Obama administration miscalculated badly. First, it bought the financiers’ false promise that massive subsidies to them would kick start a economy. But economists are now estimating that it is likely to take five years to return to pre-crisis levels of unemployment. Obama took his eye off the ball. A Democratic President’s most important responsibility is job creation. It is simply unacceptable to most Americans for Wall Street to be reaping record profits and bonuses while the rest of the country is suffering. Second, it assumed finance was too complicated to hold the attention of most citizens, and so the (non) initiatives under way now would attract comparatively little scrutiny. But as public ire remains high, the press coverage has become almost schizophrenic. Obvious public relations plants, like Ben Bernanke designation as Time Magazine’s Man of the Year (precisely when his confirmation is running into unexpected opposition) and stories in the New York Times that incorrectly reported some Goldman executive bonus cosmetics as meaningful concessions have co-existed with reports on the abject failure of Geithner’s mortgage modification program. While mainstream press coverage is still largely flattering, the desperation of the recent PR moves versus the continued public ire and recognition of where the Adminsitrations’s priorities truly lie means the fissures are becoming a gaping chasm.

So with Obama’s popularity falling sharply, it should be no surprise that the Administration is resorting to more concerted propaganda efforts. It may have no choice. Having ceded so much ground to the financiers, it has lost control of the battlefield. The banking lobbyists have perfected their tactics for blocking reform over the last two decades. Team Obama naively cast its lot with an industry that is vastly more skilled in the the dark art of the manufacture of consent than it is.

Guest Post: No One’s Issuing Credit—Why Are Auerback and Parenteau?

By John Ryskamp, an attorney and author of The Eminent Domain Revolt

Why, in their article on Latvia’s austerity budget, are Marshall Auerback and Robert Parenteau giving Latvia credit for warm, fuzzy feelings? Especially in the context of Draconian cuts? It’s because Auerback and Parenteau don’t know what they want—their emotions are not grounded in any articulated policies. So they sound friendly. But are they friendly?

Let’s take a look. Maybe they just haven’t got their terms straight. For example, they say: “Mainstream economics insists that one path to full employment is via lower wages.” No, that’s not mainstream economics—that’s police state economics. That’s simply liquidation. They seem blithely unaware that since the power structure in America decided the suburbanization binge was over—that our suburban cow had ceased to be a profit center and had turned into a cash guzzler—America is no longer a paying proposition. So power is taking its flunkey, Uncle Sam, out of government.

That’s liquidation: power is withdrawing government from American society—and right on cue, the rest of the world is following suit, including Latvia.

Memories are short—and sometimes, even truncated. Just because World War II cut short Mellonesque liquidation, don’t for a minute buy the argument that somehow it wasn’t still policy right through the Roosevelt Administration—or that it isn’t always waiting in the wings, asserting itself all the time against countervailing forces (we shall return to those forces).

Liquidation is what is going on in Latvia. There is no attempt to achieve full employment or any other level of employment. Check out liquidation’s repertoire of techniques:

1. monetization
2. cartelization
3. currency race to the bottom gambits
4. credit contraction
5. induced supply chain collapse

and that’s just a very few of them—including, of course, shrinking the budget. The problem is that we don’t have a SINGLE academic study of liquidation as a sociopathology. When and why is each technique picked up and put down by liquidation? We just don’t know. Indeed, according to a supply chain management professor in the UK, to whom I put this question, there is no academic study of supply chain deterioration.

Power goes to power. Power is the assumption AND deduction of power. Power is the means AND the end of power. So Andrew Mellon would have had us believe, and when the going gets tough guess what? We believe it. They seem to have swallowed it in Latvia, and in the United States. I see no evidence of tax strikes, uprisings or any organization revolutionary movement, calling liquidation what it is. The protests are as vague and helpless as the implied protests of Auerback and Parenteau. We must toughen our minds.

Look what Auerback and Parenteau say is the motive of the powerful in Latvia (and their superiors elsewhere). They say the policy of power is to “internally deflate.” This is imprecise. Latvia is liquidating, but also somehow the policy is to maintain full employment. Huh? For them, Latvia is acting “under the mistaken assumption that the [currency peg] was inviolable,” and then they go on to cite the numerous problems with a currency peg.

But it’s not a problem if liquidation is your goal, and looting the population is one way you go about it. I don’t think the powerful in Latvia were under any assumption, mistaken or otherwise, about a currency peg. It is a liquidation technique, a technique for looting—it is not tenable to believe it is invoked without knowing why it exists and what it does.

They call a “hidden assumption”—unknown to the powers in Latvia which provoked collapsing labor costs and prices—the idea that “a debt deflation spiral does not do the host country in as domestic private incomes are deflated.” It is not credible that anyone in a position to invoke a collapse in income, demand and prices, does not know the point of these gambits. It is liquidation. Nor do Auerback and Parenteau show any evidence that the powerful in Latvia share their concerns and are simply naïve, or wrongheaded.

Look at the other thoughts they put in the heads of the powerful in Latvia: “Policy makers have tied both their hands and their feet behind their backs so that markets could work their self-adjusting magic.” Where is the evidence that the powerful in Latvia believe there is such a thing as a market, much less that it is self-adjusting? There is none. Indeed, all the evidence Auerback and Parenteau put forward is that the powerful in Latvia are putting forward all the liquidationist tricks put forward under any police state, Mussolini, Hitler, Stalin—you name it.

There is nothing magical, and no mystery, about a police state. What is mysterious is constantly imputing benign motives to people when the evidence shows they are carrying out police state acts.

Here’s another one: “In each of these nations, if the private sector is retrenching already, and the public sector tries to retrench on top of that, unless a massive swing in foreign trade can be accomplished, policy makers are unwittingly inviting falling private nominal incomes and private debt distress into the picture as they reverse fiscal stimulus.” Perhaps the problem with this notion is that Auerback and Parenteau regard as stimulus, bailing out bankrupt Ponzi schemes. Co-conspiring is stimulus? A new definition of the word “stimulus,” to quote the guy in Rules of the Game. But then, I guess if you believe it isn’t, then the logical conclusion is that those who promote “stimulus” are capable of doing things “unwittingly.”

In short, Auerback and Parenteau impute good faith where all the evidence shows there is only liquidation. Why? Because they’re soft on rights. Almost everyone else is, too. The day we gave the political system near absolute power over facts (we did it here in 1937 with West Coast Hotel v. Parrish), and thereby denied ourselves any rights, we let the political system define all the terms. In return for a middle class existence, we surrendered our right to find out the facts. It’s called “health and welfare.” We let the political system decide that. We are not allowed to intervene as individuals.

So we haven’t really inquired into the facts, and we’ve sort of lost the ability to inquire into the facts. Auerback and Parenteau are examples of this. It sounds like their approach tolerates “some” liquidation, “some” level of unemployment. They don’t really understand that the countervailing force to power, is rights. For example, the authors of the U.S. Constitution see only two forces. They see the police state (which wanted to hang them all), and important facts.

Important facts are unchanging facts of human experience, facts which history has demonstrated, are robust and resilient in the face of attempts to affect them. For the Founders, these facts included protected speech. For us—or at any rate, for those of us who have persisted in factual investigations—these facts also include housing, liberty, maintenance, education and medical care.

When important facts are defended, power weakens; when important facts are not defended, power strengthens. That’s the sum total of the Constitution. How can you defend important facts against assault, when you can’t provide the evidence that they are important, because you don’t know that the issue is importance?

Police states know perfectly what important facts are—and they hate them. Does that put you, reader, in the crosshairs? Gee, d’ya think?

It would clarify the thinking of Auerback and Parenteau, and clarify our response to what they write, if they could tell us with regard to two facts they consider so important in their article—income and employment—whether they think those are important facts as defined above.

I think they are indicia or aspects of maintenance, and I think maintenance turns back attacks by interrelating maintenance with income and employment—and also with housing! And also with protected speech! The maintenance of important facts—which, according to this analysis, is what the law does, and only what it does—is a complex, ongoing venture which requires vigilance—political, and intellectual and observational vigilance.

