Thursday, 30 April 2009

An Analysis of International Monetary Relations – Part 2: Where We Are

These days, references to the Great Depression and the Bretton Woods system abound. Analogy with the past crises is supposed to shed light on the present.

In analogy, we seek to establish sameness between two disparate objects. “Bone to dogs is like meat to cats” highlights the universal need of animals for food. The analogy works because that need is a defining and unchanging attribute of animals.

History is dynamic. The snapshots of historical events – a Great Depression here, a monetary crisis there – might have some surface resemblance to some aspects of the current crisis, but they could offer nothing by way of understanding the problem at hand. The secret of understanding history is knowing the nature of its dynamism, the way the changes take place.


”A major lesson of the crisis is that the remarkable overall performance of the global economy between 2003 and 2007 contained within it the seeds of its own destruction”.
Thus spoke the U.S. Treasury secretary Timothy Geithner the other day in the Economic Club of Washington.

Has the crisis turned him into a dialectician? “The global economy containing the seeds of its own destruction” – Hegel himself could not have said any better.

The answer is No. His absurd time frame betrays his tenuous grasp of the roots of the crisis. (The time frame is absurd in terms of understanding the crisis, but it is not random. Geithner unwittingly ties the rise of mortgage products with the destruction of Fannie Mae and Freddie Mac; 2003 is about the time Fannie and Freddie were neutered.)


The crisis we are witnessing is not the result of any exuberance in any particular period, however much the exuberance might have played a role in it. It is not the doing of rogue traders, unscrupulous speculators, careless lenders or irresponsible borrowers -- even though these elements were all present. Neither is it a Black Swan, a 100-year flood, or a once-in-a-lifetime event. All this by way of saying that it is not an aberration. It is the natural, necessary and inevitable consequence of the working of the so-called Anglo-American model of finance, rightly claimed as the most developed form of finance. This point is critical. The crisis came about because of, not despite, the system’s sophistication and is an inseparable part of it. The moment we approach it as an exception, we are lost.


The point about “natural, necessary and inevitable” outcome must be understood. The adjectives refer to a state of affairs brought about by the internal developmental logic of the system. Only knowing, conscious human action can interrupt or derail such process. Good intentions, grand ideals, great expectations and the like would not do; they are literally immaterial.


In the early days of television, there were grandiose predictions that the new medium would bring culture to masses. Banjos in Alabama were going to play Appassionata, mortgage-ridden farmers around Chicago, Chaconne. We know how that one turned out.

There is nothing preordained about TV turning into a vast wasteland. It could bring culture to masses. But the “business model” sets the direction and limitation of what can be achieved. Trash TV is the natural, necessary and inevitable fate of a medium whose raison d’etre is selling stuff to masses.

The same goes for the notion of the Internet bringing literacy to the masses. Or microloans brining prosperity to Indian peasants. Or casinos solving the housing and employment problem in Atlantic City – remember that one? You get the idea.


Finance capital has a distinct mode of existence which creates the realm of finance. The uncritical eye sees this sphere as something independent, different and separate from the “real economy”. Hence, the nonsense about whether the “real economy” – like pornography, never defined but always assumed to be understood – could be affected by the losses in Wall Street. You recall this was the intellectual question of the last year.

In reality, finance capital is an integral part of the economic system of a country. In its less developed stages, when its size is relatively small compared to the industrial capital and its activities limited to simple lending and borrowing, it has limited sway over the economy. As its size, reach and complexity increases, its influence likewise grows. This real-life development is reflected in the rise of the academic discipline of finance, which, originally a backwater part of economics, has come to dominate the mother science.


In its latest, historically most developed form, finance capital morphs into speculative capital. This is a gradual process, with the size of speculative capital constantly increasing. At this stage, trading, the mode of existence of speculative capital, begins to influence financial markets to the point that even public finance decisions must be made with an eye to accommodating its needs.
The government has taken the first step toward a revival of the 30-year bond, an unexpected shift that could provide an important tool to grapple with the nation’s troublesome budget deficit and its creaky pension system.
This is The New York Times, reporting the Treasury’s decision to reissue the 30-year bond. The paper frames the decision as the creation of a budget management tool, but few paragraphs later in the same article, the Treasury officials flatly refute that spin.
Treasury officials said yesterday that the decision had nothing to do with the budget deficits.
So what prompted the decision? Perhaps the following – again, from the same article:
Wall Street ... has been clamoring for a revival of the bond almost since it was abandoned in 2001 ... The 30-year bond is a longer-term security that is more volatile than shorter-term securities. And Wall Street traders love volatility because it is an opportunity to make money. The committee from Wall Street that advises the Treasury on the sales of government debt recommended this week that the 30-year bond be revived.

Still, where exactly was Wall Street's interest in reviving the long bond? Were there not sufficient amounts of Treasuries to play with?

The answer is No. The daily volume of the repo and tri-party repo market alone in which the U.S. Treasuries exchanged hands had reached and surpassed $6 trillion. That is, the entire public debt of the U.S. government was being turned over once a day. What was driving this feverish activity?

I touched upon this question in several places, including here, in discussion the structure of the financial markets in the U.S, and also here and here. I will return to this subject in detail in Vol. 4 of Speculative Capital. The critical point to note is that an increase in demand increases the price of treasuries and pushes their rates down. Treasuries rates are the frame of reference for all commercial rates in the U.S. and much of the globe. In this way, finance capital encourages borrowing by all parties, large or small, public or private. The U.S. consumer, whose real income has been falling since 1971, sees this as an opportunity. So the consumer debt soars and the reach of finance capital is extended.


I repeat: finance capital is an integral part of a nation's economy. As it develops and expands: i) its reach extends beyond the national borders; and ii) it becomes the catalyst and enabler not only of the monetary relations but the economic relations as well. Globe-spanning operations of large corporations presuppose and rely on “sophisticated” capital markets.


As an example of economic relation, take the case of WalMart. The company produces virtually all its products in China. That is the main reason China has amassed $2 trillion reserves, about $800 billion of which is invested in treasuries.

Meanwhile, cheap imports from China enable WalMart to reduce the cost of living for all workers. That helps keep wages low and profits high for all corporations. At the same time, workers have to borrow the shortfall in their budgets due to their low wages. It is a perfect one-two punch.


The first and foremost order of a system is self-preservation. The “order” is not so much a conscious mandate but a built-in mechanism; a system without such mechanism could not exist and would not last.

Finance capital’s immediate self-interest, expansion through maximizing profit, collides with and contradicts its existence as a going concern. This is most vividly seen in the case of speculative capital – capital engaged in arbitrage. Arbitrage is self-destructive; it eliminates opportunities that give rise to it. The destruction you are seeing in all spheres of the economy, not in businesses anymore but in the business models, is the natural, necessary and inevitable consequence of what transpired in the past 35 years.

That is where we stand now, where money, to the tune of $13 trillion that the U.S. government has committed to every sphere of economic activity, cannot solve an economic crisis. That is what is qualitatively different about this crisis. And that is why it is no use looking back at the past crises for solutions; none will be found.

Thursday, 23 April 2009

PPIP Death Watch, Installment #382

More evidence the PPIP will fail: a similarly designed plan is floundering. The Washington Post reviews the Term Asset-Backed Securities Loan Facility (TALF) program and finds it wanting:
In its first two months, the government's signature initiative to support consumer lending has fallen well short of expectations, deploying only a fraction of the amount officials had hoped to extend to stimulate auto loans, student loans and credit card lending.
The TALF structure, through partnering private and public investment, was supposed to support as much as $1 trillion a month in new lending. However, in April it backed only $1.7 billion in loans, about a third of March's total.

What's wrong? Problems include (1) Private investors see the government as an unreliable partner that could suddenly turn around and change terms or impose restrictions on them (2) The brokerage houses, the key intermediaries that arrange the lending transactions and hold assets as collateral, are being unduly cautious. They're afraid of making mistakes that will incur Congressional or media wrath.

The money graph:
... the challenges in getting TALF running at full speed show the difficulties facing the Treasury and the Fed as they design new programs to try to deal with the financial crisis. The Public-Private Investment Program, designed to buy loans and securities from banks, is structured similarly to TALF.

Best Line of the Day

From Jeffrey Goldberg's "Why I Fired My Broker":
I took a random walk down Wall Street and got hit by a bus.
Read the Atlantic article for one man's soured take on investing, from the viewpoint of a little guy. You can practically hear him laughing bitter tears. Especially precious is the dialogue on the second screen, when the author is being given the lowdown on brokerages. No, they're not given him unbiased advice. No, they're not his friends. The brokers are just selling. Don't get fooled by the plastic smiles.

