Wednesday, December 28, 2011

European Central Bank Bets the Ranch

The European Central Bank has evidently been taking EU sovereign debt as collateral, even as it expands its balance sheet to a record size in order to finance the EU's banking system. Taking sovereign debt as collateral bets the solvency of the ECB on the solvency of the EU. In the event of a sovereign default, the banks borrowing from the ECB may well not be able to repay their debts to the central bank. The ECB might theoretically try to sell its collateral to recover its losses. But the very act of selling the sovereign debt would likely push down its value, impair European banks all the more, and further weaken the ECB. The ECB, for practical purposes, may be making uncollateralized loans when it takes EU sovereign debt as "collateral."

The ECB surely realizes this. But it may have little choice, since Europe's banks probably have limited amounts of other assets they could tender to the ECB as collateral. Without the ECB's loans, the European financial system would probably have to pull back on lending, forcing an economic contraction at a time when Europe desperately needs growth to escape the claws of the sovereign debt crisis. So the ECB probably has little choice but to bet the ranch. Its hopes of repayment rest primarily on whether or not Europe grows. Europe's prospects for growth depend heavily on whether or not its governments can institute effective fiscal policies. Given the EU's political dysfunction, one cannot help but wonder whether the ECB will lose the ranch.

Sunday, December 11, 2011

The Sovereign Debt Crisis: Europeans To Live In Glass Houses

The latest EU proposal for resolving the sovereign debt crisis promises "automatic" consequences if member nations' annual budget deficits exceed 3% of their GDP. The European Commission, the executive arm of the European Union, can also impose additional requirements. All this is supposed to keep EU members on the straight and narrow, never spending excessively, texting while driving, or using any cuss words.

But there's a catch. EU members holding 74% or more of the union's voting power (votes are allocated among EU members by size, similar to the U.S. House of Representatives) can vote to lift the sanctions. Virtually all of EU members fail to comply with its requirement to keep total national sovereign debt at not more than 60% of GDP. Many have trouble meeting the 3% budget deficit requirement. In other words, the members of the EU are not without sin. If a fellow member nation needed dispensation from the "automatic" consequences and the EC's sanctions for going over the 3% limit, would the other EU nations be the first to cast a stone? When you live in a glass house, you will do unto others as you would have them do unto you. The 74% catch (we can call it "Catch-74") renders the "automatic" consequences semi-automatic and creates a go along, get along dynamic that is antithetical to the notion of fiscal discipline.

Only Britain dissented from the latest proposal, steering its own course in turbulent seas, Union Jack snapping briskly in the wind. It's unclear that Britain's tack makes economic sense. But if the EU fails to definitively resolve the crisis, there may be many on continental Europe who will think themselves accursed not to be among the happy few who chose to keep their monetary policy independent.

Tuesday, December 6, 2011

Will EU Members Learn to Share?

The latest leaks from high ranking EU officials concerning the sovereign debt crisis hint at the possibility of not one, but two bailout funds. Details are scarce; but maybe that's the idea. They can keep the palaver going as long as you don't ask what army of investors is supposed to step out front and center to fund this financial engineering. That's the key to making the bailout work--or not. Someone has to plop a lot of cold, hard cash money on the barrel head in order to truly end the crisis. S&P, however, is threatening to downgrade most of Europe. Whence will investors find the courage to buy the EU's financial engineering when they see the price of sovereign debt credit default swaps escalating?

This is something the leaders of Germany and other wealthy EU nations spend little time publicly admitting. Instead, they focus on how to impose discipline, austerity and clean living on the profligate. Greece, Ireland, Portugal, Italy, Spain and perhaps other nations would have to earn every Euro they spend, and would pay penalties for deficits, failing to wash behind their ears, and using cuss words. Somehow, enough righteousness is supposed to transport the EU to the utter bliss of true currency union.

But the EU is missing an important point. The world's most successful currency union, the United States, exists perennially in a state of financial imbalance. For over a century, the wealthy states on the East Coast, more recently with the wealthy states on the West Coast, have subsidized less wealthy states in between. These imbalances have existed in the form of federal subsidies to farmers, ranchers, the mining industry, the railroads, and more. The Interstate Highway System was another big subsidy, benefiting large, thinly populated rural states more per capita than it benefited densely populated states. But none of the United States tries to hold others of the United States to fiscal rectitude. Imbalance is implicit in the structure of the Constitution, apportioning as it does two Senators to each state no matter how large or small. And imbalance runs the other way. On a per capita basis, the less wealthy states probably provide more people to serve in the military than the wealthier states, resulting in steeper non-financial costs on the former when America goes to war. Americans tolerate imbalance because national unity is more important to them than any rigorous reconciliation of ledgers.

To make the EU really work, Europeans need more than just their economic welfare. Financial self-interest isn't the superglue required for political union. Neither is sheer power. Rome's legions, Napoleon's armies, and the Third Reich's panzers all failed to hold Europe together. Angela Merkel, Nicholas Sarkozy and other proponents of the EU have shrewdly played their cards to keep the crisis from tipping over into financial panic. But the EU needs greatness in its leadership, calls to electorates to seek a new destiny. That's missing, and given the historical divisions among Europeans, a most tribal collection of peoples, it's not surprising that issuers of EU sovereign debt credit default swaps are selling their contracts dearly.

Monday, December 5, 2011

Retire By Making Your Dollars Last

Managing your money in retirement is often depicted as a problem of how to allocate your portfolio, how quickly to draw down your net worth, when to begin taking Social Security and whether or not to buy long term care insurance. But managing one's financial assets is only part of the picture. Consider how you spend--the less your cash outflow, the easier it is to afford retirement. And you don't necessarily need to become a connoisseur of cat food or learn the dozens of ways to prepare rice and beans.

Pay off the mortgage. One of the most surefire ways to reduce month expenses is to pay off the mortgage. Since your retirement income will probably be less than your income while working, offloading the mortgage will improve the quality of your sleep.

Take the auto mechanic off your speed dial. Buy cars that are reliable and known for longevity. With the increased computerization of cars, the cost of repairs is skyrocketing. You don't have to buy a tinny econobox. If you can afford a luxury car, choose an Acura or Lexus, not some other brands that enrich repair shops.

When it comes to appliances, spare your back. High quality in home appliances isn't, to borrow a stock market phrase, closely correlated with price. The most reliable and long lasting washing machines and dryers tend to be the traditional, modestly priced top loaders. Currently fashionable side loaders have their attributes, but at the cost of higher purchase prices and less longevity. Plus you have to bend over or kneel down to get access to them. Your back and knees may have an opinion as to whether or not that's a good idea. Cheaper, more reliable, longer lasting, and easier on the back and knees is a pretty good bargain.

Use generics whenever possible. Generic drugs can be much cheaper than name brands. Why pay for a fancy name when the medication is the same at a lower price?

Avoid credit card debt. The most expensive loans most Americans take are credit card balances carried over from month to month. If you use credit cards, only charge what you can pay off at the end of the month. That way, you earn rewards, cashback bonuses, etc., without paying any interest. Why enrich banks in your golden years?

Thursday, December 1, 2011

The Federal Reserve and Its Petard

Even casual readers of today's financial news know interbank lending is drying up on an international scale, and that the world financial system is getting the shakes. That's why the Fed and other major central banks announced yesterday a currency swap program to ensure dollar liquidity in Europe and elsewhere. But even as the Fed mounts up and tries to lead the charge, we should remember that it is tripping over its own ultra low interest rate policy.

The Fed's principal monetary weapon is to control the fed funds rate. That's the rate banks charge each other for overnight loans. The Fed has targeted a rate of 0 % to 0.25%, and has promised to hold it there until Antarctica is covered by tropical rain forest. A bank with excess funds can't hardly make a plugged nickel when its lending rate is virtually indistinguishable from zero. And when you consider that many of the larger European banks that are now desperate for dollar funding are, by virtue of the EU sovereign debt crisis, not glowingly golden credit risks, it's no surprise that American and other banks with excess dollars are stuffing entire bulbs of garlic into their mouths any time an EU bank asks for a loan. In other words, the Fed's own zero interest rate policy is hampering interbank lending that could alleviate the very credit crunch it's now desperate to combat.

I leave it to you, dear reader, to decide what to say about the Fed and its petard.

Wednesday, November 30, 2011

Does the Federal Reserve Have a Secret Bailout Plan For Europe?

Today's announcement of a coordinated monetary easing program led by the U.S. Federal Reserve, providing currency swap lines to the central banks of other major nations, was the news the stock market wanted to here: a walloping big dose of moral hazard that infused dollar-denominated liquidity into an increasingly stressed European banking system. The Dow Jones Industrial Average blasted upward 490 points, the largest move in two and a half years. Markets always love it when a governmental body reduces their risks. Recall, however, that there is no such thing as the elimination of financial risk. It can only be transferred. If risk is transferred away from market participants by a government program, you know who just got the short end of the stick. (Hint: look in the mirror.)

The Fed's move came when the EU was wobbling precariously at the edge of the precipice. The recent spasms and convulsions of EU member governments has accomplished nothing except prove that the EU's governance process couldn't hold together a neighborhood book club. The absence of action by elected officials has led many to urge that the European Central Bank monetize the EU's sovereign debt by buying it up. But the ECB, hewing to its charter purpose of maintaining price stability, has only dipped a toe or two in the shark infested waters of the EU sovereign debt markets. Even as it buys a distressed nation's debt, it sells debt of stronger nations in order to keep the supply of Euros stable. This, however, doesn't monetize debt.

The Fed, by contrast, has promised with its currency swap program, to print dollars early, often and in bulk. The swap lines are priced to provide Black Friday discounts, except for the next 14 months. The Fed provides to other central banks dollars in exchange for Euros (or Canadian, British, Japanese or Swiss currency), with the other central bank obligated to return the dollars at the same exchange rate as existed when the swap was entered into. Thus, the Fed nominally has no risk.

