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.