Friday, 29 June 2012

That Barclays LIBOR-fixing matter......

Bob Diamond, CEO of Barclays, is fighting for his career.

The extent of the LIBOR-fixing scandal for which Barclays was fined by the FSA on the 27th June is still unclear: many other banks are thought to be involved - probably all of the LIBOR panel banks. Barclays was the first to admit guilt, and its fine was reduced by 30% because of this. However, the media furore since has cost Barclays far more than that: its share price dropped by over 15% after the FSA announced its findings, and there have been persistent calls for Diamond to resign. He has now been "invited" to appear before the Treasury Select Committee to explain Barclays'  behaviour.

Both Diamond's acceptance letter and the FSA report identify two quite separate and distinct forms of LIBOR-fixing. The first is the more widely reported, since it concerns the behaviour of traders - who everyone loves to hate anyway - and there are some salacious emails providing evidence of traders influencing LIBOR submitters with promises of champagne. The emails provide excellent colour for journalists and they do suggest that influencing LIBOR submitters was normal practice for traders even though it is a flagrant breach of Chinese walls. But the second, which is less glamorous, is far more serious, since it amounts to a bank attempting to deceive investors by manipulating market data. That is fraud.

The relevant sections of the FSA report are very clear.

Here's issue number 1. As expected - and as Diamond identified in his acceptance letter to the Treasury Select Committee - it concerns traders:
Inappropriate submissions following requests by derivatives traders 
8. Barclays acted inappropriately and breached Principle 5 on numerous occasions between January 2005 and July 2008 by making US dollar LIBOR and EURIBOR submissions which took into account requests made by its interest rate derivatives traders (“Derivatives Traders”).  At times these included requests made on behalf of derivatives traders at other banks.  The Derivatives Traders were motivated by profit and sought to benefit Barclays’ trading positions.    
..............10. Barclays also breached Principle 5 on numerous occasions between February 2006 and October 2007 by seeking to influence the EURIBOR (and to a much lesser extent the US dollar LIBOR) submissions  of other banks contributing to the rate setting process.  
I shall be interested to hear how the other banks responded to Barclays' traders attempting to talk down (or up) their LIBOR submissions. I suspect that like the Barclays' LIBOR submitters, they were only too pleased to help.

Diamond, in his acceptance letter, distances himself from the activities of these traders and blames the desk supervisors. On the face of it this seems reasonable, since even though he was head of Barclays Capital at the time he couldn't really be expected to know everything that traders get up to. But there is a much bigger issue here which is identified further down in the FSA report. I shall return to it later on.

Now to issue number 2. It has nothing to do with traders.
Inappropriate submissions to avoid negative media comment 
12. Barclays acted inappropriately and breached Principle 5 on numerous occasions between September 2007 and May 2009 by making LIBOR submissions which took into account concerns over the negative media perception of Barclays’ LIBOR  submissions. 
13. Liquidity issues were a particular focus for Barclays and other banks during the financial crisis and banks’ LIBOR submissions were seen by some commentators as a measure of their ability to raise funds.  Barclays was identified in the media as having higher LIBOR submissions than other contributing banks at the outset of the financial crisis.  Barclays believed  that other banks were making LIBOR submissions that were too low and did not reflect market conditions.  The media questioned whether Barclays’ submissions indicated that it had a liquidity problem.  Senior management at high levels within Barclays expressed concerns over this negative publicity.   
14. Senior management’s concerns in turn resulted in instructions being given by less senior managers at Barclays to reduce LIBOR submissions in order to avoid negative media comment.  The origin of these instructions is unclear.  Barclays’ LIBOR submissions continued to be high relative to other contributing banks’ submissions during the financial crisis.   
Couldn't be clearer, really. During the financial crisis, senior Barclays management deliberately falsified LIBOR submissions in order to make their funding costs look lower than they were and therefore fool investors into believing that the bank was in better shape than it actually was. Nothing whatsoever to do with traders breaching Chinese walls.

Diamond obviously realised that he couldn't get away with blaming traders for this, so in his letter he focuses on the other banks alluded to in paragraph 13. Actually he has a point, and I think we will discover soon that other banks were also making submissions that were far too low in order to make themselves look stronger than they were. I am particularly interested in the findings regarding RBS and UBS, both of which were bailed out in the financial crisis.....either the market massively misread their creditworthiness at the time, or they lied about their funding costs. But that doesn't excuse Barclays' behaviour. Quite apart from the market effect of deliberately quoting lower rates than those they were actually paying, they also lied about their funding costs in order to deceive investors and the public at large. That is unacceptable. And although Diamond was not CEO at the time, he was the head of Barclays Capital and a member of the senior management team at Barclays.

Now to return to the real issue underlying issue no.1. Here is the FSA again:

Systems and controls failings 
15. Barclays breached Principle 3 from January 2005 until June 2010 (the “Relevant Period”) by failing to have adequate risk management systems or effective controls in place in relation to its LIBOR and EURIBOR submissions processes.  Barclays had no specific systems and controls in place relating to its LIBOR and EURIBOR submissions processes until December 2009 (when Barclays started to improve its systems and controls).   
16. The extent of Barclays’ misconduct was exacerbated by these inadequate systems and controls.  Barclays failed, at a number of appropriate points during the Relevant Period, to review whether its systems and controls were adequate.
Compliance failings
17. Barclays failed to conduct its business with due skill, care and diligence when considering issues raised internally in relation to its LIBOR submissions.  Barclays therefore breached Principle 2.  LIBOR  issues were escalated to Barclays’ 4 Investment Banking compliance function (“Compliance”) on three occasions during 2007 and 2008. In each case Compliance failed to assess and address the issues effectively.
18. Compliance’s failures meant that Barclays’ breaches of Principles 5 and 3 were allowed to continue.  Compliance’s failures also led to unclear and insufficient communication about issues to the FSA.   
So traders weren't breaching Chinese walls, actually. The Chinese walls WERE NEVER THERE. Barclays had no means of ensuring that its LIBOR submission process was safeguarded from inappropriate influence from other areas of the business. And it didn't care.

This is a major failure of internal control akin to those we see in virtually all "rogue trader" events. And Diamond is in fact treating this as a "rogue trader" event. The junior staff actually involved in the rate fixing are being sacked. But the senior management responsible for the internal control failure that made it possible for these people to influence rates inappropriately, are they being sacked too? Doesn't look like it. After all, the person heading up Barclays Capital during the period in question was one Bob Diamond - and he is clearly hoping to hang on to his job, as his pre-emptive repudiation of his bonus shows.

It won't do, and I hope the Treasury Select Committee see through this smokescreen. Bob Diamond is culpable for BOTH parts of the LIBOR-fixing scandal at Barclays. He should be sacked.

Wednesday, 27 June 2012

The money machine

The financial system is short of liquidity.

"What???" you say. "Despite the trillions of dollars that the Fed, the Bank of England, the Bank of Japan and even the ECB have been pumping into it through their various varieties of money creation? How can the financial system POSSIBLY be short of liquidity?"

Trust me, it is. But the conventional banking system isn't short of liquidity. The shadow banking system is. And this is a very serious matter, because the shadow banking system and conventional banking system are critically interlinked. If money stops circulating in the shadow banking system, it can't circulate in the conventional banking system either. The effect is that conventional banks end up awash with cash that they daren't lend out, and the shadow banking network grinds to a halt. Which is what is happening.

So why isn't money circulating in the shadow banking system, and why does this affect the transmission of money in the conventional banking system?

Firstly, let's explain what the shadow banking system is. Essentially it is a network of non-bank financial institutions that together perform functions akin to those of conventional banking. The three principal activities that ensure the flow of funds through the shadow banking system are repo (repurchase agreements), securities lending and rehypothecation. These three also create the links between conventional and shadow banking and are the means by which money flows through the financial system as a whole.

Let's imagine a large bank funding itself in the interbank repo market. A repo consists of two transactions - a spot sale of assets and a future purchase of the same quantity and quality of assets. The combination of these two transactions is effectively the same as a short-term secured loan and is normally recorded as such in the books of the parties concerned, although there have been notorious examples of repos being recorded as sales (Lehman 105, MF Global). The collateral on this secured loan is the assets sold, which have to be of sufficiently good quality to be acceptable to the lender. Note that as these assets are collateral - i.e. do not belong to the holder unless the owner defaults - they do not form part of the asset base of the holder.

