The Brooklyn Bridge
Ilargi: I should read up on my Great Depression literature. Maybe I should call Ben Bernanke, that way I could finally figure out if he's really and actually studied the period. I mean, that’s what people say all the time, but his actions offer no proof that he knows anything about the 1930's. No, I’m kidding, I’m sure Ben read all the books he could find; it just doesn't mean he'll use the acquired knowledge for the greater good of the people, and after all, Ben has another (even?!) greater good to take care of. That's somewhere in the small print in his job description, explicitly or implicitly.
The 1930's came back to me through the day when I was looking at Goldman Sachs' latest actions. You see, one of the things that stands out most for me from that time, let's say roughly 75 years ago, is the immense shifts and transfers of power, money and ownership that were facilitated by the fact that so many parties, companies and individuals, were forced to sell their property for pennies on the dollar in desperate attempts to keep their homes, their farms, their factories, to keep their people employed and, ultimately, to feed their children and/or allow their employees to feed and house theirs.
Now, if you wish to see this as some sort of "natural" cycle in a free-market system, you'll probably want to call it "consolidation". If you don't, you might go for "the greatest crime in the history of America". Or, of the western world as a whole, for that matter. No matter what your opinion, it made a few people very rich and a lot of people very poor.
So let's look at Goldman Sachs these days. Goldman states they have raised the cash to pay back $10 billion in TARP loans. Doing so would pressure other banks to do the same, or risk being seen as less healthy, or even in very poor health. This could not only sink and bomb share prices for these other institutions, it could have consequences for their relationship with the government and the Federal Reserve as well. I'm specifically thinking about the oh-so-secret results of the stress tests for 10 of the main banks in the US that have allegedly been completed last week. Again, I say allegedly, because we are not allowed to know if any test has even taken place, nor what was tested for or was concluded.
Larry Summers may have said that all 19 stress-tested banks are fine, but the word is also that at least more than one need additional funds, and some even will have to be provided with, in Tim Geithner's words, lots of extra money. Many voices, William Black's not the least among them, have stated that the stress tests are just a sham, but, much as I admire Black, I think perhaps the tests are not quite so hollow. Their goal just may not be what it's presented to be.
If Goldman pays back the TARP funds before the stress test results are reported, the Treasury, which is firmly in the hands of the Hank Paulson and Robert Rubin and Larry Summers clan, in other words Goldman Sachs and Citigroup, can point to that payback, compare it to other banks that don't repay funds, and use that as a reason to put huge pressure on, or even take over, one or more banks. Don't forget that Goldman and Morgan Stanley turned into banks from securities companies 6-7 months ago. JPMorgan will pay back the funds, like Goldman, no problem there. Question is, what will happen to less politically powerful institutions?
Goldman Sachs has raised $5.5 billion for a fund to buy discounted private equity holdings. I know, $5.5 billion may not seem to be a lot of money, but that' s where the sweetness gently rubs. Keep two things in mind: 1) they'll start with a focus on assets that go for pennies on the greenback, and 2) there's a precedence in the PPIP plan for what I would call extreme leverage (for this sort of scheme), where private capital need only bring in 3%-5% of the purchase price for -toxic- assets. They've done it once, why not again? The assets they aim to buy will primarily come from 1) pension funds that have their backs against the wall just trying to meet monthly payment obligations, and 2) banks that need to meet regulatory capital requirements in order to stay alive. It's a bit like a cheap mob flick: "Nice bank you got there, you wouldn't want anything to happen to it now, would you?"
In the real world, Goldman Sachs may pay back the $10 billion it got through TARP, and it may do so for political reasons. Goldman also received an estimated $13 billion through the government bail-out of AIG. Has it volunteered to pay that back as well? If so, I haven't seen it. That should be demand number one at the Treasury, but I haven't seen that either. Down the line, it'll all mean more consolidation, more money and power concentrating in ever fewer hands, in a time when everyone with a sane mind can agree that there already is far too much of that, as evidenced, in the first place, by the fact that there are financial institutions that are considered too big to fail.
If the government plans to do something about that, what can I say: again, I haven't seen any sign of it. Not only that, the mighty are set to get a whole lot mightier, and they're using you money to do it, to achieve a goal that is very clearly not in your best interest. We're walking backwards, we're not making things better, we're helplessly watching them turn against us ever more. And the president has record approval numbers, so that won't change for now, or a long time into the future.
I was going to bring up the need to break up institutions like Goldman and JPMorgan and CItigroup,. but, in the light of all this, why would I even care trying to bring it up? Reinstating Glass-Steagall, which would mean keeping billionaire bankers from using your deposits to satisfy their own gambling addictions, would be the single best thing that could happen to the country today.
But in all frankness, looking out over the land, I am forced to admit that the very possibility of that happening is so far off, trying to discuss it here would be laughably dishonest to you. The concentration of political power in the hands of financiers today is in all likelihood unprecedented in history. What honesty says is this: get the hell out of the system what you can, run with what you can hold in your two bare arms, because it's all set to steamroller all over you and your families.
If you want to know what that will be and feel like, give Bernanke a call and ask him to recommend some books on the Great Depression.
Wall Street in Wells Fargo Moment as Euphoria Meets Stress Test
No amount of enthusiasm for Wall Street earnings reported this month -- and there was plenty on April 9 to send Wells Fargo & Co. shares up 32 percent after the bank announced a record first quarter -- can overcome what President Barack Obama may soon have to say. That’s because the results that matter, the ones that will determine whether San Francisco-based Wells Fargo and 18 other U.S. banks need more government cash, won’t be revealed until the end of April, when the Obama administration’s stress tests are completed. Treasury Secretary Timothy Geithner has said he expects some lenders will require "large" amounts of capital, and that could take the bloom off any rosy first-quarter report.
"There will be a pregnant pause until the outcome of the stress test is known," said Dino Kos, a managing director at Portales Partners LLC in New York who has worked at Morgan Stanley and the Federal Reserve Bank of New York. "The test is ultimately about who gets diluted and how much." The six largest U.S. banks by assets are set to report their latest quarterly figures over the next two weeks. Analysts’ estimates compiled by Bloomberg show that four of them will post a profit. Only Citigroup Inc. and New York-based Morgan Stanley may disclose losses. Citigroup, Goldman Sachs Group Inc. and JPMorgan Chase & Co., all based in New York, are scheduled to announce results this week. Bank of America Corp. in Charlotte, North Carolina, and Morgan Stanley will report next week.
Wells Fargo pre- announced earnings last week, saying first-quarter net income was $3 billion, or 55 cents a share, more than double the average estimate of analysts surveyed by Bloomberg. Earnings were bolstered by an increase in the bank’s mortgage business, mainly from homeowners refinancing loans at lower rates. "We do expect first-quarter earnings will be better than previous quarters, but what investors are really looking most forward to are the results of the stress tests," said Tom Kersting, an analyst at Edward Jones & Co. in Des Peres, Missouri. "Just looking at the first-quarter results may mislead some people as far as the results of the stress test."
One reason quarterly results may not be enough to win the confidence of investors is that the Financial Accounting Standards Board approved new rules earlier this month that make it harder to determine how much capital banks will need if the longest recession since the Great Depression deepens. "The question is how regulators are going to deal with the kind of FASB-adjusted earnings that we’re going to see, which are going to look very rosy, but will of course be completely non-cash," said Joseph Mason, an associate professor at Louisiana State University in Baton Rouge who previously worked at the Treasury’s Office of the Comptroller of the Currency.
Changes to fair-value, or mark-to-market accounting rules approved by FASB on April 2 allow firms to use "significant" judgment in gauging prices of some investments on their books, including mortgage-backed securities. The changes, which apply to first-quarter results, could boost capital balances by 20 percent and earnings by as much as 15 percent, said Robert Willens, a former managing director at Lehman Brothers Holdings Inc., who now runs his own tax and accounting advisory firm in New York.
Banks will also be allowed to exclude from net income any losses they deem "temporary," making it easier to provide a flattering earnings picture, said Kersting at Edward Jones.
The accounting changes probably won’t offset loan charge- offs that are growing so quickly "that by the end of the year all the top-line revenue will be eaten up by credit costs," according to Paul Miller, an analyst at FBR Capital Markets in Arlington, Virginia. Wells Fargo, which bought Wachovia Corp. about three months ago, said last week it set aside $4.6 billion in the quarter to cover bad loans and reported net charge-offs of $3.3 billion for uncollectible loans at the combined companies. That wasn’t enough, Miller wrote in a research note the same day. He estimated Wells Fargo needed $6.25 billion in loan provisions. "Wells Fargo is under-reserving for expected future losses," Miller wrote. Investors should focus on the banks’ bad-loan charges and provisions as opposed to revenue or loan growth, Miller said in an interview.
"It doesn’t matter how much money you make if you lose it on the back side," he said. "And right now these guys have lost a lot of money relatively speaking because of the loans they put on their books years ago." Goldman Sachs, the sixth-biggest U.S. bank by assets, may post a profit of $1.70 a share on April 14, according to the average estimate of 15 analysts surveyed by Bloomberg. Morgan Stanley, the fifth-largest bank, probably will report next week that it had a 19-cent loss, according to the average of 11 analysts’ estimates. The two former securities firms, which converted to banks in September, will also announce their results for the month of December because they changed their reporting year. Both companies had a loss in the three months from September through November, when their fiscal year previously ended, and analysts predict they also lost money in December.
Analysts and investors expect the banks to try to record losses in December instead of the first quarter in the hope that people will overlook the one-month results.
"They can probably throw a number of things under the rug and put that behind them," said David Killian, who helps oversee about $500 million, including investments in Goldman Sachs and Morgan Stanley, at Sterling Asset Management LLC in King of Prussia, Pennsylvania. Mark Lake, a spokesman for Morgan Stanley, and Lucas van Praag, a spokesman for Goldman Sachs, declined to comment. Morgan Stanley and Goldman Sachs each received $10 billion in loans from the government last year under the Troubled Asset Relief Program. While Goldman Sachs Chief Executive Officer Lloyd Blankfein, 54, said this month that banks have "an obligation to the taxpayers" to repay government money as soon as they can, Morgan Stanley CEO John J. Mack told employees on March 30 that "it’s the wrong time to do it now."
Banks should keep the government money "to help us get through this very difficult time in financial markets and a very difficult time in the economy," the 64-year-old Mack said. Goldman Sachs may announce plans to raise money through a share sale this week, the Wall Street Journal reported on April 10. Raising fresh funds would make it easier for the bank to repay the government. Still, some analysts cautioned that such a move would pressure rivals to do the same, making those unable to pay more vulnerable. JPMorgan CEO Jamie Dimon, 53, also has said his firm would like to repay the $25 billion it received in TARP funding. The second-largest U.S. bank probably will report earnings April 16 of 32 cents a share, according to the average estimate of 17 analysts surveyed by Bloomberg. Dimon said on March 27 that the last month of the quarter was "a little tougher" than January and February, which he said were profitable for the bank.
Citigroup, scheduled to announce its results on April 17, may lose 35 cents a share, according to 14 analysts surveyed by Bloomberg. It would be the sixth straight quarterly loss for the bank, which has received $45 billion in bailout funds. CEO Vikram Pandit, 52, said in March that the lender was profitable during the first two months of the year. Bank of America, the largest by assets in the U.S., may post earnings of 4 cents a share, according to an average of 19 analysts’ estimates. The bank, scheduled to report first-quarter results on April 20, may require a third round of government capital, according to David Fanger at New York-based Moody’s Investors Service, which downgraded the firm’s credit rating last month.
Regulators may push the bank to raise $36.6 billion in capital after the stress tests are completed to bring its capital ratios in line with peers, Oppenheimer & Co. analysts said in an April 8 report. The stress tests, designed by President Barack Obama’s administration to show how much extra capital the 19 largest U.S. banks may need to survive a deeper economic downturn, are controversial. Wells Fargo Chairman Richard Kovacevich called them "asinine" in a speech at Stanford University in California on March 13, saying the results would provide opportunities for short sellers to drive down bank stocks. Wayne Abernathy, executive vice president of the American Bankers Association in Washington, said his group is concerned that investors will place too much weight on the results of tests based on scenarios that are unlikely to happen. He also noted that banks can open themselves up to "rumor mongering" in the markets.
That view was echoed by Camden Fine, president of the Independent Community Bankers of America, a Washington trade group that represents community banks. "The Treasury has painted themselves into a corner," Fine said in an interview last week. "They are damned if they do and damned if they don’t when they announce the results. If they don’t give out enough information, or the information is presented in the wrong way, it could cause markets to plunge." While Treasury officials say they haven’t decided how much information will be released, the results will become known once it is determined how much capital each bank is required to raise. The U.S. Federal Reserve has told banks, including Citigroup and Goldman Sachs, not to discuss the tests during earnings calls with investors.
Regulators are using two economic scenarios for the tests. The first is a "baseline" forecast of 8.4 percent unemployment and 2 percent economic contraction in 2009, followed by 2.1 percent economic growth and an 8.8 percent jobless rate in 2010. The other is a "more adverse" scenario, with 8.9 percent unemployment and 3.3 percent contraction in 2009, followed by a 10.3 percent jobless rate and 0.5 percent growth in 2010. The U.S. unemployment rate has already exceeded the baseline forecast, reaching 8.5 percent last month, the highest level since 1983. Gross domestic product probably fell at a 5 percent annual pace in the first three months of 2009, more than in the adverse scenario, according to the median estimate of economists surveyed earlier this month. "The bottom line is if the unemployment rate peaks at 10 percent these banks can make it through," FBR’s Miller said. "But if it peaks closer to 12 percent, nobody makes it. Or very few people make it."
Wells Fargo May Need $50 Billion in Capital, KBW’s Cannon Says
Wells Fargo & Co., the second- biggest U.S. home lender, may need $50 billion to pay back the federal government and cover loan losses as the economic slump deepens, according to KBW Inc.’s Frederick Cannon. KBW expects $120 billion of "stress" losses at Wells Fargo, assuming the recession continues through the first quarter of 2010 and unemployment reaches 12 percent, Cannon wrote today in a report. The San Francisco-based bank may need to raise $25 billion on top of the $25 billion it owes the U.S. Treasury for the industry bailout plan, he wrote.
First-quarter net income rose 50 percent to about $3 billion, Wells Fargo said last week in announcing preliminary results that topped the most optimistic Wall Street estimates and sparked a 32 percent jump in the stock. The bank attributed the profit to a surge in mortgage originations and revenue from Wachovia Corp., acquired in December. Full results are scheduled for April 22. "Details were scarce and we believe that much of the positive news in the preliminary results had to do with merger accounting, revised accounting standards and mortgage default moratoriums, rather than underlying trends," wrote Cannon, who downgraded the shares to "underperform" from "market perform." "We expect earnings and capital to be under pressure due to continued economic weakness."
Wells Fargo raised its provision for loan losses by $4.6 billion in the quarter, below Cannon’s estimate of $5.4 billion. FBR Capital Markets analyst Paul Miller wrote after the announcement last week that he expected a $6.25 billion increase. Net charge-offs were $3.3 billion in the quarter, compared with $2.8 billion in the previous period at Wells Fargo and $3.3 billion at Wachovia. The current numbers are artificially low because consumers received tax refunds and a there was a moratorium on some mortgage defaults, wrote Cannon, who predicts a "re-acceleration" of charge-offs in the second quarter. The ability of Wells Fargo and 18 other U.S. banks to withstand further economic deterioration is being determined by the government’s stress tests, which will be completed by the end of April. Treasury Secretary Timothy Geithner expects that some lenders will require "large" amounts of capital.
While Wells Fargo is likely to pass the test, regulators may "push for higher capital levels," wrote Credit Suisse analyst Moshe Orenbuch in New York, who initiated the shares with a "neutral" rating today. "Given rising unemployment, continued home price declines and general macroeconomic headwinds, WFC’s consumer and commercial portfolios remain at risk for meaningfully higher credit losses over 2009 and 2010," Orenbuch wrote. Wells Fargo fell 36 cents, or 1.8 percent, to $19.25 at 2:22 p.m. on the New York Stock Exchange. It has dropped 35 percent this year. Wells Fargo trails only Bank of America Corp. in U.S. home lending.
How Treasury could force banks to take their medicine
And whether financial institutions will need to disclose stress test results
Major stress tests for the 19 largest U.S. financial institutions are due at the end of April and, depending on the results, government officials are
expected to make further capital injections as part of the Treasury Department's latest program to jump start the economy. The results of the stress test are likely to vary widely with government officials preparing individualized funding options for the 19 banks, each with $100 billion or more in assets under management, as part of its Capital Assistance Program, or CAP. The tests are being completed by the Treasury and the Office of the Comptroller of the Currency, where the large banks are registered. However, it's unclear whether banks will have the option of ignoring the results. Regulatory observers argue that there are a wide variety of ways bank regulators could pressure banks to take government capital or do other things, even if they are opposed to the idea.
David Brown, partner at Alston & Bird LLP in Washington, contends that the capital injection program could be tied to a program the Treasury Department is formulating that would create a public private fund that will seek to entice private investors with government help to buy nearly $1 trillion of toxic assets from bank balance sheets. Brown said he wouldn't be surprised if regulators expected certain banks to sell assets into the public-private fund as a condition on raising government capital through the CAP program.
Kenneth Lore, partner at Bingham McCutchen LLP in Washington, said government officials may not be so explicit in their pressure tactics. "There are so many subtle ways the government can exert its pressure with a wink and a nod," Lore said. "The banks may send a non-verbal message, 'you're going to need us later so you should listen to us now.' You won't know what the pressures will be."
Securities and banking attorneys expect most of the banks undergoing stress tests to release information publicly about the government's expectations after the tests are completed on or around April 30. However, government officials are pressing banks not to disclose information about the stress tests in the next few weeks before they are complete. There is a worry that details will spill out during bank earnings season, which starts this week. Treasury officials expect earnings season to be completed before the stress tests are finished. Nevertheless, many of the banks are expected to sign capital assistance program documents, whether they are seeking out immediate capital infusions or they plan to spend six months to raise capital before evaluating whether they want government funding.
"Banks will have to disclose signing of those papers because it's a material agreement," Brown said. John Olson, partner at Gibson Dunn & Crutcher LLP in Washington, said that given the public and investor interest in stress test results, he expects most of the 19 institutions to be under a great deal of pressure to publicly disclose how they did and what actions they are taking in response in an 8-K Securities and Exchange Commission filing. "To be safe, most will file that disclosure in an 8-K SEC filing even though it may not be required by any specific line item, because doing so automatically updates their existing shelf registrations, which they may want or need to use to raise new capital," said Olson.
Brian Lane, a partner at Gibson Dunn in Washington, said he believes a decision to disclose information will be based on the extent of the action they chose to take after the stress tests are administered. Banks that decide to take six months to see if they can raise capital on their own before considering government capital injections may decide that information may not be material enough to disclose, Lane said. However, banks that sign on immediately to get government funding are likely to decide they need to make a public SEC filing. "Then it probably will be material," Lane said.
The stress tests seek to examine whether each bank has sufficient capital reserves by evaluating whether it would survive over the next couple years based on a series of hostile economic projections for that period. Those include a pessimistic scenario where the unemployment rate rises to 8.9% by the end of this year with home prices falling an additional 22% for the same period. However, many aspects of the negative scenario are already coming to pass, leading regulatory observers to believer that more of the 19 banks will need even more capital than originally expected.