Consider, however, what might happen when the Fed is dealing with the ECB. The latter won't print money; and consequently has available only so many Euros to swap with the Fed. If the ECB needs more dollars than it has Euros to offer in swap, it's out of luck under the currency swap program. But the Bernanke Fed is clearly hellbent on delivering liquidity, and the delivery process used would only be a technicality. If one process isn't enough, they'd use another. This is the approach the Fed took in the 2008-09 financial crisis, when it expanded the scope of its quantitative easing to buy mortgage-backed securities, commercial paper, business loans, car loans, and other consumer loans. Had the crisis worsened, the Fed probably would have bought the kitchen sink and Uncle Arnie's old lawnmower.

The Fed has its thumb in the European dike. Its currency swap program has bought a little time for Europe's politicians to get their act together. But let's be real. Even though the politicians fervently claim that they will now give the crisis their full attention, experience teaches that they will fail. The EU has a herd of cats dynamics, and true European fiscal discipline and reform is less likely than Bernie Madoff being paroled.

What if the ECB needs more dollars than the currency swap program could provide? This may be a possibility. European banks may experience yet more difficulty getting dollars to fund their dollar-denominated loans as the EU crisis metastasizes. To prevent a credit crunch, the Fed may decide that it would buy EU sovereign debt. The Fed has wide latitude to decide how to implement monetary policy. While buying sovereign debt denominated in a foreign currency would be a first, one suspects that the Fed would, as it has in the past, liberally interpret its mandate in order to do what it considers necessary.

Buying EU sovereign debt would set the Fed on the slippery slope. If there were losses, where would the losses land? (Hint: look in the mirror.) And what if the Fed's money printing were inflationary? Where would the burden of inflation land? (Hint: don't shift your gaze.)

Of course, high ranking government officials in the U.S. and Europe would decry such a scenario as preposterous. But consider that Europe is deadlocked in a death spiral. The politicians can't function and the ECB firmly believes it is legally precluded from monetizing the EU's sovereign debt. The one governmental body in the world that has the resources and willingness to step in is the Fed. Today's action takes the heat off Europe's politicians, if only momentarily. They will probably take it as an excuse to stall and delay instead of impose harsh conditions on all of their electorates (which would be austerity for the spendthrift nations and payment of the bailout costs by the wealthier nations). They'd probably figure they could get away with inaction because the Fed would surely step in with more moral hazard.

If the Fed monetized EU sovereign debt using dollars, that would likely signal the demise of the Euro, with the dollar substituting as Europe's common currency while European nations again issued local currencies. This was the way Europe worked in the 1940s, 50s and 60s. In such scenario now, the Euro bloc might be able to disentangle itself from the crisis, albeit painfully, without triggering a worldwide credit crunch. Maybe that's the Fed's secret plan.

The Fed's not above acting dramatically if quietly. We've recently discovered that it loaned over a trillion dollars to distressed banks during the 2008-09 financial crisis, far more than it had previously acknowledged. Ben Bernanke demonstrated that he would act when it looked like no one else could or would. The eyes of the world may again turn to him, and we shouldn't expect inaction.

Sunday, November 27, 2011

Hidden Bargains

If you want a Black Friday bargain, you have to be ready to be pepper sprayed, horse collar tackled, and perhaps trampled a few times. There are easier ways to get bargains.

Business Laptops. If you're in the market for a laptop, look at less expensive business models. Unlike laptops specifically aimed at consumers, business laptops are designed for heavy duty use, careless handling (it's the company's property, after all), and enough longevity that sales reps can convince corporate buyers the equipment is cost effective. Many business laptops are shock and spill resistant. They are often preloaded with good quality software. This, all for a price in the $500 to $700 range. Business laptops don't come in pastel colors, and are heavier than personal laptops (the additional ruggedness adds weight). But a well-made one delivers good value for the dollar.

Prepaid Cell Phone Plans. Prepaid plans give you direct feedback about your usage, by forcing you to buy more time when you're running low. These periodic demands for money teach you how much your yacking actually costs. You learn to reduce this negative feedback by controlling phone usage. You save by not paying for time you don't use.

Balanced Investing. A portfolio that's about 50% stocks and 50% bonds offers comparative stability in returns (see Investors who enjoy stable returns are less tempted to trade, incur lower transactions costs, and face less of the volatility that tempts one to buy high and sell low. By reducing these negative factors, balanced portfolios can deliver good long term returns.

Renovated Homes. It's axiomatic among real estate professionals that home renovations, with rare exceptions, boost the value of a house less than 100 cents on the dollar cost of the renovations. This necessarily means a recently renovated home is a comparative bargain for the buyer who carefully researches prices and figures out where the actual market price is. A home that was renovated in the past year or two has a good chance of being a bargain. One that was renovated five or ten years ago may have appreciated enough that buyers don't really get a discount from the renovations (depending on the market). A beat up, water damaged foreclosure sale may a good deal. But so may be a sparkling recently renovated home. Do your research.

Year Old New Cars. Cars on a dealer's lot that are brand new, but one model year old can be an excellent bargain. The dealer will seriously discount them (sometimes with a quiet subsidy from the manufacturer) in order to make room for current year models. Year old new cars can be a better bargain than year old used cars, because they have no mileage but sometimes sell for not much more than a used car with 10,000 miles. Buying what the seller doesn't want is a good way to get a bargain.

Wednesday, November 23, 2011

The EU Sovereign Debt Crisis: Skipping a Few Dominos

A hooded figure of Death appeared at the Euro's door today, scythe in hand, beckoning insistently. Germany held an auction of 6 billion Euros worth of 10-year bonds (called "bunds") and sold only 60% of it. The German central bank, the Bundesbank, bought the rest. But that's like your right hand buying from your left hand. The German auction was catastrophically bad. And, who knows, the Federal Reserve may have contributed to the shortfall, by subtly putting pressure on U.S. banks to trim their Euro-denominated exposure (see

By contrast, the U.S. Treasury Department today sold $29 billion of 7-year Treasury notes, receiving three times as much in bids as it was offering (or close to $100 billion in bids). Even though the U.S. may be approaching another credit rating downgrade, the greenback remains a sturdy oak in a forest of blighted trees.

That the German bund auction went so badly means the European sovereign debt crisis is fastfowarding more rapidly than anyone anticipated. Next to topple were supposed to be Italy, Spain, France, Belgium, and Austria. Then, the Netherlands, Finland and Luxembourg would be at risk. But Germany was seen as the last bastion of stability, the wealthy uncle who could save the family if disaster struck. Indeed, the latest concept being proposed for salvation, the Eurobond that was to be backed on the entire EU, would be feasible only if Germany's creditworthiness was beyond question. That's no longer true. If Germany can sell only 60% of a bund auction, how could the EU as a whole sell a Eurobond auction?

The sovereign debt crisis has skipped the intermediate dominos and smashed directly into Germany. The German government continues its opposition to Eurobonds. At this point, that may be irrelevant because the viability of the Eurobond has been called into question. One naturally asks what else might be on the table. That's the really scary part. There is no Plan B. Germany has always been the fallback, the backup, and the backup to the backup. After Germany there's no one, not the IMF, not America, not China, not Russia and not Brazil.

The EU sovereign debt crisis is now proceeding at warp speed. That doesn't mean collapse is imminent. Experience teaches that the financial markets hear what they want to hear and need only one or two rosy press releases from prominent government officials to stage a relief rally. Time and time again, that's the way the EU has kicked the can down the road and avoided the moment of truth. But the EU's principal tactic has been to substitute new debt for old debt, offering promises to replace the promises that this member nation or that couldn't keep. Actual transfers of wealth to reduce debt doesn't seem to be on the agenda. But this paper-for-paper game keeps expanding the amounts of debt outstanding, and investors will eventually tire of playing (as they did with the German bund auction today). When that happens, the Grim Reaper will be waiting to collect his due.

Tuesday, November 22, 2011

The EU Sovereign Debt Crisis: A Farewell to Globalization?

Today, the Federal Reserve announced a new round of stress tests for the six largest American banks to find out how well they would withstand a market discombobulation emanating from the EU sovereign debt crisis. Translated from regulatory speak to plain English, this is a strong hint to the big banks that they straightaway ditch as much of their EU exposure as they possibly can, devil take the hindmost. Those banks that don't move with alacrity will be required to boost capital levels, an exercise detested by bonus loving bank executives (which would be about all of them).

It is ironic that the Fed would try to quietly build a firewall around the U.S. banking system. It has preached internationalism throughout the past four years as the financial markets belly flopped, and maintains generous dollar-denominated lines of credit to foreign central banks. The latter measure helps the dollar fulfill its role as the world's reserve currency, ensuring that there are enough dollars for the wheels of commerce. But encouraging major U.S. banks to offload Euro-denominated obligations de-globalizes. In effect, the Fed is saying, "Lafayette, nous allons partir."

Euro-denominated investments will face downward price pressure if U.S. banks begin casting them away. The Fed surely knows this would be bad for the EU's banking system, which is desperately reaching for any lifeline in turbulent seas. One can't help but wonder whether the Fed has concluded that the EU may not be able to pull itself out of its nosedive.

Sunday, November 20, 2011

Why the Congressional Supercommittee Can't Reach a Budget Deal

Today, news services report that the Congressional supercommittee tasked with the responsibility for reaching a $1.2 trillion budget deficit reduction deal has a snowball's chance in a convection oven of success. That's really not surprising. Even though last summer's debt ceiling debacle taught every member of Congress that fooling around with the federal government's financial standing is reckless, the problem is that the American electorate doesn't want a deal. We have a Democratic President and Senate, and a Republican House. We want fiscal stimulus to combat with the nation's economic woes, but we also want fiscal conservatism to constrain long term debt growth. In other words, we want to have it both ways. That's not how to reach the compromises needed for a deficit deal. That's a formula for failure.