Prior to the 2008 financial crisis, the US repo market ran largely on mortgage-backed securities and their derivatives, most of which were assigned ratings of AAA or similar. Those securities are now regarded as toxic, so since then, markets have turned to other forms of "safe" assets - particularly the bonds of highly-rated sovereigns. Regulation on both sides of the Atlantic has encouraged this by requiring large banks to hold substantial quantities of safe liquid assets (usually their own government's debt) as a liquidity buffer. If a large bank doesn't have sufficient acceptable collateral, it is not able to borrow in the repo market.

However, a large bank that is short of collateral does have a saviour at hand - funds. Hedge funds, pension funds, other kinds of investment funds. These funds hold safe long-term assets such as government bonds. But they like to get a short-term return on these assets, so for a fee they will lend them out. So the bank can borrow securities from a fund and pledge them as collateral in a repo transaction. This would typically be done as a reverse repo/repo pair: the fund pledges securities to the bank and the bank re-pledges those securities in the repo market. This practice is called rehypothecation. The amount borrowed is less than the market value of the securities: the difference is called the haircut. Haircuts get bigger each time the securities are rehypothecated. The difference in the haircut on each rehypothecation is equivalent to the spread between borrowing and lending and represents a real return to the lender.

People familiar with conventional banking will recognise this transaction series as credit intermediation and maturity transformation - borrowing short and lending long - which is the traditional business of fractional reserve banking. Both fund and bank have lent out long-dated securities in return for short-term cash funding. And further, credit creation is involved. The bank pays the fund cash it doesn't yet have and settles it when it receives the cash it borrows in the repo market - exactly as conventional banks do when they lend money ahead of obtaining settlement funding. The accounting for this payment creates a deposit in exactly the same way as conventional fractional reserve banking and therefore expands broad money just as normal bank lending does. Much of the expansion of M4 (broad money) prior to the 2008 financial crisis occurred in this way.

So this is "shadow" banking.  It's just like conventional banking except in two critical respects: there is no deposit insurance and usually no lender of last resort (shadow financial institutions typically have no access to central bank funding). And it is largely unregulated. Hence the requirement for safe collateral. Really, it's financial pawnbroking.


And conventional banks depend on it. The deposit base of conventional banks has shrunk over the last few decades as people have invested their savings in pensions, long-term savings schemes linked to insurance, financial assets and property. All of those except the last are providers of funds and collateral to the shadow banking system: the last has until recently been an important source of "risk-free" assets. The shadow banking network is the means by which the funding that previously came mainly from bank deposits finds its way back into conventional banks to enable them to perform their lending function: the mechanism by which this happens is the interbank market, which conventional banks use to fund deposit drawdowns and other outflows. 

So the whole financial system, including conventional banking, depends on there being a plentiful supply of safe assets for use as collateral. But just look at what has been happening to sovereign debt! Sovereigns are losing their AAA ratings: even the mighty USA has been downgraded, although as the US Treasury is still the world's most liquid financial instrument by a country mile the downgrade hasn't made much difference. And around the world, sovereigns are finding ways of removing sovereign debt from circulation, either through fiscal consolidation or by buying it back.  The Fed and the Bank of England have both had two rounds of Quantitative Easing (QE) in which they have removed from circulation large quantities of the safest and most liquid government debt in the world. As a result there is now a serious shortage of AAA-rated assets in the shadow banking system. This is of course partially offset by the large amount of cash held by banks - but as they will only lend to safe prospects or in return for good collateral, the cash is not doing much. Lots of it is parked at central banks for a few basis points in interest.

I am amazed that politicians are arguing about why the yields on UK gilts are at all-time lows. The Government insist it is because their fiscal consolidation programme is increasing market confidence, while the Opposition claim it is because markets don't think the UK will come out of recession any time soon. I don't believe either story. To me, one look at the state of the global money machine is enough to explain why UK gilt yields are below inflation. Demand for these is outstripping supply, so their price is rising (which causes yields to fall). The same is happening to other high-quality sovereign debt.

The financial system is short of liquidity. But not cash. It has lots of that, and the central banks keep providing more and more - while removing from circulation the liquidity that is really needed, namely government debt. It's like a car owner who keeps putting petrol in his car to keep it running when the problem is an oil leak. Eventually his engine will seize up and the car will stop running even though the petrol tank is full to overflowing.

I have some sympathy (well, not much really) for the central banks' predicament. Governments aren't usually too happy for central banks to dish out cash willy-nilly, and they want to know that central bank management are being prudent, because central bank losses do rebound to the State. So central banks generally will only lend cash to banks that can provide decent collateral. But the same governments that don't like central banks to accept risky collateral (thereby keeping safe assets in circulation) also don't want to issue new debt to replace that being removed from circulation. Fiscal consolidation is fashionable and EVERYONE is trying to cut their deficits and run balanced budgets. And those same governments, in the interests of making the financial system safer and protecting small investors, also insist that funds and banks hold increasing quantities of their bonds, while reducing their new debt issuance and encouraging central banks to remove existing bonds from circulation. No wonder UK and US government debt yields are crashing through the floor.

The financial system is at serious risk of seizing up completely due to lack of collateral. There are a number of possible solutions to this. One is to accept that cash is the future and guarantee all cash deposits, including wholesale and interbank deposits. This would remove the need for safe assets as collateral - the repo market could become an unsecured funding market. An interesting side effect of this would be to make it much more difficult for funds to lend out their assets to gain short-term returns, and they might start acting more as custodians.

A second would be for regulators and investors to reconsider what is meant by "safe" assets. A quick look at this chart shows that the Basel assumption that sovereign debt is intrinsically safe is clearly very wrong - just as prior to 2008 the habitual classification of mortgage-backed securities as "safe" turned out to be very wrong. No sane person would regard corporate bonds issued by Apple as riskier than, say, Brazilian sovereign debt - yet that is the assumption. The asset bases of multinational companies are larger and more secure than most countries, and many of them have been in existence for longer, too. The direction of regulation at the moment is to push investors towards government debt. Perhaps that should change, in the interests both of protecting investors and providing more liquidity to the shadow banking system. Goldbugs reading this post will no doubt suggest gold as an alternative safe asset, but there is an even greater scarcity of gold than there is of government debt - and guess who has been buying it? Yup, central banks. Anyone would think they WANT this system to seize up!


The third, and most radical, solution would be to reconsider the nature and purpose of government debt. I've mentioned previously that in financial terms there is no significant difference between government bonds and currency. Government bonds are usually callable term-limited, interest bearing bonds, though they can be perpetual (no maturity date) and they can be zero-coupon (non-interest bearing). All fiat currency (notes and coins) is callable zero-coupon perpetual Government debt. In the shadow banking system, both currency and Government debt are forms of money, and the shadow banking system acts as a sort of money exchange system, intermediating government debt into currency and back again. All that conventional QE does is expand one form of money at the expense of the other, and by so doing it makes the shadow banking system's currency intermediation function  extremely difficult. We should be looking for the balance between the two forms of money that enables the money transmission and intermediation machine to function most efficiently. But to do this, we have to stop thinking of government debt as something that governments need to keep society working, and redefine it as something that banks and markets need to keep the money machine working. 

Therefore I fundamentally disagree with all those who believe that governments should stop issuing debt, whether because they think governments can simply create the money they need or because they think governments should meet spending commitments only from tax receipts. Debt issuance isn't about government spending: MMT theorists are correct that a fiat currency-issuing sovereign can simply create the money it needs and doesn't need to borrow from investors (though fiat currency issuance is of course borrowing at zero interest, as I explained in the paragraph above). No, government debt is a GOOD for which there is a worldwide demand. We should produce as much of it as the world demands. It is one of the most productive assets of our economy.

Now, I can just hear the howls of outrage at the idea that the government should issue MORE debt in order to help the financial system. After all, we pay interest on this debt, don't we? Well, at the moment, no we don't. The amount we are paying in interest on government debt is below inflation - and other trusted sovereigns, notably the US and Germany, actually have negative yields at the moment, which means that investors in those bonds are making a loss. Yields so low that the real rate of return is below zero are in my view a clear indication that there is not enough of the asset in circulation to meet demand. So there is definitely scope for government to issue more debt without incurring real cost.

