Friday, October 8, 2010

Turbulence and Trends

A trend is a trend is a trend.

But the question is, will it bend?

Will it alter its course

through some unforeseen force

and come to a premature end?

-- Sir Alec Cairncross

I’ve had a lot of meetings this week, and very little time to reflect on fast moving events. This entry may be light on cites and hyperlinks as I’m in a bit of a rush today. It will also lack much in the way of perspective or insight as I find it impossible to distance myself just now from the swirling turbulence around me.

Here in Britain, several banks were offered partial nationalisation as an alternative to private recapitalisation. Strangely, this seems to have encouraged them to more strenuous efforts to recapitalise. The plan is now being held up as a model as it seems to force managements to confront their undercapitalisation as a problem that they can solve to their advantage or that will be solved for them to their heavy personal cost.

Iceland collapsed. It was more of a hedge fund than a country, with it’s 200,000 population supporting a massive leveraged position in financial markets via risk loving bankers and financiers. There were approximately 200,000 British depositors in accounts offered by Icelandic banks. Local authorities (municipalities) and charities were also big investors, exposed for more than £700 million. As a result, the government has frozen Icelandic-owned assets in the United Kingdom – using terrorism legislation, naturally – to provide the basis for a partial recovery of the losses likely to be incurred. This is causing more stress between the two island nations than they have known since the Cod Wars of the 1980s. Also causing tension is a rumour that Russia might bailout Iceland with $4.5 billion of credit, leading to speculation that the Russians may be eying the vacant airbase formerly used by Americans. This is problematic as Iceland is a member of NATO, and so has spurred efforts toward finding European alternatives.

Europe continues to call for collaboration while each country unilaterally defines and acts on its self-interest. That is the way it should be, and I approve heartily. I would rather not have the European Union making hasty decisions or holding such concentrated powers that it can force a uniform resolution across all member states. Either the EU builds consensus for action in the common interest, or it remains impotent. Either is preferable to too much concentration of power in Brussels.

In an attempt to shut just one stable door in a barn full of bolting horses, the Treasury has laid legislation before Parliament to reform the treatment of UK bank insolvencies and deposit insurance arrangements. Roughly described, the Financial Services Authority will decide if a bank is bust, the Bank of England will be responsible for overseeing its resolution and ensuring financial stability of the system, and the Treasury will oversee a new deposit insurance scheme that no one can currently describe but will make permanent the rise in protection to £50,000 per depositor. Despite the massive failure of Lehman, and the huge losses incurred by investors and hedge fund prime brokerage clients in London, the legislation is completely silent on the insolvencies of investment banks and broker-dealers and other institutions of systemic importance to financial markets. My fear is that the failure to address the systemic issues as a whole will be a vulnerability exploited by US banks and authorities as they try to undermine London as a financial centre, gaming the fragile global markets.

There is still a touching confidence among many in the City that the US authorities will provide the “leadership” to reinforce collapsing markets. As John Plender of the Financial Times quipped, “Gaul votes for Rome to take the strain.” This seems to me to display a total incomprehension of the way US authorities operate to externalise pain and loss to the greatest extent possible in times of crisis. Gaul, after all, was an occupied state that was militarily and economically exploited to Rome’s advantage for centuries before Rome’s collapse. Saving Gaul was never a high priority once Rome was threatened.

Elsewhere in the world, bureaucrats continue to show up at the office in the morning and check to make sure all boxes are ticked, all forms are correctly ordered, and all initiatives in progress continue their stately way forward unimpeded by global chaos. I find this comforting, although much of their efforts will ultimately prove futile and failed.

Finally, an optimistic note. I was reminded yesterday that the vast bulk of “wealth” created during the Greenspan/Bernanke bubble years accrued to the very top percentiles of population – with many in the OECD middle class and lower class either stagnating or getting poorer as they mired themselves in unsustainable debt. While opportunity and employment grew strongly in emerging countries, there too the elites gained disproportionately as income inequalities surged. The crash of global financial markets therefore will have disproportionate effect on the elites, impoverishing them to a far greater extent, although it will be felt throughout society as employment, pensions, investments and public services contract.

Once we hit bottom of this downturn, some years hence in all probability, we may experience a democratisation of wealth and opportunity like none seen since the end of World War II when education reforms and unionisation laid the groundwork for the rise of the American and OECD middle classes. Those who have lost economic and political power during the boom years, are likely to organise and retake authority within economic and political systems during the bust years. The collapse of concentrated wealth in Wall Street will spur more collaborative capital formation and investment throughout the economy. This could provide reorientation of economic progress toward more equitable, sustainable and democratic outcomes in coming generations. I hope so, it’s the only bright spot of the week.

Saturday, October 2, 2010

Financial Eugenics: The Paulson Plan for Survivor Bias

As I write this I don’t know the outcome of the attempt to ram through legislation for looting the US Treasury of $700 billion before the end of the Bush administration. I suspect that Congress will force the passage of the bill in some form because the media and political narrative on the necessity of the measure is unremitting and so horribly biased.

No alternatives will be considered.

No constraints on the unilateral executive authority of Hank Paulson will be considered.

No assurances that funds will be used to unlock credit markets or promote lending to the real economy (as opposed to the financial robber barons) will be considered.

Instead, the bill will get laden with an additional 300 pages of pork to sway the dissenters, adding to the tab imposed on the American taxpayer.

Having listened to all 42 minutes of the late night Treasury briefing of investment banks on Sunday, there is no doubt in my mind that this legislation represents the sort of federal largesse for Goldman Sachs, Morgan Stanley, Citibank and JPMorgan Chase that the Iraq war provided for Halliburton and Blackwater.

The most cynical moment in the call is when the Treasury official confirms, ”our preference would be to help the healthy banks become even healthier” rather than helping troubled banks or illiquid banks.