Unemployment fell to 8.5% by the end of March and Standard & Poor's Case-Shiller forecast, which the Treasury Department's pessimistic housing scenario is based on, reported March 31 that home prices fell to 19% in the 12 months ending in January. Already, government officials are working on creating a more-pessimistic scenario. This has led bank observers to speculate that government officials will expand and change their financial rescue programs to include significant capital injections and toxic asset purchases. "This is going to evolve over time," Lore said. "It would be foolish for them not the change the rules if circumstances change."
William Black: The Lessons of the Savings-and-Loan Crisis
William Black calls them as he sees them, which is why we enjoy talking with him. Black, 57 years old, was a deputy director at the former Federal Savings and Loan Insurance Corp. during the thrift crisis of the 1980s, and now serves as an associate professor, teaching economics and law at the University of Missouri, Kansas City.
At FSLIC, a government agency that insured S&L deposits, Black prevailed in showdowns with the powerful Democratic Speaker of the House, Jim Wright, and helped identify the infamous Keating Five, a group of U.S. senators (including Sen. John McCain, the Arizona Republican who lost his bid for the presidency in 2008) who tried to quash his attempt to close Charles Keating's Lincoln Savings & Loan. Wright eventually resigned amid unrelated ethics charges, and the senators were reprimanded for poor judgment. Keating went to jail for securities fraud.
"It's like Gresham's law: Bad money drives out the good. Well, bad behavior drives out good behavior, without good enforcement." –William Black
Barron's: Just how serious is this credit crisis? What is at stake here for the American taxpayer?
Black: Mopping up the savings-and-loan crisis cost $150 billion; this current crisis will probably cost a multiple of that. The scale of fraud is immense. This whole bank scandal makes Teapot Dome [of the 1920s] look like some kid's doll set. Unless the current administration changes course pretty drastically, the scandal will destroy Barack Obama's presidency. The Bush administration was even worse. But they are out of town. This will destroy Obama's administration, both economically and in terms of integrity.
So you are saying Democrats as well as Republicans share the blame? No one can claim the high ground?
We have failed bankers giving advice to failed regulators on how to deal with failed assets. How can it result in anything but failure? If they are going to get any truthful investigation, the Democrats picked the wrong financial team. Tim Geithner, the current Secretary of the Treasury, and Larry Summers, chairman of the National Economic Council, were important architects of the problems. Geithner especially represents a failed regulator, having presided over the bailouts of major New York banks.
So you aren't a fan of the recently announced plan for the government to back private purchases of the toxic assets?
It is worse than a lie. Geithner has appropriated the language of his critics and of the forthright to support dishonesty. That is what's so appalling -- numbering himself among those who convey tough medicine when he is really pandering to the interests of a select group of banks who are on a first-name basis with Washington politicians.
The current law mandates prompt corrective action, which means speedy resolution of insolvencies. He is flouting the law, in naked violation, in order to pursue the kind of favoritism that the law was designed to prevent. He has introduced the concept of capital insurance, essentially turning the U.S. taxpayer into the sucker who is going to pay for everything. He chose this path because he knew Congress would never authorize a bailout based on crony capitalism.
Geithner is mistaken when he talks about making deeply unpopular moves. Such stiff resolve to put the major banks in receivership would be appreciated in every state but Connecticut and New York. His use of language like "legacy assets" -- and channeling the worst aspects of Milton Friedman -- is positively Orwellian. Extreme conservatives wrongly assume that the government can't do anything right. And they wrongly assume that the market will ultimately lead to correct actions. If cheaters prosper, cheaters will dominate. It is like Gresham's law: Bad money drives out the good. Well, bad behavior drives out good behavior, without good enforcement.
His plan essentially perpetuates zombie banks by mispricing toxic assets that were mispriced to the borrower and mispriced by the lender, and which only served the unfaithful lending agent.
We already know from the real costs -- through the cleanups of IndyMac, Bear Stearns, and Lehman -- that the losses will be roughly 50 to 80 cents on the dollar. The last thing we need is a further drain on our resources and subsidies by promoting this toxic-asset market. By promoting this notion of too-big-to-fail, we are allowing a pernicious influence to remain in Washington. The truth has a resonance to it. The folks know they are being lied to.
I keep asking myself, what would we do in other avenues of life? What if every time we had a plane crash we said: 'It might be divisive to investigate. We want to be forward-looking.' Nobody would fly. It would be a disaster.
We know that with planes, every time there is an accident, we look intensively, without the interference of politics. That is why we have such a safe industry.
Summarize the problem as best you can for Barron's readers.
With most of America's biggest banks insolvent, you have, in essence, a multitrillion dollar cover-up by publicly traded entities, which amounts to felony securities fraud on a massive scale.
These firms will ultimately have to be forced into receivership, the management and boards stripped of office, title, and compensation. First there needs to be a clearing of the air -- a Pecora-style fact-finding mission conducted without fear or favor. [Ferdinand Pecora was an assistant district attorney from New York who investigated Wall Street practices in the 1930s.] Then, we need to gear up to pursue criminal cases. Two years after the market collapsed, the Federal Bureau of Investigation has one-fourth of the resources that the agency used during the savings-and-loan crisis. And the current crisis is 10 times as large.
There need to be major task forces set up, like there were in the thrift crisis. Right now, things don't look good. We are using taxpayer money via AIG to secretly bail out European banks like Société Générale, Deutsche Bank, and UBS -- and even our own Goldman Sachs. To me, the single most obscene act of this scandal has been providing billions in taxpayer money via AIG to secretly bail out UBS in Switzerland, while we were simultaneously prosecuting the bank for tax fraud. The second most obscene: Goldman receiving almost $13 billion in AIG counterparty payments after advising Geithner, president of the New York Fed, and then-Treasury Secretary Henry Paulson, former Goldman Sachs honcho, on the AIG government takeover -- and also receiving government bailout loans.
What, then, is staying the federal government's hand? Have the banks become too difficult or complex to regulate?
The government is reluctant to admit the depth of the problem, because to do so would force it to put some of America's biggest financial institutions into receivership. The people running these banks are some of the most well-connected in Washington, with easy access to legislators. Prompt corrective action is what is needed, and mandated in the law. And that is precisely what isn't happening.
The savings-and-loan crisis showed that, too often, the regulators became too close to the industry, and run interference for friends by hiding the problems.
Can you explain your idea of control fraud, and how it applies to the current banking and the earlier thrift crisis?
Control fraud is when a seemingly legitimate corporation uses its power as a weapon to defraud or take something of value through deceit.
In the savings-and-loan crisis, thrifts engaged in control frauds in order to survive. Accounting trickery proved to be the weapon of choice. It is at work today with the banks, and it is their Achilles heel. You report that you are highly profitable when you engage in accounting-control fraud, not only meeting but exceeding capital requirements. These accounting frauds create huge bubbles, which in turn create large bonuses, which in turn lead to huge losses.
Why then is there so much smoke and so little action?
First, they are inundated by the problem. They are trying to investigate the major problems with severely depleted staffs. Honestly. We have lost the ability to be blunt. Now we have a situation where Treasury Secretary Geithner can speak of a $2 trillion hole in the banking system, at the same time all the major banks report they are well-capitalized. And you have seen no regulatory action against what amounts to a $2 trillion accounting fraud. The reason we don't see it -- aren't told about it -- is that if they were honest, prompt corrective action would kick in, and they would have to deal with the problem banks.
Are there any parallels between the current crisis and the savings-and-loan crisis that give you hope?
Of course. Objectively, our case was even more hopeless in the S&L debacle than in the current crisis. If we were able to do it in such an impossible circumstance back then, we have reason for hope in the current crisis. I know how easily things can get off course and how quickly things can turn back again. The thrift crisis went through several lengthy courses and distortions before it finally was resolved under the leadership of Edwin Gray, the chairman of the Federal Home Loan Bank Board, which oversaw FSLIC.
We went through almost a decade of cover-ups by a Washington establishment intent on helping thrift owners. Back then, we had the Justice Department threatening to indict Gray, the head of a federal agency, for closing too many thrifts. Next, there were those so-called resolutions, where the regulators worked day and night -- to create even bigger problems for the FSLIC. Years later, these so-called resolution deals had to be unwound at great expense by closing down even larger failures. Or how about the bill to replenish the depleted thrift-insurance fund that was blocked and delayed by then-Speaker of the House, Texas congressman Jim Wright?
You say the evidence of a breakdown in the regulatory structure comes from the fact that America avoided an earlier subprime crisis in the 1990s.
Exactly. Why had no one heard of the subprime crisis back in 1991? Because America's regulators also faced down the crisis early. The same thing happened with bad credits being securitized in the secondary market. Remember the low-doc or no-doc mortgages done by Citibank? Well, the problem didn't spread -- because regulators intervened.
Obama, who is doing so well in so many other arenas, appears to be slipping because he trusts Democrats high in the party structure too much.
These Democrats want to maintain America's pre-eminence in global financial capitalism at any cost. They remain wedded to the bad idea of bigness, the so-called financial supermarket -- one-stop shopping for all customers -- that has allowed the American financial system to paper the world with subprime debt. Even the managers of these worldwide financial conglomerates testify that they have become so sprawling as to be unmanageable.
What needs to be done?
Well, these international behemoths need to be broken down into smaller units that can be managed effectively. Maybe they can be broken up the way that the Standard Oil split up back in the early 1900s, through a simple share spinoff.
The big problem for the last decade is that we have had too much capacity in the finance sector -- too many banks have represented a drain on our talent and resources. All these mergers haven't taken capacity out of the system. They have created even bigger banks that concentrate risk to the taxpayer, and put off dealing with problems.
And a new seriousness must be put into regulation. We don't necessarily need new rules. We just need folks who can enforce the ones already on the books.
The bank-compensation system also creates an environment that leads to mismanagement and fraud. No one has to tell someone they have to stretch the numbers. It is all around them. It is in the rank-or-yank performance and retention systems advocated by top business executives. Here, the top 20% get the bulk of the benefits and the bottom 10% get fired. You don't directly tell your employees you want them to lie and cheat. You set up an atmosphere of results at any cost. Rank or yank. Sooner rather than later, someone comes up with the bright idea of fudging the numbers. That's big bonuses for the folks who make the best numbers. It sends the message -- making the numbers is what is most important. There is a reason that the average tenure of a chief financial officer is three years.
Compensation systems like I have just described discourage whistleblowing -- the most common way that frauds are found in America -- because the system draws upon the cooperation of everyone.
The basis for all regulation and white-collar crime is to take the competitive advantage away from the cheats, so the good guys can prevail. We need to get back to that.
AIG in spotlight over derivatives
The unit that all but destroyed AIG has failed to sign up for the overhaul of the global derivatives market which was given added impetus by the troubles at the US insurance group. AIG confirmed that its financial products unit, whose soured bets on credit default swaps forced the company into government hands last year, did not adopt the "Big Bang" protocol that has been signed by more than 2,000 market participants.
The protocol, created under the auspices of International Swaps & Derivatives Association, is intended to make it easier for investors in the opaque market for credit derivatives to know what will happen to their contracts if debt defaults occur. It came into force on Wednesday. AIG Financial Products opted to eschew the protocol and make bilateral agreements with counterparties on more than 200 outstanding derivatives trades. People close to the situation said the highly complex nature of many of AIG FP’s trades, particularly the credit default swaps on mortgage-backed securities, made it easier to negotiate with individual counterparties rather than adopt a catch-all protocol.
"We fully intend to adhere to the protocol but for technical reasons have decided to do so through bilateral agreements with our counterparties," AIG said. Company officials added that for simpler transactions, such as CDSs written on individual corporate bonds, AIG FP would adopt a contract similar to the protocol. AIG FP’s move raised eyebrows, with worries that because AIG is not a signatory to the new credit derivatives regime, it could choose not to abide by a credit event ruling. Senior bankers and AIG downplay AIG FP’s absence from the protocol as the unit unwinds its legacy positions, runs down its portfolio and is no longer an active participant in the market.
Earnings Recovery Could Take 20 Years
Over the long haul, stocks track earnings (the 10% market return over the past century was composed of 2% real earnings growth, 3% inflation, 4% dividends, and 1% multiple expansion). It therefore makes sense to get a sense of how fast earnings are likely to recover once this depression ends.
John Mauldin discussed this issue in his newsletter last week. John still believes the recent rally is a suckers' rally and that we'll likely be working our way out of this hole for years. One reason for that pessimism is the conviction that earnings won't just snap back to pre-crash highs the way they have in recent recessions.
In short, because the peak earnings of 2007 were inflated by leverage (debt), and that leverage is now been stripped from the system. Last time we went through an extended period of deleveraging, after the 1920s, it took 18 years for earnings to regain their old highs. If this recovery mirrors the 1930s recovery, S&P 500 earnings won't regain their highs until 2025 or so.
John also thinks that the current rally in the stock market will fail as soon as the stimulus bleeds off and the Bush tax cuts phase out next year:
[L]et's look at a very interesting chart sent to me by one of my readers, Chad Starliper of Rather and Kittrell in Knoxville, Tennessee. It shows all the cumulative drops in earnings from major peaks, along with the recovery paths. What is interesting is the divergence between the pre- and post-WWII periods. Our experience since 1945 is one of rather quick recoveries, averaging about 3-4 years until earnings rise above the old highs.
The thicker black line shows a drop of 69.2% from peak earnings since 2007. Prior to World War II, it took 12-20 years for earnings to recover. Earnings are still dropping. As I will point out in the next few e-letters, we live in a world (not just the US) that is in a deep recession. There is massive deleveraging and deflation. The recovery is going to be quite slow, and that portends a slow recovery in earnings, which suggests protracted churning in the stock market.
Even ignoring the disastrous 4th quarter of 2008, what if earnings drop by 80% or more, which is quite possible? That means they have to rise by 400% to get back to new highs. That could take some time. Even if they could rise at an unlikely 24% a year, it would take six years to see new highs. Look at what a mountain corporate earnings must climb.
Consumers are retrenching, and savings rates are likely to rise for at least 3-4 years, back to 7% or more, leaving consumer spending not at 70% of US GDP but closer to 63%. That will be a rather large adjustment, and will mean that a lot of productive capacity will have to be closed or allowed to lie in disuse for a long time. We just built too many strip malls and car factories and restaurants. It is going to take some adjustments.
Further, the Democratic Congress and the Obama administration are going to enact the largest tax increase in history in 2010, just as the economy is barely recovering. The Bush tax cuts go away, because the Republicans could not make them permanent when they had the chance. We are going to pay for that with a likely dip back into a recession in 2010, or at the very least a prolonged weak economy.
Tarp investigator seeks evidence of book fiddling
The official policing the $700bn Tarp fund says he is investigating whether banks have "cooked their books" to secure bail-out money. Neil Barofsky, special inspector-general for the troubled asset relief programme, told the Financial Times he was seeking evidence of wrongdoing on the part of banks receiving help from the fund, which was designed to ease credit conditions and support distressed industries "I hope we don’t find a single bank that’s cooked their books to try to get money but I don’t think that’s going to be the case," said Mr Barofsky, who has been dubbed the "Tarp cop". Just how banks value mortgage-backed securities and other assets on their books has been an issue of intense debate as the financial crisis has unfolded.
Large banks from Citigroup to Goldman Sachs and hundreds of regional banks have taken billions from Tarp to rebuild balance sheets weakened by the financial crisis.
But institutions applying for Tarp money had to show they were fundamentally sound, potentially prompting them to mis-state their assets and liabilities. Mr Barofsky also said the Treasury’s expanded term asset-backed securities loan facility (Talf) was ripe for fraud. The former New York prosecutor said the decision to expand the Talf to encourage investors to buy distressed, or "legacy", assets from banks could put public money behind investments that were backed by fraudulent mortgages.
"One of our strongest recommendations of the last report was do not expand the Talf to buying legacy assets. If its structure is not changed considerably it’s very, very dangerous," he said. "We know the triple A rating [ascribed to the securities by credit rating agencies] was a sham. We could be buying securities that are backed with assets that we know were likely riddled with fraud." Mr Barofsky revealed at a Congressional hearing earlier this month that he was involved with "probably more than a dozen" investigations into possible wrongdoing and fraud. He told the FT that potential fraudsters would pay attention when his team began seeking indictments. "Indictments can serve as great deterrents," he said.
Mr Barofsky declined to detail what crimes institutions could have committed. But securities fraud, wire fraud and false statement were all possible lines of inquiry, he said. In the first public allegation of Tarp fraud, the Securities and Exchange Commission, with assistance from Mr Barofsky’s office, claimed in January that ProTrust, a Nashville-based company, offered clients a fictitious opportunity to invest in the government’s bail-out scheme. With scant reporting requirements when the bail-outs began at the end of last year, banks had a fairly free rein on what to do with Tarp money. Concerned about a lack of transparency, Mr Barofsky has written to all of them to ask how the funds were spent.
"We haven’t served a single subpoena," he says. The preliminary audit will be published in the next few weeks, after analysis of the "pretty detailed descriptions with what banks say they’ve done with the money". That fulfils part of his office’s transparency remit and is not necessarily a trawl for fraud. But big banks are potential targets. The energetic – and potentially aggressive – approach to following the money chimes with the belated rush to oversight in Congress and the outrage over how legislation allowed $165m bonuses to be paid to executives at AIG, the bailed-out insurance group. "One of our main areas of focus [on executive compensation] is to see if there was a significant communications breakdown as to how that policy decision was made," says Mr Barofsky.
Ilargi: An interesting bit of 'number calling' by Tyler Durden. Yes, we can have a trillion discussions on them, but overall they're pretty accurate.
Observations On The U.S. Debt
Some observations on the total U.S. debt (the number are conservative) without commentary. The total is subject to interpretation and the probabilistic treatment of contingent liabilities and guarantees as well as the netting of derivative notionals.
Total US Debt so far: $115 - $315 Trillion dollars? (excluding/including derivatives notional)
$380,000 - $1,037,000 per person.
The break out:
$9.7 Trillion in bailouts
$11 Trillion in national debt
$17 Trillion in corporate/financial debt, and $13.8 Trillion in household debt
$1 Trillion in credit card debt
$10.5 Trillion in mortgages
$52 Trillion in social security/medicare obligationsLike other government trust funds (highway, unemployment insurance and so forth), the Social Security and Medicare Trust Funds exist purely for accounting purposes: to keep track of surpluses and deficits in the inflow and outflow of money. The accumulated Social Security surplus actually consists of paper certificates (non-negotiable bonds) kept in a filing cabinet in a government office in West Virginia. These bonds cannot be sold on Wall Street or to foreign investors. They can only be returned to the Treasury. In essence, they are little more than IOUs the government writes to itself.$200 Trillion in U.S. bank derivatives (notional)
Total excluding derivatives: $115 Trillion
Total including derivatives: $315 Trillion
In budgetary context:
$2.3 Trillion budget deficit this year, $10 Trillion in the next 10 years.
In the context of the consumer balance sheet:
$20.5 Trillion of residential real estate
$8.8 Trillion of equities
$7.7 Trillion of deposits and cash
$4.1 Trillion of consumer durable goods
$1.6 Trillion of corporate bonds
$960 Billion of municipal securities
$920 Billion of agency paper
$273 Billion of treasury notes and bonds
Total: $44.9 Trillion
My question is: everyone knows the social security underfunding can not be funded - it is a matter of 10 years at most before we hit the SS wall... and yet we brush it under the carpet. Does this mean we have 10 years at best before the economy collapses and thus we will just speculate on increasing market volatility, gambling more and more each day, until the emperor's clothes are revealed? What are the unintended consequences of trading for the sake of trading and increasing volatility?What happens after the SocSec obligations can no longer be postponed. Is this a problem that can be inflated as well, and is the magnitude of the inflation necessary to plug a $50 trillion domestic hole too big for the global financial system? Also, is the $1.2 quadrillion in listed and OTC derivatives (essentially vol bets) which is an unprecedented number, a direct inferrence of the increasing desire by all market participants merely to speculate instead of invest?