I propose that the right amount of government debt for a trusted sovereign to issue is the amount that maintains the real rate of return at the same rate as the rate paid by the central bank on cash deposits - currently about 25 basis points, I think. Government spending needs should have no influence on this basic principle. Government then will be indifferent as to whether it meets its spending commitments through debt issuance or currency creation, because the real cost will be equivalent: if it chooses to issue more debt, it will pay interest above inflation; if it chooses to issue currency, it should experience reduction in the purchasing power of the currency equal to the interest cost on the equivalent debt issuance.

I am well aware that this is a controversial proposal. But I have approached it from a purely monetary perspective, without getting into arguments about the morality of government debt and spending. What government should do with the money it receives from the sales of its quality product, obviously, is to spend it on things that improve the quality of its product still further. What exactly those things are is an entirely separate economic and political issue that I do not intend to address in this post.

The financial system is short of liquidity. Let's create some.


Sunday, 24 June 2012

A financial Nuremberg?

Ever since the 2008 financial crisis, there have been calls to bring to account the people responsible for the near-collapse of the international financial system and the subsequent worldwide recession. But very few have been prosecuted, either nationally or internationally. In individual countries, notably the USA, some have been convicted of fraud and further prosecutions are pending. But there has been no international action against the principal actors in this drama - the financiers, the politicians, the regulators, the auditors and the economists. Again and again we hear people asking why no senior bankers are in prison, why there is no enquiry into how the financial system came so close to collapse and why no-one has been prosecuted for causing such devastation across the whole world.

There are several reasons for this. Firstly, very few of these people have committed actual crimes under existing national or international law: endangering the international financial system isn't currently a crime, so unless there is evidence of actual fraud there is no basis for prosecuting these people. Secondly, there is no independent international body capable of conducting such an investigation or prosecuting the culprits. Thirdly, there is insufficient understanding of the global nature of the crisis. People still talk as if the banking collapse was in "their" country: so, for example, they will call for a UK enquiry into the collapse of Northern Rock, HBOS and RBS, without seeing that these need to be examined in the context of a worldwide catastrophic collapse of retail and investment banking.

And yet within the last century the international community, horrified by what was done, did create an international body capable of prosecuting people for crimes that previously had never been imagined. I refer, of course, to the Nuremberg trials after World War II, and the subsequent creation of the International Criminal Court. We have not had a war, and in no way can the financial crisis be regarded as repeating the horrors of the Holocaust. But the devastation that was caused in the financial crisis has nevertheless wrecked lives and communities, and we are nowhere near recovering from it yet. It seems appropriate to regard what was done as similar to war crimes.

So I would like to propose the following:

  • The creation of a new international crime of "endangering the global financial system and/or seeking to profit from its collapse"
  • An international body under the aegis of the United Nations to identify those principally responsible for the 2008 financial crisis and where appropriate to bring prosecutions against them in the International Criminal Court
  • The establishment of a permanent international overseeing body for the global financial system, with powers to call to account, and if necessary bring prosecutions against, the management of systemically-important institutions who act recklessly in pursuit of individual or corporate profit.  

I realise that this would involve nations voluntarily surrendering some control of institutions that they consider their own. It would particularly be an issue for the US and UK, I think. But in the interests of peace, nations have already surrendered the right to bring to justice war criminals themselves. Surely it is now time that nations surrendered the right to control financial institutions that, if mismanaged, can endanger the economy of the entire world?

UPDATE. I should make it clear there that the problem as I see it is that finance is an international industry, but there is no international body capable of regulating it or bringing to account those who endanger it.  The Nuremberg trials were criticised for the fact that they prosecuted people for crimes that did not exist in law at the time they were committed. This is a reasonable criticism, and it may be that it would not be appropriate to attempt to prosecute those responsible for the 2008 crisis. But we should look firstly to investigate how the crisis happened, how it was managed and what we can learn from it for the future: this should be done impartially and from an international perspective. Secondly, we should look to put in place international laws and institutions to deal with these problems in the future. National laws and institutions are inadequate.

Thursday, 21 June 2012

The monsters of Spain

Anyone remember Too Big To Fail?

Ever since the financial crisis of 2008, there have been cries for large banks to be broken up. The idea is that no bank should be so large that it cannot be allowed to fail because if it did it would pose a threat to the domestic or international financial system.

So far no banks have actually been broken up, apart from some that failed in 2008 - Lehman and ABN AMRO, for example. But governments and regulators around the world have been looking at ways of limiting bank size (taxing liabilities, for example), ensuring that failed banks can be resolved quickly and safely, and promoting competition in the banking sector to reduce bank power by giving customers more choice.

Except in Spain. The Bank of Spain has taken the OPPOSITE view. Over the last four years it has promoted, encouraged and facilitated the merger of the regional savings banks - the cajas - into much larger conglomerates. Its stated aim is to reduce the number of cajas from 45 to 10. That is by any standards a significant consolidation in the regional banking marketplace.

The reason is the awful exposure of the cajas to Spain's property bubble and their serious lack of capital. When it burst in 2008, many of the cajas lost huge amounts of money, leaving them seriously distressed or actually insolvent. The Bank of Spain's chosen rescue strategy for these cajas is to merge them with other banks. If the banks they chose were themselves in good shape, this wouldn't be a bad strategy. But that isn't what they are doing. Like Frankenstein, they are artificially giving life to dead bodies. And like Frankenstein, in doing this they are creating monsters.

Bankia was such a creation. In December 2010 seven cajas merged to create the monster that is Bankia. All of the seven were in financial trouble and would probably have gone bankrupt due to bad property loans if the merger had not gone ahead. But the merger alone was not sufficient to create a viable bank. The Spanish government, via its bailout fund FROB, contributed 4.5bn euros of capital to the new creation in the form of (non-voting) preference shares. Without that capital Bankia would not have been able to commence trading. It was propped up by its sovereign from the start.

In July 2011 Bankia was floated. Foreign investors wouldn't touch it, so the shares were mainly sold to Spanish companies and individuals.

It now appears that some of the cajas that merged to form Bankia were, shall we say, somewhat less than accurate in declaring the extent of their bad loans. Not surprisingly, the investors are furious. Private investors are currently pooling funds with the intention of pursuing civil action, and Spanish prosecutors are investigating whether the IPO was fraudulent.

Meanwhile, of course, Bankia has gone bust. But it is a LARGE bank - the fourth largest in Spain in terms of assets. Its operations are too extensive and too critical to the Spanish economy for it to be allowed to fail.

You see, the trouble with monsters - as anyone who has read Frankenstein would know - is that they can't be controlled by their creators. Bankia now needs bailing out, because it is Too Big To Fail. But Bankia is also too big to be bailed out by the Spanish sovereign alone. The Spanish government has had to seek help from the EU.

Nor was Bankia the only monster the Bank of Spain tried to create. It also tried to merge the solvent Cajastur (which had already absorbed the collapsed Caja Castilla La Mancha) and two smaller cajas with the desperately troubled Caja de Ahorros del Mediterraneo CAM), itself a sprawling conglomerate of twenty-seven smaller banks that it had gradually absorbed over the previous twenty years. CAM was a non-profit-making organisation with extensive ties to the regional government of Valencia: the chairman of the board was personally appointed by the then President of Valencia, who was subsequently prosecuted for bribery, fraud and corruption.

In March 2011 the attempted merger failed when the extent of CAM's bad loans became clear. The merged entity would have required capital from FROB of 2.78bn Euros, twice the original estimate. There is no doubt that had the merger proceeded the new entity would have suffered the same fate as Bankia - failure and nationalisation, putting the Spanish banking system at risk. Wisely, the management of Cajastur decided not to proceed. CAM was nationalised in July 2011 - effectively transferring the liability for its bad debts to the Spanish government - and sold to Banco Sabadell for 1 Euro. The chairman of the board was forced to resign; the Director General, together with five other directors, was dismissed and is now facing prosecution for suspected accounting fraud.

There are other caja merger disaster stories too. Caja Unnim was created in 2010 from the merger of three cajas: it went bust in 2011, was nationalised and then sold to BBVA for 1 Euro. Catalunya Caixa, Spain's fourth largest savings bank,  was created in July 2010 from the merger of Caixa Catalunya, Caixa Tarragona and Caixa Manresa: it was partially nationalised in 2011, as was Nova Galicia Caixa, created in 2010 from the merger of Caixa Galicia and Novacaixa.