They remind me of a friend's pet iguana. Occasionally the animal would come over and stand close to his leg, which reminded me of a dog nuzzling its owner. At first I thought, "Oh, that's cute. He's reaching out, seeking companionship." My friend quickly disabused me of that notion: "He just wants to be fed." And I watched the reptile more closely and realized it was true. There was no warmth in those beady eyes, only the cold stare of self-interest.

Why Citi’s Accounting Trick Makes Even Less Sense Than You Think

No one appears to have pointed out the following yet. (The reasoning strikes me as sound and would destroy any last vestige of credibility for the accounting weirdness that allowed Citigroup to book a $2.5 billion gain because the company edged ever closer to bankruptcy, which drove down the value of its debt.)

First the quick recap (and it’s still not completely clear to me what Citigroup did, but I think I’ve got the basic accounting principle down at least). Citi’s earnings were buoyed by a rule that, according to Bloomberg, allows companies “to record any declines in their debt as an unrealized gain.”

The Business Insider went on to explain the rationale thusly:
In other words, because Citi's debt is trading at distressed levels, the company could, theoretically, book some balance sheet gains by buying it back -- reducing liabilities by more than it costs to retire that debt. Of course, they haven't done that yet. But they could!
But could they? Of course the accounting rule implies this, leading us to a real noggin scratcher of a paradox: run your company into the toilet and watch your earnings soar! Shouldn’t this alone tell us that something here might be mathematically suspect? That maybe these accountants have overlooked something rather, um, important?

Let’s back the truck up and play with some real-world numbers, simplifying everything. Let’s say Winkie’s Widgets sells bonds (debt) that would pay $110 million in 12 months. Let’s say average investors want a 10 percent yearly return on a well-run company of Winkie’s size and characteristics. So they pony up $100 million for the offering.

First day of trading in the bonds: oops, a big bombshell. Winkie’s has been making widgets out of old rebar from nuclear reactor cooling towers; they’re secretly up to their necks in lawsuits; they’re staring at bankruptcy at close range. Immediately the price of the bonds plummets to $55 million. Investors now are saying: "Hey, you’re pretty risky after all, so we want a 100 percent yearly return."

Now the CFO of Winkie’s should be glum, but he’s no slouch. He realizes he's looking at a big chunk of gold: the company can book a $55 million gain on earnings. The reasoning: Winkie’s could go onto the market and buy back their bonds for $55 million, retire the existing $110 million of bonds, and pocket the difference.

Sounds great. But what's missing? The backend of this transaction. Winkie’s has to come up with $55 million. Because the widget maker is judged to be a high bankruptcy risk, it will pay a very steep premium for funds ... basically investors will want a 100 percent return. That’s what the bond buyers want now, remember?

So Winkie’s borrows $55 million at 100 percent, buys up its old bonds and books a profit of exactly ... zero. There is no profit. There’s simply the illusion of profit. This is why I don’t understand how accounting types can defend this sort of bookkeeping. It ignores what's going on at the heart of the bond valuation.

Am I missing something? Dissenters welcome.

Wednesday, 22 April 2009

A Good Man in a Bad Business

David Kellermann, the acting CFO of Freddie Mac, was found dead of apparent suicide. He was 41.

Alas, poor David Kellermann. I knew him not. The news reports said that he was a “hard worker”, “a good guy”, with “extraordinary work ethic” and “integrity”. His apparent suicide in a weird way confirms that; imagine a good man with extraordinary integrity witnessing the going-ons in the mortgage industry. But being good is not enough. Like the charitable work of society ladies – sending get-well cards to wounded soldiers – it could be perfectly useless. Like the cultural activities of financiers – takeover artists underwriting operas – it could be downright detrimental. Sartre developed the notion of praxis – the activity of an individual or group in an organization with an eye toward some end – precisely to reach beyond the inadequacy of this in-itself do-gooding.

I cannot speculate on what David Kellermann was going through; if I did that I would be writing fiction. But I am certain that he did not know about the history of the destruction of Fannie Mae and Freddie Mac that I chronicled in three parts here, here and here. Had he known, he would have been a more cynical man, but he would be alive now.

Sometimes ignorance is bliss. Sometimes it kills you. Poor David Kellermann.

Tuesday, 21 April 2009

Hey Look! The Emperor's Buck Naked!

The Fourth Estate is getting surly. About time, I say. For a while, I thought they were pliantly going to go along with the fraud that is this quarter's earnings season for the major U.S. banks. But the cojones have dropped into place, the rapier wit is sharpening, and the acid is starting to fly off the tip of some tongues ...

Anyway the metaphor gaining prominence to describe the banks' numerical trickery is legerdemain -- if you're unsure about the meaning, think "magician."

Huffington Post politely dismisses the banks' results.

Andrew Ross Sorkin of the New York Times lances the boil.

Sunday, 19 April 2009

U.S. Banks' 1Q Earnings: Take with Grain of Salt

Oh Lordy. Major U.S. banks are putting up a string of deceptive earnings. The only useful exercise this quarter is diving behind the numbers to uncover what’s really going on. It ain’t pretty. The latest exposé comes from Dan Denning at Daily Reckoning. Check this out:
... all of the banks benefitted from what financial sector analyst Meredith Whitney called "back door financing." Whitney described what amounts to Fed-sanctioned front-running of the fixed income market by the banks. The Fed publicly telegraphed its intention to buy $750 billion mortgage backed securities from Fannie Mae and Freddie Mac and $300 billion in U.S. Treasury bonds. And that was AFTER it announced in late November of last year it would be wading in as a buyer for all agency bonds to support the U.S. mortgage market.
What’s front-running? Simple: you get out in front of a customer’s order to line your own pockets. The illegal version goes like this: Shady Brokers ‘R Us gets an order from the Orphans Fund to buy 5 million shares of GE. First, Shady quietly slips in its own order and buys up, oh, let’s say 100,000 GE shares at $10 each. Then it executes that large Orphans Fund order; the heightened demand pushes the stock price up to $10.30. Shady now turns around and unloads its own shares at a price near $10.30, making out nicely.

Again, this is the illegal version. The legal version is what happened after the Fed announced publicly it would buy up agency bonds, mortgage-backed securities and U.S. Treasuries in the above amounts. If you were a private company that cared about getting the best price (unlike the Fed), and for some reason had to make those huge buys, you'd be very hush-hush and discreet about your purchases. Otherwise your competitors get there first and drive up the price and make you overpay.

Of course the U.S. government is the dumb money here. Or maybe not so dumb, as it appears the Fed actually wanted to overpay and make a gift to the banks.

Moving along, the really crazy stuff (if you haven’t seen this already) relates to Citigroup. Believe it or not, the bank essentially made a bet against itself and won $2.5 billion! This is sort of like if you said, "I'll bet $10 I'm the dumbest guy in this school" and your friend (who thinks you're stupid but not that stupid) says "You're on." And when the final class ranking comes out, you happen to anchor the #552 spot among 552 students and you say, "Ha ha. Told you I was pretty freakin' dumb. Now pay up." You might think this gives you an incentive to underachieve. Hmm.

I’m not quite sure of the precise details on how Citi's wager worked, but at the heart of it were the credit default swaps that are bought as insurance against bankruptcy:

... in plain English, Citi profited because it made a bet that the cost of insuring itself against a default would go up. The credit default swap market is the place where you can bet on the credit worthiness of a firm, or, essentially, the chance that a firm might default on its bonds. Citi appears to have reported a $2.5 billion trading gain in the fourth quarter precisely because the market thought the company stood a good chance of failing (hence the widening CDS spread).
So it appears (as Denning notes), that if Citi was in even worse shape, on death’s door, it could have made even more on these derivatives. So think about that for a moment: $2.5 billion of Citi’s just-reported earnings were because the company went from “stinks” to “really stinks.” Remove this alone and Citi reports a $1 billion loss from the quarter.

Caveat investor.

Saturday, 18 April 2009

Advice from the North: Make Banking Boring Eh?

I know that Canada, our frostbitten neighbor to the north, gets its share of ribbing. It's seen as a big, bland place with agreeable people who seem to belong on the set of a James Stewart movie. If Latinos are fiery red, Canadians are a dull and cool shade of blue.