(for commenters, i bring your attention to the fact noted above that these numbers are subject to interpretation - this is merely meant to provide a frame of reference for the U.S. problem)
Goldman to buy discounted private equity holdings
Goldman Sachs has raised $5.5 billion for a fund to buy discounted private equity holdings – the largest amount ever raised for a fund of this type – as investors anticipate a flood of forced sellers trying to offload private equity stakes. Goldman’s Vintage V fund last week closed to new investors after 10 months of fundraising, having surpassed its goal of $5bn. The fund is a so-called secondary fund, which buys investors’ holdings in private equity and buy-out funds. The successful fundraising reinforces the view that the private equity secondary market is where most deals are expected to happen in the next year, as investors try to raise cash. JPMorgan Chase is also raising a secondary fund and is believed to have attracted $500m over the past few months.
Banks, which account for about 25 per cent of private equity investors, are expected to be big sellers of their holdings as they seek to raise capital. David de Weese, a principal at Paul Capital, a secondary market firm, said: "There is $130bn of private equity on the balance sheets of the six big US banks and AIG. AIG alone has $30bn. When you have a federal regulator sitting in your office, you develop a new view of what you are willing to sell." Investors who buy into private equity funds cannot redeem their investments. A sale to another investor or secondary fund is the main way out. Until recently, they often sold at a premium. However, the holdings have in recent months been changing hands at record discounts of more than 50 per cent of the original value. Mr de Weese said that hedge funds with private equity holdings had emerged as new sellers, especially if they were facing big redemptions.
Pension funds and endowments are also sellers, as the fall in the value of their equities has left them overweight in private equity. Last year, the Calpers pension fund sold more than $2bn in private equity. Harvard’s endowment fund tried to sell $1.5bn in holdings this year, but was unable to get a high enough price. Orin Kramer, chairman of the New Jersey pension fund, said: "The secondary market will become very interesting, We’re carefully watching it. But it’s a pretty treacherous due diligence. There is too wide a gap between what sellers pray for and what buyers will pay in aggregate, a lot of private equity valuations are overstated. They don’t reflect reality."
Bankruptcy-related M&A has ‘only just begun’
Bankruptcy-related mergers and acquisitions have hit their highest level globally since August 2004, and are set to keep rising as more companies are forced into distressed sales, according to Thomson Reuters data and restructuring practitioners. Thomson Reuters identified 34 announced deals in March alone, and 67 so far this year, where the target company was in bankruptcy or administration proceedings. The vast majority were in the US or Japan – reflecting the earlier onset of the recession in the US and more liberal bankruptcy rules in both countries, which allow companies to continue operating while they reorganise.
Among the highest-profile deals were those of Delphi , the US car parts maker that recently sold its brakes and suspension business to a Chinese buyer, and BearingPoint, the US technology consultancy that sold its government operations to Deloitte. Practitioners around the world forecast that the number of transactions involving distressed companies must rise further. "We’ve only just begun," said Gregory Milmoe, a US restructuring partner at Skadden, the law firm. "Given the dearth of capital and the substantial increase in the number of companies that will be troubled, one would expect the M&A rate to increase dramatically."
Richard Stables, global co-head of restructuring at Lazard, said: "People cannot borrow as much as they once could, so you’ve got to figure out how to fill the gap?.?.?.?That’s why you may think about selling part or even all of the business." Monthly totals for bankruptcy M&A peaked at 87 in July 2002 and slumped to seven in May 2007, just before the credit crunch hit. In the last downturn, a flurry of telecoms and technology company failures led to asset sales to strategic buyers as well as private equity buyers. This time, industrial and retail companies have been the most prominent distressed sellers but private equity buyers have been few because debt has become far more expensive. Insolvencies traditionally peak a year to 18 months after the start of a recession, so more bankruptcy-related sales are forecast to emerge later this year, practitioners said.
'Surgical' Bankruptcy Possible for G.M.
The Treasury Department is directing General Motors to lay the groundwork for a bankruptcy filing by a June 1 deadline, despite G.M.’s public contention that it could still reorganize outside court, people with knowledge of the plans said during the weekend. Members of President Obama’s automotive task force spent last week in meetings and on conference calls with G.M. officials and its advisers in Detroit and Washington. Those talks are expected to continue this week. The goal is to prepare for a fast "surgical" bankruptcy, the people who had been briefed on the plans said. G.M., which has been granted $13.4 billion in federal aid, insists that a quick restructuring is necessary so its image and sales are not damaged permanently.
The preparations are aimed at assuring a G.M. bankruptcy filing is ready should the company be unable to reach agreement with bondholders to exchange roughly $28 billion in debt into equity in G.M. and with the United Automobile Workers union, which has balked at granting concessions without sacrifices from bondholders. President Obama, who was elected with strong backing from labor, remained concerned about potential risk to G.M.’s pension plan and wants to avoid harming workers, these people said. None of these people agreed to be identified because they were not authorized to discuss the process. G.M. declined to comment and the Treasury Department did not comment.
One plan under consideration would create a new company that would buy the "good" assets of G.M. almost immediately after the carmaker files for bankruptcy. Less desirable assets, including unwanted brands, factories and health care obligations, would be left in the old company, which could be liquidated over several years.
Treasury officials are examining one potential outcome in which the "good G.M." enters and exits bankruptcy protection in as little as two weeks, using $5 billion to $7 billion in federal financing, a person who had been briefed on the prospect said last week. The rest of G.M. may require as much as $70 billion in government financing, and possibly more to resolve the health care obligations and the liquidation of the factories, according to legal experts and federal officials.
Since replacing Rick Wagoner on March 31, G.M.’s chief executive, Fritz Henderson, has sent increasingly clear signals that bankruptcy is probable unless agreements are reached with labor and the bondholders by the administration’s June 1 deadline. Unlike Mr. Wagoner, who refused until his final days at G.M. to consider a Chapter 11 filing, Mr. Henderson has deployed staff to work with legal and government advisers, although he does not agree a bankruptcy is inevitable. Last week, he said G.M. was proceeding on a dual track, hoping to restructure out of court, but also preparing for a filing. "If we need to resort to bankruptcy, we have to do it quickly," Mr. Henderson said in an interview with the Canadian Broadcasting Corporation.
John Paul MacDuffie, an associate professor at the Wharton School at the University of Pennsylvania, said he saw little chance of an out-of-court restructuring, given that the Obama administration had rejected G.M.’s proposed revitalization plan in March. It was submitted without the concessions that were required from bondholders and the union, and which have still not been reached. "The simplest way to frame it is that they took the loans, there were conditions on the loans, they didn’t prove their case for financial viability, and they didn’t meet the deadline, either," Professor MacDuffie said. Lawyers for G.M. and the government have much work to do before any bankruptcy case can begin, executives with bankruptcy experience said last week.
First and foremost, G.M. would have to formulate a business plan that addresses virtually every aspect of the company that it hopes to transform while under bankruptcy protection. It would have to show how it would save billions of dollars through agreements with its bondholders and unions, how many dealers it plans to keep, and the plants and offices it plans to either close or preserve. The plan also needs to give a candid forecast of the car market, a tricky prospect given the sharp falloff in sales over the last few months, these executives said. Treasury has hired the Boston Consulting Group to help with the business plan, according to a notice posted April 8 on FedBizOpps.gov, a government procurement Web site.
Participation from banks also may be needed, and because of the weak economic climate, lenders are likely to insist that G.M. wring as much out of its operations as possible. "It’s a complex system and you’ve got to be thinking big," Professor MacDuffie said. Finally, legal experts said, G.M. would have to try to prevent panic among consumers in the event of a bankruptcy filing. The government has said it will guarantee G.M.’s vehicle warranties. Since then, G.M. has started an aggressive advertising campaign stressing that car buyers should have confidence in the company, and offering to make nine months of payments, up to $500 each, for owners who lose their jobs. One delicate issue for federal officials is the fate of G.M.’s employee pension plans, which could become the responsibility of the federal pension agency if G.M. seeks their termination.
G.M. faces an unfunded liability of about $13.5 billion for its plans, which had $84.5 billion in assets and $98 billion in liabilities as of Dec. 31. That amount could sink the pension agency, requiring its own bailout before a G.M. case could be resolved. The White House has at least one option to protect the plan. The Supreme Court, in a landmark 1990 case, ordered the LTV Corporation, a steel maker, to take back responsibility for its pension plans after it emerged from bankruptcy protection. The pension agency had allowed the steel company to terminate its plans, only to see LTV negotiate a new plan with the United Steelworkers of America in which it agreed to make up a large portion of benefits that workers had lost. LTV eventually sought bankruptcy protection again and liquidated in 2002, when the federal pension agency assumed the company’s pension liabilities.
While Mr. Obama’s auto task force has held only one meeting with G.M.’s bondholders — who had rejected the company’s previous reorganization plan as too onerous — it is still seeking to win union support for a swift bankruptcy, one person involved in the discussions said. But the task force is reasonably confident that its restructuring plan could still pass muster with a federal bankruptcy judge even if the union does not accede to the proposal, this person said. A creditors committee for the "new G.M." would be formed in advance, to start working as soon as the case begins, while those with claims against G.M. would be asked by Treasury to quickly agree on terms to settle the claims.
Still, if the government and G.M. cannot bring all creditors on board, they are likely to argue that creating the new G.M. is an emergency move needed to preserve the value of the carmaker’s good assets. Bankruptcy judges are given a lot of leeway to decide what is in the best interest of all parties in a bankruptcy case. Another question hanging over G.M. is the fate of Delphi, the giant supplier of auto parts that has been in bankruptcy for more than three years. Delphi, which was once owned by G.M., has been in talks with G.M., the auto task force and its lenders over its own restructuring. The administration has set an April 17 deadline for Delphi to reach an accord over G.M.’s continued support for the parts supplier, which could be pushed back as late as April 24, according to a person briefed on the matter. Should Delphi fail to reach an agreement with G.M. and the administration, it could be forced to liquidate, this person said. In that event — a prospect that the task force is preparing for — the government and G.M. may acquire some parts of Delphi’s business out of liquidation.
GM's Plan For Brief Stay In Bankruptcy Faces Hurdle
General Motors Corp.'s strategy for a quick trip through bankruptcy court is likely to spark legal challenges from bondholders worried about getting steamrolled. Key members of an ad hoc committee representing GM bondholders have begun preparing arguments against the auto maker's bankruptcy plan, according to people familiar with the strategy. GM's leading bankruptcy plan would break the company into two parts: a good GM made up of strong assets, such as Chevrolet and the auto maker's Chinese operations; and a bad GM of underperforming assets and billions of dollars in obligations that essentially would be wound down in bankruptcy court.
Proceeds from the government's eventual sale of equity in the good company in part would go toward paying parties that have leverage over the auto maker. Those include the United Auto Workers union, which is owed tens of billions in health-care payments; and unsecured bondholders, who hold $29 billion in GM debt. Even though unsecured bondholders would get stock in the good GM, the people familiar with the matter said bondholders are concerned that GM's so-called 363 sale unnecessarily pushes bondholders to accept hefty losses on their investments. The threat of legal opposition is one reason GM management had resisted filing in bankruptcy court for protection from creditors. GM and the government have a handful of different game plans to emerge from bankruptcy court within a few months, rather than the typical stay of at least a year.
But all those plans are subject to the discretion of a bankruptcy judge and the cooperation of stakeholders. "It's the ultimate democratic process," a GM executive said, summing up the complications that can arise in bankruptcy court. Some bondholders fear GM's fast-track reorganization inappropriately mirrors what was done last fall when Lehman Brothers filed for bankruptcy protection as the U.S. financial system seized up. They draw a contrast to the dire situation at Lehman, which was believed to be melting so quickly that it required a quick sale of its trading operations to Barclay's Capital.
"Neither GM nor any of its brands are melting ice cubes, so creditors would be very concerned if any action by the automotive task force or GM tried to use the Lehman decision as an example," said one of the people familiar with the bondholder group's position. Members of the bondholders' committee have begun expressing their concerns to the Obama administration's task force. The task force has said it plans to meet with the bondholders, but it was unclear when such a discussion might take place. The Treasury Department declined to comment.
Bob Gordon, a bankruptcy lawyer with Clark Hill PLC in Detroit who isn't involved with the GM case, said bondholders may have a difficult time standing in the way of GM's plan. Under Section 363 of the U.S. Bankruptcy Code, plans such as GM's "are done quite frequently when there is someone who wants to acquire assets but wants to make sure certain claims stay with the bankrupt estate," he said. The question for the court is whether the debtor used reasonable business judgment in crafting an exit strategy, and bankruptcy judges often side with the debtor, Mr. Gordon said.
Some bondholders' committee members fear there is little they can do to slow momentum on GM's 363 plans, given the $13.4 billion in taxpayer money invested in the auto maker and the enthusiasm within the administration for the 363 route. Yet even if they don't prevail, bondholders say a legal challenge could discourage similar fast-track efforts down the line. "Many people in the distressed-investment business would be concerned about the long-term impact on the U.S. Bankruptcy Code, which many people would want to protect [even] after the fact," said one of the people familiar with the bondholders' group.
Bailed-Out Banks Face Probe Over Fee Hikes
The committee overseeing federal banking-bailout programs is investigating the lending practices of institutions that received public funds, following a rash of complaints about increases in interest rates and fees. Since the Troubled Asset Relief Program was launched last October, banks bolstered by capital infusions have boosted charges on a wide range of routine transactions, hiked rates on credit cards and continued making loans criticized as predatory by consumer advocates. The TARP funds are intended to open lending spigots and make it easier for people to borrow money.
Last week, for example, Bank of America Corp. told some customers that interest rates on their credit cards will nearly double to about 14%. The Charlotte, N.C., bank, which got $45 billion in capital from the U.S. government, also is imposing fees of least $10 on a wide range of credit-card transactions. Citigroup Inc., another recipient of government cash, is trying to entice customers to borrow at high rates. "You could get $5,000 today," Citigroup's consumer-finance unit wrote in fliers mailed to customers. The ads don't disclose that the loans often carry annual interest rates of 30%.
The interest rates "compare competitively to similar offers in the market" and vary depending on the creditworthiness of borrowers, a Citigroup spokesman said. Citigroup has received $50 billion in capital from taxpayers, and the U.S. government will soon own as much as 36% of the company's common stock. "To continue to offer competitive products and services and responsibly lend in this current environment, we must adjust our pricing," said a Bank of America spokeswoman about the company's new fees and interest rates. The U.S. government's ownership stakes in hundreds of banks, as well as political ire stoked by lucrative pay and perks, are raising the specter of new regulation on basic banking practices. First-quarter results due starting this week will be scrutinized for signs of how much taxpayer-funded capital is being funneled into loans.
Elizabeth Warren, chairwoman of the Congressional Oversight Panel, the body named by Congress to oversee the federal bailout, said the panel is working on a report examining instances of potentially inappropriate lending by banks that got taxpayer capital. "The people who are subsidizing the activities of the banks through their tax dollars are the same people who are furnishing the high profits through consumer lending," Ms. Warren said in an interview. "In a sense, we're asking taxpayers to pay twice." Last month, a Senate committee narrowly approved a bill that would rein in many credit-card marketing and pricing policies, including ballooning interest rates. Proponents of the legislation say many of the largest card issuers have received government aid and so should be subject to greater scrutiny.
Banks say that raising fees and rates, even on low-risk customers, is a legitimate way to recoup some of the costs of the bad loans still on their books. They also say taxpayers have a financial interest in seeing the industry quickly return to profitability. Any revolt over price hikes could intensify the crisis by depriving institutions of a key income source, say banks. New restrictions on these lending practices "may truly have an impact on profitability," said Gerard Cassidy, a bank analyst with RBC Capital Markets. The controversy underscores the quandaries of Washington's dual role as owner and overseer of U.S. banks. While shoring up the banking system is a goal of federal regulators and the White House, what is good for the bottom line of banks isn't necessarily good for their customers.
So far, regulators are focusing mostly on nursing banks back to health. "To my knowledge, the TARP funds weren't supposed to change consumer-protection requirements that apply to all institutions," Comptroller of the Currency John Dugan said in an interview. Mr. Dugan's office oversees most of the nation's biggest banks. One bank that advocacy groups like the Consumer Federation of America and the Consumers Union are watching is Pacific Capital Bancorp. The Santa Barbara, Calif., bank-holding company got $180.6 million from TARP and is an issuer of so-called tax-refund anticipation loans. These are loans made to people who want immediate access to their state and federal tax refunds, and typically have annual interest rates that exceed 100%.
Debbie Whiteley, a Pacific Capital spokeswoman, said the bank isn't using TARP capital to make tax-refund loans. Still, the government infusion is helping to improve the bank's overall financial health, according to the company, meaning it will be in better position to make a variety of loans. Regional banks U.S. Bancorp and Wells Fargo & Co. offer "checking account advance" loans that allow customers with direct-deposit accounts to access funds before they are credited to a customer's account balance. The short-term loans carry annual interest rates of about 120%. U.S. Bancorp and Wells Fargo said the loans satisfy customer needs for emergency credit. The cost to borrowers is relatively low, according to the banks, because the loans usually are repaid within weeks.
Last year, U.S. banks and savings institutions collected $39.5 billion in deposit-account charges, and fees for everything from ATM usage to balance transfers accounted for about 25% of the industry's total revenue, according to the Federal Deposit Insurance Corp. A big chunk of that revenue comes from overdraft fees. The industry's median overdraft charge is up 10% to $27.50 in the six months since the government began pumping capital into banks, according to Moebs Services Inc., a Lake Bluff, Ill., research firm. The median charge previously held steady for five years. Meanwhile, the average annual credit-card rate has climbed to 12.35% from 11.38% six months ago, according to CreditCards.com.
Don Mawson, a 49-year-old who works in Boston for State Street Corp., said he called Capital One Financial Corp. to complain about its decision to increase the late-payment interest rate on his credit card to 29.4% from 7.9%, even though he has never missed a payment. Mr. Mawson says the bank, which got $3.6 billion from the federal government, declined his request. A company spokeswoman declined to discuss Mr. Mawson's account but said Capital One is increasing some interest rates "to reflect the current risk environment." Unhappy customers can cancel their accounts, she added. The government has demanded that TARP recipients provide detailed accounts of what they're doing with taxpayer-funded capital. According to an analysis of federal data by The Wall Street Journal, overall loan volume at 470 banks that got TARP capital was down 1% from the quarter ended Sept. 30, compared with a 2.2% decline at banks with no capital infusion as of March 20.
Citigroup's Place on a Roll of Shame
Eleven years ago this week, banking mogul Sandy Weill took a victory lap at the Masters Tournament. Today his creation is on a government list of losers. This week is Masters golf time, a fact that takes me back precisely 11 years ago to an afternoon when I walked the grounds of the Augusta National course with Sandy Weill as he basked in the glory of the just-announced Citigroup merger deal between his company, Travelers Group, and Citicorp. Weill, an Augusta member, was there for the golf and various events orchestrated by Travelers (then a Masters sponsor). Getting my first on-the-ground exposure to the famous tournament, I savored the golf as well. But my real purpose for being there was to report a major FORTUNE article that we published 10 days later, A Helluva Candy Store. In it, I described Weill as having happily experienced "the most electric week in his life."