The end result of this disastrous merger activity is that, according to the IMF, MORE THAN HALF of the large and medium-sized banks in Spain are now partially or wholly dependent on state support. Only the three largest banks are both fully independent and well-capitalised. All the rest are either already nationalised, about to be partially nationalised (Bankia) or are likely to require partial nationalisation as economic conditions worsen. How this can be regarded as an improvement on the previous network of smaller regional banks is beyond me. Smaller banks can be, and in my view should be, allowed to fail. But instead of allowing the smaller cajas to fail, Spain has created monsters - and now the monsters are draining the Spanish sovereign of its lifeblood.

Unlike Frankenstein's monster, though, these monsters do not seek independence. On the contrary, they have developed a symbiotic relationship with regional and national government which ensures their survival. The Spanish sovereign has become dependent on its banks for funding, just as its banks have become dependent on their sovereign for capital. George Soros described the relationship of banks and sovereigns in the Eurozone as being like "conjoined twins": nowhere is this more apparent than in Spain. To my mind this is the primary reason for Spain's insistence that even quite small banks must be bailed out or merged, not allowed to fail. If the banks fail, the sovereign bleeds to death.

So the challenge for the EU and the IMF is how to separate the banks from the sovereign without causing terminal damage to both. At present no-one has any sensible proposals for doing this, although this post from INET has some interesting ideas. The EU seems unable to think beyond the next bailout, and the IMF actually wants MORE public backstopping of banks (though without public control of banks - moral hazard, much?). But find a way, we must, even if that means painful surgery. The end of Frankenstein carries an awful warning: the death of Frankenstein leads inevitably to the death of his creation. Spain rightly fears the failure of its banks: but far more should banks fear failure of the Spanish sovereign, because if that fails they must fail too - and the rest of Europe with them.

Saturday, 16 June 2012

The real tragedy of Europe

This, courtesy of Pedro da Costa of Reuters:



This is a slightly more comprehensive chart than the one I used at the start of my post The European Disaster Story.

Spain's adult unemployment rate is now the same as the unemployment rate in the United States in 1933 at the height of the Great Depression. Greece will be at the same level or worse very soon. What a terrible waste of human life and potential.

This is the real tragedy of Europe.


Friday, 15 June 2012

The real bailout

According to James Mackintosh of the Financial Times, JP Morgan produced some figures today that showed where the money provided to Greece in its much-publicised bailouts actually went. Here's what James said on twitter:
"JP Morgan estimates only €15bn of €410bn total "aid" to Greece went into economy - rest to creditors. No wonder they are cross"
No wonder indeed. The price they paid for those bailouts has been severe cuts in public spending and five years of deep recession. Their adult unemployment is now about 20% and their youth unemployment over 50%. And there is no relief in sight, only further cuts and deeper recession. The Greek economy is collapsing.

No prizes for guessing who the main creditors are, either. Banks, of course. This fun interactive graphic from Thomson Reuters shows which countries' banks are the most exposed to Greece and therefore, presumably, have benefited the most from the bailouts.

In the most recent bailout, of course, the private sector has taken substantial losses - up to 75% NPV haircut on their holdings of Greek debt. But they had already sold a lot of it. Guess who they sold it to? National central banks and the ECB - none of which took a haircut, though they did forego some interest. So quite a bit of the bailout money has also gone to those institutions. But their purchases of that debt were also effectively a rescue of the banks that were overexposed to Greek debt.

So directly or indirectly, the main beneficiaries of Greek bailout money have been French and German banks. "Aid" to Greece? Anything but. The Greeks can be justifiably angry that their economy has been wrecked in order to fool German taxpayers into believing that they were rescuing a profligate southern state when actually they were bailing out their own banks and protecting France.

The Thomsons Reuters graphic also includes exposures for two other countries that have received "aid" in return for wrenching fiscal austerity. Click on the buttons to see who really benefited from their bailout money. For Portugal, the main beneficiary has been Spanish banks - well, heaven knows they need it (although I suspect most of the exposure is in the largest banks, which are not the ones in trouble). Ireland is interesting, because the banks most exposed are UK banks, though closely followed by German ones. It would seem that despite the UK's steady refusal to participate in Eurozone rescue packages, some of the bailout money is propping up its banks. Nice.

The Spanish bailout acknowledges that the main problem lies with the domestic banks not the sovereign, and therefore imposes "austerity" - of a sort - on the banks, not the people. It is the first sovereign "bailout" to do this. But it won't remain like that for long. Spanish sovereign debt yields are already rising to unsustainable levels. Banks holding that debt will have to mark down the value of those holdings and face substantial losses as a result. At the moment the ECB is not buying the debt, but it is only a matter of time until it does. And eventually Spain will require a sovereign bailout - at which point the screws will be turned on the Spanish people, even though they are already buckling under self-imposed austerity measures and have adult and youth unemployment rates higher than Greece. The Bundesbank's Jens Weidmann is already making noises about higher taxes and deeper spending cuts for Spain. That gives a clue as to which banks are most exposed to Spanish government debt (apart from its own, of course), and the graphic confirms it. German banks, of course. And French.  

Italy has not yet been bailed out, and is introducing a range of increasingly desperate measures to try and reduce their government debt significantly - it currently stands at about 120% of GDP, double the Maastricht limit. But yields on its debt are already rising, affecting the value of banks' holdings as with Spanish debt. Again, a quick look at the graphic shows who is most exposed. French banks, this time. And German.

By now it should be apparent where the bailout money has mainly been going, and - more importantly - where it will go when first Spain and then Italy require sovereign bailout. Yes, the UK and Spanish banks have benefited. But they aren't the main beneficiaries overall. The Thomson Reuters graphic shows that the principal beneficiaries of bailout money are French and German banks.

So Germans, too, should be angry. Not with the Eurozone sovereigns, but with their own banks and the French banks. Because it is the reckless lending of those banks, primarily, that has brought the Eurozone to its knees.  Yes, we can blame the half-baked Euro for the trade imbalances within the Eurozone, and the incompetent ECB for the crippling deflation in the periphery that is now dragging the entire Eurozone into recession. But the debt crisis - that was created by banks. And it is those same banks that are now receiving trillions of euros in bailout money, one way or another. All the hard work that Germans put in to repair their economy after reunification is going to waste as their taxes and their savings are used to bail out banks, whether indirectly via sovereign bailouts or directly through infusions of capital.

Let's end this madness. Stop inflicting pain on the people of Europe in order to prop up banks. And even more, stop lying to them. The banks that have lent so recklessly across borders are bust. If they are to be bailed out, let them be bailed out by their own governments - if their electorates agree. And if their electorates don't agree, LET THEM FAIL. America's FDIC has much to teach us on this, and Europe would do well to create an equivalent institution. Their mantra is - protect depositors, provide emergency access to funds, take over payments systems, then wind up the failed institutions. Europe should do the same.  Let there be no more covert or overt bailouts of banks.

Saturday, 9 June 2012

How to bring down a bank

This, from a comment on Richard Murphy's blog.
a. If the EU lends money to the Spanish government it presumably then lends it to the banks.
b. According to orthodox theory every debt liability has a corresponding asset
c. If that is true the worst that can happen is that the transaction is neutral so far as Spain is concerned
d. It seems possible that it could actually reduce sovereign debt depending on the interest charged on the loans to the bank
e. When Europe lends to a state it imposes conditions
f. It follows that if a state lends to the banks it can equally impose conditions
g. The state can therefore require that the banks use the money to repay deposits from ordinary people and money owed to pension funds
h. After that the banks can go hang, because it is those liabilities which blackmail us into helping them
i. That money is then with depositors and pension funds
j. The state can then require them to give it to the state for use in rebuilding the economy
There are numerous problems with this.

