Sunday, February 28, 2010

Will the Greek Debt Crisis Visit America?

The Prime Minister of Greece, George Papandreou, will visit President Obama on March 9, 2010. This follows a meeting between Papandreou and German Chancellor Angela Merkel on March 5, 2010. The earlier meeting is acknowledged to be about Greece's sovereign debt crisis, and the discussion will no doubt concern Greece's progress toward fiscal prudence and the conditions for a German-sponsored bailout. Although the German public is largely opposed to a bailout, the German government may have little choice but to offer some assistance at some point fairly soon. Germany, Greece and the rest of the EU share a common currency and a common market. They're more intertwined than the world's money center banks. Germany profited from Greece's profligacy, which expanded Germany's export markets. Germany will surely have to bear some of the burdens of that profligacy, although we can expect the German government to strike a hard bargain in terms of requiring Greek austerity.

President Obama's willingness to meet with Papandreou is somewhat perplexing. The White House announced that the two would discuss a "broad range of strategic issues." Okay. Like overfishing of tuna in the Mediterranean? Or the effect of air pollution on the physical condition of the Parthenon? Or improved anti-terrorist security measures at the Athens airport? Or a joint condemnation of Iranian and North Korean nuclear ambitions? Or is it possible they might discuss Greece's sovereign debt crisis?

President Obama needs to watch where he's walking, because there's a political bear trap on the trail in front of him. A lot of people outside the Tea Parties wouldn't begin to brook the idea of American assistance to help Greece deal with its sovereign debt crisis. (We don't need to discuss how Tea Partiers would feel about this issue.) Yet, what on earth would Obama and Papandreou talk about at a time like this other than Greece's sovereign debt crisis?

President Obama has an increasing number of political adversaries, and he doesn't need to be his own worst adversary. He's more popular overseas than in the U.S., but he shouldn't heed the siren call (okay, that double entrendre was intended) of his foreign fans. With the resurgence of populism, paranoia about the Trilateral Commission, the Council on Foreign Relations, the Bank for International Settlements, and, of course, the United Nations, is ballooning. A meeting with Papandreou announced with a vague description of an agenda will only inflame the already uncontrolled imaginations of the fearful.

The United States has no business assisting the Euro bloc nations having sovereign debt problems. Government bailouts shift the bailee's losses onto taxpayers. Whatever the plus and minuses of the federal government's bailouts of Wall Street, we cannot take on the burdens of other nations' irresponsibility. Assistance to Greece would raise a firestorm of anger among the American electorate that would snuff out any chances the Obama administration has for health insurance reform and perhaps many other of its key policy initiatives that would benefit the American people.

No doubt, the leaders of Spain, Portugal, Ireland, Iceland and other nations with sovereign debt problems must be maneuvering for their meetings with President Obama. He needs to keep his schedule filled up with appearances at elementary schools and visits by Girl Scouts to the White House. Many of the now prosperous economies of East Asia, which may be the economic engines that pull the rest of the world out of the current recession, went through hell after their own 1997-98 debt and currency crises. The IMF took them to the woodshed and did something with a stiff birch switch. The outcome was much more fiscal discipline and financial prudence, and comparative prosperity today. China, which didn't take IMF money, has always assumed that it would have to get by on its own, and acted accordingly. Its self-sufficiency has paid enormous dividends. People don't prosper when they go on the dole. Neither do countries.

Thursday, February 25, 2010

Will the Europeans Take the Lead on Reforming Derivatives Regulation?

On Leave It to Beaver, when Beav did something to dig himself deep into a hole, his brother Wally would say, "You've really done it now." The big banks on Wall Street may have really done it now in the derivatives market.

News media today report that Goldman Sachs and other Wall Street firms have been buying credit default swaps that would rise in value if Greece were to default on its sovereign debt. This follows other recent reports that Goldman Sachs helped Greece disguise the level of its indebtedness by offering derivatives transactions that wouldn't appear to be debt. Thus, Goldman helped Greece appear more fiscally sober than it was. Moreover, other European nations seem to have drunk of this same derivatives cup to sweep national debts under the carpet.

It would be difficult for an EU member to scold Greece for profligacy if it had indulged in similar extravagance. The Wall Street firms involved in these deals have the EU nations exactly where they want them--financially bound to the Street while mutually lacking the moral standing to police each other.

But then, it seems that Goldman (and other firms) may have also bet on a Greek default, after having aided its fiscal excess. If so, they would have gained perhaps hundreds of millions in fees for their derivatives products and then who knows how much profit if Greece collapses under a heavy debt burden that Wall Street facilitated. To make things worse, credit default swaps are sometimes thought to affect the market for the primary debt to which they relate, with increased credit default swap trading activity and rising prices fostering greater doubt about the debtor's chances. Thus, buyers in the credit default market might exacerbate the debtor's problems and thereby increase the profit potential of their credit default swaps.

If it's true that Goldman and other major Wall Street firms have been on both sides of the table with Greece (for them and then against them), they would have been too clever by half. Continental Europeans almost reflexively mistrust "Anglo-Saxon capitalism." They have limited faith in market forces, and are quite willing to accept the stability of government control over market volatility. Business people are not as highly regarded in the EU as they are in the U.S., and don't have the political pull in Berlin and Paris that they do in Washington. Per capita income in Western Europe was, some 40 years ago, close to per capita income in America. Today, it's about thirty percent lower. The Europeans have been willing to pay the economic price for slower growth in exchange for greater stability. After the American-spawned mortgage crisis and credit crunch of 2007-08, they've lost a lot of faith in market forces. The sovereign debt mess would only reinforce these feelings.

There's a good chance that Europe will take the lead in reforming the regulation of derivatives. The EU already leads the U.S. on antitrust enforcement and electronic privacy. Big American companies like Microsoft and Intel have had to knuckle under to EU regulatory imperatives that reached beyond the requirements of U.S. law. Goldman Sachs, J.P. Morgan Chase and other denizens of Wall Street are not worshiped across the pond. Even worse, they've made various European governments appear to be easy marks. No one likes to be seen as a gullible dupe, especially not high ranking government officials who are the likely dupes. Regulatory fervor is undoubtedly rising east of the English Channel.