Well, as the world knows, that electricity got grounded. No banking company is today more worrisome, to more regulators, than Citigroup. Still, Citi -- too big and interconnected to fail and pumped up by government money -- survives. So I was therefore especially startled when a FORTUNE subscriber pointed out to me that Citi is conspicuous on a list of "Failures and Assistance Transactions" that is posted, quite obscurely, on a Federal Deposit Insurance Corp. website. The data goes back to the panic year of 1934, the first year of the FDIC's operation. In the more recent panic year of 2008, the FDIC handled 25 true failures. They ranged from tiny Hume Bank, of Hume, Mo., with its $14 million in deposits, to the very large Washington Mutual Bank, with $188 billion. (Wamu, of course, was taken over by JPMorgan Chase).
But in the midst of these failures are five items of "assistance," listed together. They are all Citigroup banks: Department Stores National Bank (deposits: $301 million); Banamex USA ($876 million); Citicorp Trust Bank FSB ($7.2 billion); Citibank (South Dakota) N.A. ($42 billion); and one of the largest holders of deposits in the nation, Citibank National Association ($230 billion). How did Citigroup's banks get on this list? Because on Nov. 23, the U.S. government, by way of the Treasury and the FDIC -- and the Federal Reserve, as an ultimate backstop -- stepped in to guarantee up to $306 billion of Citi's assets. The FDIC's maximum exposure, which qualifies as its "assistance," is $10 billion.
Technically, the FDIC aid amounted to what it calls "open-bank assistance," and an absolute rarity this is. Before Citi rudely inserted itself into this picture, the last instance of such assistance was in 1992, when a small bank in Princeton, Texas, was propped up by the FDIC because it was judged vital to its community. But neither competitors nor Congress liked open-bank assistance, wondering why the institutions getting it shouldn't just be allowed to fail. So a 1991 banking law called FDICIA, and a subsequent amendment to a related law, essentially barred the FDIC from granting such assistance -- except in instances of systemic risk. And even then, the procedures set up by the law for determining that systemic risk truly existed were extraordinary. The law says that before assistance can be granted two-thirds of the boards of the FDIC and the Federal Reserve must first recommend the step and that the Secretary of the Treasury, before making a final determination, must confer with the President.
So did Treasury Secretary Henry Paulson make a trip to the Oval Office last November, or even make a phone call, to consult with President Bush and say that FDIC assistance -- and much more -- must be granted Citi? Or did the exigencies of the financial crisis sweep aside procedure? We may know a precise answer to those questions when Hank Paulson completes the book that he is known to be feverishly writing. For now, what we know is that the second-largest banking company in the nation, Citigroup -- founded 11 years ago by an exuberant Weill -- will forever have its banks tabulated on the FDIC's list of "Failures and Assistance."
Action on AIG Unit May Cost Taxpayers
American International Group Inc.'s financial-products unit is on track to wind down by year end, but the controversy over bonuses that led to the loss of some key people may have made the process more costly for taxpayers, the unit's head said. AIG Financial Products head Gerry Pasciucco, in his first extensive public interview since the bonus dustup last month, said 20 of the unit's 370 employees quit amid the controversy, in which taxpayers and members of Congress decried retention payments to employees at the unit that helped topple the big insurer. While the drama over the $450 million bonus program, which reached a fevered pitch last month in Washington during testimony of AIG Chief Executive Edward Liddy, has faded, the financial-products staff still needs "certainty" about compensation, Mr. Pasciucco says, but the situation "seems to have stabilized."
AIG Financial Products is the unit largely responsible for the parent company's collapse. It sold billions of dollars of guarantees on complicated securities tied to mortgages, and those guarantees pushed the company into the arms of the government. AIG told the Treasury in March that the unit's overall portfolio stood at $1.6 trillion and represented "significant risk." "Failure to pay the required retention payments, therefore, could have very significant business ramifications" as AIG needed the employees to complete the job, the company said. AIG paid the bonuses, but Mr. Liddy asked some employees to give at least some of the money back voluntarily. Mr. Pasciucco says the controversy "hurt morale" and "stunned people such that our wind-down has slowed down." He added, "Taxpayers probably have been damaged."
In addition to losing employees, he says the unit's trading partners were concerned about being drawn into the controversy and the unit's work was set back by weeks. But despite the fears, Mr. Pasciucco says, the unit remains on schedule to have the "vast majority" of the $1.6 trillion "de-risked" by the end of the year. AIG agreed to pay the retention bonuses in early 2008, before the bailout, at a time when the problems with the unit's housing-market bets were becoming more serious. The government has now committed as much as $173.3 billion to aid AIG. Mr. Pasciucco took over the subsidiary after the government rescued the ailing insurer last year and has been overseeing the process of dismantling the unit's remaining business.
That includes tens of thousands of trades, mostly with other large financial institutions, that, among other things, promise to make payouts if, for example, interest rates rise or fall, or commodity prices spike or plunge. Many of the trades are currently hedged, which is intended to limit losses, but Mr. Pasciucco said maintaining the hedges "is a task," which is one reason to pay bonuses to keep employees who are familiar with the portfolio. Mr. Pasciucco said that as a result of the bonus controversy, some employees' children were harassed, and some had clubs ask them to resign. "It doesn't surprise me that some senior people said, 'You know what, I've had enough,' " he said.
New York Attorney General Andrew Cuomo, a vocal critic of the bonuses, in March said employees had agreed to give back about $50 million. AIG declines to update that figure. Overall, Mr. Pasciucco said, about a third of the resignations were from the financial-products office in London. He said that Jake DeSantis, an executive who announced his resignation in a New York Times op-ed piece amid the controversy, is still on the job short term as the commodity business he works on is resolved. AIG didn't make him available for comment. Compensation is still an issue, Mr. Pasciucco indicated. AIG was due to pay out roughly $230 million of the bonuses for the current year, but Mr. Liddy told Treasury Secretary Timothy Geithner that he would try to reduce that amount "by at least 30%." He also said some employees would take a 10% pay cut, and the 25 highest-paid, active contract employees would cut their remaining 2009 salary to $1.
In the wake of the controversy, however, Mr. Pasciucco suggested that the unit's employees are wary that their pay could again come under political attack. He said within the coming weeks and months, AIG in concert with the government needs "to give them some certainty about how they're going to be compensated." Among the employees who resigned were two top executives at Banque AIG, a French subsidiary of the financial-products unit. Before the resignations, AIG had described a scenario to the Treasury Department under which $234 billion in trades could default amid resignations. A person familiar with the matter said French authorities were confident that AIG would succeed in hiring competent managers to replace the two departing executives at Banque AIG. Commission Bancaire, a French banking regulator, had no comment.
China Slows Purchases of U.S. and Other Bonds
Reversing its role as the world’s fastest-growing buyer of United States Treasuries and other foreign bonds, the Chinese government actually sold bonds heavily in January and February before resuming purchases in March, according to data released during the weekend by China’s central bank. China’s foreign reserves grew in the first quarter of this year at the slowest pace in nearly eight years, edging up $7.7 billion, compared with a record increase of $153.9 billion in the same quarter last year. China has lent vast sums to the United States — roughly two-thirds of the central bank’s $1.95 trillion in foreign reserves are believed to be in American securities. But the Chinese government now finances a dwindling percentage of new American mortgages and government borrowing.
In the last two months, Premier Wen Jiabao and other Chinese officials have expressed growing nervousness about their country’s huge exposure to America’s financial well-being. Chinese reserves fell a record $32.6 billion in January and $1.4 billion more in February before rising $41.7 billion in March, according to figures released by the People’s Bank over the weekend. A resumption of growth in China’s reserves in March suggests, however, that confidence in that country may be reviving, and capital flight could be slowing. The main effect of slower bond purchases may be a weakening of Beijing’s influence in Washington as the Treasury becomes less reliant on purchases by the Chinese central bank.
Asked about the balance of financial power between China and the United States, one of the Chinese government’s top monetary economists, Yu Yongding, replied that "I think it’s mainly in favor of the United States." He cited a saying attributed to John Maynard Keynes: "If you owe your bank manager a thousand pounds, you are at his mercy. If you owe him a million pounds, he is at your mercy." Private investors from around the world, including the United States, have been buying more American bonds in search of a refuge from global financial troubles. This has made the Chinese government’s cash less necessary and kept interest rates low in the United States over the winter despite the Chinese pullback.
There have also been some signs that Americans may consume less and save more money in response to hard economic times. This would further decrease the American dependence on Chinese savings. Mr. Wen voiced concern on March 13 about China’s dependence on the United States: "We have lent a huge amount of money to the U.S. Of course we are concerned about the safety of our assets. To be honest, I am definitely a little worried." The main worry of Chinese officials has been that American efforts to fight the current economic downturn will result in inflation and erode the value of American bonds, Chinese economists said in interviews in Beijing on Thursday and Friday.
"They are quite nervous about the purchasing power of fixed-income assets," said Yu Qiao, an economics professor at Tsinghua University. Economists said there was no sign that the Chinese government had deliberately throttled back its purchases of overseas bonds to punish the United States for pursuing monetary and fiscal policies aimed at stimulating the American economy. While those policies may run a long-term risk of setting off inflation, they also may benefit China if they rekindle economic growth in the United States and thereby revive China’s faltering exports. The abrupt slowdown in China’s accumulation of foreign reserves instead seems to suggest that investors were sending large sums of money out of mainland China early this year in response to worries about the country’s economic future and possibly its social stability in the face of rising unemployment.
Evidence of such capital flight included a flood of cash into the Hong Kong dollar. Mainland tourists were even buying gold and diamonds during Chinese new year holidays here in late January. China’s reserves have soared in recent years as the People’s Bank bought dollars on a huge scale to prevent China’s currency from appreciating as money poured into the country from trade surpluses and heavy foreign investment. But China’s trade surpluses have narrowed slightly as exports have fallen, while foreign investment has slowed as multinationals have conserved their cash.
Jun Ma, a Deutsche Bank economist in Hong Kong, predicted that China’s foreign reserves would rise only $100 billion this year after climbing $417.8 billion last year.
Some economists contend that slower growth in Chinese foreign currency reserves is not important to the economic health of the United States, even though it may be politically important. In the first quarter, instead of the Chinese government sending money out of the country to buy foreign bonds, Chinese individuals and companies were buying many of the same bonds. "The outflow would mostly end up in the U.S. anyway," even if China is no longer controlling the destination of the money, said Michael Pettis, a finance professor at Peking University, in an interview on Thursday.
Heavy purchases of Hong Kong dollars by mainland Chinese residents early this year also have the indirect effect of helping the United States borrow money. The Hong Kong government pegs its currency to the American dollar, and stepped up its purchases of Treasury bonds this winter in response to strong demand for Hong Kong dollars. But China’s economy appears to be bouncing back from the global economic downturn faster than its trade partners’ economies. If that proves true, the result could be an increase in imports to China while its exports recover less briskly. This would limit trade surpluses and leave the People’s Bank with less money to plow into foreign reserves.
China Mulls New Stimulus to Boost Consumption, Bolster Recovery
China’s government is considering additional stimulus measures to boost consumption and bolster growth just as the nation shows more signs of recovering. The government will issue some "guideline" policies and continue to use fiscal and taxation measures to spur an expansion, the official China Securities Journal reported today, citing Gao Huiqing, a researcher at the State Information Center as saying on April 11. On the same day, Premier Wen Jiabao, said in an interview with state media that China will "closely" monitor changes in the domestic and world economy and "hammer out" new response plans when needed.
China has seen "better-than-expected" changes in the economy after the government rolled out its 4 trillion yuan ($585 billion) stimulus package, Wen said in the interview, citing stronger industrial production, expanding manufacturing index and rallying stock market. Still, Gao, affiliated with the National Development and Reform Commission, said such a recovery, which was spurred by a rebounding market and sales of property and cars, may be short-lived. "While the stimulus is indeed having an effect on loan growth and some measures of economic activity, the trend decline in exports is unbroken," said James McCormack, head of Asia sovereign ratings at Fitch Ratings in Hong Kong. "Chinese gross domestic product growth will remain below potential until the global economy recovers."
China’s 2009 exports may shrink by as much 10 percent and risk the nation’s growth target of 8 percent, Zheng Xinli, the deputy policy research head of the ruling Chinese Communist Party, said at a conference on April 11. Growth probably slowed for the sixth quarter to 6.3 percent in the first quarter compared with a year earlier, according to a median estimate by 12 economists surveyed by Bloomberg News. China’s State Council will meet on April 15 to discuss a new stimulus package, the Oriental Morning Post reported on April 11, without citing anyone. The new package will be focused more on social welfare spending and on boosting consumer consumption, the Shanghai-based newspaper said, without elaborating.
China is projecting a record fiscal deficit this year to fund spending on airports, railways, power grids and welfare homes. Policy makers have also lowered interest rates and rolled out industry revival plans to prevent a slump just as the global economy falls deeper into a recession. To spur domestic consumption to make up loss of overseas sales, China is subsidizing 20 billion yuan this year on rural purchases of televisions and refrigerators and plans to increase spending on welfare by 29 percent. In the long term, an expanded social safety net may also boost demand. The State Council issued this month an 850 billion yuan health-care plan, including building at least one hospital in every county and expanding medical insurance coverage to 90 percent of the 1.3 billion population by 2011.
China Pledges Aid to Neighbors
China announced a $10 billion infrastructure fund and $15 billion in credits and loans to help its Southeast Asian neighbors face the global financial crisis -- while Beijing's domestic stimulus efforts continued to show signs of growing money supply. The aid was orignally to have been unveiled by Chinese Premier Wen Jiabao at the Association of Southeast Asian Nations summit in Thailand, but the event was canceled because of the political turmoil. Foreign Minister Yang Jiechi, who announced the plan Sunday via China's official Xinhua news agency, said China plans to establish a $10 billion "investment cooperation fund" with the 10-member Asean to boost construction, energy, information and communications projects.
It also offered $15 billion in credits and loans to the 10-member Asean, whose members include Thailand, impoverished nations such as Laos and Myanmar to the developed city-state of Singapore. Terms of the aid weren't made public. Signaling concern for several small, but key, allies, Mr. Yang offered $39.7 million in aid to Cambodia, Laos and Myanmar. China also pledged 300,000 tons of rice to poor countries and 2,200 scholarships to students from the region. Meanwhile, loans by Chinese banks in yuan grew in March to a record high and the central bank said it would keep pumping out money, as Beijing continued to unleash credit in an effort to stimulate the economy despite concerns about asset bubbles and bad debt. Data released Saturday by the central bank showed 1.89 trillion yuan ($276.51 billion) in new yuan loans in March. The People's Bank of China, the central bank, said Sunday that it would make sure the money continues to flow.
China at risk amid surge in bank lending
China faces a surge of bad loans and speculative bubbles as the country’s banks open lending and flood the market with record levels of money supply, economists are warning. There are fears that while the short-term effects of the 5 trillion yuan (£500bn) lent by banks between January and March may nudge China’s economy back towards previous rates of growth, the rate borrowing could soon plunge the quality of Chinese banks back to the bad loan "dark ages" of a decade ago.
Over the weekend, one former senior figure in China’s parliamentary standing committee, Jiang Zhenghua, warned attendees at a conference in the capital of the huge "hidden dangers" that bad loans pose to the overall financial system in China.
The peril appears to lie in the speed and geographical spread of lending: the mostly state-owned banks, scattered throughout both economically weak and strong parts of the country, are duty-bound to follow Beijing’s orders to lend. Few analysts believe that the banks have the mechanisms or expertise to assess the quality of the borrowers. Ning Xiangdong, the deputy director of china economy research at Tsinghua University told The Times, said that the huge volume of loans had been extended to help put the economy back on track, but would definitely create a large number of bad loans in their wake. "It won’t cause the banks to collapse, but this sudden rise in loans will cause the banks’ quality to fall," he said.
The March total of new loans rocketed to almost 1.9 trillion Yuan – a liquidity rise that far outstripped analysts’ forecasts and was taken by both equity and commodity traders as an unalloyed "buy" signal. Helped along by rumours that further economic stimulus measures will soon to be forthcoming from Beijing, Shanghai stocks leapt to an eight-month high. Monday’s bull-run brought the gains in Chinese shares to nearly 40 per cent so far this year – a rally thought to have been funded by money lent on central government orders. The surprisingly high loan growth number means that, in the space of just three months of intensely vigorous lending, China’s mostly state-owned banking sector has all but reached Beijing’s target of 5 trillion yuan of new loans for the whole of 2009.
And with the People’s Bank of China indicating yesterday that it would maintain its moderately loose monetary policy and vowing to supply "ample liquidity", analysts believe that the full total of new loans this year could fly as high as 9 trillion yuan. Traders believe that the record jump in lending is already making its mark as a bubble-inflating force in commodities. Copper futures in Shanghai have, for two consecutive sessions, hit their upper trading limit after rising 7 per cent. Copper futures have rallied more than 85 per cent since their December nadir, driven by the belief that the lending glut will quickly translate into the sort of infrastructure and construction products that have historically fuelled China’s insatiable hunger for metals.
Chinese Bias for Baby Boys Creates a Gap of 32 Million
A bias in favor of male offspring has left China with 32 million more boys under the age of 20 than girls, creating "an imminent generation of excess men," a study released Friday said. For the next 20 years, China will have increasingly more men than women of reproductive age, according to the paper, which was published online by the British Medical Journal. "Nothing can be done now to prevent this," the researchers said. Chinese government planners have long known that the urge of couples to have sons was skewing the gender balance of the population. But the study, by two Chinese university professors and a London researcher, provides some of the first hard data on the extent of the disparity and the factors contributing to it.
In 2005 , they found, births of boys in China exceeded births of girls by more than 1.1 million. There were 120 boys born for every 100 girls. This disparity seems to surpass that of any other country, they said — a finding, they wrote, that was perhaps unsurprising in light of China’s one-child policy. They attributed the imbalance almost entirely to couples’ decisions to abort female fetuses. The trend toward more male than female children intensified steadily after 1986, they said, as ultrasound tests and abortion became more available. "Sex-selective abortion accounts for almost all the excess males," the paper said.
The researchers, who analyzed data from a 2005 census, said the disparity was widest among children ages 1 to 4, a sign that the greatest imbalances among the adult population lie ahead. They also found more distortion in provinces that allow rural couples a second child if the first is a girl, or in cases of hardship. Those couples were determined to ensure they had at least one son, the researchers noted. Among children born second, there were 143 boys for 100 girls, the data showed.
The Chinese government is openly concerned "about the consequences of large numbers of excess men for social stability and security," the researchers said. But "although some imaginative and extreme solutions have been suggested," they wrote, China will have too many men for a generation to come. They said enforcing the ban against sex-selective abortions could normalize the sex ratio in the future. The study was conducted by Wei Xingzhu, a Zhejiang Normal University professor; Li Lu, a Zhejiang University professor; and Therese Hesketh, a University College London lecturer.
Why the Fight against Tax Havens Is a Sham
There were many fine words about the fight against tax havens at the G-20 summit. But the reality looks very different: The OECD's new tax haven blacklist contains exactly zero entries. The heads of state of the world's most powerful nations seemed somewhat tired, and yet extremely satisfied. On the Thursday of the week before last, after hours of negotiations, they had finally agreed to a plan for a new, cleaner global financial system. "The era of banking secrecy is over," the official communiqué issued at the end of the G-20 summit in London concluded. From now on, the authors wrote, "non-cooperative jurisdictions, including tax havens," can expect to face sanctions and be placed on a list of countries not in compliance with the "international standard for exchange of tax information."