Look at California. The Golden State is the home of the no new taxes movement. In 1978, an amendment to the California Constitution severely limiting real estate taxes was approved by the state's voters in a referendum called Proposition 13. The antitax sentiment that propelled Proposition 13 to success set down deep roots in the state, and today California is a fiscal mess. Voters want good public services and schools. But they don't want to pay for them. To accommodate voters that want to have it both ways, California's state and local governments made fools of themselves with budgetary and borrowing shenanigans that accomplished little except kick the can down the road while schools and other public services deteriorated. Everyone--voters, politicians, public sector unions, and government employees--are to blame. There's no meaningful solution in sight. California has governmental gridlock that makes the federal government look somewhat functional even on bad days.

California, first in so many trends, will be America's fiscal future, unless we make up our minds to grow up. We have to pay for what we want, which could mean raising taxes. We also have to live within our means, which could mean cutting back on federal expenditures. We have to elect a government that can and will make decisions. But today, in Washington and across the nation, we are a house divided. That does not portend well for the future.

Of course, if there is no debt deal and the financial markets panic, all eyes will turn toward the Federal Reserve. This moment, if it occurs, will reveal the fallacy in the Federal Reserve's policy of endless accommodation. Because the Fed has been there when everything else failed, everyone now assumes that the Fed will always be there for us. Neither Congress nor the President have the incentive to actually do anything. Doing things in Washington necessarily means you will make enemies. And elected politicians always prefer to avoid making enemies. So it's better to do nothing and wait for the appointed officials and career civil servants at the Fed bail us out, because we know they will try. Of course, a few disheveled Cassandras foam at the mouth about moral hazard and the limitations of monetary policy. But ebullient pronouncements by inflation doves on the Federal Reserve Board allow the rest of the government to hear what it wants to hear and rationalize inaction. So Washington bubbles along, believing six impossible things before breakfast, and peering through the looking glass for the imminent arrival of prosperity that won't cost us anything.

Wednesday, November 16, 2011

The EU Sovereign Debt Crisis: There Are No Safe Havens

The EU sovereign debt crisis has metastasized in two weeks from being a problem with Greece, to being a problem with Italy, Spain and France. Bond yield spreads for the debt of these much larger countries are widening away from German bunds. The dollar is once again dearly loved in the capital markets in spite of the Federal Reserve's persecution of positive returns on dollar denominated loans. The EU's much touted expansion of its bailout fund to over one trillion Euros is d.o.a. With the large Romance language speaking nations on the cart approaching the guillotine, a trillion or two just doesn't amount to jack, especially since this proposal was simply another paper shuffling shell game to flim flam creditors into believing that swapping new EU debt for old debt was somehow in their interest. The EU's overall ability to repay has been deteriorating. Why would new debt be attractive?

With all the turmoil, one would think that gold would be skyrocketing in value. But it hasn't. Since reaching its peak of $1923 per ounce this past summer, gold dropped below $1600 and has recently meandered around in the $1700s. As we discussed in September (see, gold is intimately linked to financial assets, and derives its value from financial market interactions. It's no safe haven.

Nor is anything else. Countries that are viewed as having sound currencies, like Switzerland, have been intervening in the currency markets to keep their exchange ratios down. Otherwise, capital will flood in, drive up the value of their currencies, and wreck their export businesses.

Weirdly, the U.S. dollar has by default remained the world's safe haven. If nothing else, investors know that, in the worst case, the U.S. Treasury will conspire with the Fed to print however much money it takes to pay America's debts. The Congressional Supercommittee tasked with reducing the federal deficit is on the verge of belly flopping. But the financial markets remain sanguine, evidently believing that capital has nowhere else to go.

Sunday, November 13, 2011

Old-Timers and Their Rolls of Cash

Back in the 1950s, 60s and 70s, it was commonplace for men who had lived through the Great Depression to keep rolls of cash in their pockets. Many carried $200 or $300, equivalent to $1,000 to $2,000 today. Usually, these weren't wealthy men. They were ordinary men who had learned from experience that life is unpredictable, usually in a bad way. In their time, banks had failed, the stock and real estate markets had collapsed, unemployment had risen to 25%, families had fallen apart, young people felt lucky to have a job--any job--and prosperity returned only after the world survived the crucible of a horrendous world war. Cash was their insurance policy against all kinds of hazards, including the uninsurable. Cash felt good.

We're now in another era of uncertainty. While government safety nets, stimuli and other measures have kept us out of a Depression, the unresolved debt crises in America and Europe, as well as depressed real estate and volatile stock markets, continue to inhibit recovery. Another downturn may be in the offing. Federal deposit insurance relieves us of the need to keep large amounts of paper currency on hand. But the value of cash is strongly correlated with increases in market volatility, and cash is getting to be extremely valuable now.

Safety nets are wearing thin. Government benefits for many have run out and there's no room in the budget for more. Many are one paycheck away from homelessness. Illness, layoffs, disability, a new roof, a major auto repair, and other unpredictable expenses wait in ambush. Credit is tight. The only people who can get loans are the ones that don't need them. Keep 6 to 12 months living expenses in an emergency fund that's FDIC insured. Then set aside some more money to cover hell and high water expenses. The chances of another worldwide financial crisis swirl like a morning fog that may not lift. All the newfangled financial engineering hasn't made the world a safer place. The old-timers knew one thing: cash is the best port in a financial storm.

Thursday, November 10, 2011

The Cost of Poor Governance

The world is mostly run by organizations. Some are large. Many are small. But almost everything of consequence is done by organizations. How well an organization functions is crucial to its success. Today offers vivid examples of why an organization's governance processes matter.

The European Union. The first and best example is the structurally flawed EU. Its charter calls for a constrained and disciplined central bank, mandated to prevent price inflation. The 17 EU members that adopt the Euro are required to control their fiscal expenditures and hold deficits to 3% of GDP or less. But there are no effective controls over fiscal spending. Thus, when Greece, Ireland, Portugal, Italy and just about all other 17 members violated the deficit limits, the EU had no effective way to police their conduct. These tight monetary controls and basically non-existent political controls combined to produce a toxic excess of debt that can't be addressed in time-honored fashion by depreciating the Euro. And the EU's clumsy governance process, which generally requires unanimity of its members, prevents a swift response to a rapidly deteriorating crisis.

The EU's governance flaws have already proven costly. The EU has already committed hundreds of billions of Euros to a bailout fund. Then, there are the losses that creditors have taken or will take in the Greece bailout. In addition, we have the expense of the Benelux bailout/nationalization of Dexia, SA, and the failure of MF Global. Ongoing market consternation over Greece's and Italy's failed governments is imposing more costs as stocks gyrate. And then there are the future costs, which are now inevitable even if we don't yet know what they are.

The EU is a political entity without effective political governance. That's a formula for disaster, and the disaster is upon us. The European Union remains a wealthy part of the world, and has the economic resources to solve its problems. But it doesn't have the governance process to determine the baseline question: how among creditors, debtors, insurers and taxpayers will the cost of the sovereign debt crisis be allocated? So the EU--and the rest of the world--may suffer severe consequences.

Pennsylvania State University. The Penn State child abuse scandal has blown up the pristine reputation of a storied football program and ended the career of the greatest college football coach of all time. This, because people holding crucial positions in the university's internal governance process allegedly couldn't figure out that the welfare of minor children is more important than the reputation of their football program. This isn't altogether surprising. The day-to-day pressures on employees of maintaining and enhancing organizational performance can exaggerate their perception of the importance of the organization's priorities, and diminish their perception of external considerations. Personnel may forget that the organization exists within a larger community, and ultimately is subordinate to that community. This is true of universities, and also of major Wall Street banks. Failure to maintain perspective and humility can be very costly, both to the organization and those that are victimized.

The United States of America. There's a lesson for America from the two preceding examples. But we see little sign that the processes of the federal government have improved since the debt ceiling debacle a few months ago. The budget deficit supercommittee is wallowing in dysfunction. The President hasn't exactly been front and center to provide leadership. One gets the sneaking suspicion that all elected officials in Washington are laying the groundwork to play the blame game in next year's election, rather than trying to actually do something. But fingerpointing falls into the category of poor governance. Unless America figures out some way to make things work, we can look forward to sharing the fate of the EU and the Nittany Lions.

Wednesday, November 9, 2011

Italy: A Financial Run in the Making

If you ever wanted to see what a bank run looks like, you can watch the 1946 film, It's a Wonderful Life, starring Jimmy Stewart, or you can watch Italy. Greece's deterioration in the past few weeks laid the foundation for Italy's distress. As Greece was sucked down the drain, Italy began wavering, and then wobbling. Now, yields on Italy's bonds are skyrocketing, exceeding 7%. That's the range bond yields for Greece, Ireland and Portugal reached before those nations went down the tubes. Italy isn't literally a bank, and holders of Italian bonds can't go to the counter and make a withdrawal. All they can do is sell in the secondary market for whatever price is available, and lots of them are.

Rumor has it that the ECB is buying Italian bonds in an effort to stabilize the situation. But that would be a temporary measure. The ECB by itself is a wee bazooka, unless it starts printing money and that's not allowed by its charter. The EU has already announced that it has no plans to bail out Italy. Indeed, its bailout fund, the EFSF, doesn't have enough money to bail out Italy. Nor does the IMF. Nor do the Chinese or the Brazilians. Eyes will inevitably turn toward America. But the political situation here precludes a fiscally funded bailout for Italy. And the Fed, which has no compunctions about printing money, can't print Euros. Its bazooka uses different ammo.

Italy is on its own, and Jimmy Stewart is no longer around to step in and calm things down. It's up to Italy to persuade the fixed income vigilantes that it can pay its debts as they fall due. That's a tall order in this time of Euro-skepticism.

Compared to Italy, Greece has a small amount of sovereign debt outstanding. Yet Greece's problems were enough to knock down a major European bank, Dexia, and a significant American brokerage firm, MF Global. If Italy's bonds maintain their downward trajectory, it's entirely possible that more financial firms will fail. Sadly, we don't have enough readily available information about the bond holdings, derivatives exposures and counterparty risks of financial institutions to easily predict which ones might be in trouble. That lack of information exacerbates the potential for systemic risk. Volatility reigns supreme in the financial markets.