By all indications, neither Congress nor the Obama administration are focused on reforming the regulation of derivatives. Heavy duty lobbying by Wall Street is probably the most important reason for their inaction. But that will leave an open field for the Europeans to do as they please. Ninety percent of life is just showing up, as Woody Allen once said. American participation would help shape the future regulatory structure, and make it more closely resemble something we'd prefer. It's fallacious to think that the regulation of the derivatives markets won't change just because of somnolence on the Potomac. The world today is much bigger than the United States, and will move on with or without the United States.

Wednesday, February 24, 2010

Why the Derivatives Market Will Surpass the Stock Market

After the financial crisis of 2007-08, and now the ongoing sovereign debt crisis, the derivatives market will, for many, live in infamy. Mortgage-related derivatives have pretty much disappeared, although many old ones continue to bedevil the banking system. Derivatives products for governments have been suddenly thrust into the spotlight by the sovereign debt crisis, and it's likely that these products will lose popularity as a result of their newly-found notoriety.

But the derivatives markets will live on, and mostly likely thrive, because the heat is on in the stock markets. Today, the SEC placed controversial limitations on short selling. If a stock's price drops 10% during a trading day, short selling will be permitted only if the national best bid price for the stock rises. This limitation will continue for the rest of the trading day and the following trading day. A number of hedge funds, including some that are known to focus on short selling and others not, opposed this restriction. So did at least one large bank, Goldman Sachs, which earns a lot of profits from proprietary trading.

The fact that professional traders opposed the short selling ban indicates that the prospects for the derivatives market are good. If the pros can't short sell stocks, they'll look for derivatives contracts that accomplish the economic equivalent. Indeed, a big bank like Goldman might take the lead in developing such contracts. An important reason why derivatives were so central to the growth of the mortgage market is that the lack of regulation of mortgage-related derivatives allowed the big banks to develop products and ways of doing business that were highly profitable (at least in the short run, but that's what matters for determining executive bonuses). There is considerable demand in the markets for the ability to sell short. The only question is what alternatives could be created to circumvent the new short selling restrictions.

The obvious stratagem would be to create a derivative in the nature of a single stock futures contract or a similar forward contract for delivery of the stock. Any such contract would presumably not be listed on a U.S. commodities exchange (the point is to avoid regulation), but would be traded over-the-counter. If necessary, it could be transacted overseas, in a friendly regulatory environment where the government didn't necessarily coordinately closely with U.S. regulators. If the firm offering such a derivative wanted to cover its exposure, it could itself trade in this friendly environment to hedge the customer contracts it sells, and just about no one would know the better.

Then again, the firm offering the derivatives equivalent of a short sale might not want to cover its exposure. The big money in proprietary trading comes from making one-sided bets in markets where prices are volatile. The day-to-day humdrum of market making in a stable market is like operating a grocery store--you make pennies at a time if you make pennies at all. If a firm thought itself skilled at making proprietary bets, it might take on unhedged exposure in the hope of hitting a home run. Sometimes, these bets pay off, and the temptation will be there in a world where the size of one's bonus establishes one's social standing. Without regulators around to frown about undue risk, temptation may triumph, as it did in the mortgage derivatives market.

Either way, the new short sale restrictions will hinder the small, individual investor trading a few tens of thousands of dollars in an online brokerage account. But the big boys with financial muscle will further the evolution of the derivatives market.

Another sign that the derivatives market is destined for growth is the news story that emerged in late January reporting that the exchanges are thinking about asking the SEC for authority to price quotes and transactions in increments less than a penny. See Apparently, alternative tradings systems like the so-called dark pools are pricing in sub-penny increments, and the exchanges are thinking they might need to meet the competition. The problem will be that the bid-ask spread (the difference between the bid price at which investors sell stocks and the ask price at which they buy stocks) will shrink when sub-penny prices are used. The bid-ask spread approximates the profit potential for brokerage and specialist firms making markets. As it shrinks, the profitability of the stocks business will diminish as well. Big bonus mania will push the financial firms toward the derivatives markets, where opacity is king and bid-ask spreads are indeterminate from the customer's standpoint (or, as much as the traffic will bear, from the dealer's standpoint). For a real-life illustration of how opacity and big profits intertwine, see

If serious reform of derivatives regulation by the U.S. and other major economic powers was in progress, the blessings of transparency would spread across the derivatives market and stratagems to circumvent the short selling restrictions would be harder to develop. Furthermore, the expansion of the derivatives market that is rendered inevitable by the shrinking margins in the stocks business would be fairer to investors. But the prospects for meaningful reform have diminished as the stock market has partially recovered and Wall Street has mounted a relentless anti-regulatory lobbying campaign. That leaves unchecked a humongous loophole in the regulatory structure through which the big banks can shove investors' money into an opaque and ungoverned environment where, as with mortgage-backed and mortgage-related investments of the early and mid-2000s, another shadow banking system can evolve, bubble up and pop again.

Tuesday, February 23, 2010

Greece, the Euro and the Currency Quandary

The following is entirely fictional.

Dour winter winds chilled the yard at the Butner, NC medium security facility. Inmates tried to exercise under the muddy gray overcast, their unprotected fingertips aching from lack of warmth. Jorge stepped around the weightlifting area and approached the older man seated on a bench.

“Hey, Bernie.”

“Hello, Jorge.”

“Bernie, I was wondering if I could get your advice on something.”

“Sure. What’s on your mind?”

“I got a chicken tamale for you, made the way you like. I figured it would help you think.”

“Oh, thanks so much, Jorge. My brain is firing up already.”

“Bernie, I got a prob . . . Well, my sister in Bogota has a problem.”

“What’s that?”

“She has some money, some U.S. dollars. And she’s trying to figure out what to do with them.”

“You mean, what to spend them on?”

“No. Like what to put them in.”

“You mean what to invest in--stocks and bonds?”

“No, I . . . she don’t like stocks and bonds because, you know, the big guys in New York, they got control over those markets. No one else knows what the stocks and bonds are really worth.”

“I understand that point. Uh, how much money does she have? I mean, depending on how much she has, you might be able to find special investments.”

“Bernie. . . Can you keep a secret?”

“Sure, Jorge. I’m very good at keeping things secret.”

“Okay, she has about ten million.”