If you practice this vigilance, you really see what Latvia is doing, even according to the generous (naïve?) interpretation of Auerback and Parenteau. It is saying that income and employment are goals, not facts. It is saying that income is maintained by destroying income, and employment is maintained by destroying income. In short, complete nonsense. The evidence shows that income and employment ARE facts, are important facts, not goals, and not policy.

This is why I say that the only response to liquidation, is individually enforceable rights. And that’s why I wrote the New Bill of Rights. It says:

No individual shall be involuntarily deprived of liberty;
No individual shall be involuntarily deprived of housing;
No individual shall be involuntarily deprived of maintenance;
No individual shall be involuntarily deprived of medical care;
No individual shall be involuntarily deprived of education.

If this was the law in Latvia, could the cuts described by Auerback and Parenteau, occur? No.

Is this a laundry list of worthy goals, a grab bag of ideals? No. It is the progress we have made—exercising the individually enforceable rights we have—toward investigating the facts of human experience. We have pretty conclusively demonstrated, with regard to the facts above, that they are important facts.

You only have to understand the issue, to find that this process of evaluation is continually going on. For example, is property an important fact. It may interest you to know that the investigation is inconclusive so far. Also, we are revisiting the settled principle that an exercise of religion is an important fact. Who knew?

If you want to see a perfect example of this investigation going on with respect to a fact—from an initial point of view that it should be left to politics, to a point of view that individuals have control over it—look at the new right to education in the state of New Jersey. I suggest you go to, to understand the exacting—but exactly vital—process we have to go through, in order to fight liquidation.

Are Capital Restrictions On Their Way to Becoming Respectable in Some Circles?

We’ve had (depending on when you define the starting point) at least two decades of a concerted push by the US towards more open capital markets (no doubt based not simply on the belief that the Anglo/Saxon model was superior, but also on the notion that US financial firms would come out on top).

Many orthodox economists will concede that restrictions on capital flows and trade can be beneficial for developing economies, but would not endorse them for mature ones. Yet the Panglossian faith in wide open capital markets airbrushes out a few inconvenient considerations. One is that the extensive historical dataset constructed by Carmen Reinhard and Kenneth Rogoff shows a strong correlation between high levels of cross border capital flows and bank crises. Two is that high levels of international money flows poses more than a wee problem of national sovereignity. How do nationaly based financial regimes regulate firms with global operations?

The Financial Times reports on a move afoot in the EU that will restrict investors in the EU from putting funds in private equity firms outside the EU, and also restricting the ability of foreign investors to buy European companies (frankly, as someone who has worked on more than a few cross border deals, a good business generally has no trouble finding domestic buyers. If local/regional players, who presumably have an information advantage by knowing the local market, won’t stump up for a particularly business, why should an offshore investor do better? Yes, there are always exceptions, but one needs to be plenty wary).

Reader Swedish Lex noted:

In parallel with the Greece/Goldman/default swaps/hedge fund vampire night dinners, etc., the EU is slowly advancing on the proposal to regulate hedge funds and private equity firms (and their managers).

The industry has spent vast recources over the past year in trying to water down the draft legislation, which was not entirely brilliant to start with. What seems to elude the industry is that all the bad press feeds back into the legislative process. Most of the 736 Members of the European Parliament had a vague understanding of this aspect of the financial industry to start with and, probably, believe that it has significantly contributed to the financial crisis. The very bad PR for hedge funds and over-leveraged and job slashing PE firms over the past weeks are hardly helping the industry.

What I find silly is that the Industry, in its efforts to convince the Parlamentarians, and the other relevant EU Institutions, are using the same bad old arguments like if you regulate in Europe, it will scare off investment and the pensions of ordinary people are jeopardized. Well yes, the EU does not welcome trashy short-term cancerogenus cash spreading from Cayman funds run by math nerds that design real nukes one day and their financial equivalent the next.

There will be a compromise in the end, but it is too early to say what it will be. Greece etc. could continue to have an interesting influence on the debate.

From the Financial Times:

Europe risks building a protectionist wall between itself and the global private equity industry if plans for a sweeping overhaul of regulation in the sector go ahead, some of the world’s biggest institutional investors have warned.

The warning from the International Limited Partners Association, representing 220 of the biggest pension funds, endowments and sovereign wealth funds, comes at a sensitive time with European Union lawmakers and member states close to agreeing new rules

Investors based in the EU could be barred from investing in private equity funds based outside the 27-country bloc, said the ILPA, whose members have more than $1,000bn (£667bn) invested in private equity worldwide.

In addition, the proposed regulation could “severely disturb” many of the world’s biggest private equity groups by depriving them of access to EU investors, while in turn reducing foreign investment into EU companies.

“Not only will EU investors have reduced access to non-EU private equity managers, there exists a real concern that the proposal will effectively close Europe off from the capital solutions . . . that comprise the global private equity industry,” it said.

Yves here. The chutzpah is breathtaking. Foreign firms are trying to bully EU officials? This is a great way to win friends and influence people. So what if they are severely disturbed? Europe functioned before there ever was a PE industry, and from what I can tell, its hotbed of innovation, the German Mittelstand, does not have much traffic with PE investors.

The idea that what is good for the private equity industry may not be good for the average citizen appears not to have occurred to these operators. Tone-deaf behavior like this ILPA letter is only good to feed the already high suspicions of about whether financiers have any social conscience.

The fake stress tests

A post by Edward Harrison

About a month ago I wrote a post called “The coming wave of second mortgage writedowns” the gist of which was that the big four banks (Citi, JP, BofA, and Wells) had a shed load of exposure to now worthless second mortgages. With many first mortgages now hopelessly underwater, it stands to reason that second mortgages on those same properties have zero value.

The big four are certainly well aware of this problem and are looking for ways to extend the wherewithal of underwater borrowers and pretend they don’t need to take losses on these loans. On paper, these companies are very well capitalized. However, in the real world, the likely losses they must eventually take on loans already on their books would probably render them insolvent. This is what I hinted yesterday in my post on the stress tests.

I said:

I would say the stress tests were a mock exercise to instil confidence in the capital markets. This was important first and foremost because it would induce private investors to pay for bank recapitalization instead of taxpayers. But it was also important for the economy as a whole as the sick banking sector was dragging the whole economy down. The key, however, is that the tests were a mock exercise. Despite the additional capital, banks are still hiding hundreds of billions of dollars in losses in level three, hold to maturity, and off balance sheet asset pools. If asset prices fall and/or the economy weakens, all of this subterfuge would be for nought.

-Geithner: jusqu’ici tout va bien

And when I use the phrase ‘mock exercise,’ by mock, I mean fake. Mike Konczal has done a remarkable job of putting these two concepts – the worthless second mortgages and the stress tests – together.

He writes in a recent post:

Let’s talk specifics: Last June I made a DIY Stress Test, using values reversed-engineered from the public documents, where you could play around with the values online or download an excel spreadsheet yourself (it’s still one of my favorite blogging items). The backbone of the overview of results, page 9 from the Federal Reserve’s document, looks like this:

I’m going to isolate the four largest banks Frank questioned about second-liens, along with their loses as they’ve legally sworn to being accurate during the stress test:

Again, this is data as reported to the government by the major banks during the stress test of 2009. So what’s going on here? The four major banks have about $477 billion in junior liens, either in the form of a second mortgage or a home equity line of credit. If you go to the Fed Funds data online, you’d see that there’s about a trillion dollars of 2nd/Juniors out there, so the four major players have about half the market.

The four major players each report that they expect to have a 13-14% loss on these items under an “adverse scenario”, with Citi reporting a 20% loss under an adverse scenario. That means of the $477bn, $68.4 bn is junk that’ll never be collected on. This, combined with all the other expected losses (see the link to the stress test for the rest) meant that the four biggest players needed around $53bn to be raised.

Notice how Frank’s letter, and pretty much anyone you’d speak to who isn’t working for the four largest banks, assume that second liens in the country aren’t worth 86% of their value (for a 14% loss). You see in Frank’s letter “no economic value.” Huh. Well, that’s a problem.

Let’s look at these values again, assuming that the expected total loss would be 40%, and then 60%.