Sunday, November 6, 2011

The European Union's Only Option

The downfall of George Papandreou, prime minister of Greece, illustrates the European Union's only option for survival. Germany and France dictated the terms of the latest iteration of the bailout for Greece, which included tough austerity requirements and a 50% haircut for creditors. Both Greeks and creditors squawked, but ultimately knuckled under. Then, Papandreou threw a wrench in the works by calling for an ad hoc national referendum on the deal. Why he latched onto this misguided notion remains unclear. Whatever the reason, it threw the financial markets into a tizzy.

The prime ministers of Germany and France summoned Papandreou to be chewed out in Cannes. Most likely, George didn't get much time to work on his tan. Back in Athens, he called off the referendum. His next move was to maneuver for a coalition government, while his opposition called for snap elections. Germany and France stepped in again and made it clear that they wanted Greece to have a unity government that would implement the terms of the revised bailout.

Next thing you know, Greece is announcing that it has reached a tentative deal for a unity government. Tomorrow, Greek politicians will spar over who their next national leader will be. It won't be Papandreou.

What's happened in Greece was dictated by Germany and France. The Greeks weren't given a choice. They were told what bailout they would get and what governmental process they would use to implement it. In essence, Germany and France have assumed supervisory political control over Greece. This--the political unification of the EU--is the union's only chance for survival. Economically speaking, the EU's continuation depends on a transfer of wealth from the well-off nations of northern Europe to creditors of the more profligate EU members. The price of this transfer is political domination by the north.

Germany's been through this once before. When the Berlin Wall fell, prosperous West Germany unified with moribund East Germany. West Germany paid a very high price in bringing its formerly Communist sibling into the world of free enterprise. But the West Germans wanted unity and they were willing to pay for it. Now, Germans depend on the Euro Zone to sustain their prosperity, and they are gradually coming to realize their reluctant willingness to pay for the survival of the EU. The continued fecklessness of Greece and its government in dealing with the crisis has forced Germany and France to take charge. By the most contorted of processes, the EU is evolving toward political unity.

It's not inevitable the process will continue. Other nations are in trouble. Italy is the next target of the sovereign bond vigilantes. Interest rates on its bonds are rising sharply vis-a-vis German bonds, and it has recently agreed to be monitored by the IMF. Many Italians are irked by this infringement on their sovereignty. If Greeks and Italians feel put upon enough, they can simply leave the EU. That might seem highly irrational, since it could lead to the collapse of their financial systems and steep recessions. But let's not forget that twice in the last century Europe descended into horrific world wars that killed tens of millions of people. Europeans are eminently capable of highly irrational and self-destructive behavior.

No one knows all this better than the Germans, who were the most irrational and paid an enormous price for their self-destructiveness. That's why they're willing to pick up the tab now for the profligacy of their neighbors, but only if they can exercise political control over the spendthrifts. The question is whether Europeans, with their vast cultural differences--far greater than those between folks north of the Mason-Dixon Line and those to the south--can achieve the compromises and concessions needed for lasting political unity. The post-Communism breakups of Yugoslavia and Czechoslovakia tell us that Europeans don't always have a preference for political unification. Expect a bumpy ride in the financial markets while the EU works things out.

Wednesday, November 2, 2011

The Greek Referendum: What European Union?

Is there even such a thing as the European Union? The Greek prime minister, George Papandreou, has just announced an impromptu referendum to be held toward the end of this year, in which the Greek people will decide if they will accept the austerity and other measures required by the EU's bailout of Greece. The referendum was not previously mentioned by Greek leaders to the EU, and the EU is displeased, to put it mildly. It's holding back a bailout payment of 8 billion Euros that was to have been given to Greece in mid-November. Greece hasn't back down, and EU leaders are suggesting that Greek voters be asked to decide whether or not Greece should remain in the EU. Who knows? The Greek electorate may respond with a digital salute.

The Greek prime minister also faces a no confidence vote this Friday, Nov. 4, 2011. His legislative majority has been shrinking, and he officially has just barely enough votes to survive. If the no confidence vote fails, Greece will hold early elections. Those could further delay implementation of the EU's bailout plan.

The referendum and no confidence vote throw a massive wrench into the EU's governance "process." As it is, the EU has no established way to deal with a problem like the ongoing sovereign debt crisis, in which its very existence could be threatened. Europe's leaders have been winging it, meeting every week, and issuing innumerable upbeat press releases to manipulate the financial markets upward. Somehow, this ad hoc process produced a back of the envelope bailout that might at least delay the day of reckoning. But all the EU's efforts have now been suspended by the unexpected announcement of the Greek referendum and no confidence vote.

The referendum and no confidence vote demonstrate that there simply is no European Union. At its moment of greatest crisis, the fate of the EU rests on a snap decision by a Greek politician to hold a plebiscite and a no confidence vote. No one else in the EU signed off on this sui generis procedure. Yet, the EU, its currency, its financial system and its economic fortunes rest on the political vagaries of a country whose GDP is maybe 2% of the EU's GDP. There isn't a European Union. The EU has no rules, no governance process, no decision makers and no efficacy. It's like a group of people who have jammed themselves onto a very small life raft and are working against each others' efforts to keep the thing from tipping over.

If the EU blows up, the rest of the world will be dragged down as well. All this because of the political dysfunction of a nation with 0.5% of the world's GDP. That the fate of the European Union, and the world's financial system and economy, should rest on the electoral process of a small nation like Greece suggests that the interconnectedness of the world's financial system and economy has gone too far. Technology, derivatives and other linkages allow capital--and more importantly, financial risk--to flash around the globe almost instantaneously. While that's good when life is copacetic, reality is that some days are rainy. Today's hyperquick, hyperactive, and opaque financial system guarantees not only that capital flows immediately to the most attractive profit opportunity, but also that risk and financial contagion move equally fast in unpredictable, and therefore unhedged, ways. It may be time to establish significant limits on the extent to which financial risk can be palmed off. When faced with risk, people have a tendency to become responsible. But when you can pass the hot tamale to someone else, expediency trumps maturity. What we desperately need today is responsible behavior.

The only firewall left for the financial system is the taxpayer. Because taxpayers are becoming increasingly stressed, central banks have printed or will resort to printing money. This isn't a solution, just a kick of the can down the road. The Greek prime minister's decision to hold a referendum and no confidence vote serves as a reminder of a truth that is rarely acknowledged: there is no way of the current financial crisis without serious pain for everyone. The Greek prime minister is asking Greeks to grow up, face the fact that they will have to endure tough times, and agree to take their castor oil. Sooner or later, the rest of the world will have to do the same. But their politicians and other leaders continue to spin tales of Lake Wobegon, where everyone is in the top 1% and occupies only executive suites.

Tuesday, November 1, 2011

The Really Bad Thing MF Global Did

Perhaps the worst thing MF Global did wasn't lose a pile of money speculating in hinky European sovereign debt, although that was a pretty astounding belly flop for a firm run by a former Chairman of Goldman Sachs. It was that the firm evidently tapped hundreds of millions of dollars of client funds for its own use as its fortunes tumbled. See and

The financial markets have, since the Middle Ages, been built on trust. Without trust--especially by customers of financial institutions--the financial system couldn't exist. Brokerage firms such as MF Global are required by law to segregate customer assets and keep detailed records of customer accounts, so that the other people's money with which the firm is entrusted remains intact. When a firm uses customer funds for its own purposes, it violates the most fundamental principle of the customer-broker relationship: that the firm will be a faithful custodian of the customer's assets.

MF Global's customers appear to have primarily been big, fast money players, hedge funds and the like that can move their accounts at a moment's notice. MF Global also appears to have financed its activities with short term credit--financing that can evaporate faster than frontrunner status among GOP contenders for the Presidency. Running a firm with short term financing and professional money managers for customers is like drinking with a bunch of Good Time Charlies. If the bar stops running a tab for you, your drinking buddies will duck out the door muy pronto.

With the news about MF Global indulging in some helpings of customer money, a lot of hedge funds and other customers will be giving their brokers sidelong glances, looking for any flinching, eye shifting, throat clearing, hand rubbing, feet shuffling, or other signs of uncertainty. Lawyers up and down the length and breadth of Wall Street are preparing customer requests for withdrawal of accounts in draft form, ready to be delivered by e-mail, courier, snail mail, Pony Express, and even carrier pigeon at the first hint that a broker is in even a scintilla of trouble.

By casting a dark shadow over the trust between customer and broker, MF Global may have done far more damage to the financial system than its proprietary trading losses and whatever ripple effect that may have with the firm's counterparties. Now, every broker on the Street is suspect. Prudent money managers may presume that their brokers are guilty until proven innocent. The chances of further instability in the financial system has increased. Tighten your seat belt, because the ride could get rockier.

Sunday, October 30, 2011

Dexia and MF Global Holdings: Canaries in the Financial Markets?

Financial market volatility as we've had in recent months inevitably takes a toll if it continues long enough. A few weeks ago, a large Belgian-French bank, Dexia, was bailed out and partially nationalized after sustaining heavy losses from the European sovereign debt crisis. This weekend, news services report that MF Global Holdings, a financial services firm, is on the ropes because of sizeable losses in proprietary holdings of European sovereign debt. MF Global and its advisers have reportedly been seeking to sell part or all of the firm, but no transaction appears imminent. This evening (Sunday, Oct. 30, 2011), we now learn that the firm has hired bankruptcy lawyers., and

Because Dexia is a bank, its bailout was not a particular surprise. The EU could hardly allow a major bank to collapse at this moment of crisis, lest its entire financial system nosedive.