“Ten million dollars? Holy cow. How did she get that much?”

Jorge paused and glanced around before speaking. “She . . . ah . . . found it on the sidewalk.”

Bernie smiled ever so slightly. “I guess that can happen. Investing such a large amount can be complicated. I mean . . . well, let me ask, is it in a bank account now?”

“No. Cash. Cash only. That’s the only way I do bus . . . , well, it was cash when she found it.”

“Investing that much cash would be complicated.”

“I . . . she can get it . . . how, you say, washed?”


“Yeah, that’s it. Laundered. You don’t have to worry about that Bernie. I can . . . she can take care of that. The problem is what to wash it into. That’s the hard part. I was thinking . . . I mean, for her. I was thinking for her that maybe we put them in Euros. The dollar isn’t so strong any more. And the Euro has gone up a lot. But then I hear that there’s a problem with Greece or some place, like they got too much debt or a lousy government budget, so the Euro is going down. What’s going on there, Bernie?”

“As I understand it, Greece and some other European countries borrowed a lot of money, and they’re having trouble paying it back. These debt problems make their economies grow slower. Because people think Europe's economy is weakening, its currency, the Euro, is worth less.”

“The TV was saying something like Greece or someone was hiding some of their problems. You know anything about that?”

“I gather that Greece and other European countries did these fancy deals called derivatives, which disguised some of their debt so they didn’t look so financially weak.”

Jorge frowned fiercely. “I don’t like that sneaky s___. A dude who pulls sneaky s___ on me is trying to f___ me. I don’t do no sneaky s___. When a guy tries to f___ me, I f___ him back. And, you know, I f___ him to his face, ‘cause I don’t f___ around.”

With well-practiced diffidence, Bernie glanced at Jorge, seeing eyes that could pierce steel. “I’ll bet you don’t, Jorge.”

“You can take my word on that, Bernie. I mean, you know that lying bastard that put me in this place, you know, he testify against me in court, saying I’m a narco trafficker, and the judge throw in me jail? When I get out . . . “ Jorge drew a finger across his throat.

Bernie practiced his diffidence some more. “I hope we get some warmer weather soon.”

Jorge threw back his bulky head and laughed thickly. “I like you, Bernie. You stay cool. Okay, so what we doing to do? I mean what do you think my sister should do? No Euros, ‘cause I don’t like that sneaky s___. How ‘bout the Japanese yen?”

“The yen has done pretty well overall, because Japan is basically a wealthy country and has a strong manufacturing sector that exports successfully. But the Japanese government is constantly trying to push the yen down because a weak currency helps their manufacturers export.”

Jorge thought about this for a moment. “You mean they f___ their own money?”

“Well, I don’t think they look at it that way. But you’re not far off the mark.”

“S___. Then, what’s a good thing to put the money into? I mean, I don’t want gold, ‘cause then I . . . my sister has to protect it, ‘cause there’s a lot of bad people that might try to steal it, and you know, someone might start shooting, and then s___ really starts to happen. “

“I agree, Jorge. Gold isn’t an optimal investment.”

“Then, what should I . . . my sister do?”

Bernie thought for a moment, and sighed. “Sometimes, Jorge, there aren’t any great investments. The markets fluctuate, and in a down cycle, you may just have to try to hang in there until things get better. Maybe it wouldn’t be a bad idea if . . . uh, your sister just held onto the dollars.”

Jorge frowned at the walls that would mark the limits of his freedom for years to come, and remained silent while a nearby sparrow chirped. Then, the edges of his lips lifted to betray his amusement. “So, is that how you pulled off that, what you call it . . . a party scheme?”

Bernie paused, and then said, “you mean a Ponzi scheme?”

“Yeah, that’s it. Ponzi scheme. That’s how you did it, right?”

“What do you mean?”

“You say the markets sometimes go down; not always up.”

“That’s correct.”

“So when you promised people whatever, ten or twelve percent steady, all the time, no bad times, they want believe it ‘cause otherwise they gotta deal with the market going up and down, and they don't like that. And then they give you their money.”

Bernie brooded before saying, “That about sums it up. I made it easy for them to give me their money and they made it easy for me to get it. We all took the easy way out. Legally, I’m the bad guy. But it’s easier to kill sheep than lions.”

Jorge took a deep breath, and said, “I ain’t no sheep. I had to work hard . . . I mean my sister had to look hard on the sidewalk for this money. We ain’t gonna put it where people pull sneaky s___ or these other people they f___ their own money. Maybe we just have to, like you say, hold the dollars for now.”

“I think that’s the right attitude, Jorge. Playing games with debt and currencies aren’t odds on winners. People who don’t look for the easy way out have better chances in the long run. You can take that from me.”

Sunday, February 21, 2010

What the Federal Reserve Has Been Up To (In Case You Didn't Know)

Late Thursday, last week, the Fed popped a surprise on the financial markets by raising the discount rate charged to borrowing member banks from 0.5% to 0.75%. The Fed insisted this increase didn't mean much of anything, and tried to imply that it shouldn't have come as a surprise. Most market participants were surprised--mostly by the timing, but in the financial markets, timing can be everything.

Now, maybe you're wondering what else those kids at the Fed have been up to. Here's a list of other recent steps taken by the Fed to end accommodative measures it instituted during the credit crunch:

Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility: closed as of Feb. 1, 2010.

Commercial Paper Funding Facility: closed as of Feb. 1, 2010.

Primary Dealer Credit Facility: closed as of Feb. 1, 2010.

Term Securities Lending Facility: closed as of Feb. 1, 2010.

Temporary Liquidity Swap Arrangements with Foreign Central Banks: closed as of Feb. 1, 2010.

Term Auction Facility: last auction to be conducted on March 8, 2010.

Term Asset-Backed Securities Loan Facility: to expire on March 31, 2010 for most types of acceptable collateral and on June 30, 2010 for new issues.

Agency Mortgage-Backed Securities Purchase Program: to stop purchasing on March 31, 2010.