The threat promptly produced astonishing results. Less than 120 hours after the close of the London summit, the Organization for Economic Cooperation and Development (OECD) published the shortest blacklist of all time -- with exactly zero entries. Apparently not a single country today remains willing to serve as a place of refuge for global capital. The fact that all the world's tax havens seem to have disappeared overnight is primarily the result of skillful diplomacy. Even the most notorious offshore financial centers have managed to quickly purge themselves of all suspicions of aiding and abetting tax evaders. The task was not exactly made difficult for the erstwhile offenders. All a country had to do in order to be removed from the list and accepted into the circle of the supposedly purified was to provide the OECD with the solemn assurance that it intended to abide by international agreements in the future. Whether this is a step forward remains to be seen. As a result of these assurances, OECD Secretary-General Angel Gurría divided the international community into a mere two groups.
The first includes countries that behave in an exemplary fashion, such as all of the G-20 nations. This step ensured that the London summit would not become bogged down in self-criticism. The second group includes those countries that are theoretically opposed to international tax evasion, but until now have not always seen this as a reason to translate convictions into action -- by instituting concrete rules under double taxation treaties, for example. For experts, of course, the OECD list serves up a handful of surprises. For instance, hardly any tax officials would have believed that the OECD's so-called "white list" would include some of the most notorious tax havens of the recent past, such as the British Channel Islands Guernsey and Jersey. Another astonishing outcome of the new system is that China is suddenly considered a model country, even though its two so-called Special Administrative Regions, Hong Kong and Macau, are considered safe havens for tax evaders. And it borders on the miraculous that even the Cayman Islands, with a population of 50,000 people and 80,000 registered companies, have been placed on the OECD's gray list of countries willing to be reformed.
The reality is that diplomats from many states spent long days making sure their country ended up on the correct list. To avoid anyone being pilloried, a series of lively negotiations began around the world in the run-up to the G-20 summit. The important thing was to show good will. On April 1, just one day before the London summit, the Cayman Islands managed to sign seven bilateral treaties -- with the Faeroe Islands, Iceland and Greenland, for example -- to cooperate on matters of taxation. Although the specific concessions made by the Caymans, a British overseas territory, are modest, what counts is the spirit of willingness. China also took pains to avoid international disgrace. According to participants in the preparatory meetings leading up to the summit, the Chinese negotiators categorically refused to be placed on the gray list, let alone the black list. Otherwise, so the Chinese threatened, they would let the entire list project fail -- an outcome that France, for its part, was determined to prevent. Before the summit, French President Nicolas Sarkozy had boldly told French voters that he planned to wage a relentless battle against tax havens.
Other diplomats now believe that it might have been better to forget about the list altogether, especially as it is unclear what exactly will happen to the fiscal rogue states. The closing communiqué of the London G-20 merely includes a vague reference to "sanctions." "The list is complete nonsense; the process stinks to high heaven," says Luxembourg Foreign Minister Jean Asselborn, whose country was placed on the OECD's gray list. He and his fellow citizens of the Grand Duchy -- which has a population of just 485,000 but is home to 3,402 investment funds -- feel offended to have been lumped in with the worst of the offenders. "Luxembourg does not protect tax evaders, but we also don't want (German Finance Minister Peer) Steinbrück to be able to find out at the push of a button how much money a given individual has in his account," Asselborn says irately. The fact that China has been placed a step above Luxembourg is even more of a slap in the face to Asselborn. "I cannot understand how a country like France can stand up for China while opposing European Union countries or Switzerland," he says. "That destroys the glue holding Europe together."
Carl Bass is our kind of guy. Let us hasten to confess, we don't know Mr. Bass, apart from the fact that he earns his daily bread running Autodesk , which does some $2 billion a year designing and servicing software, and whose stock was a hot number until it got killed by the bear market (12-month high, 43; 12-month low, a hair under 12; current price, 19 and change). In other words, until last week Mr. Bass was, so far as we were concerned, just another corporate honcho. What brought our attention to Mr. Bass and won him our instant esteem was an item in the latest screed by our Roundtable buddy and indefatigable tech-watcher, Fred Hickey. More specifically, it directed us to February's conference call with analysts, occasioned by release of the company's earnings for the final quarter of its fiscal year, ended Jan. 31.
Mr. Bass kicked off the proceedings, as Fred noted, by telling the telephonically assembled analysts the bad news. Not only were the bum results a far cry from what he had grown accustomed to, but, he sighed, "the global economic downturn is now significantly impacting each of our major geographies and all of our business segments." The turn for the worse, he made it clear, included emerging countries where business had been robust, like China and India. And, he added, the immediate outlook was more than a touch murky.
None of which deterred an analyst, champing at the bit for good news, from asking whether there were any regions left to exploit that so far had proved immune to the global slump. "Well," responded Mr. Bass, "I think Antarctica has been relatively immune, maybe Greenland, as well, although not Iceland, as we all found out." Besides the pleasure of finding a CEO with a sense of humor and, equally important, one who doesn't suffer foolish questions gladly, the exchange struck us as symptomatic of the insatiable yearning of Wall Street, in general, and sell-side analysts, in particular, to uncover some sliver of bullishness beneath the dismal surface of the unvarnished truth.
That touching tendency to mistake dross for gold has been much in evidence in this spirited stock-market rally, five weeks running and still kicking. And it has by no means been restricted to analysts; it has infected market strategists and portfolio managers, to say nothing of economists (which is about all one can say about them without resorting to invective).
Even the most unfavorable news, from the relentless shrinkage in corporate earnings to the inexorable rise in unemployment, is all too often blithely shrugged off with the observation that "it wasn't as bad as expected," while neglecting to identify by whom. Nor does it seem even passing strange to the growing ranks of wishful bulls that banks that went begging to Uncle Sam for bailouts and were rewarded with billions have magically discovered, come the earnings reporting season, that, by gum, they're suddenly remarkably solvent (or should we say, seemingly solvent; just disregard several trillion dollars' worth of ugly stuff on their collective balance sheet, please).
We realize, of course, that Washington is on the case. And we feel for the poor, anonymous soul charged with the task of almost daily sending aloft still another trial balloon to rescue the banks. But we suppose she or he does gain a measure of satisfaction from the fact that even if the balloon goes nowhere but poof, more often than not it provides a fresh fillip to the markets. Indeed, if anything, this whirlwind activity by the administration's economic team, this profusion of blueprints for recovery, so many of which are rapidly discarded or revised or embroidered, by all rights should be giving widows and orphans the jitters rather than prompting them to take the plunge. For it smacks of confusion or panic or both. Believe us, we're impressed by the vigor of the rally and it's gone much further and faster than we expected.
And we think those hearty types agile enough to have played the big bounce deserve a big pat on the back. That doesn't mean, though, that we think it's for real or sustainable. What would cause us to change our minds is some credible evidence that the dark forces that wrought this dreadful recession are starting to dissipate. Instead, it pains us to relate, we see rough going in the months ahead. And that suggests to these rheumy eyes a disappointed market resuming its skittish ways.
Back in March of last year, we rambled on about a piece on housing by T2 Partners, a New York money-management firm. The report weighed a ton, but its heft was made more than palatable by a profusion of easily accessible bold-face tables and charts and a lucid text happily free of equivocation. We waxed enthusiastic about the analysis (and no, we hadn't been drinking). It was, of course, quite bearish.
Well, the T2 folks recently issued a follow-up to that prescient analysis, again festooned with nifty graphics and graced with straight-from-the-shoulder narration. They're still bearish and still, we think, on the money. That original report, incidentally, has blossomed into a book by Whitney Tilson and Glenn Tongue, who run T2 (you'll never guess how they got the name for their firm); the book is called More Mortgage Meltdown and is slated to be published next month (end of public-service announcement).
In their latest tome, the T2 pair begin with a crisp summary of why and how housing collapsed, in the process wreaking havoc on both the credit market and the economy. Among the usual culprits, most of which by now have had the cruel harsh spotlight of publicity turned mercilessly on them, Wall Street comes in for special mention and, in particular, its critical role in disseminating collateralized debt obligations and asset-backed securities, or -- as they're respectively, if no longer respectfully, known -- CDOs and ABSs.
Those structured monsters, note Tilson and Tongue, were a "big driver" of the surge in financial outfits' increasingly bloated profits. To produce ABSs and CDOs, Wall Street needed "a lot of loan product," of which mortgages proved a bountiful source. It's unfortunately quite simple to generate ever-higher volumes of mortgages. All you need do is lend at "higher loan-to-value ratios, with ultra-low teaser rates, to uncreditworthy borrowers, and don't bother to verify their income and assets."
The only catch is that the chances of such a mortgage being paid off are just about nil, a trifling caveat that bothered neither lenders nor pushers one whit. The result of that cavalier approach, as we all have reason to lament, in the end has been anything but happy: Today, mortgages securitized by Wall Street represent 16% of all mortgages, but a staggering 62% of seriously delinquent mortgages.
As for home prices, the T2 duo reckon, the unbroken monthly decline since they peaked in July 2006 will continue to make buyers hesitant and sellers desperate, while the "tsunami of foreclosures" will maintain the huge imbalance of supply over demand. In January, they point out, distressed sales accounted for a formidable 45% of all existing home sales and, they predict, there will be millions more foreclosures over the next few years.
They expect housing prices to decline 45%-50% from their peak (currently, prices are down 32%) before bottoming in mid-2010. They warn that the huge overhang of unsold houses and the likelihood that sellers will come out of the woodwork at the first sign of a turn argues against a quick or vigorous rebound in prices. Nor is the economy likely to provide a tailwind, since T2 anticipates it will contract the rest of this year, stagnate next year and grow tepidly for some years after that.
The first stage of the mortgage bust featured defaulting subprime loans and their risky kin, so-called Alt-A loans. Together with an additional messy mass of Alt-A loans, the next phase will be paced by defaulting option adjustable-rate mortgages, jumbo prime loans, prime loans and home-equity lines of credit.
All told, Tilson and Tongue estimate losses suffered by financial companies from mortgage loans, further swelled by nonresidential feckless lending, will run between $2.1 trillion and $3.8 trillion; less than half of that fearsome total has been realized. Which is why, they contend, we're only "in the middle innings of an enormous wave of defaults, foreclosures and auctions."
We don't want to leave you with the impression that the T2 guys are cranky old perma-bears. They aren't. At the end of their report they point out that "the stocks of some of the greatest businesses, with strong balance sheets and dominant competitive positions, are trading at their cheapest levels in years." Nothing wrong with the companies themselves, they believe; rather, the stocks got beat up mostly because of the cruddy market and soft economy. Victims, as it were, of the bearish trends.
The names they like that fall into that not exactly overly crowded category are familiar enough: Coca-Cola , McDonald's , Wal-Mart , Altria , ExxonMobil , Johnson & Johnson and Microsoft . That doesn't exhaust their portfolio picks, but those are the ones they obviously think are best suited to ride out any resurgence of the bear market.
Will Commercial Loan Losses Hurt Regional Banks?
Many midsize bank loan portfolios are more than 50% commercial and may suffer as the recession continues. Real estate is a particular worry. Bank stocks enjoyed a nice rally on Apr. 9, fueled by Wells Fargo's (WFC) surprisingly strong preannouncement of its first-quarter earnings. The KBW Bank Index, which tracks two dozen of the biggest banks in the U.S., jumped more than 20% on Apr. 9. Wells Fargo's report that mortgage refinancings went particularly well in the first three months of 2009 prompted feelings of relief among investors, who now believe banks may be able to earn their way out of their precarious capital circumstances, says Erik Oja, an analyst at Standard & Poor's Equity Research. (S&P, like BusinessWeek, is a unit of The McGraw-Hill Companies.) "Through the refinancing business in the first quarter, banks are making enough money that there's a good chance they can build up their capital levels this quarter," Oja says. That could bode well for both smaller community banks and megabanks such as Wells Fargo, Citigroup (C), and JPMorgan Chase (JPM), where residential mortgages account for a relatively big chunk of overall business. Less fortunate may be the regional banks caught in the middle, whose bread and butter tends to be commercial loans, which are seen as in greater danger of deteriorating as the recession continues.
For many regional banks, commercial loans constitute more than 50% of their loan portfolios. In an Apr. 9 note, Oja said he was "increasingly concerned about commercial lending exposure at regional banks" because "we think commercial lending credit declines may begin in force this year." In initiating Calyon Securities' coverage on 11 of the larger national and regional banks on Apr. 6, analyst Mike Mayo rated six "underperform" and the other five "sell," saying he anticipates a "rolling recession" by asset class, with loan losses in various categories peaking at different times. If as he expects, losses for all loans, commercial and other, climb from the current 2% to 3.5% by the end of 2010, Mayo predicts banks will lose $600 billion to $1 trillion over the next three years, compared with about $400 billion that they have written down on risky investments to date. David George, an analyst who covers banks for Robert W. Baird, says he foresees loan losses rising to 1.5% to 2% of all commercial loans this year from around 1% currently. But just because a certain percentage of loans goes bad doesn't mean banks can't make money, he says, citing wide spreads between interest rate accruals on loans and the much lower interest rates banks pay on deposits.
Regional banks have varying degrees of exposure to commercial loans. At the end of 2008, the percentage of commercial loans in loan portfolios was 65% for BB&T (BBT), 77% for Comerica (CMA), and 63.5% for Fulton Financial (FULT), while PNC's (PNC) and Marshall & Ilsley's (MI) portfolios were both around 56.5% commercial, according to data that CapitalIQ provided to Oja. While the banks themselves report lower percentages of commercial exposure, CapitalIQ regards as commercial loans many loans that the banks hold for investment, as well as portions of what the banks categorize under specialized lending and revolving credit. Although commercial real estate loans have performed fairly well thus far in the downturn, the weakening economy and lack of consumer demand is certain to adversely impact commercial properties, which in turn will hurt the quality of those commercial loans, says Tom Kersting, an analyst at Edward D. Jones in St. Louis. With law firms and other businesses cutting back workforce and giving up rented office space when leases expire, vacancies in office buildings are sure to rise. And new tenants most likely will pay lower rents than the former tenants were paying, says Stan Ross, chairman of the Lusk Center for Real Estate at the University of Southern California in Los Angeles. He estimates that 15% of all office space across the U.S. is currently vacant. "We can live with 10% to 12%, but we start really feeling it at 15% to 18%," he says. "And we could get [to 18%]."
Vacancies pose less of a problem for larger owners, who typically can devote cash flow from other kinds of properties to service loan payments to banks, says Ross. "We've seen some of that." A bigger issue than commercial borrowers' ability to make their annual amortizations is how they will make payments on loans that come due in full by the end of this year. In such an illiquid credit market, many of these borrowers have already had loans default as a result of debt covenants being triggered by other defaults. Banks will be more inclined to extend maturities or modify loan agreements for companies they view as good bets by virtue of their long track records. But less trusted companies likely will be required to sell off some assets or cut operating costs to pay down a substantial portion of the loans, says Ross. He estimates that banks will choose to extend or modify loans for roughly 75% of the borrowers. "The banks understand that if a shopping center is empty, it's not a question of poor management, it's a question of being impacted by poor economic times," he says. For the other 25% of the borrowers, banks can take back the assets. They can then use government programs, such as the Treasury Dept.'s Public-Private Investment Program, to sell them—or hold assets they consider good until the market returns. But that 25% is enough to cause a lot of credit deterioration in banks' commercial loan portfolios, says Oja at S&P. Total charge-offs for bad loans are now around 2%, up dramatically from lows in 2006, he says.
The Federal Deposit Insurance Corp.'s latest quarterly survey showed net charge-offs for all of 2008 of 1.28% for all 8,300 U.S. banks that the regulator guarantees. But fourth-quarter charge-offs reached 1.92%. "It's the trend that has hurt banks a lot," says Oja. Mounting charge-offs will further threaten already low equity capital ratios for most of these banks. Once the results of the FDIC's stress tests on the banks are made public by the end of April, and certain banks have been shown to be undercapitalized, the government will have to decide which ones it will force to close or merge with stronger banks—and which are worth putting more federal money into. The missing piece to the commercial lending puzzle that's critical is whether—and in what form—securitization will return, says Ross. "We had a lot of [commercial mortgage-backed] securitization, and that's typically how banks [were able to hand off the loans]." he says. "To survive in real estate, you need an exit. I teach that to all my students." There will be some problems with banks whose loan portfolios are too heavily concentrated in a particular asset class, such as strip shopping centers, or in certain locations, such as Florida. But overall, Ross says he doesn't expect further deterioration in commercial loans to destroy the banks that made these loans. And despite the recent rally in bank shares, investors aren't likely to be surprised by how badly commercial loans perform this year, says Kersting at Edward Jones. "It's priced into the stocks at this point," he says.
Iceland banking inquiry finds murky geysers run deep
Iceland’s super-rich were once heroes – entrepreneurs who gave the small country a sense of pride as they embarked on raiding missions buying up businesses in the UK and across continental Europe. But the collapse of Iceland’s banking system and currency has rocked the small country. Thousands of Icelanders have lost their life savings, unemployment has hit 9pc and interest rates have risen as high as 18pc. Demonstrations have toppled the government and central bank chief. Six months after the country’s three largest banks – Glitnir, Landsbanki and Kaupthing – were seized by the government, the entire Icelandic financial community is now under official scrutiny and its former heroes are facing tough questions.
Many of them are now the target of popular outrage. Jon Asgeir Johannesson, the boss of Baugur, has even been subject of a satirical video on YouTube, set to the theme tune of the film The Godfather. Mr Johannesson is now rarely seen in his former homeland. Nevertheless last month he claimed: "I’ll be back." The next day, several cartoons on Iceland’s internet news websites warned the public to take cover should Hurricane Jon Asgeir return to the island at three billion krona per second. Others including Lydur Gudmundsson and Agust Gudmundsson, the brothers behind Kaupthing and, Bjorgolfur Thor Bjorgolfsson and Bjorgolfur Gudmundsson, the father-and-son team who owned Landsbanki, have all but vanished from the streets of Reykjavik.
An investigation into "suspicions of criminal actions" has been launched, with institutions that attracted billions of pounds in deposits from thousands of UK citizens, businesses, local authorities and charities at its centre. Amid mounting concern that illegal activity has occurred inside publicly-traded banks Gylfi Magnusson, Iceland’s business minister, has conceded there are similarities with the country’s banking system and failed US energy company Enron. An economic crime team – with a remit to "investigate suspicions of criminal actions in the period preceding the collapse of the Icelandic banks" – has grown from four to 20 members. Among the many questions that the investigation is expected to ask are: where exactly did this money go?
How did the banks of a country the size of a single London suburb manage to burn through so many billions? And what is being done to recover assets for the creditors of the banks? Only a few months ago many believed that Iceland was just another victim of the global financial crisis. In the good times the country had benefited from the so-called carry trade, which saw financiers borrow in low interest countries such as Japan and lend in high interest countries like Iceland. But the credit crisis put an end to that. The hot money took flight. But many in Iceland no longer believe that the country is not just a victim of the credit crisis and international flight of capital. Questions are being asked about the country’s banking system that is known for its secrecy, cross-ownership and complexity. One of many shocking facts is that almost half of all the loans made by Icelandic banks were to holdings companies, many of which are connected to those same Icelandic banks.
In a radio interview last month Arnor Sighvatsson, vice-chief executive of the central bank, said: "The creditors of the banks feared that there were too many high loans to firms owned by the owners of the banks." Helgi Magnus Gunnarsson, chief of police at the economic crimes squad, who is not involved in the special investigation , explains that the scope of crisis that happened under his watch has come as a shock to him. "How much of it will end in criminal convictions I cannot say," he said. He claims the investigation will seek to establish whether any transactions included "market manipulation, insider trading, all kinds of breach of trust with shareholders about whether senior executives took loans or invested money for the people they were serving, buying their own shares without having any contract that allowed them to do so and how they invested the money of our pension funds".