So the original loss from second-liens, as reported by the stress tests, was $68.4 billion for the four largest banks. If you look at those numbers again, and assume a loss of 40% to 60%, numbers that are not absurd by any means, you suddenly are talking a loss of between $190 billion and $285 billion. Which means if the stress tests were done with terrible 2nd lien performance in mind, there would have been an extra $150 billion dollar hole in the balance sheet of the four largest banks. Major action would have been taken against the four largest banks if this was the case.

See what I mean by fake?  The point is this whole charade is transparent to anyone who actually runs the numbers. Yet, you have people like John Cassidy spreading disinformation in the New Yorker, writing puff pieces of zero negative value with drivel like this:

Other critics dismissed the tests as a sham, arguing that the economic assumptions underpinning them were too benign. As the tests unfolded, however, it became evident that the government’s loss projections were quite high, and that many banks would be forced to raise considerable sums of money—in some cases, more than ten billion dollars.

Baloney. Run the numbers like Mike did, John; and then you wouldn’t make such asinine comments. Of course the stress tests were a sham.  They were a confidence trick to raise more capital and buy time for the banks to earn yet more still. The point was to allow the banks to ease into their losses. And that’s exactly what’s been happening for the past year.

The problem with the stress tests, however, is they gave the banks a way to get from under the yoke of the government’s TARP program. The banks said, “look, we are now well-capitalized even in the worst case scenario of the stress test. We want out of TARP.”

This is bad for three reasons.

  • The big banks all paid back $25 billion in TARP funds. Smaller banks like Northern Trust paid back $10 billion or less. That’s hundreds of billions of capital that they all could have as a buffer against losses. Some of them raised additional capital to replenish the coffers. Nevertheless, net-net, we had less banking capital in the system after the repayments than before.
  • Banks free of TARP paid out a lot of cash in bonuses that could have gone to shoring up their capital base.  Every dollar paid in cash compensation to staff is a dollar less of capital.  Had these banks been under TARP, they would have been forced to pay lower bonuses – if only for this year.
  • The lower capital – and the fact that banks know that having renewed capital problems would mean the end of the line for them – means that banks are less likely to lend freely.  They understand that now is the time to husband capital. Heads would roll if a big bank or super regional which had repaid TARP had another capital shortfall.

The real question is: why is the Obama Administration running victory laps, unrolling the ‘Mission Accomplished’ banner on the credit crisis, as Mike Konczal describes it? I suspect this is just a political stunt to provide cover in the mid-term elections to somehow demonstrate that the Democrats fixed the problem which the Republicans created. 

I think it could backfire if only because the underemployment rate is still 17%. Nobody wants to hear the “I saved the economy routine” when they’re unemployed and losing their home.

Guest Post: 6 Theories On Why the Stock Market Has Rallied

There are at least 6 theories about why the stock market has rallied some 70% off its lows a year ago, even though nothing has been done to actually reverse the financial crisis.

What The Dumb Money Believes

The dumb money believes what CNBC and their trusty stock churner … er, broker … says: that the government has fixed the economy but it just has to “kick in” (and that unemployment is just a lagging indicator, nothing important. See this, this, this and this).

Therefore, these folks believe that stocks are hugely undervalued, and that if they buy while most people are still afraid, they’ll make a killing when the market goes to the moon.

Temporary Juice

Others believe that it is the quantitative easing, low rates, bank bailouts, stimulus spending, and other portions of the “wall of money” which the feds have thrown at the economy are creating a temporary pump to the stock market.

But they think that – when the spigot is turned off – the market will tank.

The Situation is Inflation

Others believe that – regardless of continued loose monetary and fiscal policy or real stock valuations, we’re in for some serious inflation.

Stocks tend to preform well during inflationary periods.

For more on inflation versus deflation, see this.

Machines Run Amok

Tyler Durden explains that all of the stock market gains have occurred after hours when mystery buyers purchase stock futures in low volume environments (and see this).

Vincent Deluard – a strategist for TrimTabs Investment Research (25% of the top 50 hedge funds in the world use TrimTabs’ research for market timing) – said last month:

We’ve never seen this before – such a huge rally, and the little guy is out.

Some argue that it is high-frequency trading or momentum-chasing trading algorithms doing the buying, and that the market will tank when they change their game.

Fed Futures

Others argue that the government is itself buying stock futures.

Some believe that the Feds aren’t buying, but that they have intentionally showered the big banks with money, and encouraged the banks to buy. In other words, they argue that the Feds are indirectly promoting a stock market rally.

Fraud Central

Karl Denninger believes that the market has rallied due to the systemic, fraudulent overvaluation of assets.

As Denninger wrote yesterday:

[A reader wrote] the FDIC to ask about [allegations of fraudulent valuations]. This was their response:

That’s the value the bank had them on their books on their year-end financials, but the true value is much less. It is similar to someone in Las Vegas saying that their house is worth $300,000 because that’s what they paid for it three years ago, but the reality is, if they had to sell it in today’s market, they’d only get $250,000 for it. The FDIC has to sell assets in today’s market…

Or tomorrow’s market.

The simple fact of the matter is that there it is, right in front of you.

A raw admission that the banks are carrying these loans at dramatically above their actual value.

Yes, this means that essentially all balance sheets must now be considered fraudulent, and thus the valuations assigned by the market to them are also fraudulent.

Extending this to the stock market as a whole you now have a market that is intentionally overvalued as a direct and proximate consequence of fraud, permitted and endorsed by the government, of somewhere between 25-40%.

Now you know why the market rallied off the SPX 666 lows to where it is now. 1139 (where we are now) * .60 (a 40% haircut) = 683.40, or awfully close to that 666 bottom.

Of course this “valuation” expressed in the market can only be maintained for as long as the fraud is. If the ability to maintain that fraud is lost for any reason then values will instantly collapse back to reflect reality.

Leave a comment about why you think the stock market has rallied, and how long you think the rally will continue.

Tom Adams: Department of “Huh?” – BlackRock’s Larry Fink as Hero?

By Tom Adams, an attorney and former monoline executive

I’m usually cynical about these “genius of Wall Street” articles, but the Vanity Fair article “Larry Fink’s $12 Trillion Shadow” by Suzanna Andrews, about the head of the world’s largest money manager, BlackRock, raises the cliche to another level. My skepticism results both from the disconnect between the glowing tone of the article versus some of the information presented, as well as how the depiction of BlackRock is at odds with my own observations of the firm.

Let’s go past the puffery and do some quick computations:

I count losses on over $12 billion dollars of CDOs and CMBS plus losses on other large investments during the crisis in this article, which i suspect misses several billion of dollars of other losses elsewhere in the portfolio.

I count dozens of highly questionable conflicts of interest combined with a seriously problematic Fed (and Geithner, once again) refusing to disclose critical information about such for conflicts. David Patterson is in hot water over $6000 in yankee tickets and about $20,000 in conflicted horse racing fees, but Blackrock can receive hundreds of millions of dollars on two sides of a deal while getting paid for dozens of other highly conflicted, government related companies. On what planet does this make sense?

I count repeated examples of an egomaniac consolidating a dangerous level of power and doubling down on its level of too big to fail with a total disregard for the any sort of systemic risk this might present.

The article also makes much of the Aladdin model, which has proven a very effective marketing tool for the firm:

But while its size was impressive, what would distinguish BlackRock was its state- of-the-art system for evaluating and managing risk. With 5,000 computers running 24 hours a day, overseen by a team of engineers, mathematicians, analysts, and programmers, BlackRock’s “computer farm” could monitor millions of daily trades and scrutinize every single security in its clients’ investment portfolios to see how they would be affected by even the most minor changes in the economy. Churning through 200 million calculations each week, its computers could simulate every imaginable shift in interest rates, every conceivable change in the financial markets, and stress-test the performance of hundreds of thousands of securities in numerous global-crisis scenarios.

Let’s start with a simple observation: did the use of Aladdin model save any of BlackRock’s clients during the upheaval of 2007 and 2008? Exactly how well did those models anticipate the market perturbations that we saw? Pretty much every quant based model performed poorly during this period. But the article is silent on this point, which is telling. If Aladdin miraculously outdid the other strictly math-based risk models, one would expect Fink would have made sure to stress this point. There’s every reason to suspect that Aladdin is yet another example of what Nassim Nicholas Taleb calls statistically-based risk models: “non-performing airbags”. They do a great job of measuring day to day risk, and a poor one of preparing users for the sort of price movements that will kill investors using leverage. And now this model and this analysis is effectively the new monopolistic rating agency for government controlled investment portfolios while displaying even less transparency than Moody’s and S&P did when their opinions dominated the market.