Firstly, the commentor confuses debt and capital. The Spanish caja banks are short of capital. That means that their debt is too high in relation to their assets.  The gap between assets and debt on a bank balance sheet is its capital. If that gap becomes too small, the bank may be unable to repay its creditors in the event of its assets losing value. Bank creditors are depositors, bondholders and other banks.  Borrowing from other banks, including central banks, is collateralised - banks have to pledge high-quality assets, typically government bonds, which will be forfeited to the lender in the event of them being unable to repay the borrowings. Obviously, then, having insufficient capital puts bondholders and depositors at risk: the smaller the capital base, the more likely it is that bondholders and/or depositors will lose their money. If the gap inverts - debts exceed assets - then the bank is insolvent.

Clearly, lending to a bank that is short of capital doesn't solve its problem - it makes it worse. So the Spanish government isn't going to borrow money from the EU to lend it to banks, as this commentor thinks. It's going to give it to them. In return it will own part of the business (partial nationalisation). This is called an equity stake and it is a balance sheet asset for the holder. So the money borrowed from the EU - a debt liability for the Spanish sovereign, as the commentor correctly notes - would be balanced by an equivalent equity holding in the Spanish caja banks. There is in my view therefore no need for the EU's loan to be included in net sovereign debt, and there is precedent for this exclusion: the UK's net national debt figures do not include the additional borrowing needed to buy its stakes in RBS and Lloyds.

However, there is little or no chance that this equity stake could reduce sovereign debt, at least in the short term. There is no interest charge on equity. There may be dividends, but a bank rescued in this manner would be unlikely to pay a dividend for quite some time after bailout. In the longer term, any gains from share price movements could eventually be realised by selling the stake - although this is by no means certain: the UK made a loss when it sold Northern Rock.

So, having made the Spanish banks' problems worse by lending them the money instead of taking an equity stake, our commentor then wants the Spanish sovereign to direct the banks to use the money to eliminate their depositor base and redeem senior bonds. Well, I suppose that's one way of eliminating the problem that lending them the money would cause.  But it kind of defeats their purpose. These banks are SAVINGS banks. If they repay savers all their money, they aren't savings banks any more, are they? And the banks would still be short of capital. It would just be EU taxpayers' money at risk instead of Spanish depositors and bondholders. And all lending would have to be funded from interbank lending - most likely from the Spanish central bank.  In effect the cajas would become state lending conduits: private savers would be forced to move their funds elsewhere and all money for lending would come from the Spanish government, directly or indirectly. And as borrowing from central banks is collateralised, the banks would need copious quantities of, er, Spanish government bonds. This arrangement would almost certainly break EU rules forbidding central banks to fund governments.

But suppose our commentor agreed with me that actually an equity stake is required? Things then become even sillier. Having providing the banks with capital, to protect depositors and bondholders, the Spanish government then insists that the banks repay depositors and redeem senior bonds. Thereby eliminating the whole point of providing the capital.

Pointless though it seems, what would actually happen if the Spanish government did this? Governments have done stupider things than this, after all.

Well, actually the same as if the Spanish government had lent the money. Savers and bondholders would be forced to move their money elsewhere and the banks would become totally dependent on the Bank of Spain for funding, for which they would need Spanish government bonds. We are back to government lending conduits and direct financing of government by the central bank, aren't we?

At which point the EU arrives on the doorstep to take over the whole shooting match.

Oh, and those savers and bondholders wouldn't have to decide where to put their money once the banks have repaid them. No, the Spanish government should "require them to give it to the state for use in rebuilding the economy". Presumably, therefore, for lending out by those same banks from which they were forced to remove their funds. There's a word for that action: it's called expropriation. Otherwise known as "theft".

This is an object lesson in how to bring down not one bank, but an entire national banking system.

To be fair to the commentor, she did climb down over some of this after I replied. But it just goes to show what very muddled thinking exists out there.




Friday, 8 June 2012

A really scary story

There was a scary headline in the FT yesterday:

         "US BANKS FACE $60 BILLION CAPITAL SHORTFALL"

And the report went on to explain:

"The 19 largest US banks are at least $50bn short of meeting new capital requirements under the Basel III accords, according to rules proposed by the Federal Reserve.
The biggest among them would probably need billions of dollars more by the 2019 deadline to comply fully with the rules. Smaller US lenders are about $10bn short of the requirements, the Fed said on Thursday."

Terrifying. And complete rubbish.

These are capital requirements that don't come into force until 2019. The third paragraph of the report says:
"....most banks should be able to reach the new levels by retaining earnings during the next few years rather than by raising capital in the market".
So NORMAL activity will be enough for most banks to meet the new requirements. No shortfall, then. Nothing to look at here. Move along, now.

But in trying to make a scary story out of nothing at all, the writer of this article has completely missed the real issues. There really is a scary story here, but it isn't the risk that banks won't meet the new capital requirements.  That's a red herring.

The real issues are further down the article. Here's scary issue number 1:
"Some banks will be able to calculate their needed levels of capital using internal models, subject to Fed approval"
If you want scary, this should do it nicely. The risk weightings of the complex instruments that failed in the 2008 financial crisis were calculated using banks' own internal models. Using a UK example, both RBS and HBOS were given permission by the FSA to use their own models to calculate risk weightings, and it is fair to say that the FSA hadn't a clue how these models worked. What we do know - now - is that the models allowed the banks to assign far lower risk weightings to the instruments than their actual risk turned out to be. Capital requirements rely on calculation of risk weights - the higher the risk weight, the more capital required to support the asset. So instruments that were actually highly risky were assigned low risk weights by banks using their own models, which allowed banks to reduce their capital - in some cases to dangerously low levels - and the regulators were so impressed with these models that they didn't bother to investigate whether the results they churned out accurately reflected the risk of the assets.

You'd think we would have learned by now that there is IMMENSE moral hazard in allowing banks to use their own models to value and risk weight assets for capital allocation purposes. So why on earth are Fed allowing banks to continue to do this? And the usual defence of this practice - "only the banks really understand these instruments so it's appropriate to use their models" - simply won't wash any more. Regulators MUST understand these instruments, so that they can verify the valuations and risk weightings assigned to them. If the instruments are so complex and so poorly documented that regulators can't understand them, THEY SHOULD NOT BE TRADED.

And here's scary issue number 2.
"Banks will have to hold the same amount of capital against their holdings of sovereign debt issued by Germany as they would for Portugal, Spain and Ireland"
What is happening is that banks are being prevented from using credit rating agencies to provide a measure of risk. If this led to banks doing their own due diligence on investments that would be a good idea.  But that's not what the article is saying. It is actually suggesting that the credit ratings agencies' ratings should be replaced with....nothing. No assessment of default risk at all.  Now, it is not in a bank's interests to tie up capital on investments that are low-risk and therefore give a poor return. If the bank has to allocate the same amount of capital against German debt as it does for Portuguese, but the Portuguese debt pays higher interest, which one will it buy? We have played this scene before. This is how the weaker sovereigns in Euroland got themselves into so much trouble - banks bought their debt in preference to stronger ones because it carried the same risk weighting but paid them a bit more. If the reporter has got this right, it suggests that the Fed (and maybe even the Basel Committee) have learned nothing from the sovereign debt crisis, just as issue no. 1 suggests that they have learned little from the 2008 investment banking collapse.

And finally - scary issue number 3. For this we have to return to the start of the article.

"....most banks should be able to reach the new levels by retaining earnings during the next few years rather than by raising capital in the market".
Now, I know I said this wasn't scary. But it is - just not in the way that the article suggests. You see, if banks are retaining earnings in order to shore up their capital buffers to meet higher regulatory requirements, they WON'T LEND - especially not to riskier prospects. Lending requires capital: every loan on the banks' balance sheets ties up a certain amount of capital, and the riskier the loan the more capital it ties up. In America prior to 2008, banks freed up capital by selling loans for securitisation. But the mortgage-backed securities market is moribund and other securities markets are much smaller. So banks are already having to keep more on their balance sheets than they did before, which ties up capital and restricts lending. If they have to retain earnings to build up their capital, they will lend even less. The US should beware. Raising capital requirements when the securities markets are not functioning properly and shareholders' returns are down is asking for a credit crunch. Banks have seven years to meet these requirements. That means seven years of restricted lending. Does the Fed have any plans to offset the economic impact of what will be a long-drawn-out credit crunch?