One of the major areas of concern is the amount of money allegedly lent by the banks to their employees and associates to buy shares in those same banks, simply using those same shares as collateral. These loans – known as "kúlu-lán" – allowed borrowers to defer paying interest on the loan until the end of the period, when the whole amount plus interest accrued is due. Several weeks before the banks collapsed, Kaupthing, Iceland’s biggest bank, announced that a Qatari investor had bought 5pc of its shares. A press release stated at the time: "Kaupthing’s position is strong and we believe in the bank’s strategy and management team." Only after the bank collapsed several weeks later did it emerge that the Qatari investor "bought" the stake using a loan from Kaupthing itself and a holding company associated with one of its employees. The bank was in effect purchasing its own shares.
Officials have also questioned why loans to Kaupthing employees to buy shares in the bank were allegedly written off days before the collapse. The state prosecutor has now hired Eva Joly, the Norwegian-French investigator who led Europe’s biggest ever fraud investigations into bribery and corruption at oil group Elf Aquitaine. She is convinced that it will take a minimum of two to three years to build up enough evidence to secure prosecutions. "Finding proof will start at home in Iceland, but my instinct is that it will spread," she said. "If there are things relevant to the UK we will get in touch with the Serious Fraud Office. If there are things relevant to Germany we will get in touch with their authorities." The investigators will also look at whether money flowed from Iceland to Luxembourg and the British Virgin Islands, especially Tortola.
"In Iceland, there is more than enough for a starting point for the investigation, given all the talk about market manipulation and unusual loans," said Ms Joly. "If these are proved they are embezzlement and fraud. The priority is tracing any flow of assets from the banks and getting them back." It is not just the financial sector that has come under the spotlight. David Oddsson, former central banker and the former prime minister (who was forced out of office as a result of the financial crisis), has claimed that Iceland needs to investigate "unusual and unconventional loans" given by the banks to senior politicians during the boom years. It has also emerged that the Central Bank had held meetings about the financial
Politicians and businessmen who traditionally held a tight grip over the Icelandic media are now losing control. Dozens of blogs have sprung up. One of the most critical is written by the former justice minister Bjorn Bjarnson, who was in government at the time of the collapse. "I have written a lot about problems in the business sector over the last 14 years, and I can only compare some parts of it to Enron," he said. "Here companies have been playing a game, using the media and publishing to make themselves look good. We only hope that the foreign media will soon begin to understand what has been going on."
Quarter of British houses unsold after six months
More than a quarter of houses up for sale have been on the market for more than six months, research showed today. Around a third of flats and 26 per cent of houses have failed to sell during the past six months, while 10 per cent of flats and 7 per cent of houses have been on the market for more than a year, according to property website Globrix.com. The group said despite interest from potential buyers picking up during the past few weeks, falling house prices and the shortage of mortgages meant sales had remained static.
It said one-bedroom flats, which are traditionally popular with first-time buyers who are most likely to struggle to get a mortgage in the current market, were proving the hardest to sell, while three-bedroom family homes were most in demand. The market stagnation is most severe in Aberystwyth in Wales, with 26 per cent of house and 23 per cent of flats that are on the market there still unsold after 12 months. Daniel Lee, chief executive of Globrix, said: "On the surface these figures make pretty grim reading and provide few positive signs that the property market will recover any time soon.
"However, on the ground there is far more optimism. Estate agents are reporting that buyer interest has picked up over the last couple of months, and we have tracked motivated sellers price cutting across the board to attract buyers. "The problem is that this activity in the market isn't yet converting into tangible sales, or at least not at the levels to clear the gridlock in the market." He said the next couple of months were likely to provide a strong indicator of the current state of the property market, as early spring is traditionally a buoyant time for property sales.
Economy will be over worst by October, says Alistair Darling
The British economy will be over the worst of the downturn in six months, Alistair Darling will declare in his Budget. The Chancellor is set to forecast that the economy will halt its fall in the last quarter of the year, which starts in October. He will predict a return to growth at the turn of the year, with a recovery well underway by the time of the next general election. The outlook will draw political accusations of over-optimism, since some forecasters are much more pessimistic. The National Institute of Economic and Social Research this week suggested that economic growth may not resume until 2012.
However, some independent economists believe the Treasury position is credible: nearly half the City analysts polled this week by Reuters said the UK economy will at least stabilise in the last three months of the year, and some predict growth will resume then. Despite bleak economic data and rising unemployment, government insiders say there are some reasons for cautious optimism, including last week's Bank of England credit survey suggesting banks are preparing to lend more to families and companies in the months ahead. Some economists also expect the US economy to pull out of its recession in the second half of the year. President Barack Obama has said he sees "glimmers of hope" for a recovery.
And the Organisation for Economic Co-operation and Development said on Friday that although all major economies are suffering a major contraction, there are some "tentative signs of improvement" in the rate of decline in France and Germany. The forecast of resumed British growth may be the only optimistic signal in an otherwise gloomy Budget. Mr Darling is set to accept that during a year-long contraction that started last year, the UK economy shrank by more than 3 per cent, the sharpest fall for a generation. Faced with an ever-growing hole in the public finances, he will also announce long-term tax rises and spending cuts to try to balance his budget over the next six years.
There will be few eye-catching giveaways, although Whitehall discussions are continuing about offering a £2,000 "scrappage fee" to people trading in used cars for new models. Despite reports that the Treasury has rejected the proposal by Lord Mandelson, the Business Secretary, sources said over the weekend that the plan remains "on the table".
In his last forecast at the pre-Budget report in November, Mr Darling predicted that growth would resume from the third quarter, which begins in July. Although the Chancellor has since admitted that he understated the severity of the recession and will have to increase his estimate of the depth of the slump, in the Budget he will only move his prediction of renewed growth back by three months.
The Treasury is signalling it believes the British downturn could be 'V'-shaped, a steep fall followed by a relatively quick rebound. Stephen Timms, a Treasury minister this week signalled the Government expects growth to resume this year, adding: "The question is when in the second half of the year." Signs of economic recovery around the New Year are vital to Gordon Brown's fragile hopes of winning a general election next spring. Labour strategists also believe the party must appear optimistic about the future, accusing the Tories of "talking Britain down". However, even if headline figures like gross domestic product are improving by then, unemployment - which lags behind economic growth - may still be rising as the Prime Minister goes to the polls.
Doubt over Britain's second wave of quantitative easing
The Bank of England's Monetary Policy Committee is unlikely to press ahead with a second £75bn wave of quantitative easing because the economy is showing tentative signs of improvement, an economist has warned. David Page at Investec said that the MPC is more likely to stop once it has completed the initial £75bn purchase of Government bonds and other assets because of the recent flow of relatively positive economic news and the risky nature of the policy. "It is our view that the MPC will complete its £75bn quantitative easing programme, but will offer no further monetary policy stimulus as we hope to see the economy stop contracting in the second half of this year," he said. A month ago the Chancellor formally gave the Bank's governor Mervyn King permission to create a total of £150bn of new money to fund the purchases, and the MPC said it would aim to spend half of that by June.
Mr Page predicted that recent signs of improvement in the services and manufacturing sectors, and in mortgage approvals, house prices and credit conditions, should develop into a broader economic stabilisation in the second half. "The Committee may well want to move monetary policy away from the 'dire emergency' level to which it is currently pegged. This could involve an unwinding of quantitative easing and an increase in bank rate from early 2010 as the Bank moves policy back to 'extremely accommodative' levels," he added. On Thursday the MPC held rates at the historically low level of 0.5pc, and sought to reassure investors that it was pressing ahead with the initial £75bn investment, after comments by Mr King two weeks earlier prompted fears that it may not spend the whole amount.
Some, however, felt that the brief statement did not go far enough to convince the market that it was committed to the unprecedented policy. "Given the general lack of transparency surrounding quantitative easing, we are a little surprised that the MPC did not take the opportunity to reassure the markets and the public that it is happy with its progress so far and that, more generally, it is taking the necessary action to support the economy and keep inflation close to its target over the medium term," said Jonathan Loynes, chief European economist at Capital Economics. Analysts hope that minutes from the MPC meeting, which will be published on the same day as the Budget on April 22, will give further insight into the Bank's plans.
The Top 10 Signs You Are Living in a Banana Republic
As the Republic’s eyes continue their glossy stare at the trillions with a T being poured into the financial bailout and this thing they mention on TV called the FED that likely 90% or more of Americans have no idea its role, who controls it and how it is accountable to taxpayers, we at the barricade in deference to David Letterman submit a TOP TEN LIST - Signs You Are Living in a Banana Republic. Why only ten you might ask? Well there are certainly countless signs that our country is a banana republic worthy of comparison to other notable despotic regimes where the ruling elite or plutocracy plunder the treasury for their own selfish interest. However, we at the barricade have learned to target your audience and the American audience has an attention span of less than 30 seconds, addicted to Ritalin and Adderall and have a lazy penchant for summaries and cliff notes. Have we lost you yet? Without further adieu.
10. When Zimbabwe (the patriarch of banana republics) and the home of the $100 Billion omelet, praises the recent US FED action of printing over $1.2 Trillion with a T and declares "Banks, including those in the USA and the UK, are now not just talking of, but also actually implementing flexible and pragmatic central bank support programmes where these are deemed necessary in their national interests. That is precisely the path that we began over 4 years ago in pursuit of our own national interest and we have not wavered on that critical path despite the untold misunderstanding, vilification and demonization we have endured from across the political divide."
Not the kind of endorsement we desire to restore confidence in our financial system.
9. When your Department of Energy is run by a DENTIST and NO ONE WHO HAS EVER WORKED IN THE OIL AND GAS INDUSTRY. And you wonder why we don’t have a national energy policy. Jimmy Carter named James Schlesinger—an apparatchik with no history in the energy sector—as the nation’s first Energy secretary. Ronald Reagan claimed he was going to dismantle the Department of Energy. His pick for Energy secretary was James B. Edwards, a man who understood drilling—he was a dentist. GHWB named former chief of naval operations Admiral James David Watkins as his energy secretary. Bill Clinton’s choices for the top Energy spot were: Hazel O’Leary, a lawyer; Federico Pena, another lawyer; and finally Bill Richardson, a politico and diplomat. George W. Bush’s choices to head the Department of Energy included Spencer Abraham, a lawyer who’d just lost his seat in the U.S. Senate, and Samuel Bodman, an engineer whose professional career was in investments and chemical production. Finally, Obama’s secretary of energy is Steven Chu, a Nobel Prize-winning physicist, Chu has experience in energy-related issues, including his job as director of the Lawrence Berkeley National Laboratory, but he’s never been in the energy business.
"It’s the mythology of the Beltway," one Houston energy analyst told me recently. "You are hopelessly compromised if you are anywhere close to the oil industry."
8. When the Treasury Department IS a wholly owned subsidiary of Goldman Sachs and the other Wall Street mega-firms that are too big to fail. No explanation needed here this is obvious to even the dopiest of americans which leads us to ………
7. The complicit failure of the national media to call out the Treasury Department’s (aka a wholly owned subsidiary of Goldman Sachs and the other Wall Street mega-firms that are too big to fail) clear conflicts of interest when it comes defrauding the Treasury at the expense of the US Taxpayer. Rachel Madow, Keith Olbermann, Daily Kos, Huffington Post, Fox News, anyone? This is easy and it makes the KBR/Haliburton/Iraqi war connection look complicated by comparison as KBR was at the time a wholly owned subsidiary of Haliburton (people had a hard time making that second jump) and Cheney was the former CEO of Haliburton but we were confused with KBR/Haliburton relationship and Cheney’s ties (not sure how we were confused but we were). This is one is so simple even my almost two year old niece understands it - Sec. of Treasury and former CEO of Goldman Sachs Hank Paulson has funneled billions to his old firm and his friends via DIRECT CHECKS and checks to AIG which is run by a former director of Goldman Sachs Edward Liddy. Liddy is only taking $1 of salary because he is such a public service saint. He has an acute financial stake in one of AIG’s counterparties—namely, his $3.2 million personal investment in Goldman Sachs stock. Media call me and I will help you connect the dots - finance is not that complicated just ask my adorable niece.
6. When only 53% of Americans feel capitalism is better than socialism. Several points here as we have never had free market capitalism in this country as our government encourages obfuscation and lack of transparency and selective disclosure/favoritism and failure is not allowed (it is an essential part of capitalism) - We don’t have failure in America. We are all Lake Wobegon - all of our businesses are above average. I didn’t get a chance to vote in this poll but if I had to choose I prefer the norweigan/swedish socialism model over the cuban/venezuelan version. We in the US get the worst of both worlds - no public education/healthcare with high taxes and privatized gains shared by plutocrats with losses shared by taxpayers. If that is your definition of american capitalism - I am amazed the polling numbers were as close as they were.
5. When the market mechanism for failed companies aka BANKRUPTCY is politicized and not allowed to function. Ask yourself this. If this is the worst economy since the great depression as some pundits have declared why aren’t more companies filing for bankruptcy protection? When did bondholders which own a risky asset class called bonds become a guaranteed non risk asset class? It is obvious that my college professors were mistaken in teaching that the only RISK FREE asset class was US GOVERNMENT DEBT SECURITIES. They are going to have to rewrite a ton of econ/corp finance textbooks (good stimulus for stuggling publishing industry) to include Bear Stearns bondholders and preferred stock holders, fannie and freddie bondholders, any bond or preferred instrument held by Bill Gross/PIMCO (the official fourth branch of the US govt.) and any bonds or preferred stocks of the too big to fail to politically connected group of financials including AIG, GS, MS, WFC, C, JPM, et al. (and maybe hold off publishing until June because GM and Chrysler debt and preferred holders may be on that list as well). Which is a perfect segue way into…………..
4. When the Democratic party (the party of FDR, Kennedy, LBJ, Carter and Mr. Barack Obama, the party of the little people, the common man, the disadvantaged, the party of farmers, laborers, labor unions, and religious and ethnic minorities) is beholden to the financial oligarchs and plutocrats and continue the same misguided policies of the last crony regime in BAILING OUT BANKERS and INDEBTING GENERATIONS by Trillions with a T. We are either in bizzaro world or a banana republic or both. "The Democrats have replaced the Republicans as the big benefactors to the financial community," said Kevin Phillips, author of "Bad Money: Reckless Finance, Failed Politics, and the Global Crisis of American Capitalism."
"The financial community is donating more to Democrats than ever before and you’ve got more Democrats in the financial community, creating a very powerful pattern there. I don’t think you’re going to see the Obama administration and Congress willing to be tough enough in dealing with these things." Hmmmmm let me get this straight, none of the big banks and financial companies bondholders are taking any hit and refuse to go into bankruptcy or receivership however GM and Chrysler may go into the not so delicate arms of bankruptcy. Is Obama more loyal to his wall street friends in the democratic monopolies in the Northeast and California or to his hard working lower/middle class constituents in the midwest which is usually a coin flip in terms of party loyalty see michigan, ohio and indiana. To quote John Lennon, strange days indeed, most peculiar momma. That or we are living in a banana republic.
3. When William Black the former Chief Fraud Investigator at the Federal Home Lending Bank (very big institution $1.3 Trillion with a T in loans) and Office of Thrift Supervision (they are a poor man’s FDIC regulating S&L’s and Thrifts) during the Savings and Loan scandal calls the current bank stress tests " A COMLETE SHAM" Let me repeat that " A COMPLETE SHAM". One more time for effect "A COMPLETE SHAM" One more time with meaning and soul for the really glossy eyed americans - "A COMPLETE SHAM"
In addition to comparing our STRESS TEST of our nations’ financial system to a counterfiet,fraud, flimflam, ruse (is that tautological enough for you America or do I need naked women shooting you with lasers to make you pay attention?) Mr. Black also called the STRESS TEST "a Potemkin model. Built to fool people."
Like many others, Black believes the "worst case scenario" used in the stress test don’t go far enough. For those of you not conversant in Crimean or Russian history, Potemkin had hollow cardboard and wooden facades of villages constructed along the desolate banks of the Dnieper River in order to impress the monarch and her travel party with the value of her new conquests, thus enhancing his standing in the empress’s eyes. Black also said, "There is no real purpose [of the stress test] other than to fool us. To make us chumps," Black says. Noting policymakers have long stated the problem is a lack of confidence, Black says Treasury Secretary Tim Geithner is now essentially saying: "’If we lie and they believe us, all will be well.’ It’s Orwellian." "The fact bank stocks have been rising since Geithner unveiled his plan is "bad news for taxpayers," he says. "It’s the subsidy of all history."
2. When William Black the former Chief Fraud Investigator and Federal Regulator during the S&L scandal uses the following words to describe the STRESS TEST of capital ratios for our NATIONS’ LARGEST BANKS- "A COMPLETE SHAM", "POTEMKIN MODEL" - fancy russian word for SHAM, "Reason for STRESS TESTS is to FOOL US and to make US CHUMPS" "’If we lie and they believe us, all will be well.’ It’s Orwellian." The Geithner debt plan is "bad news for taxpayers" If confidence is all we need to restore the financial system, then we should just nominate Tony Robbins as Secretary of Treasury.
OBTW, William Black’s book "The Best Way to Rob a Bank is to Own One" is a must read about financial fraud and regulatory capture and for the glossy eyed it has a catchy cool title. Paul Volker wrote this about the book - Bill Black has detailed an alarming story about financial - and political - corruption. The specifics go back twenty years, but the lessons are as fresh as the morning newspaper. One of those lessons really sticks out: one brave man with a conscience could stand up for us all. Robert Kuttner of Business Week proclaimed, "Black’s book is partly the definitive history of the savings-and-loan industry scandals of the early 1980s. More important, it is a general theory of how dishonest CEOs, crony directors, and corrupt middlemen can systematically defeat market discipline and conceal deliberate fraud for a long time — enough to create massive damage.
drum roll please …………………………………………………
1. When the American media are more concerned with and the American people are more aware of Malawian Adoption Law requiring an 18- to 24-month assessment period before adoption and the California legal issues down to the individual statute code surrounding artificial insemination and the Octomom, but can’t or won’t listen to ONE WORD or see William Black on any other media outlet other than the WEB or Bill Moyers. We have the former Chief Fraud Investigator screaming SHAM, SWINDLE, HEIST and we just sit there eyes glazed over wondering if the blind guy was given a fair shot on Idol. No hour slot on Larry King, no lead story on 60 minutes, not even 5 minutes on Jon Stewart’s Daily Show which is arguably the best financial and investigative journalist show on television.
My friends this is your representative republic - this is AMERICA.
Useless finance, harmful finance and useful finance
by Willem Buiter
A derivative is a contingent claim whose payoff depends on the performance of some other financial instrument or security. For instance, an American equity call option gives the purchaser of the call the right (but not the obligation) to buy a share of equity from the issuer or writer of the call option at or before some future date at a price determined today. A credit default swap (CDS) is a credit derivative contract between two (counter)parties in which the holder makes periodic payments to the issuer in return for a payoff if the underlying financial instrument specified in the contract defaults. A derivative contract is formally identical to a lottery, a (simple or compound) bet or gamble. Like any financial claim, any derivative is an ‘inside asset’ - it is in zero net supply. Because pay-offs associated with a derivative contract are functions of observable properties of other financial claims (prices, interest rates, default states), the derivative contract either re-packages existing underlying uncertainty or creates additional ‘artificial’ uncertainty. It would create additional extraneous uncertainty if it added some noise of its own to the fundamental, exogenous uncertainty that is presumably reflected in the features of the underlying security that determine the pay-offs of the derivative contract.