The article similarly has a very curious discussion of how Fink was on a short list to head of Merrill, and lost out to John Thain. The most obvious reason is massive conflicts of interest, since as the piece notes, Merrill owned 40% of BlackRock, but the story features this tidbit first:

Fink would tell people that Merrill’s board had virtually assured him that the job was his, but that the offer evaporated after he demanded he first be allowed to perform a full analysis of

the bank’s mammoth subprime portfolio to gauge the extent of its problems.

How would BlackRock not know how much crap was in Merrill’s portfolio? Even if he wasn’t sure on the ownership of the many crappy CDO deals that Merrill had originated, wouldn’t his knowledge of AIG’s portfolio (which indicated who each counterparty was) have given him a pretty good clue to Merrill’s distribution strategy? i mean, if a lowly guy like me had heard back in March of 2007 that Merrill was stuck with over $20 billion of MBS and CDO bonds, how is it this supposed genius of Wall Street seemed so unaware that he would want to be head of an insolvent company?

Similarly, how the heck did Blackrock sign up for billions of dollars of Stuyvesant Town exposure at the absolute top of the market, based on the assumption that the investors could kick out rent regulated tenants, raise rents and bring in new higher paying tenants in an environment where real estate prices (including apartment rents) were very likely soon to be plummeting? How many bad (and obvious) assumptions went into that deal that Aladdin seemed to miss? Had anyone at Blackrock ever actually picked up a local paper in the last twenty five years, which might have given them some sense of the relationship that rent regulated tenants had with their landlords? On top of which – a multibillion dollar deal entirely within one zip code? Do you really need 600 people, running 5000 computers, 24 hours a day to come up with that analysis?

So why is Larry Fink and his company the subject of such a glowing article? I had actually thought he was a pretty good businessman before I read this but he comes off looking like a bad analyst, a vengeful ratfink and a parasite who made most of his and his company’s money through government connections, blatant breaches of conflict and rule bending (oh, but he does fly commercial, so he must be a real down to earth guy). Seriously, from the time of the S&L crisis, has he ever not had a big government contract to keep the lights on, while submitting million dollar a day contracts which the government then fights to keep secret in flagrant violation of all established practices?

Where would Blackrock be without the FDIC, the RTC, LTMC, Fannie Mae, Freddie Mac, AIG, dozens of desperate state pension funds? When will someone audit their fees and assess what exactly it is they get paid for and why it is Palooka Bank in Iowa couldn’t do a better job? At least Palooka Bank would probably know better than to bet billions of dollars of its own and other people’s money on a New York City landlords being able to magically toss tenants out on the street.

Perhaps articles like these, which are so wildly out of tune with the current popular attitudes towards Wall Street genius, are finally reaching a saturation point with journalists and publications. Even as they try to celebrate one of the great bankers, they seem to run short of noteworthy accomplishments beyond cozying up to the great government fee paying machine.

Auerback/Parenteau: Coming to a Country Near You: Let a dozen Latvias bloom?

By Marshall Auerback, a fund manager and investment strategist and Rob Parenteau, CFA, sole proprietor of MacroStrategy Edge, editor of The Richebacher Letter, and a research associate of The Levy Economics Institute

Want to see the real consequence of smash mouth economics? Forget about Greece and take a look at Latvia. Its 25.5 per cent plunge in GDP over just the past two years (almost 20 per cent in this past year alone) is already the worst two-year drop on record. The country recently reported a 12% decline in annual wages in Q4 2009 versus Q4 2008. The IMF projects another 4 percent drop this year, and predicts that the total loss of output from peak to bottom will reach 30 percent. The magnitude of this loss of output in Latvia is more than that of the U.S. Great Depression downturn of 1929-1933.

Policies and systems built for failure

Mainstream economics insists that one path to full employment is via lower wages. If you want to sell more labor services, lower the price of them, namely wages. This is a classic fallacy of composition argument. What might work for one firm is unlikely to work for all firms. Wage cuts in the aggregate simply destroy aggregate spending power, unless the lost demand is made up for in other ways.

But even though Latvia’s external balance is improving (largely through a collapse of imports as a result of the collapse of domestic demand), the country is unable to deploy fiscal policy effectively due to the external constraints of its monetary system, which is predicated on the existence of a currency board system. True, the current account is now turning positive, but to suggest that every single country can “internally deflate” its economy via wage destruction of this magnitude to achieve this state of affairs is another fallacy of composition argument. The whole world cannot run trade surpluses, especially not if policy is designed to destroy demand via massive wage destruction.

More importantly, the very structure of a currency board is wrong. It requires a nation to have sufficient foreign reserves to facilitate 100 per cent convertibility of the monetary base (reserves and cash outstanding). Under this system, the central bank stands by to guarantee this convertibility at a fixed exchange rate against the so-called anchor currency. The government is then fiscally constrained and all spending must be backed by taxation revenue or debt-issuance. Pegging one’s currency, then, means that the central bank has to manage interest rates to ensure the parity is maintained and fiscal policy is hamstrung by the currency requirements (which is why organizations like the IMF love them so much; it ties governments’ hands). Latvia pegs its currency at 0.71 lat per Euro and joined the ERM in 2005 with the intent of qualifying for the euro zone. It operates a system similar to Argentina in the 1990s which ultimately collapsed and led to its default in 2001 (Argentina pegged against the US dollar).

The country’s debt is projected to be 74 per cent of GDP for this year, supposedly stabilizing at 89 per cent in 2014 in the best-case IMF scenario. A devaluation, however, would substantially raise the debt service ratios, given the high prevalence of foreign debt (about 89% of Latvia’s debt is euro denominated). The currency peg, then, not only restricted the Latvia government’s freedom of fiscal maneuver, but also created huge financial fragility because Latvians operated under the mistaken assumption that the peg was inviolable, encouraging borrowers to act with no sense of exchange rate risk. As in Argentina nearly a decade ago, a devaluation would, in all likelihood, lead to a default on external debt. Argentina did eventually manage a 25% recovery in output in the two years following Q1 2002, but only after a 190% devaluation (which was 300% at its maximum)

As Michael Hudson and Jeff Sommers have noted, “these debt levels place Latvia far outside the debt Maastricht debt limits for adopting the euro. Yet achieving entry into the euro zone has been the chief pretext of the Latvia’s Central Bank for the painful austerity measures necessary to keep its currency peg.” They also point out that maintaining that peg has burned through mountains of currency reserves that otherwise could have been invested in its domestic economy. It has also precluded the use of fiscal policy, since (by virtue of Latvia’s peg to the euro), the country operates under the same constraints as if it were already working within the Stability and Growth Pact rules.

‘Internal devaluation’ is a toxic remedy

With no room to adjust the exchange rate, the only other way to make the currency lose value is to engineer a real depreciation — that is, reduce labor costs and prices in order to make its tradable products more attractive. This is euphemistically being described as an “internal devaluation” — a one-off coordinated reduction of wages and prices across the board. It is, in reality, more like an “infernal devaluation”. It amounts to a domestic income deflation as wages are crushed in order to get the prices of tradable goods down enough so the current account balance increases sufficiently enough to carry the next wave of growth. The hidden assumption is that a debt deflation spiral does not do the host country in as domestic private incomes are deflated. The argument to justify this toxic remedy is that a reduction in nominal wages and salaries can help Latvia accomplish a boom in net exports, thereby enhancing an economic recovery which would quickly attenuate or short circuit any accompanying debt deflation dynamics that might have been set off at the inception of the internal devaluation.

Here, in a nutshell, is a country which shows us all of the misery that is enacted through the creation of self-imposed political constraints on policy. The Latvian government has voluntarily abandoned the policy tools that could make the lives of their citizens better. Policy makers have tied both their hands and their feet behind their backs so that markets could work their self-adjusting magic. They have pegged their currency; they are furiously slashing their net fiscal spending (under the IMF agreement they are due to cut their net position by 6.5 per cent of GDP — a huge fiscal contraction), and the economy continues to deteriorate.