As you can see, the Fed has been busy, busy, busy winding down emergency measures that greatly added to the financial markets' liquidity during the last year and a half. Other than the mortgage-backed securities buying program listed last, these facilities weren't getting a lot of usage recently. Nevertheless, shutting them down means the financial markets apparently are normalizing, and that would imply interest rates are headed higher than the 0 to 0.25% that remains the Fed's target fed funds rate. The Fed was administering a lot of talk therapy on Friday to reassure the markets that it did not intend the discount rate increase to raise interest rates marketwide. Still, when you look at everything the Fed has done recently to reduce the flow of federal liquidity into the financial markets, it's hard to conclude anything except that interest rates are going up (because normally, interest rates are higher than 0 to 0.25%), and perhaps sooner and faster than many people thought.

Thursday, February 18, 2010

The Federal Reserve's Discount Rate Hike: Are Market Forces Returning?

After the stock market closed today, the Federal Reserve announced that it was raising the discount rate by 0.25%, from 0.5% to 0.75%. This increase has little direct impact on the banking system, since banks rarely borrow from the Fed's discount window. But it may be a momentous signal. Since the fall of 2008, the Fed has been in total crisis management mode, with nary an accommodation that was too extreme to provide to the financial markets. It virtually gave away credit to banks and other financial institutions in an effort to prevent panic. And, last year, even while the stock market zoomed upwards some 60%, the Fed still aimed to serve and please the banking system with every imaginable amenity. As recently as last month, it still anticipated maintaining "exceptionally low levels of the fed funds rate for an extended period."

But today's announcement was made in between Open Market Committee meetings, when rate decisions are normally made. The most recent meeting was Jan. 26-27, 2010, and the next one is March 16, 2010. Rate changes in between meetings are unusual, and can be interpreted to mean that we aren't in a business as usual mode. Although a Fed governor was quoted by news services this evening as saying that the discount rate hike isn't meant to "signal any change in the outlook for monetary policy" and is just "further normalization of the Federal Reserve's lending facilities," the markets had the opposite take. The dollar jumped in afterhours trading, as did short term U.S. interest rates. Asian markets opened to the downside and overnight trading in U.S. stock index futures moved downward as well. The markets sense a shift in the wind.

The most likely reason for today's out of the ordinary rate hike was the Producer Price Index report this morning, which revealed that the PPI jumped 1.4% last month. On an annualized basis, that would be close to 17%. No one expects inflation this year to be anywhere near 17%, but any suggestion that inflation would be more than very low would put the Fed under pressure to raise rates. The Fed has pumped an extraordinary amount of liquidity into the financial system in the last year and a half, and, if inflation flares up, this heap of liquidity would be like dry tinder in a forest after a drought.

Stocks today ignored the PPI report, with the Dow Jones Industrial Average rising 83 points. That probably was because the Fed has seemed so nonchalant about inflation risk. But clearly something has happened in the minds of the Fed governors, something that was quite opaque until today's discount rate hike after the market closed. It may well be the higher risk of inflation that today's PPI report revealed. It might also involve China. The Chinese central bank has been raising the interest rate it pays on bank reserves, a measure designed to reduce liquidity in the banking system and cooling off the bubbly real estate and credit markets, and rising inflation, in China. Because China continues to informally link the yuan to the dollar, excessive liquidity pumped out by the Fed could spill over into China and counteract what the Chinese central bank wants to accomplish. America needs Chinese as a source of credit for its massive federal deficits, and the Fed probably wants to stay on good terms with its Chinese counterparts.

The Consumer Price Index for January 2010 will be announced tomorrow (Friday, Feb. 19, 2010) morning, before the stock market opens. You can bet that traders will be much more focused than yesterday on the announcement. And there are probably good odds that the CPI will be uglier than people anticipated yesterday. The high PPI was driven by an unusually large jump in gasoline prices (5.1%) and an 0.4% increase in food prices. Gasoline and food would have significant impact on the CPI. Light truck prices as included in the PPI rose 1.9%, and would also impact the CPI, as light trucks continue to be half or more of the automotive market.

If the CPI number is bad, you can expect short term interest rates to edge higher. Although a sizeable increase isn't likely until the Fed allows the fed funds rate to rise, the markets can no longer assume the cheapest of all imaginable government-subsidized credit. As interest rates rise, the costs of speculation rise, since interest charges and repayment obligations are a certainty. But profits aren't. It begins to make less sense to dive into high risk derivatives and commodities bets, even if they offer potentially high returns. Market forces forced into the wood work by the Fed's zero percent interest rate policies may now emerge. Money managers and speculators might have to re-evaluate and perhaps retrench. Stock prices could go wobbly.

But the potentially good news is that money no longer deployed in financial speculation could wend its way into the real economy. Businesses starting to see upturns in order flow may find banks a little more willing to lend to them. Most small businesses can't compete for credit with Wall Street speculators betting on asset prices bubbling up in a zero percent interest rate environment. But add an element of risk to speculation, and lenders may begin to see the attraction of lending to businesses with orders in hand.

Tuesday, February 16, 2010

Greece and Dubai: Are the Lights Dimming at the Creditors Ball?

Holders of sovereign debt are not having a very good week. Last weekend, beleaguered conglomerate Dubai World reportedly was thinking of asking creditors to accept a settlement of 60% of the face amount of their debt, or taking a debt for equity exchange. The Dubai stock market dropped away when this story ran, even though Dubai World denied making such a proposal and Dubai debt holders rejected the proposal that Dubai World denied making.

At the same time, the Greek government and EU authorities swapped proposals. The EU wanted the Greeks to put together a detailed program of fiscal reform and the Greeks wanted the EU to announce a detailed bailout package. Aside from issuing dueling press releases, both sides largely eschewed progress.

Neither the Dubai debt kabuki theater nor the EU-Greece Alphonse and Gaston routine disturbed stock markets. From Asia to Europe to North America, stocks rose today, with the Dow Jones Industrial Average increasing almost 170 points on an unexpectedly positive manufacturing report and a drop in the dollar, along with some favorable earnings reports. The stock markets' bounce is bad news for sovereign debt holders.

When a debt crisis clobbers the stock market, governments have to step in. Recall how the mortgage crisis made nervous Nellies of stockholders in 2007 and 2008, forcing the federal government to take over Fannie Mae and Freddie Mac. Then, when the collapse of Lehman Brothers imperiled AIG and Merrill Lynch, the government bailed out AIG, paying its creditors 100 cents on the dollar, and persuaded (that's one way of putting it) Bank of America to purchase Merrill. When Congress initially rejected the TARP legislation in the fall of 2008, the stock market tanked, voters' 401(k) accounts nosedived, and outraged constituents berated Congress back to a second vote that heartily endorsed TARP.