Putting all this together we can see that there is a scary story here which the FT writer has completely missed. Banks will continue to be allowed to define their own risk weightings, inevitably leading to insufficient capital allocation against risky instruments - just as in the run-up to the 2008 financial crisis. Banks will be encouraged, through one-size-fits-all capital requirements, to buy the sovereign debt of weaker nations in preference to stronger ones - just as in the run-up to the current sovereign debt crisis. And in order to build up capital buffers, banks will be discouraged from lending to poorer risks such as SME's - just when the economy really could do with an expansion of SMEs to create jobs. Wonderful.

Mind you, if you think the US story is scary, just look at this chart:

 
(h/t cigolo and @nr_zero for this one!)
These are, of course, European banks. And their capital shortfall is MUCH worse. The total shortfall is 77bn Euros just for these banks, which is by no means all of them: when smaller banks are included, the total shortfall is a massive 178bn Euros. Deutsche Bank alone is short of 10.5bn Euros. And no-one (except, to be fair, the UK) has any serious plans to recapitalise them.

That's the REALLY scary story.



Thursday, 7 June 2012

When trust is broken

This post is a follow-up to my post last year about risk and safety. In that post, I assumed that people who want or need safety trust their government to provide it. But what happens if that trust is broken?

Trust in government is the foundation of our system of nation states. People rely on government to defend the borders and provide a safe place for them to live, work and bring up children. More than that, people rely on government to create the prosperity they desire - either directly, through government spending programmes, or indirectly, through supporting and encouraging private enterprise.  And people - especially in the developed world - expect government to provide for them when they are unable to provide for themselves.

Trust in government is also the foundation of our financial system. Currency issued by a trustworthy government is regarded as risk-free. So is debt issued by a trustworthy government. Neither has any value if trust in the government is destroyed.

So what happens when people who want safety - physical, economic or financial - start to lose faith that their government can provide it? They start to look for safer places. This can take a number of forms.

  • Obviously, if their fear is that the COUNTRY is unsafe, they leave - if they can. Refugees from war zones pile across borders to countries they believe are safer. People who fear persecution on religious or political grounds seek asylum in countries with a strong rule of law.
  • If their fear is that the government cannot be trusted to provide the prosperity they desire, they may also leave. Economic migrants risk life & limb in dangerous sea crossings or conceal themselves in container loads to get to countries that have a reputation for economic strength and freedom. Alternatively, people may try to bring down the government and replace it with one that in their view will espouse policies that will bring them the prosperity they want.
  • If their fear is that the government cannot be trusted to maintain the value of money, or will seize more of it than they perceive as reasonable, they move their money elsewhere. They reject the government's money, preferring to use foreign currencies instead: they hoard cash in foreign bank accounts and buy hard assets such as gold: they hide their money in places where they don't have to admit to its existence - tax havens.

At the moment, we are seeing all of these happening in the Western world. The price of gold and precious metals is rising: cash holdings by companies and households are at a record high: tax havens are thriving. In the most troubled countries, which are part of the European Single Currency system so do not have their own currencies, investors are rejecting government debt - this is still rejection of government money, just in a different form (if these countries had their own currencies, those currencies would be falling in value). And people, particularly the young, are leaving economically troubled countries such as Ireland and Greece.

Clearly, people are fearful. What exactly do they fear, and are they justified? Let's look at the possibilities.

  • Inflation. The rising gold price suggests that people fear future inflation. There are a number of reasons for this fear, but in my view the principal one is the belief that Quantitative Easing (often wrongly described as "money printing") is inflationary. This is because historically there is a strong association between out-of-control production of fiat currency to extinguish excessive government debt obligations (monetization of debt), and hyperinflation.

    Personally I don't think QE is remotely similar to this. Every example of hyperinflation in the 20th century that I have found was a distressed sovereign shut out of debt markets, reeling from a recent severe economic shock and usually suffering a catastrophic collapse of production. The only economies I can think of at the moment that any of this applies to are Greece, Ireland and Portugal, none of which can issue their own currencies anyway. If they were to leave the Euro I think hyperinflation would indeed be a serious risk, especially for Greece which is in deep recession. But nowhere outside the Eurozone is in this kind of mess at the moment (although Hungary might be heading that way). The Bank of Japan has been doing QE for the best part of 20 years and there is no sign of hyperinflation in Japan - in fact Japan's problem is actually persistent deflation, which the Bank of Japan only just manages to keep from spiralling out of control.

    There are also suggestions from the weird fringe that Western governments, particularly the US, will at some point soon be forced to monetize debt, leading to massive hyperinflation. The thinking appears to be that other countries (especially China) will dump their holdings of US government bonds on the world market, the price will crash and the US will be forced to print money to fund its fiscal and trade deficits. If this were to happen it would indeed be a big disaster, and it is not completely beyond the bounds of possibility. But to my mind, at the moment they would do better to worry about the Eurozone, which is a real, current disaster, rather than chasing chimeras. While oil and commodities remain priced in dollars, countries will want to hold on to dollar reserves in some form, whether as actual currency or as dollar-denominated risk-free bonds - ie US Treasuries. When the US lost its AAA rating last year, FT Alphaville tried to find an alternative risk-free liquid asset to the US Treasury. They failed.
  • Government debt default.  High cash holdings suggest that people think this is potentially a problem. But not, it seems, for the countries with the most debt. Cash balances in the UK, US and Japan are at an all-time high. And these are all fiat currency-issuing sovereigns. Investors know perfectly well that in the event of debt default by a fiat currency-issuing sovereign, the currency usually collapses too, which would wipe out their cash holdings. Clearly they aren't lacking confidence in these governments at the moment - and this is borne out by the fact that the debt of these countries is trading at record low yields. So although the UK government appears to be terrified that investors will withdraw their money because of the fear of debt default, investor behaviour suggests that the UK is the least of their worries. It is the Eurozone countries, and in particular Greece, Spain and Italy, that are seeing cash leave at a rate of knots. Evidently people fear the default of these governments far more.
  • High taxation.  At present governments across the Western world are running budget deficits and their debt levels are high and rising. Concern is being expressed in some quarters that this is storing up an unacceptable tax burden for future generations.

    It's actually quite hard to determine whether or not this fear is justified, because whether debt (or currency issuance) is unsustainable depends on the economic performance of the country.  It is possible for governments to spend so much that they have to tax their populations practically to extinction. But I don't think that any Western government is anywhere near this disastrous state at present. The bigger risk is unquestionably deflation and economic collapse.
  • Bleak future prospects. Youth unemployment is at an all-time high. Countries experiencing high unemployment and youth flight are generally pursuing economic policies, in the name of "structural reforms", that cause their economies to contract, which makes unemployment - especially for the young - even worse. The Eurozone leadership would argue that the structural reforms they are imposing will eventually make the future better for young people. But "eventually" is a long time when you're young. I can't blame them for leaving in search of a better future elsewhere.


Loss of trust in government is a serious matter. The actions that people take when they perceive their government as untrustworthy may themselves be highly risky. Physical flight may involve long and dangerous journeys. Attempting to bring down a government may fail, in which case life or freedom may be forfeit - and lives may be lost even in successful government overthrow. Financial flight involves transferring life savings to another country or putting them out of reach of immediate access. And some types of financial flight are more risky than people realise. Buying gold is all very well, but when food is scarce and people are resorting to barter to get what they need, gold has little value. You can't eat gold.

Irrespective of the system of government, there are always a minority of people who don't trust the government of their country. But as long as the majority do, the government and the economic system remain stable and leaders feel justified in ignoring the discomfort of the minority. It's one of these "tipping point" questions: what percentage of the population have to have reached a position of total distrust of their government for that government and the economic system it maintains to be at risk? And how do you predict whether that tipping point will be reached, and when? What was it, in the Arab Spring, that made distrust turn into unrest and then into revolution? What would it take, in the Eurozone, for minority discomfort and flight to turn into a major exodus sufficient to force the breakup of the Single Currency?

It seems to me that many social and economic phenomena have "tipping points": pressures gradually build up, and eventually release themselves in violent revolution, economic collapse or financial catastrophe. Sometimes, after the event, we can see clearly what the trigger was: so for example, with the Weimar republic of the early 1920s, we know that the trigger for the exponential hyperinflation that Germans still fear to this day was the French seizure of the Ruhr industrial area in a misguided attempt to extract overdue payment of World War I reparations.  But more often the exact trigger is hard to distinguish, and anyway it is really only a "last straw"; what we should be looking for is the buildup of pressure that leads to the trigger event. Leaders do not pay sufficient attention to this, and all too often silence the people who seek to warn them.  So it was with the financial crisis of 2008: so it is now with the Euro crisis. There are many, many signs saying "Danger ahead". But our leaders ignore them and lead us blindly over the cliff.