If the creation and trading of derivatives were costless, derivatives result in zero-sum redistributions of wealth between the issuers and the owners of the derivative contracts. Costless derivatives would be redundant if markets were complete. When markets are incomplete, as they are in our unfortunate universe, introducing derivatives can either lead to an increase or to a reduction in efficiency and social welfare. Lower efficiency and social welfare are possible even if creating and trading derivatives were costless. Derivatives may improve the allocation of risk, but there is no guarantee that they will. It is my contention that the unbridled explosion of certain categories of derivatives has done considerable harm, and that it is necessary to regulate all derivatives trading. How can creating lotteries, even if they only mirror fundamental underlying uncertainty, be welfare increasing? The usual argument involves examples where there is a given quantum of ‘objective’ or ‘exogenous’ uncertainty in the world, e.g. uncertainty about endowments, technology and tastes (all assumed exogenous - only economists would treat technology and taste as exogenous, of course!). Markets for risk trading are incomplete and creating derivatives markets does not alter the objective/exogenous uncertainty in the world. Creating and trading derivatives is costless.
In such a world one can imagine a pension fund that wishes to hold default risk-free 10 year government securities, but unable to find them in the market, instead holding 10 year AAA corporate bonds and CDS to cover the default risk of these corporate securities. Provided the writer of the CDS is creditworthy, the pension fund could achieve its preferred portfolio mix. If the writer of the CDS has the appropriate capital structure and balance sheet, it could be both willing and able to bear the default risk on the corporate bonds than the pension fund. For the lottery created by a derivative contract to be welfare-increasing, it will have to produce a positive monetary pay-off for the purchaser of the derivative in exactly those ‘states of nature’ where the purchaser will be worst off, while at the same time ensuring that the corresponding negative monetary pay-off for the writer of the derivative does not hurt the writer of the derivative too badly. It would of course be more direct to draw up contracts contingent on the exogenous uncertainty directly. If the pension fund’s ‘endowment’ were to be negatively correlated with that of some other legal entity, and if the two endowments could be observed and verified, an endowment-sharing rule could be specified that would make both parties better off. You would not start looking for contracts specifying payments that are contingent on endogenous risk, such as default risk or the behaviour of some price or interest rate.
Derivatives, insurance and gambling
Consider the CDS. The purchaser pays a premium to the writer of a CDS. That is the price of the lottery ticket, or the price of the betting slip. If the underlying security specified in the contract defaults, the writer of the CDS pays the owner of the CDS a specified amount of money. That’s the lottery prize, or the winnings of the bet. In the UK where there are more legal forms of gambling than in most other countries, many conventional financial instruments or securities have been ‘re-engineered’ as formal bets. Spread betting on exchange rates, interest rates, stock prices and now also house price indices is a popular form of investment. The reason is that earnings from gambling are not taxed. The government presumably does not tax the gains and losses from gambling because (ignoring the value added of the gambling industry) gambling winnings equal gambling losses, so if the tax code allows loss offsets, there is not much point (ignoring progressivity of taxation & other complications) in taxing the gains and losses from gambling. Derivatives can be used to provide insurance (paying a premium to buy protection against a possible loss) or to gamble (paying a premium to acquire the opportunity to benefit from a possible gain). CDS can provide either insurance against loss or an opportunity to gamble. This is because the buyer of a CDS does not need to own the underlying security or other form of credit exposure. The buyer does not have to suffer any loss from the default event and may in fact benefit from it.
When purchasing an insurance contract, the insured party is generally expected to have an insurable interest in the event against which he takes out insurance. This simply means that he cannot be better off if the insured against event occurs than if it does not occur. Determining what constitutes an insurable interest is often complicated in practice, but simple in principle: you have an insurable interest if, when (a) the future contingency you insure against occurs and (b) the insurance contract performs (something you cannot necessarily count on, without assistance from the tax payer, if you buy your CDS from AIG), you are not better off than you would be if the insured-against future contingency did not occur. Clearly, CDS contracts don’t require an insurable interest to be present. Many other derivatives likewise don’t require an insurable interest to be present. Short selling a share of common stock in the hope/expectation of a fall in the price of the equity without either owning or borrowing the stock (naked short selling) is an example of a derivative contract without an insurable interest. Why should the state care about gambling through derivative contracts?
(1) Gambling is addictive
Like all forms of gambling (deliberate risk-seeking), gambling in the derivatives markets can be addictive. This may create a paternalism-based argument for regulating, restricting or even banning the activity. Having observed derivatives writers, purchasers and traders in action, it is clear that the thrill of the gamble is part of the motivation behind this activity. The monetary gains and losses figure prominently, of course, but the bungee-jumping, sky-diving, tight-rope-walking-without-a-net dimensions of derivatives trading definitely play a role. It cannot be a coincidence that there are so many more male than female traders and other operators in the financial markets. Testosterone is not underrepresented in the trading room. And the thrill of taking a wide-open position can be addictive. I wouldn’t be surprised if Gamblers Anonymous had a special chapter for derivatives gambling. I am generically underwhelmed by arguments for protecting compos mentis adults against themselves based on paternalism, but the list of arguments would not be complete without it.
(2) Moral hazard or micro-level endogenous risk.
This is the familiar argument already mentioned before, that if the insured party (the purchaser of a CDS, for instance) can influence the likelihood of the insured-against contingency (the default of the underlying security) occurring without the writer of the insurance contract (the issuer of the CDS) being aware of this, there is an obvious case of market failure and potential source of inefficiency. It’s also likely to be an illegal form of market manipulation.
(3) Derivative contracts as "bearer lottery tickets"
Unlike most conventional lotteries, the lottery tickets created as part of many derivatives contracts are traded in secondary markets, sometimes over the counter (OTC markets), sometimes on organised exchanges. These lottery tickets or betting slips are not just traded after they are issued (sold by the writer in the ‘primary issue market’), most of these derivative contracts are bearer securities: their ownership is not registered. The owner is anonymous. Listed common stock, by contrast, is an example of what I have called a ‘registered security’. There is an ownership register, which is, at least in principle, in the public domain. Clearly, establishing the beneficial ownership of an equity share may not be a simple matter of looking in the shareowners register in the jurisdiction where stock is listed, but with bearer securities the task is hopeless. The writer of the derivative contract does not in general know the identity of the current owner of the contract. If the writer does not know this, the supervisor and regulator, or the state agency in charge of macro-prudential supervision (typically the central bank) does not know it either. There is therefore absolutely no way to determine whether the current distribution of the ownership of derivative contracts is systemically stabilising or destabilising, whether it is too concentrated or too dispersed. When a notional gross $60 trillion worth of CDS outstanding at the peak (yes, I know it’s ‘only’ $30 trillion now and much of it is ‘offsetting’ in some ill-defined way) and possibly around $400 trillion gross outstanding of total derivatives, we are talking ignorance on a cosmic scale.
(4) Risk-seeking by the over-confident
Even if the secondary markets for derivatives functioned properly (no bubbles, no liquidity seizures, no wide-spread defaults), these secondary markets can, like the primary issue market, redistribute the additional risk represented by any derivative either in a way that improves the ultimate allocation and sharing of risk or worsens it. Once a new derivative market is created, this market can either be used to hedge existing risk or to take on additional risk. I have seen no reliable statistics on the identities of the counterparties in the leading derivatives markets. My best guess is that most of the activity is not between households and financial intermediaries or between non-financial enterprises and financial intermediaries, but among financial intermediaries, mainly among different banking or shadow-banking player. Much of this trading appears to be driven by overconfidence and hubris. I have yet to meet a trader who did not believe that he or she could not beat the market. Because collectively these traders effectively are the market, they are collectively irrational, as they cannot beat themselves. So the risk ends up being concentrated not among those most capable of bearing it, but among those most willing to bear it - those most confident of being able to bear it and profit from it.
The collective hubris of the banking sector (broadly defined to include all the shadow-banking sector institutions like hedge funds, private equity funds, SIVs, conduits, other investment funds, AIG-style insurance companies etc.) means that enormous volumes of bets are placed on the behaviour of endogenous variables. The first consequence of this is that, since derivatives trading is not costless, scarce skilled resources are diverted to what are not even games of pure redistribution. Instead these resources are diverted towards games involving the redistribution of a social pie that shrinks as more players enter the game. The inefficient redistribution of risk that can be the by-product of the creation of new derivatives markets and their inadequate regulation can also affect the real economy through an increase in the scope and severity of defaults. Defaults, insolvency and bankruptcy are key components of a market economy based on property rights. There involve more than a redistribution of property rights (both income and control rights). They also destroy real resources. The zero-sum redistribution characteristic of derivatives contracts in a frictionless world becomes a negative-sum redistribution when default and insolvency is involved. There is a fundamental asymmetry in the market game between winners and losers: there is no such thing as super-solvency for winners. But there is such a thing as insolvency for losers, if the losses are large enough. The easiest solution to this churning problem would be to restrict derivatives trading to insurance, pure and simple. The party purchasing the insurance should be able to demonstrate an insurable interest. CDS could only be bought and sold in combination with a matching amount of the underlying security. Ideally, it ought to be possible to for me to buy a CDS by demonstrating an insurable interest in terms of my "utility", i.e. by demonstrating that, should the underlying security default, I would be worse off in one way or other, not necessarily because I own the underlying security. In practice, this would be wide open to abuse and manipulation.
(6) Macro-endogenous risk
Financial markets are inefficient in any of the ways specified by James Tobin in a great 1984 paper - information arbitrage efficiency, fundamental valuation efficiency, functional efficiency or Arrow-Debreu full insurance efficiency. Financial markets even often are technically inefficient. A market is technically or trading efficient if it is liquid and competitive, that is, it is possible to buy or sell large quantities with very low transaction costs, at little or no notice and without a significant impact on the market price. We have seen many examples, from the ABS markets and the commercial paper markets to the interbank markets of massive and persistent failures of technical or trading efficiency. Even in those financial markets that are reasonably technically efficient, like the US stock market, the foreign exchange markets and the government debt markets, Tobin saw frequent departures from efficiency in the less restricted senses of the word. He accepted that financial markets possessed what he called ‘information arbitrage efficiency’ that is, that they were informationally efficient in the weak and semi-strong sense. You cannot systematically make money trading on the basis of generally available public information. Clearly, however, trading profitably on the basis of insider information is possible.
He did not believe that financial markets consistently possessed ‘fundamental valuation efficiency’: financial asset prices do not necessarily reflect the rational expectations of the future payments to which the asset gives title. Key financial markets, including the stock market, the long-term debt market and the foreign exchange market are characterised both by excess volatility and persistent misalignments, that is, prices deviating persistently from fundamental valuations. Tobin also contested the notion that the financial markets delivered ‘value for money’ in the social sense. "the services of the system do not come cheap. An immense amount of activity takes place, and considerable resources are devoted to it." (Tobin [1984, p. 284]). Tobin referred to this aspect of efficiency as ‘functional efficiency’. Finally, the system of financial markets can be efficient in the technical, information arbitrage, fundamental valuation and functional senses without possessing what Tobin called Arrow-Debreu full insurance efficiency, that is, without supporting Pareto-efficient economy-wide outcomes. The reason is that real world financial markets interact with labour and goods markets that are inefficient in every sense of the word.
When financial markets are inefficient, the distinction between fundamental, exogenous variables and endogenous variables disappears. CDS prices can become quasi-autonomous drivers of the bond prices. The tail can wag the dog. The redistributions of wealth associated with the execution of derivatives contracts can trigger margin calls, mark-to-market revaluations of assets and liabilities, forced liquidations of illiquid asset holdings through fire-sales in dysfunctional markets, defaults and bankruptcies. Activities in derivatives markets, including futures markets, can feed back on sport markets and real production, consumption and storage decisions. Unbridled derivatives markets may be liquid, but the question is, to what purpose? If, as I believe, there is no economic rationale for ‘naked’ CDS positions (that is, CDS that do not insure an open default position in the underlying security), then liquidity of the CDS market only serves those who want to trade naked CDS. This, in my view, only wastes real resources through (a) churning and (b) unnecessary bankruptcies.
I want to end on an upbeat note. I believe that effective and efficient financial intermediation is a necessary condition for prosperity. To those who doubt this, I recommend a reading of two books about the true microfoundations of financial intermediation, Hernando de Soto’s, The Mystery of Capital: Why Capitalism Triumphs in the West and Fails Everywhere Else, New York: Basic Books (2000) Prosperity Unbound: Building Property Markets with Trust, by Elena Panaritis (Palgrave MacMillan 2007). If you have only time for one, read the shorter work by Elena Panaritis. It describes the fascinating story of how personal possessions (characterised through informal, insecure property rights) were turned into secure property rights and thence into productive capital through a World Bank project in Peru. The book shows the importance of local knowledge and of a deep understanding of the institutional prerequisites for a successful market economy based on collateralisable wealth (especially real estate). To raise the quality of the rule of law in the property sector to the point small businesses can credibly offer land and other real estate as collateral for formal sector finance requires a formal titling authority, a state capable of reliably maintaining property records, a functional judicial system, corruption levels bounded from above etc.
The world described in these books, where the foundations of a productive market economy are being put in place, appears light years removed from the world of Wall Street and the City of London. In Peru, access to formal sector finance on reasonable terms thanks to the newly created ability to offer collateral and perfect security interest, has lifted many out of grinding poverty. In Wall Street and the City of London, massive resources and lobbying power were devoted to turning complex, long-term relationships into tradable securities - preferably into tradable bearer securities, even when the informational preconditions for this transformation to be effective were not satisfied. Increasingly, as in the case of bearer instruments like mortgage-backed securities for instance, the ultimate issuer and the current owner of the instrument knew nothing about each other. And even with simpler bearer securities, most of the time no-one knows who the current owner is, not even the supervisor and regulator. The endless churning of contingent claims, including derivatives, when the purchaser has no identifiable insurable interest, turns financial intermediation into a market-mediated betting shop. Then the betting slips become bearer securities and are themselves traded, either OTC or on organised exchanges, and the derivative transactions volumes expand to dwarf the transactions in the markets for the underlying financial claims (let alone the markets for the underlying real resources). At that point, the betting tip of the financial tail of the real economy dog does all the wagging. It does not create value but redistributes it in a way that consumes real resources and exposes the real economy to unnecessary risk. It’s time to tame the tiger.
With Advocates’ Help, Squatters Call Foreclosures Home
When the woman who calls herself Queen Omega moved into a three-bedroom house here last December, she introduced herself to the neighbors, signed contracts for electricity and water and ordered an Internet connection. What she did not tell anyone was that she had no legal right to be in the home. Ms. Omega, 48, is one of the beneficiaries of the foreclosure crisis. Through a small advocacy group of local volunteers called Take Back the Land, she moved from a friend’s couch into a newly empty house that sold just a few years ago for more than $400,000.
Michael Stoops, executive director of the National Coalition for the Homeless, said about a dozen advocacy groups around the country were actively moving homeless people into vacant homes — some working in secret, others, like Take Back the Land, operating openly. In addition to squatting, some advocacy groups have organized civil disobedience actions in which borrowers or renters refuse to leave homes after foreclosure. The groups say that they have sometimes received support from neighbors and that beleaguered police departments have not aggressively gone after squatters. "We’re seeing sheriffs’ departments who are reluctant to move fast on foreclosures or evictions," said Bill Faith, director of the Coalition on Homelessness and Housing in Ohio, which is not engaged in squatting. "They’re up to their eyeballs in this stuff. Everyone’s overwhelmed."
On a recent afternoon, Ms. Omega sat on the tiled floor of her unfurnished living room and described plans to use the space to tie-dye clothing and sell it on the Internet, hoping to save some money before she is inevitably forced to leave. "It’s a beautiful castle, and it’s temporary for me," she said, "and if I can be here 24 hours, I’m thankful." In the meantime, she said, she has instructed her adult son not to make noise, to be a good neighbor. In Minnesota, a group called the Poor People’s Economic Human Rights Campaign recently moved families into 13 empty homes; in Philadelphia, the Kensington Welfare Rights Union maintains seven "human rights houses" shared by 13 families. Cheri Honkala, who is the national organizer for the Minnesota group and was homeless herself once, likened the group’s work to "a modern-day underground railroad," and said squatters could last up to a year in a house before eviction.
Other groups, including Women in Transition in Louisville, Ky., are looking for properties to occupy, especially as they become frustrated with the lack of affordable housing and the oversupply of empty homes. Anita Beaty, executive director of the Metro Atlanta Task Force for the Homeless, said her group had been looking into asking banks to give it abandoned buildings to renovate and occupy legally. Ms. Honkala, who was a squatter in the 1980s, said the biggest difference now was that the neighbors were often more supportive. "People who used to say, ‘That’s breaking the law,’ now that they’re living on a block with three or four empty houses, they’re very interested in helping out, bringing over mattresses or food for the families," she said.
Ben Burton, executive director of the Miami Coalition for the Homeless, said squatting was still relatively rare in the city. But Take Back the Land has had to compete with less organized squatters, said Max Rameau, the group’s director. "We had a move-in that we were going to do one day at noon," he said. "At 10 o’clock in the morning, I went over to the house just to make sure everything was O.K., and squatters took over our squat. Then we went to another place nearby, and squatters were in that place also." Mr. Rameau said his group differed from ad hoc squatters by operating openly, screening potential residents for mental illness and drug addiction, and requiring that they earn "sweat equity" by cleaning or doing repairs around the house and that they keep up with the utility bills.
"We change the locks," he said. "We pull up with a truck and move in through the front door. The families get a key to the front door." Most of the houses are in poor neighborhoods, where the neighbors are less likely to object. Kelly Penton, director of communications for the City of Miami, said police officers needed a signed affidavit from a property’s owner — usually a bank — to evict squatters. Representatives from the city’s homeless assistance program then help the squatters find shelter. To find properties, Mr. Rameau and his colleagues check foreclosure listings, then scout out the houses for damage. On a recent afternoon, Mr. Rameau walked around to the unlocked metal gate of an abandoned bungalow in the Liberty City neighborhood.
"Let the record reflect that there was no lock on the door," Mr. Rameau said. "I’m not breaking in." Inside, the wiring and sinks had been stripped out, and there was a pile of ashes on the linoleum floor where someone had burned a telephone book — probably during a cold spell the previous week, Mr. Rameau said. "Two or three weeks ago, this house was in good condition," Mr. Rameau said. "Now we wouldn’t move a family in here." So far the group has moved 10 families into empty houses, and Mr. Rameau said the group could not afford to help any more people. "It costs us $200 per move-in," he said. Mary Trody hopes not to leave again. On Feb. 20, Ms. Trody and her family of 12 — including her mother, siblings and children — were evicted from their modest blue house northwest of the city, which the family had lived in for 22 years, because her mother had not paid the mortgage.
After a weekend of sleeping in a paneled truck, however, the family, with the help of Take Back the Land, moved back in. "This home is what you call a real home," Ms. Trody said. "We had all family events — Christmas parties, deaths, funerals, weddings — all in this house." On a splendid Florida afternoon, Ms. Trody’s dog played in the water from a hose on the front lawn. The house had mattresses on the floors, but most belongings were in storage, in case they had to leave again. "I don’t think it’s fair living in a house and not paying," Ms. Trody said. She said the mortgage lender had offered the family $1,500 to leave but was unwilling to negotiate minimal payments that would allow them to stay. She said she and her husband had been looking for work since he lost his delivery job with The Miami Herald.