This is something likely in store for Greece, which has recently introduced a new round of austerity measures in order to ensure the success of its latest bond offering. Greece and other countries now face the prospect falling private sector incomes – that is, after all, the direct and immediate result of higher taxes on businesses and households, and lower government expenditures. Euro area nominal GDP is already estimated by the OECD to have fallen over 3% in 2009. Unless the trade deficits of the nations pursuing fiscal retrenchment can swing sharply into surpluses (as lower domestic incomes lead to less import demand, and lower costs of production lead to higher exports), private debt defaults will now start to multiply and cascade through the system. Last week, as we mentioned, Moody’s placed 4 Greek banks on downgrade watch. This is just the start – the fiscal retrenchment has only just begun to take effect. By taking these steps to avoid a public debt default, we would suggest these economies are now poised for more private debt defaults.

We believe private investors do not yet get this connection, but it will be made very clear in the months ahead. Latvia, with a GDP collapse of nearly 25%, will become the poster child of the region in this regard. This private debt distress will back up into higher loan losses at German banks. Germany’s hard won current account surplus will continue to fade Loan growth is already dead in the water in Europe, and if the above analysis is correct, banker perceptions of private sector creditworthiness are about to go “pear shaped”, as they so delightfully put it in London.

Paradox of public thrift

But that’s not all. Each of these countries are about to discover what we will call the paradox of public thrift. Argentina discovered this in 2001-2. Latvia and Estonia have recently rediscovered it. Ireland is rediscovering it, and within the next three months, Greece will no doubt discover it as well. We will let Bill Mitchell’s comments depict the nature of this paradox for you, because it really does capture the essence of the dilemma at hand:

From Ireland: Gov’t took billions of €’s out of the economy in the form of public service pay cuts, pensions cuts, dole cuts + wave of private employees replaced by agency workers at minimum wage rates… Guess what? January tax receipts crashed yet again below projections. After two systemic budget cuts, the tax receipts keep tanking. The mainstream consensus? We need more cuts (except for bankers and top civil servants who don’t have to take wage cuts)! And the international bond market is happy with Ireland. One day we shall be able to compete with China on a level wage scale, and generous tax incentives for Multinationals. In the meantime, say hello to all the Irish immigrants for me.

This is the future discovery awaiting Greece, Spain, Portugal, Italy…and the UK…possibly Japan…and perhaps the US, although it could manage to skirt the issue for another year. In each of these nations, if the private sector is retrenching already, and the public sector tries to retrench on top of that, unless a massive swing in foreign trade can be accomplished, policy makers are unwittingly inviting falling private nominal incomes and private debt distress into the picture as they reverse fiscal stimulus.

As private incomes fall, tax revenues fall. In order to hit fiscal targets promised to global bond holders, further expenditure cuts must be implemented, and further tax hikes must be rolled out. As the Irish blogger reveals above, this is not a theory — it is already happening, but policy makers and investors are not willing to acknowledge it. Yet for those who understand the fiscal balance cannot be changed without influencing the cash flows and financial balances of the remaining sectors of the economy, the paradox of public thrift at this juncture is far too evident.

We are by no means defending the generous pension benefit levels of euro zone government workers, the early retirement ages, the corrupt tax practices, etc. These are decisions the citizens of each nation need to make on their own, preferably in full awareness of their consequences, both short and long run. It is not our place to dictate the trade-offs citizens chose in each nation.

The question we are raising, however, is whether the private leverage ratios in many of these countries will allow them to withstand the pressures of transitioning back to growth in the absence of fiscal autonomy. The now prevalent global quest for “fiscal sustainability” may place these economies on a path of private debt default, which is ultimately unsustainable for the economy as a whole. If fiscal retrenchment is to be enacted, then orderly private debt renegotiation and private asset liquidation must be accomplished at a large scale and in a timely fashion. Yet our experience is that this is no easy trick, as the near locking up of various financial channels following the Lehman debacle illustrated in no uncertain terms. Usually such a recipe delivers a financial implosion.

Even the Honorable David Walker, CEO of the Peter G. Peterson Institute, former Comptroller General, and ardent foe of government waste and reckless spending is coming to understand the precarious nature of the current situation. In a February 24th piece on with Larry Mishel, Walker insists on the primacy of job creation at this juncture, and recognizes this may actually serve his goal of reducing fiscal deficits in the long run:

President Barack Obama is in a difficult position when it comes to deficits. Today’s high deficits will have to go even higher to help address unemployment. At the same time, many Americans are increasingly concerned about escalating deficits and debt. What’s a president to do?

The answer, from a policy perspective, is not that hard: A focus on jobs now is consistent with addressing our deficit problems ahead.

We have seen this movie before

That, dear readers, is the real deal, and it is not being reported or openly discussed. We have seen this movie before in Argentina almost a decade ago. They eventually got out with a massive “external” currency devaluation of 300% and an equally massive swing in the trade balance. But the costs of delay were enormous: from 1998-2001, Argentina suffered its worst recession ever and pushed 42% of its households into poverty.

And not every country can do what Argentina has done. Again, the whole world cannot run trade surpluses, the first mover has an advantage until the second mover moves, etc. Plus, Argentina had an explicit debt repudiation and a 300% “external” devaluation that was timed right with global recovery, hardly the sort of conditions that pertain today.

The US has so far managed to resist anything of this magnitude. But as the voices of fiscal retrenchment intensify, a future not unlike Latvia, Greece and Argentina could await. It has taken the people of Iceland to make the first stand against this growing neo-liberal madness. In a historic referendum, over 90 per cent of the population has rejected a proposal for the repayment of billions of pounds lent by Britain and Holland to compensate depositors in a failed Icelandic bank.

The deal would have saddled citizens of Iceland with an additional $16k in debt to compensate the UK and Holland with a $5.3 billion note for the failure of their local banks. This, in a country of a mere 300,000 citizens. The vote failure has already prompted the ratings agencies to downgrade the country to junk, as well as leaving an IMF-led loan in limbo. The “experts” are declaring this a disaster for Iceland, but they and their banking allies must secretly be dreading the result, demonstrating as it does that an international bailout watchdog is truly powerless when the people of the bailout recipient nation want to have nothing to do with a poisoned chalice of an economic “rescue”, which does nothing but create a country of indentured serfs.

It is now time for the rest of us to follow the Lilliputians of Iceland: to take the rentier juggernaut down before it completes the task. Time to pry the vampire squid off our faces so we can see the light of day again. Hopefully, Iceland represents the future, not Latvia.

Guest Post: TED gets furious, tells Yves to go away and, errm, not be so furious

By Richard Smith, a London-based capital markets IT specialist

Hmm, I wonder if Yves’s resolution authority post will become the econoblogosphere’s equivalent to Clochemerle’s shattered urinal and its entourage of rioters. Surely not; yet it’s impressive how often such modest, utilitarian objects – a pissoir, a blog post about a financial reform proposal – can unexpectedly become the focus of great public ire.

It’s clear that regulators need the legislative authority to wind down a financial firm – that’s been unfinished business since Glass-Steagall was abolished, which left FDIC flapping in the breeze, and bit the hapless Fed and Treasury very heavily in the backside once they finally noticed there was something of a financial crisis on; 12 September 2008, according to Hank Paulson’s memoirs. Better late than never, I suppose.

It’s clear that regulators need to monitor the exposures of large complex financial institutions. It’s clear that no-one has a clue how to wind down a large complex financial institution that has chunky derivatives exposures and large overseas deposits, otherwise there wouldn’t be this continuing low-key faff about Citigroup. It’s also clear that this administration doesn’t exactly have a glittering track record of grabbing the financial reform agenda by the throat, and that its flustered-looking second round initiatives, the Volcker rule and the resolution authority, are, for the moment at the very least, light on detail and short on plausibility.

So you might think a Naked Capitalism post politely (well, relatively politely, this is Yves, but anyhow, not at all angrily, see for yourself ) questioning The Epicurean Dealmaker’s attempted defence of the resolution authority idea would be a useful addition to this great debate we’re all having.