And they are apparently the perfect teachers for wayward U.S. bankers. This article I found wonderfully refreshing. It shows the Canadian banking system as a resounding triumph of common sense (and, it also seems, executives have a sense of decency and modesty, unlike Wall Street where swaggering arrogance rules).

Check out the quote below. Can you imagine, say, Dick Fuld saying this without a smirk?
Ed Clark is a plainspoken, polite and prudent Canadian bank CEO with a few simple rules: "We should never do things for our customers and clients that we don't actually understand. If you wouldn't put your mother-in-law in this, don't put our clients in it."
It was clear to Clark that the explosion in subprime lending would end badly. And as for Wall Street's mortgage origami -- creating securities out of scores of different risky home loans -- he basically says that when you see a product wrapped in mind-numbing complexity, you should stay the hell away:
"Our U.S. subsidiaries did not do any subprime lending. Nothing. Zero," Clark said. "We just said, 'Stay away from this stuff. We know where this is going.'"

Another villain in the financial crisis were toxic mortgage-backed securities - risky loans that were chopped up and resold in countless different ways. Many banks gobbled up the now virtually worthless investments. Ed Clark got out 4 years ago saying they were just too complex.

Clark: "As soon as you see that complexity, you say, 'How can I possibly think I actually can guess whether this will work or not?' And as soon as I hear that, I say, 'Get out of it.'"
Which makes you wonder: Here's a humble guy, not a rocket scientist intellect, but a veteran banker who saw how badly the expansion of subprime lending would end. Why did so few on Wall Street figure this out? Were they really and honestly that blind? Or did they kind of know what was going on, and decide they'd just vigorously milk the cow anyway until it ceased producing and keeled over, at which point they'd scuttle away with their big bonuses well in pocket?

Friday, 17 April 2009

Of Baseball Cards and Bad Assets

Check out Mike over at Rortybomb; he's got a good post on the accounting method known as mark-to-market. The principle is simple (and makes sense to me): You value an asset on your books (your bicycle, your Jim Rice rookie baseball card, your synthetic CDO) for what the market is willing to pay. None of this whining that, "Well, my Jim Rice card IS worth $85; it's just that the damn paper mill closed last summer and everyone's worried about their jobs, so there's a shortage of liquidity among baseball card buyers right now." Or the banking industry version: "Well, my synthetic CDO IS worth $85 million; it's just that the damn financial crisis and irrational fear are stifling credit markets, so there's a shortage of liquidity among CDO buyers right now."

Mike links to a good New York Times wrap on the mark-to-market rule change that went down April 2 (note: I don't usually comment on people's faces, but this accounting chairman has got a real Jabba the Hutt thing going here; it reminds me of that old Spy magazine feature "Separated at Birth").
It is not clear how much bank profits will improve as a result of the change; that will depend on how much the banks use their newly approved discretion to set values. Nor is it clear whether investors will put much faith in the new figures.

Early answers to those questions may become available within a few weeks. The board said banks could apply the new rules to their financial statements for the quarter that ended this week.
As I posted yesterday, I think the banks will use the accounting rule change, along with a strong earnings season, to KILL THE GEITHNER PLAN IN THE CRADLE. They don't like his PPIP proposal to buy their dodgy assets because they don't want the true prices of the loans and securities revealed (through an auction process). They would have to readjust the inflated values they've assigned to a huge crumbling pile of assets, then look out: landslide. Some institutions would become all-too-obviously insolvent.

One more excerpt from the Times that shows the accounting standards board itself knows the banks are playing with the numbers (this from an objecting member of the panel):
One of the dissenters, Thomas J. Linsmeier, argued that accounting rules already allowed the “fiction all banks are well capitalized,” adding that the changes would “make them seem better capitalized.”
One thing that troubles me a lot in this financial crisis: we're getting deeper and deeper into the jungle of opacity. (Changing accounting rules to make it easier for banks to disguise the health of their assets; government stonewalling on releasing information about which banks got what funds through TARP and what collateral they put up; stress test results being released in a general way so as not to implicate any lousy banks).

There's a huge irony behind all this: what we need to work toward in a post-Lehman world is a more transparent financial system. Part of the reason we're in such a mess is because there were too many dark corners we didn't understand. But so far, the evidence we can summon the courage to become more transparent seems awfully weak.

Thursday, 16 April 2009

JPMorgan Flips Geithner the Bird

I’m surprised bloggers aren’t atwitter over this story that hints that Treasury Secretary Geithner's PPIP plan is starting to look DOA:
Speaking on the company's just-concluded conference call, JP Morgan (JPM) CEO Jamie Dimon downplayed the PPIP, saying the bank had nothing to sell into it, and that it certainly had no interest in partnering with the government as a buyer.

What's more, he said, he didn't consider the PPIP to be that big of a deal, suggesting that it's just one small piece of what Treasury is doing to prop up the system.

Earlier I suggested that U.S. banks were secretly terrified of the Geithner plan: it would expose how much they had overvalued their bad assets. Meanwhile, almost everyone else concluded the major banks should be gleeful, not glum. They argued that Geithner's plan to buy toxic bank assets through a public-private partnership (PPIP) would mean big subsidies for private investors, huge overpayments landing in the laps of the banks, and heavy losses for taxpayers.

But what if the banks (or investors) can’t game PPIP for easy profit, and further, what if the plan inherently doesn’t result in huge overpaying? Then you have to wonder if the banks sat back and thought, “Man, we are really screwed.” They had rejected the market offers on their assets, saying they were “fire sale” prices -- and Geithner among others appeared to buy into this fiction. But PPIP would expose the lie.

If you’re a major U.S. bank, you have to be smart at this point. How to reject PPIP? The smart tactician acts from a position of strength. Don’t denigrate the plan at its unveiling. You have to wait ... get stronger (or at least appear to) ... then attack and kill it.

First thing to do: Get those damn pesky mark-to-market accounting rules (that force asset values to be reconciled with current market prices) changed. Banks like them fine in bull markets, but they're a bitch when things go bear. And indeed, earlier this month:
FASB will now let companies use “significant judgment” to value assets when those assets are trading in inactive markets under distressed circumstances.

Also, the standards have been relaxed by which companies have to take impairment charges when they take losses on their investments, particularly in cases where they plan to hold those assets to maturity or where they don’t have to sell them quickly.
How does that help? Simon Johnson at Baseline Scenario ponders whether it could be cover for allowing the banks to ignore the results of the PPIP auctions:
For example, Bank A puts up a pool of loans for auction, but doesn’t like the winning bid and rejects it; Bank A doesn’t want to be forced to write down its loans to the amount of the winning bid. Or, alternatively, Bank B sells a security to a buyer, and Bank A holds the same security; Bank A doesn’t want to be forced to write down the security to the price of Bank B’s transaction.
I think the truth is simpler. If the banks are terrified about what the auctions will reveal, they want to stay well away in the first place. The more assets that change hands at auction, the harder it is for them to deny the value of what they have on their books, even allowing for “significant judgment.”

I think they needed the accounting changes, before first-quarter earnings, to disguise the true state of their health. Right now they need to look stronger than they actually are. Being able to fudge the asset values helps because the second thing to do to kill PPIP is:

Have a good earnings season. You need to score big, across the industry, while deflecting attention away from how much your great results stem from government intervention in the market. So far the banks are well on track: solid numbers from Wells Fargo, Goldman Sachs, JPMorgan.

Third thing: Someone has to go first and at least float the trial balloon that “we’re not going to sell into this PPIP; we don’t really need it.” Ideally someone respected who has weathered this crisis better than most. Enter Jamie Dimon of JPMorgan.

The other banks hang back, and if Dimon doesn’t get slapped down, they start to say, “Hey, you know, we don’t really have anything to sell into PPIP either -- we’re not really in bad shape after all.” It’s important to keep participation in PPIP low (or non-existent); if you don’t, it will be hard to escape a large-scale revaluation of assets, even with the recent weakening of accounting rules.

NOTE: I don’t mean to lay this out as a conspiracy -- I don’t think it is at all -- only that the banks are really smart, and if they’re looking to bury PPIP, their thinking would be much along these lines.

I’m going to stick my neck out here: PPIP will fail badly because the banks won't show up to play, unless the government forces them to.