In the meantime, she said, "I still got knots in my stomach, because I don’t know when they’re going to come yank it back from me, when they’re going to put me back on the streets." The block was dotted with foreclosed homes. Three of her neighbors said they knew she was squatting and supported her. One is Joanna Jean Pierre, 32, who affectionately refers to Ms. Trody as Momma. Ms. Pierre said Ms. Trody was a good neighbor and should be let alone. "That’s her house," Ms. Pierre said. "She should be here." Ms. Trody said that living here before, "I felt secure; I felt this is my home." "This is where I know I’m safe," she added. "Now it’s like, this is a stranger. What’s going to happen?" Even without furniture or homey touches, she talked about the house as if it were a member of her family. "I know it’s not permanently, but we still have these couple days left," she said. "It’s like a person that you’re losing, and you know you still have a few more days with them."
They shoot real estate agents, don't they?
It's a terrible thing to come to terms with, but I am the reason the world is in an economic tailspin. Me, alone. All those foreclosures, short sales, bank failures, job losses, bailouts, plummeting stocks, the ripple effect into Europe, China, even Madoff: all my fault. Moi. That last house I sold at 253 Carrington Way? That was the tipping point, I'm convinced. I sold it for $657,500 in August 2005, and now Zillow is damning it at $537,000. I would weep to call the owners now and say, hey, want a market analysis? Sound like fun? I know, you'd rather shove shards of glass under your fingernails, I hear you.
In any case, I'm your neighborhood real estate agent, and I'm really, really sorry. And to think it all began so innocently. Nine years ago, back in the early aughts, it felt like the right thing to do, getting that real estate license. Laid off from three (count 'em, three) publishing jobs, I was looking for a job I couldn't lose. I asked a couple of real-estate friends what they thought about their job security. "Do they lay off real estate agents?" I asked. There was a stifled guffaw. "You could murder a couple people, but if you had some good listings in the bag, you're probably fine." It was between a real estate license ($200) and an MBA ($65,000). I did the math and, boom, I was a real estate agent.
Those early years were insane. I hit the ground running, holding on for dear life to a market taking off like a jet plane. You could send out a mailing -- or an ad, or a flier, possibly just a phone number -- and get 20 calls on it. My phone would not stop ringing. Countless e-mails burned my eyes night and day. People were crazed for houses, lusting after them, bidding up and up and up, clawing at each other just to get the house. It was a frenzy of nesting, a compulsion to cocoon, to own no matter what. Houses were hoarded like porn, lunged and pawed at like food dropped into villages at wartime.
And we as real estate agents were, what? Mindless spokes and wheels in a transaction? Pawns in some mad game? Satan's evil linchpins? The instigators of the world's demise? I'm still not sure. Regardless, we drove around like maniacs with our buyers to "just listed" properties -- i.e., they came on the market half an hour previous -- took a jog through some mediocre house, then sprinted back to the office to advise our clients not just how to write an offer, but how to write one that would be accepted. That is, teach them how to punt and feint: make the offer good for an hour only to force the sellers' hand; show up at first light with the paperwork and a check to greet the sleepy homeowner getting his newspaper (à la "Sopranos"); strike all contingencies. Or last but not least: bid blind with an escalation clause. That is, bid $5,000 or $10,000 over the highest amount offered, whatever that happened to be. Basically: tie a cloth over your eyes and just throw money.
But those full price or 10K-over asking offers didn't always cut the mustard, especially if there were four of them on the table. We'd suggest to our buyers to make it personal: to go for the Lifetime moment. To show up in person at the bidding table holding the hands of their adorable children; to pen missives such as: "The minute I crossed the threshold of your beautiful home, I knew this was the one. Your home is just like my grandmother's. She died last week." (This is where you well up, OK?) "But she would have loved to see me buy a house just like yours. Here's $500,000 for your home assessed at $350,000, please take it, oh please, I'll do anything."
Houses of all kinds, in any shape at all, were selling instantly, even "psychologically impacted homes." I'll never forget one horrid slab ranch where there'd been a murder. The listing broker hadn't even bothered to remove the police tape from around the house before offers began pouring in. In total, five bids rolled in on the home, each at least 5K over asking, with the winning bid striking the mortgage as well as the inspection contingencies. I heard the sellers threw in the ghost as well.
By 2002 my office was brimming with new, fresh-faced agents from every walk of life: software engineers, teachers, retail store owners, landscape architects, all manner of escapees from the corporate world, ready to learn on the fly and cash those commission checks as fast as possible. More seasoned agents cast them flinty glances as if to say: "Have you ever heard of a real estate cycle? Sure we're flyin' high, but strap on those seat belts, kids, this roller coaster is going down."
But no one was paying attention then. We relative newbies thought this was just the way things were. Wake up, work, crash, repeat. There were lavish Christmas parties, over-the-top award ceremonies deifying top producers who were making truly crazy money, new cars in the lot, fresh duds on our backs, and no one really felt the sting of the check on all those dinners out. Let's put it this way: The bon temps roo-layed. We had 10 phone lines, and at times they were all ringing at once.
Did we make money? Yes. Did we work for it? Yes. I worked seven days a week for months at a time. I lost 10 pounds, lived on PowerBars, filled my gas tank two, three, four times a week. I answered my phone in the bathroom, at weddings, funerals, my birthday surprise party, while eating my PowerBar, even at a wake. I worked on holidays, weekends, many times up at 6 and dropping by midnight. Once I lost a bid for my buyer clients, let's call them the Smiths, because I had slipped home at noon to take a shower, having had no time in the morning because of a painfully early home inspection.
I left the phone outside the shower stall, but I guess I never heard it. An hour later I saw the call, called them back and found them furious: Their dream home had come on the market, they were standing in the open house, and where was I? Showering? By the time I got there, breathless and wet-haired, the owners had already signed another offer, $18,000 over asking. Mrs. Smith wept, Mr. Smith cursed, then fired me. I felt sick. The guilt was actually worse than the lost commission. Their American dream shattered by me.
Predatory loans? We thought they were just "creative," a term not at all pejorative back then. I don't even think the term "predatory loan" existed until it was time to lay down some serious blame, as in 2007 and on. In any case, I had some lower-income clients who were part of this collective insanity. That is, everyone had drunk the same Kool-Aid, so they wanted a house as badly as everyone else. I actually rooted for them to get a loan, any kind of loan, to get them into the house they wanted. They had a 3-year-old daughter and one on the way, and both worked two jobs while trying to learn English, which they were picking up with astounding speed.
We aggressively house-hunted, bid and got the house, and they were ecstatic and very grateful to me, even though the house, at just over 850 square feet, could barely contain them. There were tears and hugs at the closing, where my phone rang and rang and screamed some more. So yes, back then it was a piece of cake to pay my bills and put something away, but my hair was falling out, I was so stressed. I was not a great partner to my husband. Most of my friends had given up on seeing me. Even my cats didn't recognize me when I dragged myself home at night.
Fast-forward to now.Now, my cats not only recognize me, they wish I would get a life, as does my husband. My hair is back in place on my head. My office is filled with empty cubicles; phones are answered on the first ring. Papers flutter about on empty desks. Of course the economy is terrible, but something more is going on. It's eerie. Even the top brokers are sleeping late, reading more, and wondering what the hell to do. Award ceremonies have been canceled. Holiday parties are ancient history.
Just as for everyone else, the future is impossible to predict because the combination of elements in play is unique. In the wee hours, the faces of my clients parade before my eyes. Sleepless, I get up and see what their home is worth now; pray that they still have their jobs. Then I Google "best paying jobs of the future" and read: dental hygienist, database administrator, systems analyst. I have a good cry and go back to bed.
I've checked in on my lower-income clients and thankfully they've both kept their jobs, but their home would be a short sale if we had to put it on the market now. They told me they've made ends meet by inviting a relative up from New York to stay and pay some rent by living in their already crowded home. I can't imagine which room they're putting him in. The Smiths: They'd hired another agent to come to their rescue after I took that fateful shower, and had had no problem overbidding on another home. Now their home is one of the dozens of foreclosures in town. Days on market: 342. Price changes: five and counting. Just the other day I read that Mr. Smith's company was slicing employees like cheese from a giant wheel.
What am I doing now? I take depressing classes on the labyrinthine procedure of conducting short sales, orchestrate foreclosures, show buyers countless homes before they confess they'd like to "maybe wait a year or two," watch sellers break into tears as they sign a listing contract. Try to figure out how to market myself via social networking, which gags me, but what can you do? Lord knows, I live to Facebook, Twitter, tweet, blog, gather, LinkIn, YouTube, Gawk, Boing Boing, friend, Rain Actively, Digg, Xanga, Squidoo, Top Produce, and MySpace my way into the hearts of my buyers and sellers.
My phone has been, for all intents and purposes, silent for weeks now. I keep checking to make sure it's on. Sometimes I'll make a few calls just to use up those minutes I've already paid for. Today I ran into an agent from my office in our local drugstore whom I hadn't seen for months. She told me she'd gotten a job at American Girl. She'd been a full-time real estate agent for 26 years. I asked her how she liked retail. "I love it," she said unconvincingly. "People are so happy when they're buying dolls." Huh?Another real estate friend has gone back to doing trade shows for medical products.
A downtown agent got a job in a fancy French restaurant where he hasn't worked since college ("when the aprons fit"). Now he says he's one of those waiters standing in the corner staring out the window waiting for customers, the ones he felt sorry for walking by the restaurant on his way to show houses in 2004. Other friends complain about getting pink slips. At least they're getting a pink slip. (Unemployment, anyone? Maybe even COBRA? A pipe dream for us commission-based folks.) There's something a tad respectful about a pink slip. It says: You had a job, now you don't anymore. As opposed to crushing silence and empty in boxes, which mean, I guess it sure looks like/isn't this a dead ringer for/heads up: you don't have a job anymore.
Last week, my phone actually rang. I nearly had a heart attack. It was a real live potential seller. A neighbor from down the street with a horse property -- not the most common thing in my hood but there are a few. She said that, "among others," she would be interviewing me, a few high-end brokers from neighboring offices, and three horse property specialists. Can we say "disincentivized by the competition"? I tried to rally. How can I get around the fact that I've never sold a horse property? I suppose I could show up in jodhpurs, compliment the seller on her tack barn ("Great saddle choice! I love this kind, don't you? You know ... leather"), put hay in my hair. Whatever it takes to get the job. After all, my last paycheck was in October. Holy deeded manure pile!
Desperation has become a familiar face; at times it even stares back at me in the mirror in the morning. But I don't think I'm alone. As the orchestra plays, sliding down with all of us on the tilting deck of the Titanic, I can see it now: my fellow real estate agents and I wishing each other well as we call out, "Hey, see you at American Girl!" or, "I hear Orange Julius is hiring. You go, girl!" So if you hear whinnying or see me cantering about town on a some fetching filly, not to worry. That's just me trying to get the listing, along with everybody else.
Mr. Soddy’s Ecological Economy
Innovative and opaque instruments of debt; greedy bankers; lenders’ eagerness to take on risky loans; a lack of regulation; a shortage of bank liquidity: all have been nominated as the underlying cause of the largest economic downturn since the Great Depression. But a more perceptive, and more troubling, diagnosis is suggested by the work of a little-regarded British chemist-turned-economist who wrote before and during the Great Depression.
Frederick Soddy, born in 1877, was an individualist who bowed to few conventions, and who is described by one biographer as a difficult, obstinate man. A 1921 Nobel laureate in chemistry for his work on radioactive decay, he foresaw the energy potential of atomic fission as early as 1909. But his disquiet about that power’s potential wartime use, combined with his revulsion at his discipline’s complicity in the mass deaths of World War I, led him to set aside chemistry for the study of political economy — the world into which scientific progress introduces its gifts. In four books written from 1921 to 1934, Soddy carried on a quixotic campaign for a radical restructuring of global monetary relationships. He was roundly dismissed as a crank.
He offered a perspective on economics rooted in physics — the laws of thermodynamics, in particular. An economy is often likened to a machine, though few economists follow the parallel to its logical conclusion: like any machine the economy must draw energy from outside itself. The first and second laws of thermodynamics forbid perpetual motion, schemes in which machines create energy out of nothing or recycle it forever. Soddy criticized the prevailing belief of the economy as a perpetual motion machine, capable of generating infinite wealth — a criticism echoed by his intellectual heirs in the now emergent field of ecological economics.
A more apt analogy, said Nicholas Georgescu-Roegen (a Romanian-born economist whose work in the 1970s began to define this new approach), is to model the economy as a living system. Like all life, it draws from its environment valuable (or "low entropy") matter and energy — for animate life, food; for an economy, energy, ores, the raw materials provided by plants and animals. And like all life, an economy emits a high-entropy wake — it spews degraded matter and energy: waste heat, waste gases, toxic byproducts, apple cores, the molecules of iron lost to rust and abrasion. Low entropy emissions include trash and pollution in all their forms, including yesterday’s newspaper, last year’s sneakers, last decade’s rusted automobile.
Matter taken up into the economy can be recycled, using energy; but energy, used once, is forever unavailable to us at that level again. The law of entropy commands a one-way flow downward from more to less useful forms. An animal can’t live perpetually on its own excreta. Neither can you fill the tank of your car by pushing it backwards. Thus, Georgescu-Roegen, paraphrasing the economist Alfred Marshall, said: "Biology, not mechanics, is our Mecca."
Following Soddy, Georgescu-Roegen and other ecological economists argue that wealth is real and physical. It’s the stock of cars and computers and clothing, of furniture and French fries, that we buy with our dollars. The dollars aren’t real wealth, but only symbols that represent the bearer’s claim on an economy’s ability to generate wealth. Debt, for its part, is a claim on the economy’s ability to generate wealth in the future. "The ruling passion of the age," Soddy said, "is to convert wealth into debt" — to exchange a thing with present-day real value (a thing that could be stolen, or broken, or rust or rot before you can manage to use it) for something immutable and unchanging, a claim on wealth that has yet to be made. Money facilitates the exchange; it is, he said, "the nothing you get for something before you can get anything."
Problems arise when wealth and debt are not kept in proper relation. The amount of wealth that an economy can create is limited by the amount of low-entropy energy that it can sustainably suck from its environment — and by the amount of high-entropy effluent from an economy that the environment can sustainably absorb. Debt, being imaginary, has no such natural limit. It can grow infinitely, compounding at any rate we decide.
Whenever an economy allows debt to grow faster than wealth can be created, that economy has a need for debt repudiation. Inflation can do the job, decreasing debt gradually by eroding the purchasing power, the claim on future wealth, that each of your saved dollars represents. But when there is no inflation, an economy with overgrown claims on future wealth will experience regular crises of debt repudiation — stock market crashes, bankruptcies and foreclosures, defaults on bonds or loans or pension promises, the disappearance of paper assets.
It’s like musical chairs — in the wake of some shock (say, the run-up of the price of gas to $4 a gallon), holders of abstract debt suddenly want to hold money or real wealth instead. But not all of them can. One person’s loss causes another’s, and the whole system cascades into crisis. Each and every one of the crises that has beset the American economy in recent years has been, at heart, a crisis of debt repudiation. And we are unlikely to avoid more of them until we stop allowing claims on income to grow faster than income.
Soddy would not have been surprised at our current state of affairs. The problem isn’t simply greed, isn’t simply ignorance, isn’t a failure of regulatory diligence, but a systemic flaw in how our economy finances itself. As long as growth in claims on wealth outstrips the economy’s capacity to increase its wealth, market capitalism creates a niche for entrepreneurs who are all too willing to invent instruments of debt that will someday be repudiated. There will always be a Bernard Madoff or a subprime mortgage repackager willing to set us up for catastrophe. To stop them, we must balance claims on future wealth with the economy’s power to produce that wealth. How can that be done?
Soddy distilled his eccentric vision into five policy prescriptions, each of which was taken at the time as evidence that his theories were unworkable: The first four were to abandon the gold standard, let international exchange rates float, use federal surpluses and deficits as macroeconomic policy tools that could counter cyclical trends, and establish bureaus of economic statistics (including a consumer price index) in order to facilitate this effort. All of these are now conventional practice.
Soddy’s fifth proposal, the only one that remains outside the bounds of conventional wisdom, was to stop banks from creating money (and debt) out of nothing. Banks do this by lending out most of their depositors’ money at interest — making loans that the borrower soon puts in a demand deposit (checking) account, where it will soon be lent out again to create more debt and demand deposits, and so on, almost ad infinitum.
One way to stop this cycle, suggests Herman Daly, an ecological economist, would be to gradually institute a 100-percent reserve requirement on demand deposits. This would begin to shrink what Professor Daly calls "the enormous pyramid of debt that is precariously balanced atop the real economy, threatening to crash."
Banks would support themselves by charging fees for safekeeping, check clearing and all the other legitimate financial services they provide. They would still make loans and still be able to lend at interest "the real money of real depositors," in Professor Daly’s phrase, people who forgo consumption today by taking money out of their checking accounts and putting it in time deposits — CDs, passbook savings, 401(k)’s. In return, these savers receive a slightly larger claim on the real wealth of the community in the future.
In such a system, every increase in spending by borrowers would have to be matched by an act of saving or abstinence on the part of a depositor. This would re-establish a one-to-one correspondence between the real wealth of the community and the claims on that real wealth. (Of course, it would not solve the problem completely, not unless financial institutions were also forbidden to create subprime mortgage derivatives and other instruments of leveraged debt.)
If such a major structural renovation of our economy sounds hopelessly unrealistic, consider that so too did the abolition of the gold standard and the introduction of floating exchange rates back in the 1920s. If the laws of thermodynamics are sturdy, and if Soddy’s analysis of their relevance to economic life is correct, we’d better expand the realm of what we think is realistic.
Nanotech Exposed in Grocery Store Aisles
Report finds Miller Light, Cadbury and other brands have toxic risks
Untested nanotechnology is being used in more than 100 food products, food packaging and contact materials currently on the shelf, without warning or new FDA testing, according to a report released today by Friends of the Earth. The report, Out of the Laboratory and onto Our Plates: Nanotechnology in Food and Agriculture, found nanomaterials in popular products and packaging including Miller Light beer, Cadbury Chocolate packaging and ToddlerHealth, a nutritional drink powder for infants sold extensively at health food stores including WholeFoods.
"Nanotech food was put on our plates without FDA testing for consumer safety," said Ian Illuminato, Friends of the Earth Health and Environment Campaigner. "Consumers have a right to know if they are taste-testing a dangerous new technology." Existing regulations require no new testing or labeling for nanomaterials when they are created from existing approved chemicals, despite major differences in potential toxicity. The report reveals toxicity risks of nanomaterials such as organ damage and decreased immune system response.
"Nanotechnology can be very dangerous when used in food," said report co-author Dr Rye Senjen. "Early scientific evidence indicates that some nanomaterials produce free radicals which destroy or mutate DNA and can cause damage to the liver and kidneys." Report co-author Georgia Miller, Friends of the Earth Australia Nanotechnology Project Coordinator, said many of the world’s largest food companies, including Heinz, Nestle, Unilever and Kraft are currently using and testing nanotechnology for food processing and packaging. Without increased federal oversight, these companies could begin sale of these products whenever they choose.
"There is no legal requirement for manufacturers to label their products that contain nanomaterials, or to conduct new safety tests," said Miller. "This gives manufacturers the ability to force-feed untested technology to consumers without their consent." Nanotechnology, the manipulation of matter at the scale of atoms and molecules, is now used to manufacture nutritional supplements, flavor and colors additives, food packaging, cling wrap and containers, and chemicals used in agriculture.
"Friends of the Earth calls on the FDA to stop the sale of all nano food, packaging, and agricultural chemicals until strong scientific regulations are enacted to ensure consumer safety and until ingredients are labeled," said Illuminato. The report, released internationally today in the U.S., Europe and Australia details more than a hundred nano food, food packaging and food contact products now on sale internationally. The Australian government has already welcomed the report and announced that it will begin exploring regulation of nano food and nano agriculture as a result of the report. The full report can be found at www.foe.org.