TED doesn’t think so. His counterblast comes in three pieces – first, a pointless ad hominem preamble in which he simply tells us all that Yves is tired and should go on holiday (this seems to be a wild overinterpretation of Yves’ latest doomed resolution to sort out her sleep schedule), second, a central piece actually about the pretext for the post in which he misses some of Yves’ points, and connects with others (since it will make him look better than he deserves, I will skip the rejoinders he gets right); third, a piece about the unfairness of describing folk working in the banking industry as banksters, with a little homily on anger attached.

But but but…like the thought or not, pretty much everyone working in the banking industry, even lowly little guys like me, and certainly including such grand figures as TED and Yves, is a beneficiary of the rapacity (in the good times) and bailouts (in the less good times). That’s the most illuminating part of the post, that glimpse of how TED sees the world and his place in it; somehow decoupled from inflated asset values and inflated fees, and not at all ashamed.

Yet we banksters certainly should be trying very hard to fix what’s broken, and feeling embarrassed rather than defiant and angry and a bit whiny; and, at least in the less exalted banking circles that I adorn, that’s exactly what’s happening. And some of us, at our different paces, constrained by our variously acute and conflicting requirements for food, shelter, capacity to look after our loved ones, and a sense of integrity, are looking for something altogether different to do. And that’s fair enough too, I should think.

TED’s final point seems to be for Yves to discover how tired, bitter, humorless, full of hate, angry, strident and self-righteous she is, and to understand the awful danger of being like that. At least, I think that’s the gist of his concluding and very egregious sermonet; he isn’t quite this direct about it, but I’m damned if I can work out who else the subject of all those epithets is meant to be. Get this scorcher:

Anger has a personal cost, too. Unless it is leavened with reason, and moderated by the acknowledgement that no-one is perfect, hate and anger can be highly corrosive. Justifiable anger is a wonderful source of energy, and a marvelous spur to action. But nurtured, coddled, and sustained overlong, anger can constrict the vision, dull perceptiveness, and calcify the brain. It can blind you to the good in others, to the alternatives available to you, and, in the end, to the truth. If left untreated too long, eventually others tire of your stridency and self-righteousness, and you sink back into justified and bitter obscurity, another valued voice in the debated stifled by irrelevance.

Is this crazy bombast actually serious? Unless it’s a wry piece of self-referential irony – TED’s capable of that sometimes, unlike many IB types. A moment of deliberate self-deflation, or just more ad hominem, with extra pomposity? The reader must decide for himself, because I just can’t tell, this time.

Links 3/8/10

Apologies for thin links. I need to get on a different schedule, something that is less out of whack with normalcy, and this is going to necessitate a cutback in posts over the next few days.

Bonobos opt to share their food BBC

Defenders and Demonizers of Credit Default Swaps Rajiv Sethi (hat tip reader Sundog)

The WP: Obama close to reversing Holder on civilian trials Glenn Greenwald, Salon. More evidence of the “Obama as wuss” theory.

Eurozone Eyes IMF-Style Fund Financial Times and Germany Backs European Version of IMF Wall Street Journal

Real Personal Income Less Transfer Payments Tim Duy

Iceland Voters Reject Bank Bailouts in Crushing Electoral Defeat; Neo-Liberalism In Context Jesse

The Euro Has Been a Smashing Success George Melloan Wall Street Journal (hat tip reader Swedish Lex)

Trading Away Productivity Alan Tolenson and Kevin Kearns. New York Times

Antidote du jour:

More on the Resolution Authority Headfake

Self-deception is a remarkably useful form of mental disturbance. Calculated liars have to keep their stories straight, while the deluded are sincere and often unshakable in their misguided beliefs.

The Powers That Be insist that a magic bullet called a special resolution authority will solve many of the problems with the “heads I win, tails you lose” taxpayer backstopped financial system with inadequate oversight. The prospect of taking terminally sick banks out and shooting them will supposedly reintroduce moral hazard and make banks behave responsibly again.

The problem is that there isn’t much evidence to support this optimistic belief. Investment banks were seen as normal enterprises, at risk of bankruptcy, before the meltdown, yet that did not prevent Bear, Lehman, and Merrill from getting themselves into trouble that ultimately proved fatal. And the leaders of these enterprises did not take meaningful financial hits (oh yes, they were less rich than they would have been otherwise, but none of them is at risk of spending his waning years subsisting on dog food), a lesson surely not lost on other bank CEOs.

Then we have the wee problem that the idea of a special resolution authority looks not credible. We’ve harped more than once that as long as the firms crucial to debt markets remain deeply connected to each other, the idea that one can be taken out gracefully without impacting the others is a fairy tale. We’ll believe this comforting story only if we see measures to cut back counterparty exposures, most importantly in the repo and credit default swaps markets.

Bob Teitelman, editor of The Deal, gives a more detailed evisceration of the problems with the idea (I’m jealous that I didn’t write this myself):

The absence of resolution authority has become as handy an excuse for the mess as any, like the lack of a League of Nations after World War I…..Resolution authority, in short, is the Maltese Falcon of regulatory reform. What is this strange bird? Simply put (though nothing here is simple), it’s the legislative authority to wind down a financial firm. In fact, this definition is about as far as anyone ever gets on the subject….In its grandiose form (as if its normal form isn’t ambitious enough), the mere presence of resolution authority will scare the crap out of stockholders, creditors and counterparties and make them do their job, which is insuring that banks don’t go all suicidal, blow themselves up and force regulators to do their jobs….

But something about resolution authority feels too good to be true. Resolution authority is modeled after the Federal Deposit Insurance Corp.’s power to deal with failing banks. That’s fine, but when was the last time the FDIC tackled a promiscuously interconnected, global, highly leveraged giant? Given that we seem to have no idea how finance is wired, how can we be sure that we can halt contagion from spreading from a firm rotting faster than a day-old corpse?….Resolution authority might even trigger self-fulfilling prophecies — setting off an early scramble for the exits, while regulators are still watching the feature. And what about overseas assets?….

Who believes that if Goldman, Sachs & Co. was flaming out, the feds would not flinch? Answer: no one with a measurable IQ. Resolution authority resembles proactive bubble defense: The optimal time to use it is before the anticipated corpse turns blue. But if Paulson had shuttered Lehman right after Bear collapsed, would he be praised, pilloried or prosecuted like a dog? Lehman would have howled, Congress would have whined, so try door No. 3. Resolution authority demands, well, resolution in the face of a spitting mob. And yeah, money; no free lunch here. To make it fly requires a hero — Volcker played that role once on inflation — willing to lose everything. Alas, such lunatics are rare, making resolution authority just a dusty prop from an old movie.

Yves here. Aside from pointing out the obvious, glaring operational issues, Teitelman points out that there is a massive political problem: for resolution authority to prevent contagion, the sick financial firm probably has to be taken out and shot relatively early. Look how quickly Bear went into a death spiral, a mere ten days. Paulson, who was famously aggressive (like it or not, it did take nerve to put Fannie and Freddie into conservatorship) stepped back on Lehman (this seems to have been in part collective frustration of the officialdom team when the Barclays rescue was blocked by the FSA, of having not been prepared for that deal to fail, but it was also clear at the time that Lehman was not going to be rescued, that the bad press on Bear meant the next firm that foundered would not be helped).

Remarkably, the often-sound Epicurean Dealmaker defends the fantasy resolution authority. And his choice of metaphor undermines his argument. He uses both a “break glass” emergency image and the same expression in the article. Surely he must recall the Neal Kashkari “break the glass” memo mentioned in Sorkin’s Too Big Too Fail. It was well received by the higher-ups and was totally useless in practice.

ED offers two defenses, that the vagueness give regulators flexibility and discretion. Ahem, regulators always have those available to them. And the powers that be had that in spades during the crisis. They went around and did rescues that were widely criticized for their inconsistency and ad-hoc-ness. Why were Bear’s shareholders given anything at all? Why were WaMu’s sub bond holders crammed down (and worse, as John Hempton bitterly argues, a bank that he believes was not insolvent taken out and shot?). In fact, that very “flexibilty” meant that the authorities seemed to be constantly overcorrecting in response to whatever criticism they had gotten on their most recent salvage operation.