America is now a centrally planned economy where the Treasury will determine which firms survive and prosper through allocation of scarce capital to an undercapitalised financial sector.

Clearly what is going on here has nothing to do with kick starting the credit markets or stabilising the equity markets or restoring depositor confidence in banks. (Treasury official: “No provision in the legislation that mandates re-lending.”) What is going on here is a blatant attempt to provide government funds to a select cadre of firms (not all banks) which are chosen to be the survivors feasting off the carcasses of their less fortunate and less well-connected brethren as the downturn intensifies in the years to come.

The crash in equities will still happen. The debt deflation of the economy leading to mass commercial and consumer credit defaults will still happen. The collapse of many national, regional and local financial institutions will still happen. The bankruptcy of many municipalities and shortfalls in state budgets will still happen.

This bill is about engineering survivor bias to friends of the Bush administration so that they profit disproportionately from the collapse of these markets using the funds provided by the taxpayer via the unreviewable and unconditional authority of the Secretary of the Treasury.

The basic plan is to set up a federal money laundering operation. Bad assets come in, get laundered by the Treasury and put in a new AAA “wrapper” (as it’s termed on the call), and good assets go out, issued as Treasury guaranteed securities. Whether the final value of the legislation this week is $700 billion or $150 billion is irrelevant as long as the laundering operation can accommodate the throughput, as that number is only a cap on total extensions at any one time.

The SEC will support the plan and survivor bias by relaxing FASB 157 on mark to market accounting. If there is no agreement on what an asset is worth, it is worth whatever the firm holding it says in its Level 3 accounts or the Treasury Secretary accepts in buying it.

The Federal Reserve will support the plan by relaxing the definition of “control stake” in US banks and bank holding companies to allow secretive cabals to hold through private equity and offshore hedge funds. No one knows the beneficial owners of these ill-transparent private equity investors, and so it is the ideal way to reward loyal and helpful insiders, legislators and officials – as well as cede further ownership of American assets to foreign stakeholders who would be politically unacceptable if publicly acknowledged. Many foreign creditors are irate at the losses their funds, banks and pensioners have sustained from investments in the United States, and this plan provides a secret way to buy them off and keep them lending and investing as their own economies are roiled by the deflation to come.

For the past year the survivor bias has been orchestrated from the Federal Reserve, with its extension of innovative credit facilities and selectively engineered rescues or forced mergers. That has been very useful, but that well is now dry. The Fed has no more good assets to trade for the bad assets the banks can offer. And the supply of bad assets just keeps growing as market illiquidity spreads further from the core of the mortgage backed securities market. Instability is now leading to a realistic threat that the Fed and Treasury could lose control of the deflationary process.

Part of the reason the Paulson Plan is so attractive is that it recapitalises the Fed by promoting the unwinding of repos and lending facilities which left the Fed holding toxic assets. As the repos and credit facilities gradually unwind, these toxic assets can now be taken back by the banks and exchanged for good cash. The Fed gets its balance sheet Treasuries and cash back to restore its flexibility to intervene anew.

Favoured private equity and insiders who swap US dollars for equity in the banking system will presumably be aware of the survivor bias being engineered on their behalf. Sovereign wealth funds, investment funds and private equity investors ripped off in the first round of recapitalisation may be willing to come back in once it is clear to them that the next round will benefit from official favouritism. Warren Buffett’s timely stake in Goldman Sachs is clearly linked to his confidence the Paulson Plan will benefit them disproportionately.

A factor which is probably critical but has received little discussion is that literally thousands of Bush administration apparatchiks will need jobs come January, and a fair selection of GOP House and Senate legislators and their aides too. What better way to enahance their CVs in their final months in power than to distribute $700 billion or so in pre-Christmas largesse to the most remunerative employers in the world? And what better way to ensure the corporate largesse is returned to the GOP to win back the White House and Congress in 2012 as the recession fuels public anger?

And then there is a huge arbitrage opportunity as well so that everyone makes money for years to come. According to the conference call, the pricing on offer from the Treasury will be a bit below Level 3 pricing. The toxic assets will be repackaged and resold with a new AAA wrapper, possibly priced well below what the Treasury paid, assuring a huge profit on both immediate liquidation by the banks and ultimate maturity by investors. The Fed gets its cash and Treasuries back; the banks make huge profits; the foreigners and off-shore tax avoiders get disguised ownership of the American financial system; the taxpayer gets ripped off. What’s not to love?

Think back to Fisher’s Theory of Debt Deflation in Great Depressions. Dollars become “bigger” as deflation takes hold because each dollar can buy more assets as assets deflate. That means that as these clowns crash the markets, their $700 billion of liquid cash funnelled to their friends and recycled through the Treasury laundrymat can progressively buy up the rest of the pieces on the gameboard at low discount prices. Game over with those who caused the crash and robbed the bank winning.

Deflation is going to happen – globally. Either we can use the course of deflation to shape healthy economies that will provide growth and employment and productive returns on investment in future, or we can allow deflation to further enrich those miscreants whose irresponsible policies led to the violent financial collapse we are about to experience.

There is a fundamentally healthy economy in America – somewhere underneath all the financial excess and chicanery and all the financial/oil/military/healthcare/developer corruption of local, state and federal politics. It will be a painful and slow process to kill off the metastasising cancerous growths on the economy, but if Americans achieved that, they could embrace a healthier and more productive and more prosperous future.

I would like to believe Americans expressed the courage to change over last weekend when they 25 to 1 rejected an unconstrained and unconditional bailout of Wall Street in favour of cold turkey deleveraging of the economy. I wish I could believe that it mattered in the political calculus, but the result of the House vote on the bill will tell us that.

Fight the survivor bias. It’s not your survival they’re engineering.