Wednesday, 6 June 2012

Calling International Rescue

I've been arguing for quite some time now that the Eurozone crisis is a sovereign debt crisis and a banking crisis, a balance of payments crisis, a currency crisis and above all a political crisis. Most people now agree with me on the first two and maybe the third, but they still aren't seeing the crucial importance of the last two. So let me explain how I think this ghastly situation came to be and how I believe it will play out.

The creation of the single currency in 1999 created a market expectation that the debt of all Eurozone countries would be backed by the full faith of the whole Eurozone, irrespective of the strength of the issuer's economy. Because of this, smaller and weaker countries in the Eurozone were able to borrow at similar rates to stronger countries. Their debt was too highly priced and they paid too low a rate - so many of them borrowed far too much. And banks, for whom sovereign debt represented an unbeatable risk-free investment because (at the time) it required no capital to support it (as George Soros points out), bought far too much of their debt.

If the single currency had been a full monetary, fiscal and political union FROM THE START, the expectation that weaker countries would effectively be backed by stronger ones would have been reasonable. This, after all, is how other currency unions such as the United States and the United Kingdom operate. These two countries have very different models for their currency unions: the United States operates on a federal model, whereas the United Kingdom works on a shared sovereignty basis. But the effect is the same. There is common tax raising and sharing at the federal or sovereign level, nationwide spending on essential services and common issuance of debt (although US states can issue their own debt as well, unlike UK regions). Much is often made of the fact that US states can and do go bankrupt - but in practice, services to the population are always maintained through Federal intervention and support. And in the UK, regions at present have no independent tax-raising powers: although there are local taxes, the tax take from these is reallocated by central government to level the playing field between richer and poorer areas. All of this makes common monetary policy and a single currency not only workable but desirable.

But the Eurozone is not a full union. The member states share a currency and operate a single monetary policy. But fiscal policy - taxation, spending and debt issuance - is the responsibility of the individual states. And I would argue that even the monetary union is half-baked. The ECB is explicitly prevented from acting as a lender of last resort, so is unusually limited (for a central bank) in the support it can give to distressed banks. It is also limited in how it can intervene in secondary markets: unlike the Bank of England and the Fed, which can buy as much of their own governments' debt as they see fit, the ECB is severely limited in the use it can make of its Securites Market Programme and has had to resort to all manner of fudge to maintain market access for distressed Eurozone sovereigns.

The events of the last two years have proved beyond a doubt that the Eurozone does not wish to guarantee the debt of its weaker members. Because of that, the prices of sovereign debt in the Eurozone are undergoing a severe market correction. This is unbelievably painful, both for the sovereigns who are seeing their borrowing costs rise to unsustainable levels, and the banks who are seeing the value of their assets drop to unsustainable levels. It is this market correction that is causing the near-bankruptcy of sovereigns and in my view the ACTUAL bankruptcy of many Eurozone banks. (I should point out that the Spanish cajas and Irish banks are bankrupt due to collapse of a property construction bubble, not because of their sovereigns' debt problems: it is in my view particularly the large French and German banks that are unsustainably exposed to Eurozone sovereign debt).

Since the underlying cause of both the sovereign debt crisis and the banking crisis is the lack of a full union, the obvious solution would be to create one. This, in one form or another, is what most commentors have suggested. Pooled debt issuance (Eurobonds), a common banking system, Eurozone-wide deposit insurance - all of these are ways of recreating the implicit guarantee. If they worked, they would restore both sovereign borrowing costs and bank asset values to pre-crisis levels.

But none of them solve the real problem. I've already mentioned it, but here it is again: The Eurozone does not wish to guarantee the debt of its weaker members.  The stronger members do not wish to accept the liabilities of the weaker ones: the weaker members do not want to put in place the financial discipline that would force them to balance their budgets and live within their means (as, for example, US states have to do). All of them want to keep the Euro, but only on their own terms. All of them want the benefits of a single currency, but not the risks: all of them want to keep the gains, but palm the losses off on someone else. And above all, all of them resist relinquishing their sovereignty and their right to self-determination for the sake of a greater union.

For this reason, I do not believe that a full fiscal, monetary and political union is remotely possible in the limited time that is left before the whole edifice collapses under the weight of unsustainable debt and impossible expectations. The adjustment of sovereign debt prices to the reality of every-country-for-itself will continue unchecked until one or more country is forced to default and a whole raft of banks fails. It is time that the world stopped hoping and praying that the currency union can be made to work. The political will to make it do so simply does not exist.

The best hope for the Eurozone now is a planned and managed breakup. Exactly what form this should take is a matter of debate: some people think Germany should leave, because of the distorting effect its giant economy has on monetary policy: others think the weaker states should leave, leaving Germany as the centre of a small group of similar states. I don't think it much matters which way it is done - the important thing is that it is planned and managed in a way that causes the least disruption to the lives and finances of ordinary people and businesses. The present situation, where the Eurozone leadership appears to be completely in denial, is the worst possible scenario.

Spain's distress call today rebounded around the world. The Eurozone is heading for a brick wall at top speed, and the world economy is already beginning to anticipate the impact.  Things are moving too fast now for Eurozone leaders to deal with this alone: world leaders must act before it is too late. Eurozone breakup is now inevitable. But it's not yet too late to prevent it being a total disaster.

Tuesday, 5 June 2012

Zombies? What zombies?

In a recent post, I noted that insolvent banks need to be treated differently from illiquid ones. Banks that are basically solvent but suffering cash flow problems need to be provided with plentiful liquidity: banks that are insolvent need to be allowed to fail (with protection for depositors and essential functions). The problem is telling the difference. Bagehot advised central banks to "lend freely against good collateral at a penalty rate" to illiquid banks. Note his advice about collateral. That's how you tell the difference - if a bank's assets are poor quality and/or its balance sheet is already so encumbered that only its poorer quality assets are available for use as collateral, it is much more likely to be actually insolvent.

The same applies to businesses. It can be hard to determine whether a business is actually insolvent or simply suffering severe cash flow difficulties. Cash flow problems, if not resolved through timely application of sufficient working capital finance, can cause perfectly sound businesses to fail. Lenders therefore need to satisfy themselves that the business's financial history is sound, it has a broad customer base, is well managed and ideally has a solid book of future orders. Proving this can be difficult for a young business, but for an established business which has a good relationship with its bankers it really should be a breeze.

During economic downturns - such as it seems the whole world is now going into - it is normal for business cash flow to come under pressure. Customers take longer to pay their bills, suppliers demand cash up front, there is an increase in bad debts and some customers say "no thanks". Well-managed companies may find themselves up against their overdraft limits and even occasionally over them. None of this necessarily means the business is going to go bust: the only one that would be likely to break a well-managed company would be the last, and then only if the market for the company's products & services completely disappears - in which case arguably its business model is insufficiently diversified. So I was appalled at this report from Ernst & Young in the Telegraph today. According to them,
Britain's recovery is being held back by a wave of "zombie" companies that should be allowed to fail but are instead undermining capitalism
This apparently is because Ernst & Young aren't seeing as many companies going bust as they would expect in the current downturn, so they think that creditors (mostly banks) are displaying forbearance towards companies in difficulties - not foreclosing on their loans, and maybe providing additional overdraft facilities.

Now, you might think this is a good thing, given my comments above about companies that are basically sound but experiencing cash flow problems in economic downturns. But Ernst & Young don't think so:
Alan Hudson, E&Y head of restructuring in the UK, said while zombie companies were still operating, they were taking market share from viable companies that should be growing and boosting the economy.....
.....because lenders continue to fund these businesses, capital is not being recycled and reinvested as it should be. 
And Ernst & Young conclude that the result is that businesses that should fail aren't being allowed to. 

The problem with this analysis is it doesn't square with the evidence. The Bank of England's April 2012 "Trends in Lending" quarterly report states that "The annual rate of growth in the stock of lending to UK businesses was negative in the three months to February.  The stock of lending to small and medium-sized enterprises continued to contract".