“Flexibility and discretion” is merely putting a happy face on “we’re going to have to improvise our way through this one yet again.” Now a certain amount of improvisation is necessary (an old saying has it that no plan survives first contact with the enemy). But for an completely untested and untrusted regime, the authorities need to convey the ground rules and key mechanisms in advance, both to prepare investors and counterparties, and more important, to debug the plan on paper as much as possible in advance.

Another ED argument in favor of flexibility amounts to, “markets evolve too quickly, you can’t really plan.” I don’t buy that in the strong form version he presents. The Bank of England prepares a Financial Stability Report twice a year, and it very clearly identified the dangers that large complex financial institutions posed pre crisis, as well as the risks posed by key markets. Unfortunately, that analysis did not translate into the kind of preventive measures that might have been warranted (but the UK also has the problem of large domestic banks with large international exposures, which means that many of the risks were beyond the authorities’ ability to contain). This means that regulators need to be vigilant about the evolution of markets, monitor exposures aggressively, and update emergency plans frequently (at least annually, and in a fundamental rather than superficial manner).

Or it points to another approach. I am very skeptical that the financial system can be made less dangerous and costly to society as a whole absent root and branch reform, which means much more aggressive oversight, with the objective of regulating activities that are critical to advanced capitalist economies (namely, the credit markets infrastructure) like utilities (I discuss how to go about doing that longer-form in ECONNED). We clearly lack the political will to do so now. In the meantime we will be subjected to various reform proposals which leave the system which has enabled the financiers to loot taxpayers on an unheard-of scale intact.

Reader Comments, Discussion on ECONNED

Reader Sundog suggested I gather reader comments on ECONNED and update them weekly, particularly since I am answering questions. In the future, I’ll do this on slower news days (probably Saturday AM into Sunday), but figured I should start now.

Also, radio/TV bookings are just starting, will also keep you updated. I was just on WLW, the Bill Chapman show, out of Cincinnati (3/7, 11:30 PM EST); will be on WBAI with Doug Henwood at 3:00 PM EST on 3/8. Some TV bookings circled for this week, not yet confirmed.

We also got a very nice review from Joe Costello at Archein, which he starts with the closing paragraph of the book:

The result has been a massive transfer of wealth, with its centerpiece the greatest theft from the public purse in history. This campaign has been far too consistent and calculated to brand it with the traditional label, “spin”. This manipulation of public perception can only be called propaganda. Only when we, the public, are able to call the underlying realities by their proper names—extortion, capture, looting, propaganda—can we begin to root them out.

The review continues here.

Here is one conversation in comments:

EmilianoZ says:
March 7, 2010 at 3:32 pm (Edit)
2 questions about “Econned”. At the beginning of chapter 2, Krugman is savaged for saying in 2008 that skyrocketing oil prices were not driven by speculation.

1) I don’t understand what argument Krugman was making about futures price and spot price. What should be the relation between futures and spot prices in presence and absence of significant speculation?

2) The other argument by Krugman is illustrated by Figure 2.1. On the horizontal axis is Quantity and on the vertical one is Price. You have two lines representing Supply and Demand. The Supply line goes up, which seems to mean that as producers make more of the same stuff they’re asking higher prices for it. Does that make sense? Are we talking price per item?

Yves Smith says:
March 7, 2010 at 6:45 pm (Edit)
One of the arguments made (Mike Masters in particular was big on this) was that investors using futures contracts as an inflation hedge was distorting prices. The data did clearly show a big increase in “non commercial” purchases of commodities futures of all sorts, generally via index funds (personally, I don’t think this was likely the main distortion mechanism; the oil market has a proud history of traders, as opposed to passive investors, pushing prices around).

Krugman basically said those futures purchases were irrelevant, since futures all converge to the spot price.

Re his chart, that depicts a general argument often made. He’s basically saying, “OK, let’s say, despite my belief otherwise, that somehow these speculators pushed prices higher than the level that would be due to fundamental forces.” In that argument, the “higher price” is the horizontal line, the price you’d get from fundamental forces is where the supply and demand lines intersect. The shaded triangle is excess inventories. If you have a higher price than dictated by the “fundamental” price, you’d expect to see inventory accumulation. He said there was no evidence of inventory accumulation, ergo the price must be right (as in the result of fundamental forces).

EmilianoZ says:
March 7, 2010 at 9:48 pm (Edit)
Thanks for the reply. So, Krugman’s argument was that futures and spot prices were converging.

But, can it happen that all the available oil is bought in the form of futures (by real users and speculators) and there aint any left to be bought on the spot?

charles says:
March 7, 2010 at 10:08 pm (Edit)
The problem lies with the definition of what is an inventory for oil. If one adopts a narrow definition (tanks in cushing, floating storage in supertankers), inventories have not raised by much and the argument by Krugman is valid. However, spare capacity in oil wells that can be tapped quickly represent a “shadow” storage capacity that can be mobilised through the intertemporal oil market (futures and OTC instruments). In normal times, this shadow storagehas no value, but when investors want to get long oil without the capacity to store it, holders of storage capacity(shadow or narrow) can ride the contango by selling the short end futures (no risk to them as they have the capacity to deliver), but knowing very well that these futures are in fact going to be rolled thus extracting a big benefit every time there is a roll, by putting themselves on the other side of the roll trade.
If one counted these “shadow” inventories that were mobilized, Krugman assertion may not be that valid…

The final problem is to find out if this mecanism is “evil” speculation, or “legitimate” market behaviour driven by an adjustement of expectations of future oil availability and demand on one side, and the real value of the dollar on the other.

Yves Smith says:
March 7, 2010 at 10:17 pm (Edit)
You need to be a professional (have access to storage) to use futures as a way to “buy” oil. In fact, only people who can take delivery are allowed to enter into contracts where they might have to take delivery.

Krugman’s point on spot v. futures would be correct if people bought oil based on spot prices (or in relationship to spot prices) which is the way it works in most commodity markets. But precisely because oil had had a history of price manipulation, prices were set for many buyers and sellers not via spot prices, but via the BWAVE, which is formula which averages futures prices.

Another question:

I’m intrigued by the 3-body problem expounded in Chapter 2 of Econned as an example of non-ergodicity in real-life. Samuelson’s ergodic assumption states that there must exist a “unique, long-run equilibrium independent of initial conditions”. On the other hand Poincare showed that solutions to the 3-body problem were so sensitive to initial conditions that infinitesimal variations in them lead to totally different outcomes.

1) It seems to me that Poincare’s findings only partially negate ergodicity. Let’s say for argument’s sake that there are 2 solutions to the 3-body problem. In the 1st we have a system like sun+earth+mars, body 2 and 3 orbiting body 1. In the second we have sun+earth+moon, body 3 orbiting body 2 that orbits body 1. Those two solutions are different but they’re still stable. What’s most important for economists? The existence of an equilibrium or the uniqueness of that equilibrium? Maybe they can work with ergodicity-lite: “there exist different long-run equilibrium states that depend on initial conditions”.

2) Extreme sensitivity to initial conditions reminds me of climate modeling. We’ve all heard of the “butterfly effect”. You launch a simulation you obtain sunny sky. You change an input variable just a wee tiny bit (like the flap of a butterfly’s wing) you obtain a hurricane. I’m not a climate scientist but my understanding is that they overcome this problem by performing a lot of simulations with a lot of different input parameters. Apparently the average of all the different results is to be trusted. This might be similar to the Monte-Carlo method where you randomly sample the space of all possible configurations. If climate scientists do it and physicists do it, why can’t economists do it too?

Yves Smith says:
March 8, 2010 at 12:23 am (Edit)
I had an elite mathematician (Harvard PhD in theoretical math, which if you know math programs, makes him one of the very top mathematicians in the US) editing the book. This isn’t a matter of two solutions to the three body problem. The number of solutions, for practical purposes, are so large as to be incomputable (or more accurately, if I recall the later Karl Sundman solution correctly, this is the problem with not being a Serious Mathematician, is that while it was in theory solvable, the proof demonstrated that any solution would require so many terms as to make it unsolvable for practical purposes).