MF Global, however, isn't a bank and doesn't have a hovering government Sugar Daddy waiting to hand over a blank check. It brokers derivatives transactions, and its operations include the clearance and settlement of derivatives trades. It also trades for its own account. The firm reportedly held about $6.3 billion in hinky European sovereign debt, and disclosed a quarterly loss of $191.6 million on Oct. 25, 2011. Moody's and Fitch have lowered MF Global's credit rating to junk, which could disrupt its normal access to credit. Some brokerage customers have apparently been exiting, stage right. Press reports indicate that, to maintain liquidity, MF Global has drawn down two bank lines of credit. Its banks include Citigroup, Bank of America and J.P. Morgan Chase. That these big boys would allow MF Global to tap out its lines of credit indicates a difficult situation. One surmises that MF Global may be facing a potentially major run by customers and, with its banks' assistance, is doing whatever it can to buy time to find an acquirer.

MF Global hired three of the largest law firms in New York to assist in a possible bankruptcy: Skadden Arps Slate Meagher & Flom, Weil Gotshal & Manges, and Sullivan & Cromwell. Chances are it wouldn't hire firms of this size and stature unless something very big might happen very soon. These firms can, on a moment's notice, throw legions of lawyers onto a matter such as a bankruptcy of MF Global. The retention of such massive potential legal resources doesn't signal a bright near term future for MF Global.

What's unclear from news stories is the condition of MF Global's derivatives clearance and settlement operation. Such operations typically are protected by the capital of the settlement and clearance firm, which may also hold collateral from counterparties. A crucial question is whether losses from the proprietary trading could spill over into the brokerage operation and impair its ability to honor its brokerage and clearance and settlement obligations. If so, the value of an unknown quantity of derivatives transactions could be thrown into doubt. Were that to happen, a pathway for financial contagion could open up and spread outward into the larger financial system. If there is a potential for financial contagion to spread, expect the Federal Reserve to open the monetary floodgates.

The MF Global situation provides yet even one more reminder that we really need to implement a new regulatory regime for derivatives. The possibility that a derivatives broker, that provides clearance and settlement services, might put customers at risk from its proprietary transactions is simply unacceptable today. For many decades now, clearance and settlement in the stock markets have been legally insulated from proprietary trading, and separately capitalized. Mistakes and misjudgments at proprietary trading desks shouldn't be able to blindside clearance and settlement customers. The Dodd-Frank legislation provides a framework for making clearance and settlement in the derivatives market much more rigorous and secure. With all the volatility we've had, it's entirely possible that more financial firms beyond Dexia and MF Global are headed for the shoals. How many more canaries in the financial markets need to stop tweeting and fall over before we have reform?

Thursday, October 27, 2011

The EU's New Bailout: Who's the Sugar Daddy?

The EU's new bailout plan may be a somewhat clever bit of financial engineering. But one wonders if it isn't too clever by half.

For political purposes, holders of Greek debt "voluntarily" agreed to 50% haircuts, giving Greece about 100 billion Euros (or $140 billion) of debt relief. It's important that the haircut be deemed voluntary, or credit default swap counterparties (i.e., insurers against a Greek default) would have to make payments to holders of Greek debt. Such payments could make the contagion spread farther out into the financial system and financing costs for other weak EU member nations could rise. Plagues are harder to contain the wider they extend, so preventing this deal from triggering a requirement for CDS payments was deemed essential.

How voluntary the haircut is depends on how much you avert your eyes. With the heads of the German and French governments directly "discussing" the issue with them, Greek debt holders may have received considerable official guidance as to where their hearts and minds lay. Since most Greek bonds are held by banks that are "volunteering," those banks won't seek payment under their CDS contracts. The nonbank holders of Greek debt could do so, but they don't hold so much that they couldn't be paid off in full if necessary without disturbing the waters tumultuously.

Of course, CDS dealers may be alarmed tonight. If CDS holders can't recover in a scenario such as today's, there would be little incentive for them to continue buying CDS's, and the CDS market could collapse. Some might think that would be a good thing. While most financial industry bigwigs, economists and politicians would say that the connectedness of the world's economy and financial system is good, there can be too much of a good thing. With so much of the international financial services industry devoted to shifting risk around, instead of helping real businesses raise capital, it's reasonable to ask whether financial interconnection has been taken too far.

But we digress. The haircut banks will take on Greek debt will be softened. Greece will issue 100 billion Euros of new debt for the remaining 50% of the old debt that isn't being written off. This new debt will be supported by 30 billion Euros (or some $42 billion) provided by the EU as collateral. In other words, the EU is absorbing 30% of any losses on the new debt. But where will the EU get this 30 billion Euros? The EU's rules preclude central bank printing of money.

That leaves you-know-who to foot the bill.

The big banks in the EU will be required to boost their capital by a combined 100 billion Euros (or $140 billion) over the next eight months. This should help create a firewall around the EU sovereign debt crisis, and hopefully prevent it from spreading beyond the weak nations that are already on the ropes. One minor detail, though: where will the 100 billion Euros come from? Although EU banks might be required to refrain from paying dividends, and try to issue new stock to raise capital, it's doubtful they can put together 100 billion Euros in the next eight months. With the tens of billions of losses these banks are facing from Greek and other debt, they may not have that much in the way of profits to add to capital. And what legion of private investors would want stock of the pigs in a poke that the EU's banks have become?

That leaves you-know-who to recapitalize the EU's sick banks.

The third component of the new EU bailout is the leveraging of the remaining uncommitted 250 billion Euros in the EU's bailout facility created last year, the EFSF. Apparently, this money will be used to guarantee 20% to 25% of the value of new bonds to be issued to replace dodgy debt of shaky EU members. Because of the guarantee, it is hoped that bond vigilantes will accept lower interest rates on the new debt that will alleviate the financing costs of the spendthrift nations that are dragging down the EU. In theory, this isn't a bad idea. All we need now is a trillion or so Euros (or about $1.4 trillion) to invest in the new leveraged bonds.

Rumor has it that China and Brazil might help to bail out the EU. China has a $6 trillion GDP and Brazil's is $2 trillion. It's hard to envision these two developing nations trying to explain to their own less well-off citizens why anything approaching $1.4 trillion of their wealth should go to bail out the much wealthier citizens of the EU. China may kick in a few tens of billions, Brazil somewhat less. But that would leave well over a $1 trillion to go.

Politics prevent the U.S. from directly providing any assistance. The IMF, with a balance sheet in the range of $400 billion, couldn't bite off a real big chaw of the needed $1 trillion plus. And with the effectiveness of CDS's to offset default risk now in question, what army of private investors would touch these puppies with a ten-foot pole? Perhaps the EU's banks could be persuaded to "voluntarily" buy some of this sh . . . stuff. But at this point, the EU's banks aren't much more than conduits for losses to fall on you-know-who.

That leaves you-know-who to pick up the tab.

Taxpayers of the wealthy EU nations may be approaching a state of bailout fatigue. Add up the $42 billion in collateral for new Greek bonds, $140 billion for bank recapitalization, and $1 trillion or more for leveraged bonds, and you get $1.2 trillion plus. The good burghers of Germany, the Netherlands, Austria and the other wealthy EU nations will, at a minimum, scowl deeply when they realize what the new EU's new bailout means. Perhaps they'll cough up the money. Then again, when this much is involved, they may balk.

Without solid sources of funding, the EU's new bailout is the same as the emperor's new clothes. Clever financial engineering doesn't amount to jack if there isn't enough funding to make it work. And even if you look high and low, it's hard to find the EU's sugar daddy.

Wednesday, October 26, 2011

The Key to Long Term Investing: Liquidity

Paradoxically, liquidity is a very important component to success at long term investing. Stocks have a good long term record, if you measure in decades. Real estate is less profitable overall, but is the long term investment of choice for many Americans since they are homeowners. Having to sell unexpectedly early, though, can ruin the value of either stocks or real estate as investments. If markets are shaky when you have to sell, you can be a big loser.

To increase your chances of long term success, you need liquidity--cash to keep you going without having to sell your long term investments. This includes having a bulked up emergency fund to cover unexpected cash needs (like unemployment or a medical crisis). It also means having a stable source of cash for a long period of time. Most people work for that stable source of cash. Those with pensions have a steady cash flow in retirement. Highly rated bonds and stocks with a strong record of paying dividends can also serve this need. Immediate fixed or inflation adjusted annuities from highly rated insurance companies can provide long term liquidity. Don't forget Social Security. It's like a pension. Even if it doesn't cover all your needs, its predictable inflation-adjusted monthly payments are the financial foundation for most retired Americans.

If your day-to-day liquidity needs are met, you can hold your long term investments until the moment you, and not circumstances, choose as the time of sale. Avoid borrowing to meet these liquidity needs. Debt tends to destabilize your finances. (See Instead, securing a steady income and living within your normal cash flows can give you a good chance to win over the long haul.

Saturday, October 22, 2011

Credit Rating Agencies: the EU Targets the Messengers

The Wall Street Journal reported on P. A11 of its October 21, 2011 edition that the European Commission, the executive and administrative arm of the European Union, may ban credit ratings for the sovereign debt of EU member nations that are in bailout negotiations or receiving bailouts. In other words, the credit reporting agencies would not be allowed to issue ratings for EU sovereign debt that investors would really want to have rated.

Information is the lifeblood of the financial markets. Without adequate information, there is no rational way to price a financial instrument. The value of information is well-evidenced by the flurry of recent insider trading cases brought by the SEC and the U.S. Department of Justice. Information can be so valuable that some people will break the law to get it.

Now, the EU proposes to have investors plunk their money down for the debt of dodgy nations without knowing a crucially important piece of information--the credit rating. The credit rating agencies attained their prominent role because the financial markets are too complex, arcane and obscure for even many intelligent and diligent investors to comprehend. While these agencies have hardly covered themselves with glory in recent years, their assessments are held by many to be important (as well as being pertinent to those institutional investors that by law can hold only investments with certain ratings).

Shushing up the credit reporting agencies will have precisely the opposite effect intended by the EC. If deprived of important information, investors will become less confident, and their interest in buying or holding non-rated debt will diminish. The price of non-rated debt will likely plummet, and only vulture funds will profit. Other institutional investors and banks will take more losses than they've already sustained. The ability of the weak members of the EU to access private capital markets will evaporate, and Europe's taxpayers will be presented with more chits to pay.