Note that this report talks about the STOCK of lending. That is the total of lending that ALREADY EXISTS - not new loans in the quarter. It includes drawn overdrafts as well as term loans. So if this stock of lending is contracting, not increasing, as the Bank of England's report suggests, where is the forbearance that is propping up zombie companies at the expense of new ones? If there is indeed forbearance when lending stock is contracting, then companies seeking new finance must be facing serious difficulties with credit availability. But the Bank of England's report doesn't support that: 
A survey of businesses conducted by the Bank’s network of Agents indicated that for most businesses, credit availability was little changed since last summer. In recent discussions, some major UK lenders noted that demand from small and medium-sized enterprises remained muted over the quarter.
This is consistent with reports that banks struggled to meet Project Merlin lending targets because there was insufficient demand from businesses for finance. Admittedly, the Federation of Small Businesses complains that businesses are still struggling to obtain finance despite recent Government initiatives, because lenders have become more risk-averse. However, this also does not square with Ernst & Young's notion that banks are propping up zombie companies. If lenders are more risk-averse, surely one would expect to see more aggressive foreclosures and less tolerance of bad debts and over-limits?

In short, Ernst & Young's arguments don't make any sort of sense. They don't square with the evidence regarding either existing lending stocks or availability of new credit, and they don't make business sense either. Foreclosing on a company that is basically sound simply because economic conditions are causing it cash flow difficulties is not remotely sensible. Bagehot's advice regarding illiquid banks is equally sound when applied to illiquid companies: "lend freely, against good collateral, at a penalty rate". So, satisfy yourselves that they have good quality assets and apply a charge over those assets, charge them through the nose for overdraft extensions and overlimits, and then lend them whatever they want. That's not forbearance - it's sound financial management.

The sharp-eyed among you just might have noticed a little factoid in the Telegraph report that might explain why Ernst & Young are so keen to see more companies go bust. The Telegraph quotes Ernst & Young's "Head of Restructuring in the UK" and their "Head of Global Restructuring". Guess what "restructuring" is? Yup, you got it. It's breaking up and sorting out insolvent companies. Ernst & Young make loadsamoney from corporate restructuring. Could it be that they are feeling the pinch themselves?

And finally, I really can't let pass their suggestion that the US Government's bailout of GM Motors in 2009 was "re-writing capitalism". As if no government has ever before rescued a failing car manufacturer. Anyone remember British Leyland?



Saturday, 2 June 2012

When history speaks

I wasn't going to do another chart-based post for a while. But I couldn't resist this one:



(h/t Steve Keen)

We hear a great deal about American public debt. And yes, it is a lot - it is now over 100% of GDP (this chart stops at 2011). And as numerous people have pointed out, it doesn't include future unfunded liabilities. The administration is under pressure to cut deficit spending, balance the budget and stop the debt growing - or even, ideally, start reducing it by running budget surpluses. The last President to do this was Clinton - you can see the effect of the "Clinton surpluses" on this chart in the latter half of the 1990s. Is this the right course of action now?

Well, from what this chart is saying, absolutely not. It would be completely counterproductive and might even plunge the US into a 1930s-style depression.

To explain why I think for the US to attempt to balance its budget is madness at the moment, it's necessary to analyse this chart. We know quite a bit about the course of American history from 1920 onwards. The 1920s were a period of rapid economic growth which ended abruptly with the Wall Street Crash in October 1929. Note the sharp rise in private borrowing at the end of the 1920s, and the corresponding rise in public debt. Private debt fell off a cliff from 1931 onwards as the Depression took hold - Irving Fisher's famous "debt deflation" - but public debt also fell, suggesting that public spending was not being maintained. Now before anyone points out that public debt and public spending aren't the same thing, here's US public spending as a % of GDP for the same period. It shows a sharp increase in public spending at the start of the 1930s and then pretty flat spending until the US entered World War II:



These charts show that there was pro-cyclical fiscal policy throughout much of the 1930s. No wonder the Depression was so appalling; the private sector was undergoing rapid, catastrophic deleveraging and there was little support from government for the people affected. And Steve Keen's chart strongly suggests that it was the spike in public spending in World War II that finally pulled the US out of depression, because it provided the counter-cyclical stimulus that the US economy desperately needed. What a pity it took a major war to persuade politicians to do the right thing.

Compare this with the period from 2000-2007. Note the massive rise in private debt - and the pro-cyclical rise in public debt. No-one in the Bush administration did anything to lean against the unsustainable rise in private debt, particularly mortgages. No, they were busy with other things. The rises in public spending in the 2000s arise at least partly from the Iraq and Afghanistan wars.

From 2007 onwards there has been an explosion in US public spending: it is rising exponentially as a percentage of GDP. The right wing's complaint is that public spending is out of control.

But if you look at the private debt line, you can see that since 2007 it has fallen off a cliff. In fact the private sector is now deleveraging at about the same pace as in the 1930s. But this time, the administration is providing fiscal support, which is why public spending is rising at a similar pace. This is the essential counter-cyclical stimulus for which Americans in the Depression had to wait 10 years. It leans against the desire of the private sector to deleverage and save, and provides support to the people affected. The Obama administration is doing EXACTLY the right thing. I hope to God they don't waver now. Attempting to tighten - as the right wing would like - would choke off the US recovery, impede the progress of private sector deleveraging and cause misery to thousands.

I don't, however, think they should be doing more. The automatic stabilisers seem to be doing their job satisfactorily and the counter-cyclical stimulus appears to match the private sector contraction pretty well. Kenneth Rogoff points out that high public debt acts as a long-term brake on growth, so expanding it unnecessarily doesn't seem to be a particularly sensible strategy.

What puzzles me in all of this is why there is so much noise from business interests about needing to cut the public sector in order for the private sector to expand. Where is the evidence that the private sector WANTS to expand? Deleveraging is contraction, not expansion. Yes, I know that a lot of the debt reduction is residential mortgages, which took a huge hit in the financial crisis and haven't yet recovered. But at the moment the private sector overall shows little inclination to expand: corporates are sitting on huge cash balances, households are saving like crazy, and those that are still over-indebted are trying to shed their debt as quickly as possible. Unemployment is still high, especially among the young. Clearly the US economy is not running at anywhere near full capacity - so what is the panic about? No way is the public sector "crowding out" private sector growth. On the contrary, the private sector's behaviour suggests that it wants to contract further and would be only too pleased for the public sector to plug the gap. Provided they don't have to pay for it, of course - and there's the rub.

There is a prevalent right-wing belief that high public spending now means high taxation later. And they could well be right. It's a bit of a gamble: public support is cheap at the moment, because US interest rates are so low (more on that in a moment), but it will have to be withdrawn later on when the economy picks up, which will be unpopular among the beneficiaries, most of whom have votes. The difficulty is judging when that moment arrives, and having the political courage to make the necessary spending cuts. If those cuts are not made, there will indeed need to be higher taxation as interest rates rise. But to me, at any rate, it is very clear that we aren't there yet. And despite the comments from business interests, market behaviour supports my view: they want the US to continue deficit spending and issuing debt. US yields rates could hardly be lower, yet show no sign of rising despite the US's high public debt.

This situation does need to be treated with caution. US government debt is used as collateral by the shadow banking network, and because of two rounds of QE and a fair amount of hoarding it is now in short supply. Providing liquidity to desperate markets is not in itself a good reason for issuing more government debt. But it does suggest that the bond markets are not likely to start punishing the US with higher yields any time soon.

And there is another reason why the US should not be attempting fiscal tightening while the private sector is deleveraging.  I mentioned unfunded liabilities. There are an awful lot of these and the US right wing is justifiably worried about them. But their solution is wrong. The US will only be able to fund these if the private sector is restored to health. And for this, it must shed more of its debt pile, which even now dwarfs public debt, as Steve Keen's chart shows. If the US attempts to restore fiscal balance while the private sector is deleveraging, it will impede the progress of that deleveraging, delaying the onset of significant private sector expansion and making it LESS likely that the US will be able to meet its unfunded liabilties in the future. It could even tip the US back into recession.

The message to the deficit-hawks is clear. The 1930s debt-deflation-without-support was terrible. It ruined the lives of an entire generation. The US has avoided making the same mistakes in the current crisis, but premature tightening would upset the applecart. They should pay attention to US history and learn to be patient.