From March 4:

liberal says:
March 4, 2010 at 7:34 am (Edit)
I’m having a Dean Baker moment.

Only thing I see missing from ECONned’s index: Dean Baker!(*)

He got the housing bubble right, for the right reasons, earlier than almost anyone.

Not to mention calling the dot com bubble, which saved me quite a bit of money.


(*) Well, not entirely. No reference to Henry George or e.g. Michael Hudson either. If we taxed the cr*p out of land, credit markets would be much much smaller, and bubbles would be far fewer. Otherwise book seems really good.

Yves Smith says:
March 4, 2010 at 7:45 am (Edit)

Just so you know, Palgrave fought me on book length (look at teeny type of endnotes and the treatment of the dedication…). Given that that the book covers over 60 years of territory, that forced some choices.

And from March 3:

Michaelc says:
March 4, 2010 at 1:40 am (Edit)
Yves, I have to commend you on Heart of Darkness. It’s an excellent piece. ‘trading sardines’, very droll

I was dismayed after reading chapter nine, to read Michael Greenberger’s presentation at the Roosevelt Institute which leaves little hope that his sensible (and revoltionary) suggestion will make it into the legislation as long as Geithner’s in charge.

Perhaps you can deliver an autogrphed pamplet containing Chapter 9 to every senator/congressman who has a hand in crafting the bill, with copies for Timmy and Summers for good measure. II’ll contrast nicely with the ISDA papers they’re more familiar with.

Banksters Win Again, Edition 1,477,536

The Financial Times give us yet another sorry update in the bankster vs. the general public saga, and the banksters continue to gain ground. Their latest about-to-be-cinched victory is beating back a pro-reform idea sponsored by Senator Dodd (yes, even he can have the occasional “Nixon Goes to China” moment). Dodd had wanted bank regulation to be stripped from the Fed and housed in a new agency.

While that model can be argued to have led to some fumbled passes in the UK during the early stages of the crisis (most notably, the Northern Rock run), many observers contend that the flaw was the failure to hash out certain operational details, rather than the structure being inherently unworkable (in general, any organization structure is going to have particular shortcomings; you therefore need to have other mechanisms in place to compensate for them).

Perhaps most important in the case of the US, the Fed is far and away the most captured, the most asleep at the switch of the banking regulators. Keeping them in charge of bank regulation is like reappointing a fire commissioner who let half the town burn down.

And the “compromise” settled upon is to allow the banks most in need of tough supervision, ones with more than $100 billion in assets (which amounts to the biggest 23, and thus includes all the 19 TARP recipients) to remain the wards of the supine Fed. Yet these are the ones that pose the biggest systemic risks. Heck of a job, Brownie.

The notion that makes this guaranteed-to-continue-to-be-weak oversight OK is that the big banks will be permitted to fail. While that may be credible for some of the really big banks (Fifth Third, for instance, is large but not systemically important) any large capital markets player is an integral part of crucial debt market operations. Those large firms in turn are deeply enmeshed via counterparty relationships, most notably repos and credit default swaps. How, pray tell, do you shut down a trading firm in an orderly fashion? You can’t freeze positions, which is what you need to do in an unwind, and not create pain and inconvenience for the counterparties. Are we going to have a firm in default (presumably with emergency credit lines) continue trading? I haven’t heard a credible solution to this rather major conundrum from the officialdom.

Ex starting a serious program to reduce the connectedness of these firms, I see only one of two likely outcomes: either a Lehman 2.0 (a firm will be allowed to fail because it will be politically necessary to have one fail, it will prove to be a mess, and then the officials, in a panic, will start bailing out the ones impacted by the unforeseen blowback) or a successor Administration will not trust the resolution procedures and will go directly to bailout (not doubt with a few punitive measures, like some forced divestitures of non-core businesses, to allow them to claim that it was not a bailout, but a new version of resolution lite).

Andy Xie reminds us that regulatory reform is a key precondition to a sustained recovery. His piece takes up one of our favorite themes: how the story of Japan’s colossal lost decades has been airbrushed here, to argue that the big Japanese mistake was insufficiently aggressive fiscal and monetary stimulus. By contrast, it is seldom reported here that the Japanese themselves believe that their big failure was not reforming their financial system in the initial years after the implosion. No one here wants to admit that we are following the failed Japanese playbook, and for the very same reasons: politicians are unwilling to take on powerful, entrenched financiers. From Xie (hat tip Crocodile Chuck):

Last year, in a moment of panic over the global financial crisis, central banks and governments poured monetary and fiscal stimulus into the global economy. The side effects of these misguided policies are already showing up….Despite the visible need for tightening, the consensus is demanding a slow and delayed exit. Japan’s “early withdrawal” is touted as an example of what could happen otherwise.

Japan has experienced two decades of economic stagnation since the collapse of the infamous bubble it suffered in the 1980s. The most popular explanations are that Tokyo wasn’t aggressive enough in stimulating the economy after the bubble burst, or that it withdrew its stimulus too early – or both. This line of thinking is popular among elite economists in the US, where it is rarely challenged. But few Japanese analysts buy it.

The Americans liken an economy in a slide to a car with a dead battery: it can be jump-started with a forceful enough push. But there’s no sound logic behind such thinking. After a big bubble bursts, an economy suffers a terrible misalignment between supply and demand. Through high prices, a bubble diverts investment and labor to unneeded activities. It takes time for an economy to normalize. The bigger the bubble, the longer it takes to heal.

The argument to “stimulate until prosperity returns” is popular because it doesn’t hurt anyone in the short term….. Japan’s tale is just a nice story that seems to support the argument.

At the peak of Japan’s bubble, the biggest in history, the excess value of its property and stock markets was more than five times its gross domestic product – more than the entire world’s gross domestic product at that time. In comparison, the excess asset value in the US bubble was less than twice its GDP, or half the global GDP. So how is it possible to just stimulate an economy back to health after such a massive correction?

Japan has run up the national debt equal to 200% of GDP — the greatest Keynesian stimulus program in history — all in the name of stimulating the economy back to health. It has failed miserably. Japan’s nominal GDP is about the same as when the stimulus began. Those who advocated the policy blame Japan’s failure on either the stimulus being too small or not being sustained for long enough – that is, the dosage, not the medicine itself, was at fault.

The bankruptcy of Japan Airlines is a sobering reminder of what is still wrong with Japan….Zombie companies that have first claims to resources have trapped the Japanese economy in stagnation for decades. The lack of shareholder rights has given the moribund companies the luxury of being able to disregard capital efficiency….

What ails Japan is a lack of reforms, not stimulus….

The crisis happened because financial professionals had incentives to bet other people’s money in a game they could not lose. With so many getting in on the act, the liquidity they threw into the trades made them effective, turning bankers into heroes, but only for a while.

The crisis showed that their behavior was indeed rational: while the losses to shareholders and taxpayers surpassed all the accounting profits that Wall Street reported during the bubble, those who made the trades are still rich, because they paid themselves bonuses in cash, not derivatives.

Obama has not been well-advised. His so-called accomplishment — stabilizing the financial system — comes from throwing trillions of taxpayers’ dollars at financial firms. He has behaved like a Wall Street trader: spending other people’s money with no thought of consequences. Anyone can do that…

Reform, not stimulus, is the solution. Only by limiting financial speculation can the foundations be laid for a healthy recovery, and to prevent another crisis.

Links 3/7/10

Dinosaur extinction link to crater confirmed BBC

Who Does What On Wikipedia? Red Orbit

Greece is a harbinger of austerity for all Jeremy Warner, Telegraph (hat tip reader Swedish Lex)

More Bank Marketing James Kwak. Now I know why Citi increased my credit line…

Stiglitz, Nobel Prize-Winning Economist, Says Federal Reserve System ‘Corrupt’ Huffington Post

Sunday Morning Comics – Goldman Sucks Edition Robert Oak, Economic Populist

Defectors Say Church of Scientology Hides Abuse New York Times. This falls into the “this is news?” category.

Volcker Says Too Soon to Cut U.S. Monetary, Fiscal Stimulus Bloomberg

China’s Bank Chief Says Currency Is Unlikely to Rise New York Times

Antidote du jour (hat tip Chris W):