But when the stock market holds up, governments have more latitude to step back and just say no to creditors. That throws the battle for repayment back into the more traditional arena of contention between debtor and creditor, with taxpayers on the sideline.

Since the 2008 government subsidized sale of Bear Stearns to J.P. Morgan Chase, this has been the best of all possible worlds for creditors. Whenever they could conjure up even a faint specter of systemic risk, stock markets panicked and governments paid them out, often at 100 cents on the dollar, no matter how reckless their loans had been. The more stocks dropped, the more leverage lenders had to put the squeeze on taxpayers. But when stocks hold steady or rise, the creditors' cries of wolf sound less compelling. If the stock markets correctly assess that these crises aren't systemic threats, the music will stop playing at creditors ball. As shocking as it may sound, bond holders may have to bear risk and losses.

To be sure, short term price movements in the stock market are often misguided, and the picture may be quite different by the end of this week or the beginning of next week. The European debt crisis doesn't appear to be in a hurry to let up; news stories of a time bomb outside J.P. Morgan Chase's Athens, Greece office indicate that someone's trying to instigate something. The Dubai situation hasn't materially improved since it first blew up last fall, which means that it's deteriorating. Debts fall due as time passes, and the more time that passes in Dubai with no progress, the closer we get to defaults. So taxpayers shouldn't breath easy yet. Lenders may yet find a way to pick their pockets.

Sunday, February 14, 2010

The Greek Debt Coverup: Headed for Cable TV?

If you like The Sopranos, you'll like the Greek debt crisis. As events unfold and people win or lose, the veneer of civility in the financial markets, diaphanous in the best of times, may be wearing through completely. People who play in the financial sandbox can be very poor losers. Perhaps we are seeing that in the latest episode of the Greek debt drama.

The New York Times reports that, in 2000 and 2001, the government of Greece entered into derivatives deals with Goldman Sachs which allowed it to downplay its true debt levels. Details are scant. The transactions are described as swaps, although they appear to take the form of sales of revenue streams like the proceeds of the Greek national lottery and the landing fees collected by Greece's airports. Evidently, the transactions were structured to let the Greek government avoid characterizing them as debt. That seems to have helped the government present a sufficiently conservative fiscal picture to meet the requirements for EU membership.

If an American public company did something like this, it might well find itself receiving SEC subpoenas. If it acted deliberately with an intent to mislead investors, its executives might have the unsettling experience of testifying before a federal grand jury (which means answering questions without having your lawyer present).

State and local governments in America aren't immune from federal regulation. When Orange County, California did some dumb derivatives deals in the 1990s, it and a couple of its officials were sanctioned by the SEC for failing to disclose serious risks of loss that later materialized. See When the Massachusetts Turnpike Authority, in constructing the infamous Big Dig in Boston, failed to disclose nasty cost overruns, it and its one-time chairman were also sanctioned by the SEC. So the principle of full and fair disclosure by governments isn't unfamiliar to the U.S. financial markets. But, in 2001, when Greece joined the EU, it evidently wasn't required to reveal how it had gussied up its financial statements.

The Times story indicates that the Greek derivatives deals were in 2002 revealed to be loans, after accounting standards changed. And, to the Greek government's credit, it reportedly turned down a financing transaction proposed by Goldman in late 2009 that would have allowed it to defer recognition of public health care expenses. (We can't help wondering what that involved--the sale of the Parthenon?)

It's interesting that this story appears now, right after the EU announced, albeit vaguely, that it would somehow not let the Greek debt situation deteriorate into financial panic. It's unclear how the Times picked up on these derivatives deals. But they must have had a source or two or three, because newspapers don't know about this sort of stuff on their own. And the source(s) must have talked to the Times recently. Otherwise, why wouldn't the Times have run the story, say, three months ago when the Dubai debt mess brought sovereign debt problems prominently into focus?

Who might the source(s) be? Logic and experience indicate market player(s) who might have taken a hit when Greek debt recovered after the EU announcement, perhaps holder(s) of credit default swaps. CDS's on Greek debt fell in value after the EU made its love-those-Greeks announcement. You don't have to have any substantive exposure to a relevant debt to buy a credit default swap. A CDS can be used to make a pure side bet, like putting money down in Las Vegas on the outcome of the Super Bowl. A player making a pure bet would have taken losses without any counterbalancing gain from underlying debt when the EU embraced Greece (okay, not quite). As we noted earlier, players in the financial markets sandbox can be very pouty losers. Maybe a speculator or two contacted the Times and clued them in, hoping that public revelation of these machinations might call into question the accuracy even now of the Greek government's accounting, and reverse recent price trends in credit default swaps.

Heightening suspicions is the fact that the Times also just ran a story about a Greek government statistician who found himself living in a world of controversy when he was allegedly associated with inaccuracies that understated the Greek government's budget deficit by more than two-thirds. See This individual, no longer employed by the Greek government and now living in New York to "escape from Greece," insists that he isn't at fault. Regardless of who understated the Greek budget deficit, why would an obscure Greek statistician suddenly be of interest to one of the most widely-read newspapers in the world? What are the chances that two stories about the inaccuracies of Greece's national accounting would randomly run in The New York Times the weekend after the EU reluctantly rides to the semi-rescue and some people lose money betting against Greek debt?

The probity of Greece's national accounting is a legitimate subject for the press, and it's quite common for newspapers to run related stories on the same day. There's no reason to think the Times did anything improper by running these stories when it did. But the Times surely didn't know about Greece's national accounting problems all on its own. Financial market players have always tried to spark the dissemination of information favoring their investments. In addition, financial crises produce volatile prices, which give banks, hedge funds and other big bonus boys the opportunity to make outsized profits. With millions and maybe billions on the line, these folks play for keeps (as in, they want to make and keep profits). They might hope that the relative equanimity produced by last week's announcement of EU support for Greece will be disturbed by these recent stories about dodgy Greek national accounting. Perhaps some holders will start selling their suddenly not so gorgeous bonds. Other players, perhaps more speculative, might step in and buy. Credit default swaps could again become fashionable.