That the EU wants to muzzle the messengers confirms the profound difficulties of its situation and the diminishing chances of successful resolution. Such blatant acknowledgement when the EU's leadership still claims it can wrassle this debt gator tells you that panic has set in among EU insiders. And where there's panic, bad things are likely to follow.

Thursday, October 20, 2011

The Failure of Bank Stress Testing

The EU sovereign debt crisis has put the lie to bank stress testing. Stress tests--analyses that supposedly test a bank's ability to survive one or more hypothetical financial crises--have been used by American and European regulators in an effort to evaluate the strength of banks. The American tests weren't followed by the immediate bailout of tested banks (although TARP, bounteous Federal Reserve subsidies and credit lines, and politically driven changes in accounting rules were much more important to their survival than stress testing).

Europe's tests were embarrassingly less accurate. Weeks after passing the first round of stress tests last year, major Irish banks needed government bailouts. Dexia, a Belgian-French bank that just got a bailout, passed the stress tests twice. This summer, stress test results announced in July indicated that only eight European banks failed, having a combined capital shortfall of 2.5 billion Euros ($3.5 billion). Now, as EU leaders squabble over the terms of the next humungous bailout, current estimates of the capital shortfalls of EU banks range as high as 80 billion Euros. To go from needing 2.5 billion Euros this past July to perhaps 80 billion a period of three months is suggestive (to say the least) of flaws in the testing process.

Comically, Europe's banking regulators are about to conduct a third round of stress tests. Major European banks are reportedly trying to shrink their balance sheets and beef up their capital in anticipation. But what's the worry? Based on our experience with the past two rounds of stress tests, we already know what results will be announced. All that's need is for the EU's regulators to figure out what assumptions are necessary for them to sound Panglossian.

You can make stress tests come out any way you want, by using the right assumptions about how bad the financial markets will get and how to value assets. Europe's stress tests might provide good fodder for the opening monologue on the Tonight Show. But don't bet your badly battered retirement savings on them.

Tuesday, October 18, 2011

A New Dawn at the Fed?

On Tuesday, Oct. 18, 2011, Chairman Ben Bernanke of the Federal Reserve said that the central bank might use monetary policy to deflate asset bubbles. In other words, if the Fed saw a potential bubble brewing, it might raise interest rates to cool things down before a whole lot of people got badly hurt.

This is a big step forward. Before you can solve a problem, you have to recognize that you have a problem. Previously, Chairman Bernanke seemed to be of the view that the Fed couldn't see a bubble, hear a bubble or speak of a bubble--at least not before the bubble painfully burst. That was problematic, since the Fed was a serial enabler of bubbles, with its periodic fire sales on credit and new paradigms. While it takes more than the Fed to tango in this respect--greedy, cynical, and manipulative banks and other market players are usually the leading dramatis personae--the central bank is the gatekeeper. It controls the cash spigot. Bubbles require cash, and a lot of cash, to thrive. The Fed decides how much cash will slosh around the financial system. The more it opens the floodgates, the bubblier things get. Conversely, shortening the shifts for the employees at the Fed's monetary printing press will drain off the punch bowl just as the party is warming up. The Fed can feed or starve the bubble, as it chooses.

In the past, the Fed hasn't wrassled with asset bubbles, which like gators are strong, mean and destructive. But if you don't get control over the gator, who knows where it will go and what it will do? While Bernanke didn't admit that the Fed has been an enabler of asset bubbles, he's taken a big step forward in acknowledging that the central bank can't sit idly by while the financial system dashes up to the edge of a cliff and positions its feet half over the edge.

Monday, October 17, 2011

Will Customer Fee Increases Hurt the Big Banks?

Recent bank fee increases are pushing consumer funds to credit unions and other financial firms. (See This is understandable from the consumers' standpoint. Why enrich banks when you're barely making ends meet? A less obvious question is whether these fee increases are bad for banks.

Banks play a potentially dangerous game. They make medium and long term loans and investments, using short term money (i.e., money that can be withdrawn quickly). Because short term deposits and other borrowings tend to cost banks less in interest expense than medium and long term loans generate in interest income, banks make profits on the difference. This game works fine as long as the short term depositors and other creditors of banks don't bolt. But, as we all know from recent financial upheavals, a run on the bank results muy pronto in its collapse--unless it's so big that the government steps in and gives the bank a blank check drawn on taxpayers.

Consumer deposits tend to be stable. This is true even for nominally short term accounts, such as checking accounts that theoretically can be closed on demand. It's a hassle for consumers to change banks, especially now that they often have direct deposits made to their accounts and direct bill paying from their accounts. The banks that have been raising fees are betting that a lot of customers will find it too bothersome to switch accounts, and will cough up $5 a month for a debit card or whatever.

But many customers may leave, particularly after a few months or maybe many months. While the banks will probably profit short term by raising fees, after a while growing numbers of customers may tire of paying for what's free elsewhere. If banks see a shrinkage in their retail deposit base, what will they do? They can either reduce their balance sheets (i.e., reduce the loans and investments they hold) or they can seek alternative funding. Banks, as a rule, don't shrink their balance sheets. If you're a bank CEO, you aren't likely to perceive a lot of benefit to making your organization smaller. The more assets the bank holds, the more profits it will hopefully make and the larger your bonus will hopefully get.

Since banks losing consumer business won't be inclined to shrink their balance sheets, they will seek alternative funding. The choices are likely to be much less stable than consumer deposits. Typical alternatives would include the fed funds market, the commercial paper market and the repo market. Funding from these markets is susceptible to great instability. Money a bank borrows in these markets can evaporate faster than a hedge fund can execute a computerized trade.

Europe's big banks are funded to a large degree in wholesale markets, more so than many of America's big banks, and are consequently less stable. That's one reason why the EU sovereign debt crisis became so acute so fast earlier this year--the money market vigilantes fled the big EU banks, and Europe's governments had to ride to the rescue. (If you have an account with a U.S. money market fund, though, your fund may have been one of these vigilantes and you'd probably consider this a good thing.)

If America's big banks experience a large enough shift in their liabilities, with less retail deposits and more wholesale funding, their risk profiles could change and not in a good way. Are bank executives are concerned? Come on. If a big bank goes way out on a limb and the limb starts to break, the Federal Reserve will climb into its Black Hawks and helicopter to the rescue. But taxpayers should be concerned. If America's big bank risk profiles tilt toward the European model, the potential for bailouts increases.

The risks of reliance on wholesale funding are well-illustrated by Lehman Brothers' collapse in 2008. When the word got around the Lehman was struggling, its funding dried up faster than rich people rushed out of New Orleans as Hurricane Katrina approached. That one time, the Fed and the Treasury Department didn't deliver a bailout by courier. They've been harshly criticized ever since. So you can bet your bippy that no large bank will ever again be allowed to fail. Period. That's why, long term, it might end up being a bad thing if consumer deposits leave big banks. Regulators should require more capital as banks' risk profiles become hinkier. Then again, a lot of things that should be done aren't.

Thursday, October 13, 2011

Why Barack Obama Would Love to Occupy Wall Street

The Occupy Wall Street protests, and similar Occupations in other cities, have captured the attention of the press and the public, being as they are spontaneous, loud, spirited and, most importantly, boisterous expressions of what a lot of people are thinking. With a diverse agenda, donated food, and small contributions that are often made online, the Occupiers bear a striking resemblance to Barack Obama's 2007-08 primary campaign. That, too, was a built on a groundswell of disaffected citizens and was notable for the large number of small contributions it garnered, often online. Obama was clever enough to keep his agenda vague, allowing a diverse collection of unhappy voters project their wishes onto their images of him--change, indeed, that they could believe in. Much of his appeal was that he could capture the attention of the politically restless--he wasn't one of the same old, same old candidates but seemingly a breath of fresh air.

Now, President Obama has sunk into the muck of incumbency. He has a track record. He's taken positions. He made changes, or not. He's proven to be a reclusive President, perhaps not understanding that people can find the human side of their leaders endearing. In public, he is poised and articulate, but not relaxed. He's no longer a breath of fresh air.

Obama's prospects in the 2012 elections against the ever-shifting GOP frontrunner don't look bad. But he's hardly got a lock on re-election. The Republicans, depending on their nominee, will capture at least some of the energy of the Tea Party movement. The Democrats, and Obama in particular, would want to counter with their own insurgency of the discontented. Whichever candidate the biggest political flash mob coalesces around in 2012 will win the election. That's why Obama would love to occupy Wall Street.

Monday, October 10, 2011

Barack Obama's Lucky Breaks

Barack Obama is a lucky man. Even as the economy idles in neutral and his ratings sink, good things keep happening to him.

Lucky Dollar. Europe's debt crisis is getting worse--a Belgian bank was just nationalized, which means more liabilities for Belgian taxpayers. The dollar remains attractive and capital is flowing into high quality dollar denominated assets. Interest rates remain low but the strengthened dollar prevents a flood of capital out of the U.S.

Bad Guys Can't Hide. U.S. counterinsurgency forces have successfully dealt with bin Laden and Awlaki. Although this is mostly the result of patient, painstaking intelligence work, there's an element of luck in these successes and Obama has been very lucky in the war against terrorism.

Occupy Wall Street. This largely spontaneous protest movement provides the Democrats with an opportunity to organize a counterweight to the Tea Party. In his typically cautious style, Obama waited three weeks before speaking favorably of the Occupiers. The protests give him an opportunity. He's lost most of the popular groundswell that got him elected in 2008, and Occupy Wall Street let's him recover some of his losses. Not all Occupiers like Obama. But not all Tea Partiers like the Republicans and that didn't prevent the Republicans from co-opting the Tea Party movement.