We're Turning Chinese, Not Japanese

Anyone out there know JPMorgan Chase's net interest margin, from first-quarter earnings? I've simply seen references to it as "huge" and at a decade-high. Reporting earlier this month, Wells Fargo boasted that its own margin reached a stunning 4.1 percent, which Mathew Padilla here notes is "extremely high."

This, I think, will be a big story for the banks this earnings season.

First, what is net interest margin? It sounds complicated, but it's really not. If I borrow $1,000 at 2 percent interest, then lend it at 4 percent interest, my net interest margin is 2 percent. It's also called the "spread." Clearly, the bigger the spread, the better my profits. In the above example, I make $20 for every thousand I lend. But if I expand that margin to 4 percentage points, now I'm making $40. Because banks are mainly about borrowing and lending, the size of the spread matters hugely for profits.

Banks are currently borrowing cheaply thanks to a hodgepodge of Federal Reserve programs to pump money into the economy. Ideally, to jumpstart the economy, the banks would turn around and share that cheap money at commensurately low lending rates. But the banks are wounded right now. They are desperately trying to milk profits through higher fees and lending revenue to compensate for past bad decisions that led to a backlog of toxic loans and securities. One way to do this: push on that spread and widen it out, then pocket the extra profits.

All this caused me to experience a deja vu moment. I began working as a financial journalist in China, where the state controls the banking system (and has a history of directing lending, poorly of course, and owns the largest banks in the system). To protect its banks, China has this neat regulatory trick. It imposes a lending floor (you can't offer funds below a certain rate) and a deposit ceiling (you can't pay depositors more than a certain rate). This creates a built-in spread, and it's a comfortable one, for the cosseted Chinese lenders.

So I became used to thinking of large spreads on net interest as a sign of a bloated, inefficient market, in need of a little infusion of capitalist lifeblood.

Of course the irony is now that the U.S. banks appear to be on the verge of beating out the fat spread in the Chinese banking system. China's industry had a 4.02 percent average spread in the first quarter, compared with the 4.1 at Wells Fargo (and I bet JPMorgan showed a similar number). Our banks can thank the Fed and government largesse and policy.

So there you have it. In this financial crisis, we're not turning Japanese. We're turning Chinese.

Wednesday, 15 April 2009

A Parting Look (Shot?) at Goldman’s “Blowout” Earnings Report

Sit tight, this will be a longish entry, but I think it’s worth trying to tie up some loose ends on the puzzle of Goldman’s moonshot on first-quarter earnings. My initial take was a bit naive and incomplete, though the suspicion was well-placed.

Investors may wonder why Goldman doesn't want them looking closely at what powered its great numbers. CFO David Viniar was notably vague during the analysts’ conference call when speaking about the division that reaped the bulk of the quarterly revenue (Zero Hedge has the transcript here).

The answer is simple: the bank itself appears to deserve very little credit for its resounding success. Goldman is like the two-year-old toddler nominally holding the baseball bat, while Uncle Sam, who’s really doing the swinging, whacks the ball and says, “Attaboy, Johnny, you just smacked one!”

First, look at the grim reality. Division by division, the first quarter was largely a flop at Goldman. Asset management crapped out (down 29 percent). Investment banking took a dive (down 30 percent). Principal investments stunk ($1.41 billion of losses, ugh, and that’s the bank’s brain trust putting its own money at risk).

The lone shining star: fixed income, currency and commodities. This group did blindingly well. It engineered a sudden turnaround that seemed to defy the laws of financial physics, like if all the molecules in your car suddenly vibrated in sync and the vehicle hopped ten feet in the air. FICC had $6.56 billion in net revenue (after losing $3.4 billion the quarter before).

Immediately something began to smell funny. You sort of wonder what Goldman's results would have looked like if the U.S. wasn’t helicoptering in bushels of almost-free money (uh, that’s for the major banks -- you little guy there, get back, hands off) and infusing tens of billions into AIG. Would the numbers have been horrible? Or maybe even horrible squared?

Let’s look at these two pieces separately, AIG first. How did Goldman make out like a bandit from taxpayer-subsidized AIG? Below is one way they probably did. Notice direct payments aren’t involved here, but the U.S. taxpayer still wears the “I’m a Chump” apron at the end of the day. This terrific insight appeared in the comment section of Naked Capitalism (a great blog with a smart, cynical, financially savvy readership). Read the original below, if you can -- it’s technical -- then I’ll translate at the end:
Want to follow the money? Here is the simple math... and this relies only on facts that either: a) are known in publicly traded markets; or b) Goldman has admitted.

1) CDS on AIG before September 2008 traded at ~200bps running plus 0 pts upfront. Today it trades at 500bps running plus 40pts upfront.

2) Goldman Sachs had $13B of super senior CDOs insured by AIG. Prior to AIG going thermonuclear and becoming an ongoing ward of the state, Goldman Sachs owned three things:
a) $6.5B of super senior CDOs naked exposure to AIG;
b) $6.5B of cash collateral in a margin account due to ongoing posting of margin against the position by AIG; and
c) $6.5B of CDS on AIG purchased for 200bps running spread to hedge their exposure in "a"

The government comes into AIG and makes Goldman whole on the super senior CDOs that they had insured with AIG (i.e., they pay them the $6.5B from "a" and Goldman gets to keep whatever margin they were already holding from "b"). At this point, Goldman has $13B of cash **AND** they own $6.5B of CDS on AIG.

Well now, given what's happened at AIG, the CDS is trading at 40pts upfront. Goldman sells the $6.5B of AIG CDS at $40-00... thereby pocketing $2.6B additional cash.

In a trade where they have $13B of exposure, Goldman pockets $15.6B of cash.

The math is strikingly simple but they get away with it nonetheless. And no one calls them out. And no one makse them return the money. And the stock market gets itself into an orgy when they say they're "going to pay the TARP money back". They raise $5B of capital yesterday and say the rest is going to come from "other sources". Well guess where $2.6B of that "other sources" comes from?? From the same taxpayers they're paying back via the windfall profits they made from the AIG transfer.

The killer is that, in pieces, they've admitted the whole thing. But no one with any sort of soap box will put the pieces together and call them to account. It makes me sick..
Okay, here’s the simple version: Goldman owned a bunch of asset-backed securities known as CDOs (collateralized debt obligations). It wanted to protect itself against losses on these investments, so Goldman did a couple of smart things. First, it “insured” the CDOs through AIG. If the CDOs lost value, AIG (the insurer) would have to make up the difference. So basically if the bank had a CDO worth $100 million, which then plunged to $80 million, AIG would kick in the other $20 million.

Then Goldman did a second smart thing -- really smart. It understood that holding an insurance policy is no good if the insurer goes belly up. So it took out insurance on the insurer. It did so by buying credit default swaps on AIG. What that means in practical terms: if the CDO value falls by say half, AIG has to make up the difference. If AIG declares bankruptcy and can’t pay, no problem: Goldman gets the same amount of money through settlement of the credit default swaps.

(If you like ghoulish analogies: Goldman drinks AIG’s blood while it’s alive, but gets to partake of the proceeds from selling its organs if the insurer dies. Goldman at this point doesn’t give a damn whether AIG lives or dies. In the financial world, this is being well-hedged.)

So you may be thinking: Well, good for Goldman. They covered the angles. And this is true. Except the U.S. taxpayer happened to indirectly throw them a “gift” of $2.6 billion during the actual playout of the little credit drama that ensued.

How? Goldman bought the credit default swaps (to guard against AIG’s failure) before the insurer had its infamous September meltdown and hasty federal bailout. So Goldman got a pretty decent price, as the insurer appeared to be in the pink of health. In September, AIG was revealed to be deathly ill, in a state akin to multiple kidney failure with an IV drip. (And of course the cost of buying credit default swaps on AIG, in the market at large, soared.)

Now here’s where the taxpayer “gift” comes in -- but the beauty of it, from where Goldman sits, is that it’s indirect. No messy fingerprints. Woo hoo!

Say AIG had croaked in September and wasn’t able to pay the insurance on the CDOs as they sank in value. No problem for Goldman: it just exercises the credit default swaps on AIG and is made whole, and life goes on. But what happens when the U.S. government intervenes to prop up AIG? The government funnels money to AIG, which in turn pays off Goldman, making Goldman whole. Either way you get the same result right?

Not quite.

In scenario number two, Goldman still has those cheap credit default swaps on AIG. Ordinarily the bank would have held on to them to hedge against a possible failure of the insurer. Now, thanks to the visible hand of Uncle Sam, it doesn’t need the swaps. It can resell them into a market where they’re worth more -- a lot more.