The nastiness index appears to be rising. The Greek and other Euro bloc sovereign debt problems remain far from resolution. Stay tuned. So far, no one has been wrapped in chains and tossed off a boat. But the plot thickens.

Saturday, February 13, 2010

The Puzzling Prosecution of Sergey Aleynikov

On Thursday, February 11, 2010, the U.S. Attorney's Office in Manhattan announced the indictment of Sergey Aleynikov, a former employee of Goldman Sachs & Co., for allegedly stealing Goldman computer code used in high speed stock market trading. Aleynikov was accused of making an unauthorized transfer of proprietary trading software on the last day of his employment at Goldman, apparently with the idea that it could help him develop a high speed stock trading platform at another firm where he was shortly to begin working.

We don't want to prejudge Aleynikov. A judicial process is motion whereby his guilt or innocence will be established. Let's assume, hypothetically and for the purposes of discussion, that he engaged in the conduct alleged and that this conduct was criminal.

We have the United States government pursuing a former Goldman employee for supposedly stealing computer software in order to advance his career at a Goldman competitor. Goldman is one of the most profitable and powerful banks in the world. Its multiple billions of dollars of profits would allow it to pursue Aleynikov around the globe, sue him in any court of any nation, and seek to prohibit him from using the stolen computer code. To the extent that he or any firm that employed him improperly used Goldman's code, he and that employer could be held liable for damages and other monetary relief. If their conduct was particularly reprehensible, a federal court in the United States might order them to pay punitive damages to Goldman.

What is the public interest in the federal government trying to vindicate the intellectual property rights of a very large bank that is fully capable of hiring legions of lawyers to protect itself? With massive amounts of investment losses to public investors from the mortgage and credit crises of 2007-08, and the various collateral morasses, there is plenty of grist for the prosecutorial mill. Prosecuting white collar crimes takes a lot of resources, and the U.S. Attorney's Office in Manhattan isn't overflowing with personnel. The taxpayers have already spent trillions of dollars on bailouts and stimulus programs to deal with Wall Street's mistakes. It takes a great deal of highly refined reasoning to conclude that amidst the worst economic crisis since 1930s, taxpayer dollars are appropriately spent on protecting Goldman Sachs from one of its departing employees.

Federal prosecutors do not pursue every potential crime that comes to their attention. A former governor of New York who allegedly paid a call girl to transport herself across state lines in order to meet him for a liaison arguably had a federal criminal problem. But he evidently will not be prosecuted--and, frankly, we would not contend that he should be.

If Aleynikov is convicted and punished after legal proceedings conducted in accordance with law, it would be difficult to muster sympathy for him. He appears to be a highly intelligent individual who either did or should have understood the significance of his conduct, whatever it turns out to have been. Sympathy should go to the American taxpayer, who now must pay for a government prosecution that will do little or nothing to protect beleaguered individual investors, punish those persons responsible for the 2007-08 financial crisis, help the unemployed, or assist those without health insurance. Granted, the cost to the government of this prosecution will probably run in the hundreds of thousands of dollars, or a few million at the most. But consider the impact if the same dollars were spent prosecuting and convicting someone who knowingly foisted crappy mortgages onto investors in mortgage-backed investments? Cleaning up the mortgage-backed securities and derivatives markets could have billions of dollars of impact, much or most of which would flow to investors. That would be in the public interest.

Wednesday, February 10, 2010

The Nine Lives of the Dollar

With feline quickness, the dollar has again pulled out of its latest nosedive. Greeks came bearing gifts, in the form of a Euro bloc debt crisis, and investors worldwide suddenly found the greenback in their hearts. Two and a half months ago, the dollar was trading at more than $1.51 per Euro. Today, it closed below $1.38 per Euro. That's close to a 10% gain (approaching 50% on an annualized basis). We're not suggesting that you jump into the currency markets. But if you're an American, your passbook savings account just enjoyed a pop in Euro terms.

Late last year, many predicted the imminent transfer of the dollar to hospice care. These days, the dollar is dancing up a storm in swanky nightspots with an endless stream of partners. There's nothing like a good old fashioned financial crisis to put the pep back in the greenback's step.

The Chairman and governors of the Federal Reserve Board are probably sleeping better, as a strong dollar portends lower inflationary risk and widens their latitude to continue monetary accommodation. The administration is likely breathing more easily, since a strong dollar attracts capital to the mountains of Treasury securities that will have to be sold soon to finance the burgeoning federal deficit. Exporters are not pleased. But reality is that the government sector of the economy is more important these days than the private sector. Although that's a very big long term problem, no more than three or four people in America are focused on the long term, while the unemployed and everyone else are wondering about today, tomorrow and next week.

Wall Street is pleased, if only because the recent volatility of currencies and the stock market, and divergence in the bond markets (corporate debt is down, Treasuries are up), provide profit opportunities. Big money is made by the big banks when asset prices soar and swoop, and churn the stomachs of investors. Volatility creates trading opportunities for returns above long term market averages. In order to cash in on these trading opportunities, the big banks have to convince you, dear reader, to be a short term investor who trades in and out. That gives them commission income and market making profits. Fastidious, disciplined long term investors who know that .300 hitters hit a lot of singles and not so many home runs, and therefore don't trade a lot, are not ideal customers for the Street, even if they impudently become personally prosperous. (See

Legend tells us there are risks when Greeks come bearing gifts. A bailout for Greece is reportedly in the works. If so, the burden will fall mostly on Germany, the economic engine of the European Union. France will contribute a high five but not too much money. The Dutch will frown and dourly push a few Euros into the pot. The Germans will probably insist on stiff terms for Greek fiscal reform, and pretend not to hear sardonic asides about jack boots, Panzers, and aspirations for continental domination. The Euro bloc bailout will probably feel ragged, begrudged and fraught with political risk (such as rejection by the Greek government due to internal opposition). Other financially troubled nations in Europe may also look to Bonn for a bailout. The burdens of bailouts could slow down Europe's recovery, which might in turn hinder America's recovery. The dollar may yet again lose its shine.