Stock Market Loves Big Government. Ignore what Wall Street says and watch what it does. Today, the Dow Jones Industrial Average rallied some 330 points on vague promises by France and Germany to do something or other to support their banks. Also heartening for stocks was Belgium's nationalization of a sovereign debt-laden bank, Dexia and, Belgium's, France's and Luxembourg's guarantees of some 90 billion Euros of Dexia's future borrowings (which presumably would be used to pay existing creditors off). In other words, losses that would have fallen on financial market participants will now fall on European taxpayers. If you're a banker, you gotta love that. Since Obama's principal policy options at this point are one variant of big government or another, he's lucky to have a stock market that will cheer his every policy success.

Thursday, October 6, 2011

Will America Ever Produce Another Steve Jobs?

It hardly needs to be said that Steve Jobs was a transformational figure, doing as much or more than anyone to create the personal computer, and decades later, the products that will gradually replace the personal computer. Jobs took the lead in adopting the mouse and graphical interfaces, critical features that made computers user friendly to non-geeks. He was a talented marketer, offering tech products that actually looked attractive and felt sleek. The massive personal computer market spawned by Jobs and a small group of like-minded geeks made possible the Internet as it exists today: a global forum for the largest informational and intellectual exchange in history. The creators of portals, search engines and social networks are singles hitters compared to Jobs' standing as the high tech world's Babe Ruth.

A rather scary question is whether America will ever again produce a figure such as Jobs. When Jobs went to high school and college, America was evolving from the rigidity and conformity of the 1940s and 1950s into a more open-minded place where being different was tolerated and, in Jobs' case, ultimately rewarded. Jobs briefly attended college. Then, he dropped out but hung out around campus, exploring what interested him, growing spiritually as well as technically. Steve Jobs was simply different, and that's why he achieved such far-ranging, innovative success. His varied interests in the arts, music, religion, and high tech were ultimately reflected in the products he created. It wouldn't have been obvious to 99% of personal computer makers that they should create a product that promotes music, like the iPod. But Steve Jobs by all indications saw the iPod, iPad, iPhone and other expansions of the digital world as just part of the same continuum.

His particular vision is gone. He leaves behind a company that employs about 50,000 people, with suppliers that probably employ tens of thousands more (and let's not forget Pixar, Jobs' other corporate creation that's now a Disney subsidiary). Entrepreneurial success like this is crucial to economic growth. Comparable figures from the past, like Edison and Ford, had similar impact on the economy. Today's contentiousness over economic, monetary and tax policies, social safety nets, and so on can't do much to solve our problems. That debate is about the allocation of costs and burdens, and does little or nothing to make the economy grow.

The way to solve our problems is to foster more rapid economic growth. As history shows, a small number of original thinking entrepreneurs can have a disproportionate impact on growth. They envision and then foster disruptive change, sweeping aside conventional assumptions and recreating the world as they see it. They produce products almost no one else could have imagined, and convince millions of other people to like and buy those products. They are strong-willed and singularly determined. Blessed with exceptional intelligence, they tend to be impatient with those less capable, whom they may micromanage and over-supervise. Highly sensitive to criticism and any imperfection in their worlds, they often don't play well with others. They're difficult to be around and their employees have to be well-compensated to put up with them. When they succeed, they become exceedingly wealthy, as do their employees and the nations that host their companies.

There is reason to doubt America's ability to produce another Steve Jobs. Our educational system posits that all holes are round--as in well-rounded--and tries to peg all kids into them. To be regarded as highly successful, kids need to get A's in all subjects, excel at taking standardized tests, and be superb athletes, musically gifted, charitably and community minded, well-traveled, immersed in at least two foreign languages, pleasant, mannerly, well-groomed, well-spoken and generally pleasing to adults. A kid who is brilliant in one or two areas, such as high tech or math, but is otherwise diffident, reticent, indifferently groomed, and unexceptional in other ways, is viewed as weird, strange, unbalanced, geeky, nerdy and not competitive for most of the best colleges. A 17-year old Steve Jobs today would probably have a tougher row to hoe than Steve Jobs had in the 1970s. There was once a time, decades ago, when America's educators understood that it was more important to cultivate a student's strengths than to turn all kids into carbon copies of the student body president. That allowed many gifted, but not well-rounded kids to grow into great successes in their individual fields.

America's obsession with well-rounded students who excel at taking standardized tests means that we are turning out legions of future administrators, bureaucrats, consultants, corporate lawyers, and mid-level executives. Those in this group who earn MBAs may accumulate small fortunes in business or finance. Very few or none will have any macro impact on the economy.

Those poorly rounded, but disproportionately talented kids who have the potential to change the world must struggle against stereotyping, unfavorable social expectations and schools that don't value them. It's important to remember that advanced economies require people who are highly specialized and that innovation comes from those that don't fit in and aren't readily accepted. America today has reverted to a troubling conformism that may hinder the full development of our children's potential. This nation remains a haven for tinkerers, inventors and garage-based business start-ups. Our best chance for future prosperity rests in their hands, not in the hands of the idiots on Capitol Hill who can barely agree on a continuing resolution. Let's try to give the nerds a better chance at the brass ring.

Tuesday, October 4, 2011

Have Derivatives Nailed Us Again?

As the stock market has plunged in recent weeks, banks stocks have often led the way into the abyss. This, in part, is because we don't know enough about the major banks.

Lack of information casts doubt on the value of a stock. Pigs in a poke sell for less than pigs out in the open. Banks, as we know from centuries of financial panics and runs, are volatile institutions that can seem healthy one day and on the verge of collapse the next. A bank's standing depends not only on its operational performance and financial condition, but also its public image. Gossip, whispers and rumors all can affect its image, and therefore its stability. Lack of information can inflame the impact of fast-moving negative news.

Europe's banks hold large quantities of troubled EU sovereign debt. The amounts are not entirely clear, but are hefty--hundreds of billions and maybe even trillions of Euros worth of dodgy debt. American banks are linked to European banks, among other ways through the settlement and clearance process for negotiable instruments, interbank loans, securities transactions, and derivatives deals. The first three exposures are pretty easily quantified. The last is not. Since most derivatives transactions are still direct, over-the-counter deals, there is no centralized venue for collecting information about many of them. No one knows if counterparty risk is concentrated in one or a few firms (a la AIG, circa 2008). No one knows if nonstandard transactions have created atypical risk profiles.

Banks often assert that they hedge their derivatives exposures. But there is no easy way to verify that. Hedges can be collateralized in whole, in part, or not at all. They can depend on creditworthy counterparties or hinky ones. They may be perfect, mirror-image hedges, or they might be approximations that don't fit any better than a used cheap suit bought in a thrift store. The Long Term Capital Management mess of 1997 resulted in part from "hedges" that turned out to be ill-fitting cheap suits.

The lack of information means that we can't tell how bad the derivatives exposures of big banks are. And that means we don't know what their stocks are worth. Hence bank stocks nose dive in times of doubt.

The Dodd-Frank legislation was supposed to cast sunlight on the derivatives market. Financial regulators are, as far as can be discerned, proceeding with perhaps some deliberate speed. The securities industry has wheeled out shiploads of lobbyists to to impede progress. Profit margins, like mushrooms, thrive in darkness. So the industry welcomes transparency as much as the Lakota welcomed Custer.

For all we know, the ghost of AIG-2008 lurks and derivatives might have done us in again. Remember that derivatives transfer risk, and an American bank doing a derivatives deal with a European bank or other firm may take on European risks as a result. Comparable risk transfer can occur if an American bank does a derivatives deal with an Asian bank that offsets its exposure by doing a mirror-image deal with a European bank. In such ways, derivatives can expand an American bank's risk profile well beyond its normal depositary and lending activities. Thus, derivatives can exacerbate the problem of too big to fail. But there's no ready way to tackle this problem, because information is lacking.

Europe's financial ministers today stopped another market rout with some talk therapy, leaking the word that they are vigorously studying the possibility of boosting the capitalization of Europe's banks. But they didn't say they had any concrete plans or proposals, just that everyone should feel good because they are concerned. The market bounced back, betting on positive rumors and gossip. But recent experience shows that bouncing balls readily fall back after going up, and the market will fall back again without something more concrete that inspires confidence. Given the darkness in the derivatives market, building confidence will be more easily said than done.

Sunday, October 2, 2011

The New Stagflation

The Wall Street Journal reported on Saturday (October 1, 2011, p. A10) that consumer prices in Europe rose 3% over the past year, the fastest pace in three years. During the same time, prices in America rose 3.8% (measured by the CPI-U, without seasonal adjustment). In both Europe and America, the economies are stagnating, either barely growing or maybe nosing downward. Unemployment remains high, especially in America. Consumer confidence is flagging. Governments are dysfunctional. Markets look askance upon banks rumored to be facing EU sovereign debt exposure. Credit default swap dealers prosper.

The atmosphere is reminiscent of the stagflation of the 1970s, with its unrelenting malaise, lousy stock market, and embarrassing leisure suits (indeed, leisure suits have made a minor re-appearance recently). Some argue that today's conditions are far removed from the stagflation of yore, comparing the 13% inflation of 1979 to today's 3.8%. But that's not all the pertinent information.

Disposable income is stagnant, and even dropped 0.1% in August after adjustment for inflation. In other words, we're losing ground. Back in the 1970s, nominal incomes largely, but not entirely, kept pace with inflation. The net result was similar to current times: people gradually lost ground. The economy grew very slowly in the 1970s, around 1% a year, and unemployment levels, although not as bad as today, were high compared to the boom years of the 1950s and 1960s. Like the past decade, the 1970s experienced a falling stock market.

When you get to the bottom line, history is rhyming pretty well even though it's not a carbon copy of the disco era. This puts policy makers, especially central banks, in a tight spot. If they raise interest rates to tamp down inflation, they increase the potential for recession. If they ease monetary policy, they facilitate inflation. The European Central Bank is keenly aware of this dilemma, contending with fear of inflation in northern Europe and high unemployment in less vigorous parts of the EU. Its governing council meets next week, with no good options to consider.