So Goldman walks away with -- ka-ching! -- an extra $2.6 billion, the author says. I can't vouch for his math, but his line of reasoning looks pretty solid. (To put that $2.6 billion in perspective, that sum is 40 percent more than Goldman’s entire reported profits for the first quarter.)

Get that? Without government intervention in AIG, Goldman sees $2.6 billion less in profits on this CDS trade alone.

(For more on how Goldman benefited in other ways on its CDOs from the U.S. takeover of AIG, see this Wall Street Journal article.)

Okay, here’s the second piece. Cheap money. Last year Goldman transformed from an investment bank to a commercial bank holding company. It could certainly see the writing on the wall (or knowing how well Goldman has infiltrated the Treasury, it was probably told what the writing on the wall was going to be).

Being a major U.S. bank today means being able to get your hands on lots and lots of cheap money. Pick a multi-billion-dollar credit facility, any multi-billion-dollar credit facility! It’s acronym soup over at the Fed these days. Here’s a summary from Peter Morici:
The Federal Reserve has provided the banks with lots of cheap funds through its various emergency lending facilities and quantitative easing.

The Federal Reserve has permitted the banks and financial houses to park vast sums of unmarketable paper on its books—securities made nearly worthless by the misjudgment and avarice of bankers. In return, the Fed has provided these scions of finance with fresh funds, cheaply, that they may lend at healthy rates on credit cards, auto loans and even mortgages.
The banks get almost-free money (apparently using their toxic asset crap as collateral), then they turn around and lend. But at cheap rates that will benefit their customers, so that’s good right? Well, that was the idea anyway. Continuing with Morici:
While the Fed cuts the banks slack, the bankers are busy turning the screws on their debtors by raising credit card rates and fees, and harassing distressed borrowers with all the zeal of the Roman army sacking Palestine.

It takes good banking skills to borrow at three percent and lend at five and make a profit.

It takes much less business acumen to borrow at two and lend at five and make a profit, and that is exactly what has happened. The extra fees are just gravy.
So Goldman also got a big boost from higher-than-normal spreads in the credit markets. The big banks are getting a really good deal on borrowing right now and giving a not-so-good deal when they lend, then slipping the fat profits in their pockets.

(Earning season game: watch the interest margins for the big banks as they report. The spread will probably be nice and wide, assuming they're making enough loans for the impact to show up.)

Meanwhile the lending picture remains grim. Lending among the major banks (flush with TARP funds) fell 2.2 percent in February. In this CNBC story Donald Trump says that banks "virtually laugh” in the faces of loan seekers, no matter how creditworthy they are.

And the beat goes on. But at least let's recognize what's happening here. Goldman should include a footnote to their first-quarter earnings, acknowledging their success was due to the banking industry’s favorite uncle, Sam. Or should he be renamed Uncle Sugar?

Why Won’t Goldman Just Come Clean?

Phew ... a whirlwind of Goldman Sachs analysis in the wake of their, ahem, blockbuster earnings report. And Goldman’s share sale got pushed out the door pretty fast; it kind of reminded me of the salesman at the used-car lot: “So what do you say ... ah, that’s just a spot of rust ... the horn does work, it’s just a little finicky ... listen I haven’t got all day, you want it or not?”

Will Goldman’s new investors wake up with buyer’s remorse? The company still hasn’t done a good job explaining what’s going on with its first-quarter earnings. Here’s a short list of things worth asking Goldman, point blank:

1. Where does that $12.9 billion you got from AIG show up in your results (when taxpayers bailed out AIG, the insurer turned around and handed out billions to counterparties on derivative trades)? After all, you had a lousy fourth quarter, a lousy December, and then out of the blue you report a spectacular first quarter, even as the jobless rate climbs and housing deteriorates further and commercial real estate takes a tumble.

Chief Financial Officer David Viniar claims AIG funds didn’t juice the bank’s income during the latest reporting period.
Viniar said profit resulting from payments from ailing insurer American International Group Inc (AIG.N) "rounded to zero" in the first quarter.
Great, that’s settled. Or is it? Notice no one asked, “How would your earnings have been affected if you hadn’t received any payments from AIG?” or “Would you have suffered losses if not for the AIG payments?” Viniar claims Goldman unwound the bulk of its AIG positions by the end of 2008. So where did the $12.9 billion go?

(Note: to be fair, Goldman claims to be hedged on its exposure to AIG, so even if the insurer goes belly up, Goldman is covered. Whether the bank is perfectly and reliably hedged is impossible to know. It's likely that Goldman doesn't want to test this either, especially if it can get the U.S. government to back up AIG instead: that's the safest option of all.)

2. How much of your profit was related to the colossal unwinding of trades by AIG’s financial products division early in the year? See this excellent blog post at Zero Hedge for what looks like a scandal (warning, it’s pretty technical).

What happened, in a nutshell: AIG knew it was going to have to crawl back to the government for more bailout funds anyway. So, before doing so, it made a whole bunch of favorable trades with its counterparties (the major banks), allowing them to pocket big profits. Here’s the Zero Hedge analogy:
In simple terms think of it as an auto dealer, which knows that U.S. taxpayers will provide for an infinite amount of money to fund its ongoing sales of horrendous vehicles (think Pontiac Azteks): the company decides to sell all the cars currently in contract, to lessors at far below the amortized market value, thereby generating huge profits for these lessors, as these turn around and sell the cars at a major profit, funded exclusively by U.S. taxpayers.
Was Goldman in any way involved in these trades? If so, how, and how much did this activity boost profits?

3. How do you reconcile these two statements about your earnings? (bold mine; FICC stands for the fixed income, currency and commodities division, which had a blow-out quarter, with $6.56 billion in net revenue):
“The revenues in FICC were very, very broad based” across the variety of commodities, rates, currencies and credit businesses, Viniar told a conference call, adding that Goldman “clearly had the benefit of higher spreads, less competition."
And this:
David Trone, a Fox-Pitt Kelton analyst, said Goldman benefited from a “windfall” in fixed income, currencies and commodities results that is “unlikely to repeat.” He rates Goldman “in line.”
Hmm. Viniar implies that nothing in Goldman’s FICC results was exceptional at all: the revenue was “broad based” (a good way to deflect further questioning -- if you say, “the revenue gains were mainly concentrated in the credit business,” some smartass might ask, “What part of the credit business?”). Also if Goldman had the benefit of higher spreads, we should be able to expect that to continue for a while right?

But Trone (though not being specific either) hints that Goldman essentially got a one-time gift from somewhere. In that case, we should treat a large part of the FICC results as a one-time gain? Yes or no?

4. Why don’t you help us understand the odd results in the FICC division, if there’s really no story there? Here’s all that’s provided in the earnings report to explain what fueled FICC:
These results reflected strong performance in interest rate products, commodities and credit products, as FICC operated in a generally favorable environment characterized by client-driven activity, particularly in more liquid products, and high levels of volatility.
After that line Goldman proceeds to tell us everything that went wrong for FICC in the quarter: illiquid assets declining, revenue in currency lower, some $800 million lost on commercial mortgage loans and securities, corporate debt and private equity investments bleeding red ink.

So what went right? Commodities is cited as one winner, but it seems relatively small. So that leaves “interest rate” and “credit” products (including default swaps). Nebulous huh? This just seems like bad disclosure. Shouldn’t companies be required to be more specific when summarizing the main force behind two-thirds of their net revenue?

And what’s a “generally favorable environment characterized by client-driven activity, particularly in more liquid products” refer to anyway? Sounds like Elaine on Seinfeld when she says, "Blah, blah, blah, blah."

Whatever happened with Goldman’s earnings, the disclosure stunk. And that’s wrong because: 1. Goldman has chosen to be a public company, and certainly enjoys being able to play with other people’s money because of that. 2. As a public company, it has a duty to honestly report its earnings and the nature of those earnings to investors. 3. Its FICC division had a HUGE quarter and there’s virtually no evidence why.

Investors deserve to know if this resulted from a “one-time” windfall and where that windfall was. That’s transparency -- and unfortunately, it’s in short supply during this crisis.

Monday, 13 April 2009

Goldman Had a GREAT Quarter! ... Uh, Wait a Minute ...

First reaction to Goldman Sachs earnings: Wow! Goldman had -- surprise -- a really good quarter. Wait a minute -- did I say really good? I mean really, REALLY good. The company blew the doors off the dump. It smacked a towering home run over the long fence in center field. The AP reported:
The New York-based bank said it earned $3.39 per share, easily surpassing analysts' forecasts for profit of $1.64 per share.
Hell, when a ballplayer crushes the pitch like this, you might assume he’s on steroids or something. Hmm. Hold that thought. Let’s number-dive the Goldman earnings.

Total net revenue (all reference to revenue after this will be to “net”, fyi) was $9.4 billion. Profit was $1.66 billion. Good so far. Now let’s look at a few segments to see what drove this crazy-good news.

Investment banking? Well, no, that was only $823 million in revenue, down 30 percent from a year ago (and even 20 percent lower than the horrible last quarter of 2008, when the company as a whole lost $2.29 billion).

Okay, okay, it’s something else. Let’s try principal investments! That’s where Goldman should really shine: lots of smart guys putting its money at risk, making big scores in the market ... er, well, hold on, that operation lost $1.41 billion in the first quarter. Geez, that ain’t it.

Asset management (and securities services)? Okay, it’s not really sexy, but who knows? Oops, dead end. That category fell 29 percent to $1.45 billion in revenue. What’s more, it even dropped 17 percent from the disastrous fourth quarter of 2008. So that isn’t the answer, not at all.

Stumped? Okay, no more teasing. It’s the FICC division. Its contribution was huge: $6.56 billion in revenue for the quarter! FICC rocks! You go guys!

Uh, what’s FICC anyway? Well, it’s Fixed Income Currency and Commodities. So that group must have just made a whopping bunch of super-smart bets on the bond market or currencies right? But hold on a second: that's AFTER it made a huge amount of stupid bets in the fourth quarter of 2008 (when FICC lost $3.4 billion)? Let’s try to imagine this ... uh, it’s really hard ... uh, I’m not seeing it.

Here’s an alternative scenario: When taxpayers shoveled tens of billions of dollars into AIG, the giant failing insurer turned around and shoveled it right out the back door to certain large counterparties for its derivative trades (credit default swaps). Goldman Sachs received $12.9 billion. That money winds up in what category? My preliminary research leads me to conclude almost certainly FICC.

Irony alert: If you have high sensitivity/allergy to irony, please stop reading now.

Now Goldman says that, presumably because of its solid quarter and bright future, it's thinking of selling stock through an offering. That would enable the company to repay its TARP funds early and thus wiggle out from under the chafing TARP restrictions on pay, etc. So here’s the playbook version:

Tens of billions in taxpayer money -> AIG, which shuffles almost $13 billion to -> Goldman, which posts absurdly profitable quarter and says it doesn’t need the TARP loan anymore (but it’ll keep that AIG money, thank you very much).

Just for the heck of it, if you strip out the FICC line from Goldman’s earnings, how much better is it doing this quarter than the last one of 2008? Take a guess.

Fourth quarter 2008: profit of $1.12 billion.
First quarter 2009: loss of $4.9 billion.

If Goldman hadn’t got that massive AIG infusion (or other money from AIG -- I'm not positive how this worked, but will bet my last dime that AIG is in the middle of it), it would have suffered a huge bloodbath of a first quarter.

Oh yeah. Sign me up for that stock sale. (Cough, cough.)

Thursday, 9 April 2009

Jeremy Siegel Screws up His Math, But He’s Got a Point

My alternative title for this entry was: "AIG Black Hole Distorts the Time-Space Continuum of Investing." It was a bit too playfully abstruse, so I deep six’ed it, though its relevance will become clear once you reach the end.

First, to understand this rather geeky entry, you should go here first, then here. Jeremy Siegel argues that the price-earnings ratio for the S&P 500 Index is badly calculated and would be more accurate if weighted by the market capitalization of its members. He correctly notes that the large losses of a few firms get added to the returns of healthy firms, thus dragging down overall profits and inflating the overall P/E ratio. Because of this, Siegel says stocks look more expensive than they really are. Note: If you’re lost already, see the next paragraph.

(Market capitalization equals number of shares outstanding times the price of each. Price/earnings ratio refers to the price of the stock divided by the earnings per share.)

Now let’s dispense with the first obvious objection: even if the P/E ratios are high now, we’re calculating them using the same formula as always, so we’re comparing apples to apples. If you applied Siegel’s weighting method retroactively, there’s a chance that that “historical average of 15” that he cites (for the index’s P/E) could shift downward to say 12, so stocks may still be far from cheap. In any event, let’s shove this objection aside, because his math fails anyway.

In his Yahoo! article, he gives a concrete example that we can parse to see where the train comes off the tracks (bold mine):
Here is where the distortion comes in. Exxon Mobil has a market value of $350 billion, while AIG's value is now a mere $15 billion (and it was only $5 billion a month ago). That means that the average investor owns more than 20 times as much Exxon Mobil stock in their portfolio as AIG stock, so that for the average portfolio of those two stocks, the oil giant has over a 95 percent share and AIG has less than a 5 percent share.

S&P says that an investor holding 95 percent of his portfolio in Exxon Mobil and 5 percent in AIG has negative aggregate earnings and an infinite price-to-earnings ratio because the losses of AIG are greater than the profits of Exxon Mobil, no matter how much you hold in each. S&P would say this even though 95 percent of your portfolio is in Exxon Mobil, a stock that sells for less than 8 times its earnings.

My methodology would weight the $45 billion earned by Exxon Mobil by 95 percent and the $99 billion loss of AIG by 5 percent to obtain a weighted average earnings of $39 billion for the portfolio. With a weighted average market value of AIG and Exxon Mobil of $335 billion, this would lead to approximately a 9 P/E ratio for the portfolio, not the infinite P/E computed by Standard & Poor's.
Now, if you’ve got a really quick mathematical mind (mine isn’t; it took me a while to realize this), you’ll wonder about a contradiction hidden in this example. The market cap, after all, is simply the sum of what all investors have paid for all the shares. So investors as a whole would be looking at an infinite P/E ratio for Exxon Mobil and AIG combined, because of AIG’s huge losses. But Siegel’s saying that your investment, even when it’s split to reflect the exact proportions of each company’s market cap, should have about a 9 P/E ratio.

Okay, that’s a bit confusing so let me try this analogy. You thoroughly mix the shares of Exxon Mobil and AIG in a large bowl. Anything you extract from the bowl (a teaspoonful, a cupful, whatever) is composed of about 95 percent Exxon shares, 5 percent AIG. Now the entire bowl has an infinite P/E ratio. But Siegel is saying that the proper P/E ratio for what you take from that bowl as an investor should be “weighted” to equal roughly 9.

So you may be scratching your pate, thinking “Where the heck did all that astronomical P/E go?” Answer: nowhere. Siegel’s math makes a subtle slip-up.

Just assign hypothetical numbers to his example. Let’s say you have $100 billion to put into Exxon and AIG shares and split the money according to their S&P weighting. Here’s where Siegel’s math crumbles: that amount of money buys proportionately much less of the larger market cap company (Exxon), so the need for readjusting the P/E's through a weighting process just washes out.

Try it with real math, assuming a mega-large investor, to keep the calculations easier: $95 billion would buy you about one-third of Exxon’s stock and the remaining $5 billion would buy about one-third of AIG’s stock. So (theoretically) you are entitled to one-third of Exxon’s $45 billion of earnings ($15 billion) but you also have to eat one-third of AIG’s losses of $99 billion ($33 billion).

So you have ... a P/E of infinity, just as the S&P calculation suggests.

But there’s a larger point where I think Siegel is correct: namely, that we have a large basically insolvent company at the bottom of the S&P that is behaving like a black hole, sucking in massive amounts of money. These are taxpayer funds, so investors are largely getting a free ride. The shareholders don’t absorb that fat loss; Uncle Sam does. So the S&P is cheaper than it looks thanks to the U.S. government.

Wednesday, 8 April 2009

Ah! So That's What the SEC Was Doing ...

This story was good for a dark chuckle of despair (bold mine):
While Wall Street executives were sinking the economy and Bernard Madoff was ripping off investors, the Securities and Exchange Commission (SEC) was engaged in a multi-million dollar effort to...rearrange their desk chairs at their Washington D.C. headquarters.

"This is a total waste of time that we should be spending conducting investigations," said Steve Ellis, Vice-President of Taxpayers for Common Sense who calls SEC’s $3.9 million dollar desk reorganization "preposterous."

According to a new report from David Kotz, the Inspector General for the SEC, employees were subjected to a massive reorganization in 2007 and 2008 that they now say was unnecessary and did not improve organization or communication. Over 600 employees, 81% of those surveyed by the Inspector General, said that the rearranging of desks was not "worth the cost and time."
So while Bernie Madoff Ponzi'ed billions of dollars out of investors' pockets, the SEC couldn't be bothered to investigate because it was too busy trying to figure out whether Joe should sit next to Fred or Mary. Or maybe Sam? You know, Sam and Joe sometimes need to talk, so what if we put Sam here, then Bill over ... wait a minute, that won't work. Bill has to be near Sally.

Good Lord. This, I predict, will be the legacy of the SEC under Chris Cox, who struck me as a poster child for the Bush "do nothing" regulators. He was striking for his cluelessness deep into the financial crisis. An especially telling Cox moment, I thought, was when he suddenly rushed over to Congress and basically said, "Holy cow, I just found out there's a $50 trillion credit default swap market out there. We need to start regulating that. Can you pass something, like, this afternoon?"

Cox appeared to be another smug Bushie who assumed his job was basically a sinecure. In essence, their thinking goes: markets regulate themselves, and the invisible hand does all the heavy lifting, so if you need me I'll be out by the cabana. He made sure that the SEC prosecuted a few nickel-and-dime fraud artists and insider traders here and there (in the grand scheme of Wall Street crime, these are like working-class weekend pot smokers). He always struck me as inept and indifferent and ideologically opposed to the very sort of job he held -- not exactly what you seek in an effective regulator.

If you want more on Cox, here's a profile of the man and the weak-kneed mess he turned the SEC into, after he inherited a respected regulator from William Donaldson.

Tuesday, 7 April 2009

An Analysis of International Monetary Relations – Part 1: How We Got Here

No economic event in the 20th century had a greater impact on world affairs than the Bretton Woods Agreement. The regime of fixed exchange-rates that it established and the collapse of that system after 25 years under the strain of its internal contradictions are both watershed events in the history of the world in general and finance in particular.

The foundation and the driver of the Bretton Woods system was the convertibility of the U.S. dollar to gold. The U.S. undertook to deliver 1 troy ounce of gold for every $35 dollars that foreign nations’ central bank presented to it. The exchange rate of major currencies was fixed against the dollar and, by extension, one another, to prevent manipulative devaluations. At the time of the signing of the Agreement in 1944, approximately 75% of the world’s gold stock was in the U.S., so there was no question about the country’s ability to honor its promise. (The stock was created because the U.S. companies that sold goods to the warring parties sensibly refused the European currencies for payment and demanded gold instead.) Dollar holdings, furthermore, earned interest. Gold did not, and had additional insurance and storage costs. So the foreign central banks that got hold of dollars did not convert them into gold. They kept them in dollar-denominated assets and earned interest. The dollar became as good as gold – even better.

In this way, a national currency became the means of settling the international balance of payments. It was an unprecedented regime. The U.S. could create dollars from thin air – via either bank reserves or the actual printing of paper money – and present them as payment for the goods and services that it acquired from abroad. This was an extraordinary power and privilege that solidified the 20th century as the American Century.

You know the rest. To finance his expensive War on Poverty and an escalating war in Vietnam, President Johnson resorted to creating money. Soon, the volume of dollars in the international channels of circulation reached a point where it was impossible to redeem them at the rate of $35 per ounce of gold; the redemption would have emptied Fort Knox many times over. The time had come for the Bretton Woods Agreement to go.

On August 15, 1971, President Nixon went on TV to announce a series of measure to fight inflation – as dollars were now everywhere, causing a rise in prices – and mentioned, almost in passing, that the U.S. would no longer honor conversion of dollars to gold; if you were holding dollars, you were stuck with them. That was the end of the Bretton Woods system and the regime of fixed exchange rates.

For the next couple of years, an informal arrangement by the major central banks managed to hold the exchange rates within a narrow band. In 1973, that arrangement, too, collapsed. Currencies were thrown into the market place to find their “correct” exchange rate in the interaction of supply and demand.


The “oil crisis” hit the U.S. in 1973. Virtually overnight, the price went from $2 to $8 a barrel.

Everyone knows the crisis was caused by the “oil embargo”, a piece of knowledge qualitatively on par with knowing that Mrs. O’Leary’s cow caused the Great Chicago Fire.

Here is what happened.

Prior to 1973, a barrel of oil was at $2:

What would happen if the left side of the above equality increased? We would then have:

In economic parlance, this condition is called an oil glut. In an oil glut, oil is cheaper because the same $2 would now buy more oil.

Now, what would happen if the right side of the equality increased?

In this situation, confronting the same barrel of oil is many more dollars; more dollars correspond to one barrel of oil, which is another way of saying that more dollars are needed to buy oil.

This condition is not called dollar glut. It is known as the “oil crisis”.


Just how many dollars were in circulation could be surmised from the price of gold that passed $800 in the 80s, which is why, long after the “embargo”, the oil price kept going up. The driver of the price was not the scarcity of oil, but the abundance of dollars.


Conservatives applauded the collapse of Bretton Woods. The gold would now stay in the U.S. (The Wall Street Journal still calls the event “closing the gold window”, implying a beneficent banker to the world who got tired of being beneficent.) Milton Friedman, given open access to the media, endlessly made the case that floating-rate mechanism would solve the balance of payment problems once and for all. If a country’s balance of payments deteriorated, its currency would weaken, resulting in less import and more export. This would restore “the equilibrium”. That is what he actually said.

More astute, less partisan people, though, mourned the collapse of the Bretton Woods. They though it signaled the end of the U.S.’s global supremacy. Indeed, it was difficult to see how the loss of a proverbial golden goose – the ability to print dollars to pay for goods from all over the world – could be anything but a setback. Even an astute practitioner of international finance such as Paul Volker titled his book, Changing Fortunes, by which he meant the fortunes of the U.S.


The realm of finance capital is the realm of theory. Practitioners know as little about it as biased ideologues and outright fools, which is why no one saw what was coming.
In the post-Bretton Woods chaos, it became impossible for corporations to plan with any degree of confidence. An adverse exchange-rate movement could wipe out the hard-earned profits of a full quarter or even a year. There had to be a regulating mechanism. In the absence of government authority, the only remaining source of discipline was private finance–finance capital–which stepped in and assumed the role of regulator.

Governments achieve stabilization through decree; finance capital does it through arbitrage. The most important point in the rise of arbitrage trading is that the practice develops logically from hedging and, on paper, is indistinguishable from it.

I showed in Vol. 1, how, from the ashes of Bretton Woods, speculative capital rose to dominate the financial markets. The new phenomenon seemed to have the potential for boundless expansion, only if the “stifling regulation” inhibiting its growth could be done away with. That brought Reagan to power. And then Thatcher.

Awestruck academics could not see the speculative capital. It was too abstract a concept to lend itself to their comprehension. What they noticed was that a “new paradigm” had taken hold in the U.S. and U.K where credit could be expanded on-demand without limits.

The currency of the new paradigm, the material form in which it manifested itself, was the dollar. It had to be, thanks to its abundance, ease of conversion and universal acceptability. So, once again, the U.S. and its currency assumed centrality in the world of international finance, only this time, the U.S. could issue dollars without any accountability or the need for keeping an anxious eye on its gold reserves. Good times were going to be had by all involved.

The “paradigm” lasted about 25 years, the same time it took for the Bretton Woods to collapse. This one ended in 2007.

Yves Smith Nails It

Yves writes:
We have been saying for some time that the policy premise of the Fed and Treasury has been that the financial crisis is that it is a liquidity crisis, not a solvency crisis. If you are of that school, the fallen prices of various assets is due to a combination of scarcity of funding plus irrational panic. Find ways to provide liquidity and give investors that magic elixir, confidence, and voila, crisis over.

Having watched the credit markets closely before the implosion, we'll agree there was plenty of irrationality. But it was in the gross underpricing of risk. The snapback to current pricing to us thus seems a return to rationality plus new fundamentals based on borrowers who never should have been lent money in the first place defaulting on such a scale as to damage overall economic activity. And that means, as plenty of Serious Economists (Krugman, Buiter, Stiglitz, to name a few) have warned, the Geithner cash for trash program is a huge misallocation of taxpayer dollars. Even granting that something must be done about the banking system, this is a covert and wasteful way to go about it.
I think her analysis here speaks to a hugely critical truth. In trying to understand this financial crisis, we are increasingly falling into two distinct camps: (1) It’s a liquidity crisis (pump more money into the system, soothe irrational investors, and all will be fine (2) It’s a solvency crisis (the financial system is semi-paralyzed because the banks (not all, but enough, and the systemically key ones morevoer) are effectively bankrupt).

My position is clear. I’m in with the #2 camp. So are many Serious Economists, as Yves notes. In fact hardly anyone credible believes #1 is true anymore. Unfortunately the small coterie of #1 diehards belongs to the Obama administration: Geithner, Summers et al. So we agree to disagree and no harm done, right?

Wrong, because believing in #1 (solve the liquidity problem and the bad stuff goes away!) leads you down a very different policy path. Meanwhile, the stakes are high. Public patience is thinning. Time is of the essence. Can you really afford to be wrong? There is a view (held by Mark Thoma, among others) that it’s okay to throw tepid support behind the Geithner plan, even though you may harbor a few reservations. If it doesn’t work, we’ll just try Plan B.

The trouble is, every squandered opportunity paints us even further into a corner. The worst outcome for the Geithner plan may be simply that nobody shows up. The Treasury buys the auction paddles, rents the venue, and the banks and private investors basically decide to stay away. The corrosive cynicism afoot in America deepens. Geithner, dragging the baggage of a failed plan behind him, casts about for yet another solution. Can we really pretend that this doesn’t carry a serious cost?

What Yves points out here to me is brilliantly obvious, but too rarely remarked on. We are acknowledged to be in a “post bubble” phase. If that is true, and you have to reconcile the price of an asset, would you go with its valuation as set during the bubble or after? The answer is so clear as to be obvious to a child.

But the new “post bubble” asset prices the banks deride as “fire sale.” They began this labeling early, smartly getting out in front of the bad news that many of their assets were rotten. The U.S. government has gamely run with this bit of wormy apple polishing. But just think about what’s more likely: That the bad assets were priced correctly before (in the middle of the froth and exuberance) or that they are priced correctly now (when the scales have fallen from our eyes and we know that there is no risk-free ride)?

Saturday, 4 April 2009

Outrage Story of the Day

My alternative title for this entry was “Meet the New Boss, Same as the Old Boss.” The Washington Post tells us here that the Obama administration has resorted to cleverness and deception to funnel money to financial companies who want the dough but not the restrictions, such as on pay, that Congress has slapped on TARP funds. Ironically, the Obama-ites would thus be taking a page from the playbook of the failing major banks. Remember how these financial institutions created entities that lived off-balance sheet until they got in trouble, at which time the retractable tether cord mysteriously appeared and they got sucked back into the mother ship. Don’t you love U.S. accounting rules?

Obama’s administration apparently has created intermediary vehicles to “wash” the money before it reaches the intended recipients, so they’re not directly getting TARP funds (and so don’t have to abide by TARP rules). If you’re thinking, “Gosh, that sounds an awful lot like money laundering,” you get the gold ring. (See the quote on the article’s second screen.) So what it essentially boils down to is this: the Obama crew has decided to circumvent Congress (the people) at will, to do what it likes to try to rescue the financial industry.

For the record: I’m not a fan of the pay restrictions, though I respect them (in essence, if you’ve screwed up, and you need money from me, then don’t whine about restrictions I impose on you -- consider it incentive not to screw up next time, huh?). I think it’s much smarter for the U.S. to simply gnaw off a chunk of preferred equity in exchange for aid, and not to get into the nitty gritty of pay scales and who gets what bonuses etc.

But what the Obama top brass are doing is troublesome. To simply do an end run around Congress isn’t the answer. If they think banks (and other companies) deserve no-strings, stigma-free cash, they need to make that argument to the people. Obama did the right thing on Guantanamo; it had become a potent and corrosive symbol of America values in decay. But why has his moral center been so badly knocked out of plumb on this banking crisis?

Friday, 3 April 2009

Let the Games Begin?

The electronic ink is barely dry on my previous blog entry, when comes this story from the Financial Times that U.S. banks may buy each other’s toxic assets under the Geithner plan.

Dear God no.

This recalls a “good news, bad news” joke I read years ago. It goes like this:

The soldiers had been fighting hard for weeks. They were hungry, tired and unwashed. One morning the captain stood before them and said, in a booming voice, “Men, I have some good news and bad news.” Everyone fell quiet. “First, the good news,” the captain said. “Today there will be a change of socks.” A lusty cheer broke out. After a pause, the captain went on, “Now the bad news. Atkins, you change with Smith, Smith you change with Jones, Jones you change with O’Reilly ...”

If the banks just swap their dirty socks (um, toxic assets) among themselves at inflated prices, nothing will be achieved other than the shifting of billions of dollars of losses onto taxpayers. This could turn out to be a breathtakingly brazen gaming of the Geithner plan. I wasn’t sure about the gaming element until the FT story mentioned that Citigroup -- highly leveraged (was the insane ratio 33-1?), mega-bailed out, Citi! -- was among those thinking of bidding on assets under Geithner’s public-private partnership!

Any bank whose lips are fused to the taxpayer teat should be tidying up its own house right now. That the Treasury Secretary did not come out and make this abundantly clear worries me. I would’ve preferred a muscular Geithner quote along the lines of “Citi won’t be using any kind of leverage to buy anything bigger than a lemonade stand, let me assure you, until it repays the government.”

I did slap a question mark on this blog heading because I’m still not convinced that this kind of gaming will be allowed. It would be a naked giveaway to the major U.S. banks who screwed up in the first place. The outcry of fury would be deafening.

If the banks wind up exchanging their rancid socks with each other and taxpayers get stuck with the laundry bill, the truth will out and heads will roll.

Thursday, 2 April 2009

Banks: Secretly Terrified of the Geithner Plan or Not?

I wanted to revisit my earlier blog entry about the public-private partnership that Geithner has laid out for buying up distressed banking industry assets. It appears that I occupy a lonely, contrarian position. The Net has been rife with theories about how banks will profit big, private investors will profit big, and the taxpayers will get the royal shaft. If this is all correct, banks should be secretly gleeful, not terrified.

I’m not sure it’s the full picture though. First, hit rewind: Bush and his Merry Bunglers wasted more than three months playing pattycake with the U.S. banks, then left Obama in a pretty bad spot. Sure, they dumped a financial crisis on his doorstep. But they also left behind something else fairly poisonous: a populace and a set of talking heads that have grown deeply skeptical of anything the government proposes. (Of course Obama’s team didn’t help itself by continuing in the footsteps of the Bushies.)

So when the Geithner plan gets unveiled, the reaction is ... “Let’s tear it apart and figure out how the Treasury Department, i.e., the West Wing of Goldman Sachs, has designed a new scheme to rip us off.” As Americans, let’s face it: we’re just in a much more cynical place right now.

The best opportunity for a plan resembling Geithner’s to succeed was early on. We Americans were all dazed and uninformed (credit default whats?) and malleable and wondering what the hell was going on. Had Paulson learned anything from Bear Stearns’ collapse months earlier, he could’ve prepared for another disaster and acted decisively when the real crisis hit. He could’ve marshaled support and pushed through a bold, smart plan for the U.S. banking industry. Instead we just kind of muddled along. He jammed his fingers in the dyke holes until the clock ran out on the Bush team, at which point they scurried out of Washington.

What that means for Geithner’s plan: in the current climate of distrust, the question for most people isn’t whether we’re being screwed, but how. The baked-in assumption for Joe Taxpayer these days is he's being screwed from the get go. That's largely how the plan is being perceived and analyzed.

If you're a bank, that's probably got you sweating a bit. That is of course if -- big IF -- you can't game the plan. Let's assume you can't (I know, a HUGE assumption, but much of the worst gaming takes place in dark corners, and right now everything about this plan has a bright floodlight aimed squarely at it). Also consider it this way: the Treasury must realize that if there’s an orgy of profiteering through related party transactions and such, Geithner is absolutely dead politically (and Obama will suffer large collateral reputational damage too).

So if you assume the bidding process will be fairly realistic (though subsidized), how much toxic junk can be moved off the books at “market prices”? Assuming the benefit from the low-interest FDIC loan isn’t too large (see entry below), the banks may not be happy at all. If overpayment is less than 10 percent, this plan seems like a total disaster for them, especially in a climate of deep suspicion where the public figures there will be overpaying of at least 30 percent.