Monday, February 8, 2010

Why Sovereign Debt Concerns Are Rattling the Stock Market

Today, the Dow Jones Industrial Average fell another 104 points. As with the down trend of the past two weeks, worries about sovereign debt problems were a major factor in today's drop. The market is down more than 7% from its 2010 peak. We'll be in correction country if the Dow drops another 250 points. Why would the profligacy of medium sized countries like Greece, Portugal, Spain and Ireland matter so much?

Because these days we're so highly dependent on government supported banking systems and economies. If governments fail, there is no backup, no Plan B. We'll have to reach for our bootstraps. But in a world now addicted to morally hazardous government handouts, bootstraps have deteriorated from neglect. Lots of folks no longer have personal safety nets. The abyss looks deep and dark.

Part of the problem is that profligacy isn't limited just to medium-sized and small countries (like Dubai). It's also become fashionable with major powers, like Japan, the U.K., and . . . ahem, we'll just look down in our laps and not name the other really big country that's borrowing an awful lot these days. If a really big sovereign debtor starts to waffle, look for a swan dive from the markets.

What can be done? In these days of governmental dysfunction, that's a damn good question. One that doesn't have a damn good answer. Politically speaking, it's ten times easier to increase government spending than decrease it, and a hundred times easier to cut taxes than raise them. The political cycle, with elections at relatively short intervals, punishes politicians for inflicting short term pain even if they provide long term gain. Long term problems like the growth of national debt are backburnered by expediencies required for re-election. The very real distress of tens of millions of Americans during the current recession justifies stimulus spending, even at the expense of increasing the federal deficit. But not indefinitely and certainly not with spending focused primarily on propping up a banking sector that is parsimonious with loans but not executive compensation. There are limits to everything--that's the most crucial lesson of the real estate and credit bubbles of the early 2000s. And there limits to deficit spending by America.

In the 19th Century, a Chinese name for America was "the Golden Mountain" (derived from the California Gold Rush, which attracted thousands of Chinese miners). Today, America is still golden, with the dollar being the world's reserve currency and America's military serving as the global police force. Most of the world wouldn't want another currency as its reserve, nor would it want another nation to protect international shipping lanes and suppress unrest. The U.S. Navy safeguards Europe's and East Asia's oil supplies, which come in large part from the Middle East. U.S. ground forces brought peace to the former Yugoslavia, after Western Europe failed. Mostly because of the strength of American arms, the Allies suppressed Saddam Hussein's aggression in the Persian Gulf. America has played the largest role in the past decade's struggle against terrorism.

The world needs America. But not at any price. We don't know where the tipping point--the point at which China, Japan and the rest of America's international creditors will turn off the spigot--will be. Recall that 100 years ago, the British Empire issued the world's reserve currency and safeguarded international shipping lanes. Today, the U.K., which may be splintering even on the island of Great Britain, is a quaint tourist destination that too greatly seeks the evanescent prosperity that sometimes comes from over-investment in the financial sector. We Americans know we need to get our house in order. We also sense, and even know, that we won't necessarily succeed. The stock market foreshadows the consequences of failure. And there is no Plan B.

Thursday, February 4, 2010

The Sovereign Debt Crisis: A Constitutional Moment for Europe?

After today's 268 point drop in the Dow Jones Industrial Average, it's clear that the sovereign debt crisis has investors rattled. What started late last year as a smallish, but high profile anticipatory default by Dubai last fall, quickly smoothed over with a partial bailout from Abu Dhabi, has morphed into a European problem. Greece seems to be in the worst shape among Euro bloc nations, with credit default swaps for its debt imitating a jack-in-a-box. Portugal, Ireland and Spain increasingly receive unflattering coverage in the financial press. The wealthier Euro bloc nations--Germany, France and the Netherlands--noticeably squirm when the news coverage turns to the question of bailouts. The European Union puts on the appearance of threatening to get a buzzcut and administer tough love. But it's hard to imagine that the EU would actually give Greece the boot. That would almost surely result in Greece defaulting on its sovereign debt, which would escalate the pressure on other weak European nations and turn the crisis into a panic. It would be like letting Lehman Brothers fail, only on an international level. We remember how the Lehman thing turned out.

So a European bailout, however distasteful to French, German and Dutch palates, is likely. The question is what conditions the bailors will impose. The problem is that the European Union prescribes fiscal conditions for membership (i.e., member nations are supposed to limit their governmental budget deficits to 3% of gross domestic product), but doesn't have much control over member nation finances. While the EU can kick out offending members, that's a nuclear remedy that can't feasibly be used in the real world because it would only make things worse. But handing over bailout Euros would reward the profligate nations at the expense of the prudent ones. (Does this sound familiar to American taxpayers?) The German, French and Dutch may refuse to simply write checks.

Europe is facing a dilemma not unlike the newly independent United States in the 1780s. The Revolution had been very expensive, and both the individual states and the Continental Congress incurred substantial debt to pay for the war. At the same time, their ties to each other were far weaker than today, while their differences led to no end of commercial disputes and debates about who should pay the Revolutionary War debt. The infant democracy was in danger of falling apart, and convened a constitutional convention to try to redraft the nation's legal framework. The result, so deeply flawed that it led to a bloody civil war 72 years later, was nevertheless workable enough that today we still limp along with it, in somewhat amended form, in spite of the legislative dysfunction it allows where Senators need to work only when 60 of them are so inclined. But one benefit of the Constitution adopted in 1789 was that the newly reconstituted United States government assumed responsibility for all Revolutionary War debt, whether incurred by the states or the earlier government under the Articles of Confederation. Thus, the price of a national bailout of the states was a far stronger federal government.

Just as the original thirteen American states couldn't afford to splinter apart, with covetous, imperialistic European nations waiting to snatch them up, the European Union cannot afford to splinter apart. This is not so much about the economic benefits of unification--lowering trade barriers and other costs of doing business and thereby spurring production and growth--as it is about the renewed financial crisis a failure of the European Union would create. But to hold the EU together and legitimize the bailout(s) for the electorates in the wealthier member nations, greater authority would probably have to be given to the central government in Brussels, especially over fiscal matters. Getting there would be difficult, just as the drafting and ratification of the U.S. Constitution was difficult. But survival may well depend its success, and necessity is the mother of invention.