The U.S. Federal Reserve, now a house divided, remains controlled by governors who view unemployment as a greater problem than inflation. Consumers should expect no relief from the Fed. While the Fed continues to insist that inflation poses no long term problem, that offers little comfort to those trying to pay this month's rent, as well as the grocery and gas bills. Nor is there much reason to believe that more intervention by the Fed will greatly affect employment levels. While the Fed acts like its mojo is working, reality is we're drifting in a new stagflation.

Wednesday, September 28, 2011

Why China Won't Bail Out Europe

With $3 trillion in foreign currency reserves, China holds the largest single pot of investment funds in the world. The EU's sovereign debt crisis, which threatens to derail the world's financial system and foster worldwide recession, may require as much as $2 trillion to resolve (see It's not surprising that some have nominated China to be Europe's white knight, contending that the Chinese are so deeply integrated into the world's economy that they can't afford to stand by while the West belly flops. This is wishful thinking.

China has its own problems. It is stuck with a huge imbalance in its own economy, being way too dependent on exports. The economic slowdown in America and other Western nations is hurting growth in China. Unemployment is rising, while the commodities inflation caused by the U.S. Federal Reserve's easy credit policies is spurring consumer price inflation in China. Real estate values have bubbled up deliriously in China, and the bubble could burst soon as China's central government now tries to rein in overly enthusiastic bank lending. Since the Chinese have invested heavily in real estate, the bursting of that bubble could be very painful. From the times of emperors, the central government in China has been expected during crises to alleviate the difficulties of the Chinese people. Its failure to do so has typically meant the overthrow of a dynasty. Today's Communist government is well aware of this history.

Longer term, the Chinese have a severe demographic problem. The Communist government's one family, one child policy has constrained the numbers of younger people. Gen X and Y, and Millenials in China are proportionately fewer than they are in America. That means a smaller number of younger workers to support retiring older folks. The $3 trillion the government has in the piggy bank could play a valuable role in keeping generational warfare to a minimum in China.

Then, there's the question of optics. China's per capita income is about $4300, just a fraction of America's $47,000 and the EU's $32,000. China's government couldn't afford politically to bail out wealthy (from the perspective of the ordinary Chinese) Westerners while a majority of its people still don't have central heating or indoor plumbing.

The possibility that the EU needs $2 trillion to extract itself from the swirl in the porcelain bowl illustrates the intractability of the EU sovereign debt crisis. There simply isn't that much hard cash floating around to pay the debts Europeans incurred to live large for the past decade. The EU's latest talk of establishing a special purpose vehicle to leverage the capital of the EU bailout fund is simply another maneuver to shuffle paper and kick the can down the road. It tries to solve a problem of too much debt by creating more debt, and could increase the EU's overall debt load without providing any means for actual repayment. Indeed, the only concept under consideration for actual resolution of part of the EU's debt problems is forcing creditors to take haircuts on Greek debt (of somewhere between 21% and 50%). Haircuts, in this instance, means losses. These losses, and perhaps many more to follow, may be the only way to truly end the EU sovereign debt crisis. The losses would land initially in Europe's big banks, and then flow through the European Central Bank and Europe's governments to taxpayers. Slow growth and recession could follow. Europe is a long way from Lake Wobegon. There simply isn't a happy ending to every story.

Monday, September 26, 2011

The EU Paper Shuffle Continues

The Dow Jones Industrial Average closed up 272 points today, mostly on rumors of an EU bailout plan in the works. As always, the market buys on the rumor, and hopes for good news.

News reports, however, indicate the EU is mucking around with another paper shuffle. The European modus operandi ever since the Greek sovereign debt crisis blew up has been to shuffle and exchange pieces of paper that increase total debt levels without solving problems. Last year, a bailout fund was created, which allowed private sector creditors to ease out of the septic tank while drawing EU member nations and their taxpayers deeper into the muck.

The latest gossip seems to focus on creating a special purpose vehicle, capitalized by the EU bailout facility, which will issue bonds to finance its bailout activities. The funds raised by issuing these bonds will be used to buy up hinky sovereign debt of potential deadbeats among the EU's members.

An interesting feature about these bonds is that they will be useable with the ECB to collateralize borrowings by European banks. This makes the SPV's bonds attractive to EU banks. Those would be the same banks that hold hundreds of billions (or is it trillions?) of Euros of dodgy sovereign debt. By investing in SPV bonds, they'll place themselves in a virtuous (from their perspective) circle where funds they give to the SPV for its bonds will circle back to them as the proceeds obtained from selling toxic debt to the SPV. Stated otherwise, they'll swap snake droppings now stinking up their balance sheets for valuable bonds that can be used as collateral for ECB loans.

It's a very special special purpose entity that, immediately upon inception, is deemed sufficiently creditworthy to serve as an issuer of collateral acceptable to the ECB. Ordinarily, only gilt edged quality securities can be submitted to the ECB for loans. But this special purpose entity is indirectly capitalized by all the EU members, and implicitly is backed by all of them. Of course, no one in a position of authority will acknowledge that the EU's members explicitly or implicitly back the special SPV's bonds. But saddling the ECB with risky collateral could very possibly blow up the entire Euro zone. So, like it or not, the EU would create its own sovereign debt analogue to Fannie Mae and Freddie Mac. Losses from the SPV will land, one way or another, on the good burghers of Northern Europe.

The apparent purpose of the SPV is to be a "bad bank" which scarfs up toxic assets from commercial banks to clean up Europe's banking system. That's not a bad idea, in theory. Such an approach worked in the early 1990s to pull the Scandanavian countries out of a financial crisis. A tough question, though, is who gets to pay Tuesday for the losses that have been sustained today. European leaders have been shuffling and swapping paper since the early stages of the crisis, in the hope that kicking the can down the road would keep the ship afloat until Europe's economies revived and grew enough to produce the wealth to pay for the losses. Unfortunately, Europe's economies, and most of the rest of the world's economies, are slowing or stagnating. Recession may loom. In such a scenario, losses can't be absorbed by economic growth. They have to be allocated among debtors, creditors, taxpayers, or a rich uncle somewhere. Except that there is no rich uncle anywhere--China and Japan might toss in a few nickels each, but not the hundreds of billions needed for a workable bailout. And among debtors, creditors, and taxpayers there is nary a shred of selflessness to be found. This is like a bunch of people at a bar, slyly maneuvering to slip out before the tab comes, sticking the last guy to leave with the bill.

The EU will no doubt try to make the latest bailout sound as elegant and clever as possible. But look beyond all the proposed vehicles, entities, bonds, exchanges and facilities, and focus on who gets stuck with the tab. If the shlemiel won't be able or willing to pay up, then the transaction is just another kick of the can down the road that allows overall debtloads to increase, and pushes the EU farther into the abyss. And right now, no one is bellying up to the bar with a fistful of cash.

Friday, September 23, 2011

Why Gold Isn't A Safe Haven

In the past couple of days, gold has dropped close to 10%, and is now trading around $1650 per ounce. That's 15% down from its recent peak price of around $1920. Why the belly flop? The answer is that, contrary to pronouncements of bug-eyed gold fanatics who drool from the sides of their mouths, gold is not a safe haven from fiat currencies or the financial system. Instead, it is joined at the hip with the financial system.

Among the most active traders in gold are hedge funds and other financial firms. These market players mainline leverage. And when they can't find a vein, they smoke the stuff. Consider the nature of leverage. It's a loan denominated in fiat currencies like the dollar and the euro. Leverage must be repaid in fiat currencies. Banks extending margin loans don't want to speculate in gold themselves, so they require repayment in dollars, euros or some other fiat currency.

Leverage financed the great gold rush of 2008-2011. This time, prospectors didn't search for yellow metal in stream beds or under the ground. They sought riches in the trading platforms of exchanges. The ones that got into the market two or three years ago hit the motherlode. But as gold bubbled up, smart players began to wonder when the party would run out of punch. The financial crisis of 2008 taught us that bubbles will burst at some point. Stocks and real estate both bubbled up and burst, and gold isn't different. Part of today's selling is to lock in profits while the getting is good. Locking in profits involves converting gold holdings to a fiat currency. That's the only way to take your gold profits and use them to repay margin loans, and buy cars, food, housing, and so on. So when money managers think the gold bubble, as valued by fiat currencies, has peaked, they will sell gold in order to obtain fiat currencies.

Other hedge fund managers may be selling gold because their investors, seeing the world go hinky in recent months, are making redemption requests to cash out. Investors may be worried about stocks, oil, or other assets besides gold that the hedge funds invested in and are now falling in value. But gold is easier to sell than some assets because it has a highly liquid market. So investor redemption requests, in effect, hit the gold market. Investors want payments in fiat currencies, not distributions of gold. That means the gold has to be sold to convert it into fiat currencies.

The players who dove into gold also traded on a leveraged basis in stocks, other commodities and maybe derivatives that no one can easily learn about because the derivatives market, three years after the financial debacle of 2008, remains opaque. Part of the selling of gold is due to speculators having to raise cash to meet margin calls resulting from falling prices for stocks, commodities other than gold (such as oil, which has lost some of its sheen) and, perhaps, derivatives contracts. In this way, leverage used to invest broadly on a diversified basis can have an interlinked downward impact when some markets go wobbly.

The recent woes of the euro add to the problem. A fall by the euro has pushed up the comparative value of the dollar. Since gold tends to trade inversely to the dollar, a good day for the dollar means a bad day for gold. That's another reason for gold investors to bail before they sustain more losses. The inverse correlation between the dollar and gold reveals a vulnerability of gold to a fiat currency.

With the financial markets and world getting hinkier by the trading minute, the selling has accelerated in the past two days. The ship seems to be sinking, and you know who is scrambling to get off first. Leverage dramatically pushed up the price of gold, and now deleveraging and other financial factors are driving it down.

Today's gold market is a creature of the financial system, and is subject to the same pressures and constraints as other assets. Gold isn't a safe haven. What is? That's the question people have been asking since they sharpened long sticks for protection and sought shelter in caves. When you have the answer, please clue in the rest of us.