If the EU achieves greater fiscal unity as a result of the sovereign debt crisis, its populace can take comfort from the world's recent rediscovery that prudence is a better long term strategy than profligacy. And other big spenders--such as Japan, the U.K., and, of course, the United States--should take notice that lunches aren't free, not even for sovereign nations, even if it takes a while to get the bill.

Wednesday, February 3, 2010

Will Wall Street Get a Pass on Derivatives Reform?

Both Republicans and Democrats, in the rush to seize the momentum of today's neo-Populism, are buying up the entire denim overalls market and learning to chew straw. But they seem to have lost focus on the derivatives market, the place where the 2007-08 financial crisis began. Had it not been for the big Wall Street firms who created and underwrote vast quantities of mortgage-related derivatives, like CDOs, synthetic CDOs, CDOs squared, and other diverse and sundry bets and side bets on the values of all variety of assets, and their amen choir of money managers and investment advisers who drank avidly of some special lower Manhattan kool-aid before chanting that real estate values would never fall, we wouldn't be where we are today. The Great Recession was caused, first and foremost, by excess on Wall Street in the derivatives market. Profligate borrowing and overspending by consumers, and poor management by the U.S. auto companies and other corporations, were secondary problems that came into play only after the financial system froze up and required a multi-trillion dollar bailout from . . . well, you and me.

The most pressing problem in the derivatives markets is the lack of information. Investors don't know and can't easily learn what they've gotten themselves into. We can say that a thousand times, but let's recall the metaphor that a picture is worth a thousand words. There are very few pictures of the derivatives market, and they would only show a bunch of people in front of computer screens shouting into telephones. Tape recordings, however, fit the metaphor nicely. In financial dealings, what people say is much more important than how they look. As luck would have it, a few tapes of the goings on in the derivatives market have surfaced.

In December 1994, the SEC sued the securities broker-dealer subsidiary of a large bank called Bankers Trust. (In the Matter of BT Securities Corporation, SEC Rel. Nos. 33-7124, 34-35136 (Dec. 22, 1994)). As it happened, BT Securities taped recorded its derivatives sales people, a common practice on Wall Street as a protective measure against customers who try to avoid responsibility for their transactions. Of course, what's sauce for the goose can be sauce for the gander and for regulators, and the SEC got plenty of sauce from the BT Securities' tapes. As presented in the SEC's allegations (which BT Securities neither admitted nor denied), here are some of the tidbits found on the tapes.

BT Securities sold a company called Gibson Greetings (a greetings card company) customized derivatives called interest rate swaps that were meant to reduce Gibson Greetings' borrowing costs. These derivatives didn't trade in a market. Thus, there was no publicly quoted price for Gibson Greetings to compare BT's prices against. BT used computer modeling to determine the value of these derivatives. Gibson Greetings, which had to account for the derivatives on its financial statements, depended on information from BT to establish their values. Some of the derivatives were leveraged, with the result that small interest rate movements could produce large changes in value.

Gibson Greetings didn't fully understand the derivatives it bought--and BT knew it. A managing director at BT was taped saying, "from the very beginning, [Gibson] just, you know, really put themselves in our hands like 96% . . . And we have known that from day one." This managing director also said, "these guys [Gibson] have done some pretty wild stuff. And you know, they probably do not understand it quite as well as they should. I think that they have a pretty good understanding of it, but not perfect. And that's like perfect for us." Thus, Gibson Greetings was at an informational disadvantage, and BT understood that was good for BT.

Many of Gibson Greetings' derivatives positions were losers. Gibson Greetings looked to BT for information about how much it was losing. BT apparently wasn't eager to give its customer bad news and understated the losses by millions of dollars. This lack of candor created a "differential" between Gibson Greetings' actual losses and the rosier picture it received from BT. The informational "differential" only exacerbated the problem. If BT had to unwind the positions, Gibson Greetings would be in for an unpleasant surprise. As a BT managing director put it," . . . the problem is that we are too far away between what he [a Gibson Greetings executive] thinks it is and what reality is . . . You know, we gotta try to close that gap." The managing director suggested more lies to offset the effect of the earlier lies: " . . . when there's a big move, you know, if the market backs up like this, and he is down another 1.3 million, we can tell him he is down another 2. And vice versa. If the market really rallies like crazy, and he's made back a couple of million dollars, you can say you have only made back a half a million."

A number of the derivatives BT sold to Gibson Greetings were supposed to reduce or offset negative effects of earlier derivatives Gibson Greetings had bought from BT. But, according to the SEC, BT did not disclose to Gibson Greetings that the terms of the new derivatives sometimes included unrealized losses or fees, totaling millions in the aggregate, that would make the transactions less beneficial to BT.

The SEC wasn't alone in getting BT tapes. In litigation brought by another BT client, consumer products giant Proctor & Gamble, more taped recorded statements were made public. In one conversation, two BT employees discussing a derivatives transaction with P&G allegedly said, "They [P&G] would never know. They would never be able to know how much money was taken out of that [in reference to large expected BT profits from the transaction]." The other employee allegedly replied, "Never, no way, no way. That's the beauty of Bankers Trust." See Another BT employee allegedly said about derivatives, "Funny business, you know? Lure people into that calm and then just totally f___ 'em."

The picture drawn by these tapes is that even large, successful business corporations have a hard time understanding complex financial instruments created by Wall Street and sold in an opaque environment. It's ironic that Wall Street apparently has recruited a number of its corporate clients to lobby against reform of the derivatives markets. If it's accurate that they don't fully understand what these financial products involve, there's a possibility they've been maneuvered by the potential predators into lobbying against regulatory reforms that could reduce the ability of the predators to victimize them. But if you don't know what you don't know, you might do yourself unknowing harm, especially if you lobby against rules to make you more knowledgeable.

There are no great or complex secrets about the basic problems in the derivatives markets. Information from these tapes showing the derivatives markets as it really operates, warts and all, has been publicly available for 15 or more years. We can see that the derivatives dealers are able to take advantage of even large, successful businesses because of the opacity of the market. Investors can't protect themselves because they don't have the necessary information; and in some cases may not even realize that they don't have the necessary information. A century after Louis Brandeis' famous observation, sunshine remains a superb disinfectant. Here are some of our suggestions for improvement, made over two years ago but still pertinent: