In the US, the healthcare bill has passed and general attention is shifting back to the economy and financial industry regulation. As in healthcare, the stakes are high, for both the general public and the financial industry. As in health-care business interests are fighting hard for every inch and as in healthcare they are defending the indefensible.

Only, the subject matter seems much more complex for outsiders and politicians. The public’s lack of knowledge on finance is being brutally abused to engender fear and control the outcome. Even if more and more politicians seem to resist the power of the lobbyists, we are all stunned by the President’s insistence that the old guard determines the agenda (Paul Volcker aside).

Often we hear that this old guard, including the bankers we bailed out are the only ones who understand the issues. Are we really that gullible? There are enough financial professionals outside banking who understand the issues, almost certainly a whole lot better than the overstretched  leaders of our  “too big to fail” banks.  What’s more is that they should have great interest in speaking their mind in opposition of universal banks that have crowded them out during the boom and made a mockery of market mechanisms, literally destroyed it.

The necessity of serious structural changes in the financial industry is blatantly obvious, it seems, to everyone I speak to, even the bankers among them. Yet, there is a sense that the focus in the debate continues to be biased towards hedge funds and a so-called shadow banking system. Fact is that it was our large “Blue Chip” commercial banks, each larger than the global hedge fund industry combined, who spiraled themselves and our system out of control. The global top 20 of them doubled their balance sheets from 2004 to 2007 to $40 trillion, close to global GDP. Even if painful for those involved, the $50 billion Madoff scheme seems trivial.  

How did the banks do it? Simply put, they started to use their triple A rated commercial banking balance sheet (which is generally a very low risk business) to underwrite more adventurous business units. Their triple A ratings allowed them to raise funds at the lowest possible rate and invest in every kind of arbitrage opportunity, anywhere. Little surprise, their expansions were breathtaking and as a “lucky” byproduct risk premiums in their models collapsed in “virtuos” reflexivity with their self-created and increasing leverage.

No independent business or hedge fund would be able to beat these banks’ muscle and capital costs. Banks took over leadership across finance and in the process crowded out a diverse and multifaceted financial industry. The crowding out and loosing market share may have not hurt so badly since the cake was grown so fast and so large, even a much smaller slice of it felt very gratifying.

However, universal banking and its success has eroded the market’s raison d’etre, the efficient allocation of risk and capital. How did our global commercial banks, now universal banks cum Super HedgeFunds convince us that they knew how to integrate and effectively manage a myriad of businesses and risk structures across finance? They never had to convince anyone, not a regulator or a client, they just did it and increasing profitability was their proof of ability.  

Now, they have walked us into a financial crisis and based on the facts their businesses and their risk models have failed. To call this crisis a black swan event is good marketing but disingenuous. This was not a surprise nor an outlier nor an accident. According to many esteemed observers it was inevitable. Banks used a stable and low risk business to leverage themselves into unknown territory with doubtable tools and insufficient understanding. It is clear and had been discussed along the way that risks exploded, quite the opposite what banks’ models portrayed.

We can observe from the debate about compensation packages, our universal banks had huge trouble aligning interests and risks of decision-makers.   Their size and diversity of functions are an important factor but, I would like to suggest that false application of risk models made it impossible.  By now almost everyone in the financial world has come to understand and simplify the complex world of risk with one simple concept: price volatility and relative price volatility. Price volatility is a more or less workable proxy for risk for short term risk evaluation.  Banks however ignored longer-term risks, implicitly assuming that every long-term investment will become a short-term investment at some point.

Price volatility as a concept and its formulaic application are one-dimensional and make it easy to dissociate oneself from the real economic risks present in any investment. Add to this the fact that decision-makers mostly did not own nor were they directly tied to the capital underwriting these risks. Further take into account that price volatility is negatively correlated with liquidity and credit expansion. While increasing leverage obviously increased risks, applied risk measures collapsed having everyone believe risks were well managed.

Equally it was impossible for banks to use and structure derivative instruments properly. However, instead of focusing reform on the inadequate institutional structures the regulatory discussion remains on the instruments themselves. Throughout history financial crises always produce the instruments deemed most damaging, in hindsight. However, their particular characteristic matters not. Once the market is granted latitude to expand liquidity too fast and by too much the legal contract to package the deals to make it happen will always be found.  Let us be fooled into punishing the tools that have improved our lives and possibilities in many ways. We neglected transparency and oversight and expanded too fast; the exact instrument used is hardly the culprit.

If we have the goal to maintain systemic stability and avoid future financial crisis, it seems much easier and more effective to avoid excessive expansion of money and/or concentration of risks than to curtail and control financial innovation. As such the FED has to be ultimately responsible for not reigning in the extraordinary credit expansion, as this is its main purpose. The FED’s structure, focus of responsibility and transparency need addressing. 

Let me summarize: commercial banks took over inherently entrepreneurial niches in finance with their large scale bureaucracies and propagated and built a consensus towards a risk model that over time degraded the market’s ability to recognize and neutralize risks in small and digestible doses. Risk and capital became to be concentrated in the least capable institutions and the market failed. Ironically, Banks’ reliance on the assumption that markets are efficient directly caused market efficiency to break down.

Maybe Mr. Krugman is right in that we don’t have to break up our universal banks, maybe a sensible regulatory framework will do the trick all by itself and disintegrate these “too big to fail” businesses. But, in order to achieve any form of satisfactory reform, the perspective of the discussion needs to change. As long as the old guard, the largest and most powerful bankers along with the Fed, determine the agenda, there is little hope of restoring an efficient and sustainable market mechanism.

The issues are complex and of global nature.  It is time to get the non-banking financial industry leaders involved at the highest level. Today they have an opportunity to level the playing field, restore the integrity of their industry and help make ‘too big to fail” a thing of the past.

Good Corporate Governance demands that our large universal banks be broken up!

Over the years we have come to accept corporate scandals as normal fare in our capitalistic system. Still, when they are uncovered, these cases are nowadays generally dealt with little tolerance.

In the ultimate conclusion the ongoing financial crisis was caused by a monumental failure of governance. The discussion on re-regulation is thus a case of implementing a sensible system of governance. So, how are we doing? Are we on the right track? If not, why?

We know all about the breakdown of checks and balances in property lending, the rating agencies with perverse incentives and lack of independence or insurance companies who crossed over into capital markets without capital and/or know-how.

Certainly, some sensible changes seem under way, yet we continue to pull a blind eye on the largest and most harmful failures of corporate governance: the Federal Reserve and Commercial Banking.

The Federal Reserve is the institution at the top of our global financial system that has not only failed to govern the system but is itself a case of bad governance. Yet, it is not even questioned, instead it is being hailed as the savior from the crisis and an expansion of its role is being discussed.

Commercial banks on the other hand are fighting Paul Volcker and a growing number of elder bankers such as John Reed ex Citi, Nicholas Brady ex Dillon Read and head of Treasury under Reagan or John Bogle ex Vanguard who are pushing aggressively for a new version of Glass Steagall.

The bankers’ main counter to a break-up is the threat of a depression.  I cannot support this argument. How could restoring rules in place before the crisis was built be any worse than what we have now?  But it is true that there has to be a basic global arrangement. Finance more than any other industry is enormously fungible and globally mobile. Any country’s solitary action would simply lead to migration. Thus, on top of all the local hurdles, we need to come together and agree on a minimum standard for corporate governance within our global system.

When Glass Steagall was abolished in 1999, commercial banks expanded into everything that promised to lift profitability, from proprietary trading and investment to investment banking, investment advice, asset management, insurance and financial engineering. At that time European banks were already happily at it. However, instead of the world following the US with a good idea, the US followed the world with a profitable idea.

If politicians were sold on a model of dispersing or diversifying risks, in actuality risk became more concentrated. The financial system is not like the car industry, it is more like the transportation industry. Imagine a company were to build trains, planes, cars, boats and bicycles. The difficulties of integrating a full range of financial businesses and risks into one balance sheet have been fully exposed by this crisis.

It is not money or the financial system per se that creates innovation, growth and an improvement in the quality of our lives. Finance is merely the means to an end, the tool to create the optimum condition for valuable production or services. If, as is the case today, the lubricant, the catalyst within a system accounts for 40% of a system’s value, something has gone horribly wrong. The numbers are staggering and they point squarely at the banks, the global top 20 of which managed a combined balance sheet of more than $40 trillion in 2007 with their core businesses shrunk to often less than 20%. Bernie Maddoff may be an attractive Media target but his $50 billion fraud looks rather unsubstantial.

Bankers made the argument that spreading their wings into different areas of finance would help them diversify their business risks, i.e. reduce the volatility of their cash flows. The assumption is correct but it does not result in proper risk management, often quite the opposite. The supposedly reduced risks, indicated by a reduction in cash-flow and market-price volatility justified banks to expand businesses and leverage further in a reflexive cycle fed by derivative structures and the Federal Reserve. The ultimate result of this madness is that the stability of the system has come to rely on the ability to expand liquidity instead of sound structures that rest on sensible governance structures.

One of the most clear-cut distinctions between business models and risk structures in finance can be made between businesses dealing primarily with deterministic services and those that deal with an array of (often uncollateralized) uncertainties and time-frames that are not deterministic by definition.

Commercial banking concerns itself with largely deterministic, low risk finance. Banks take deposits, offer transaction and payment services and lend money attached to low-risk collateral. Commercial banking is very local and relationship based. The process is simple, involved, yet factory-like, with pretty much one contract matching the next, administered and overseen by a well-run back office in a secure and organized process. With all the ancillary functions—trade finance, foreign exchange, capital market access, payment services—a large national or global bank is a layered and multifaceted bureaucratic organization. Technology and experience have matured commercial banking into a commoditized, fairly low margin business whose risk is defined principally by overall economic stability and the leverage it is allowed to take on.

As such commercial banks are not set up to analyze or take non-collateralized risks, i.e. to manage funds and advise on investment. The management of non-collateralized risks and longer time-frames is generally very specialized, independent and most successful in entrepreneurial set-ups.

Fortunately, commercial banking is quite easily definable and detachable from the rest, in particular as there doesn’t have to be a strong line of separation. I see no reason not to allow commercial banks to engage in trading, investment banking, insurance or any other financial services that a client of theirs might require, as long as they remain marginal and account for less than 20% of the business, compared to often up to 80% today.

There is no alternative to ultimately breaking up these behemoths and contrary to what bankers have us believe, it is not difficult and not nearly as dangerous as the course we are pursuing now. It is not primarily a matter of technicalities, or global economic Armageddon, it is a matter of political will… to be continued

At the State of the Union, last week the President again delivered an inspiring speech. Certainly, one feels compelled to follow the lead. His number one priority in 2010 is to revive the economy and to create jobs. Yet, as convincing as the President lays out his plan, it smacks of Sisyphus and contrary to his opening remarks avoids the tough but necessary choices.

Looking back one year, the President’s assessment is that an economic crisis of the scale of a (Great) Depression, was avoided. However, irrespective of stock-market prices and the few positive signs of economic revival he can point to, the fact remains that the US economy remains flat on its back. Worse, the fundamental causes of this developing crisis remain firmly in place. The architects of the “successful” rescue plan are showered with praise for providing the financial system with the equivalent of a huge adrenalin shot, which achieved no more than to stop the decline and send the liquid asset markets into a frenzy. One year on we are looking at the highest stock market valuation in a century of data (Dow Jones and S&P, based on four quarter trailing earnings). Wall Street said thank you with record bonuses and Time Magazine celebrated with the man of the year, Ben Bernanke.

Despite the “good news”, the President concedes, much has to be done. He lays out his plan in some detail, mentioning small businesses, tax breaks and credits, lending programs, infrastructure programs, clean energy investments and importantly, investment in education.  Most sensible observers – outside the silly right wing supply side clique – agree with the President on the necessity of these programs. Although, the devil will be in the details and there is more than just a whiff of government activism. The President’s plans are not simply an attempt to create jobs but are in my view essential to rebuild the country’s basic infrastructure that has been wholly neglected during the past decades. Despite dim-witted proclamations of still too many political leaders blindly misquoting Thatcherism or Reaganomics, there is a role to be played by government (besides waging war) such as the provision of basic infrastructure, basic education, fundamental research or a sensible regulatory frameworks. The notion that industries should regulate themselves is unjustifiable, self-serving non-sense.

As the President further points out, his measures have been (and will be) insufficient to make up for all the jobs lost and in bringing back the economy to a sustainable growth path. As many ideas that spring from his creative mind, disappointingly, the President’s carefully avoids addressing the country’s historic level of debt that has to be digested and reduced. He dares not mention the realities of this inevitability, its deflationary and destructive reality for asset prices as well as economic growth. The US alone has accumulated a debt close to 4 times its GDP, mostly carried by its financial institutions and its consumers. Put that into relation to 1.6 times GDP prior the Great Depression. And, as I have been pointing out time and again, this enormous liability was built on the backdrop of investment and risk management tools that have corrupted any semblance to efficient markets during the past couple of decades (you will find a more detailed analysis of this in the book) and have divorced finance from the real economy.  It is truly a monumental mess. Our leaders dare not mention it.

Any sensible strategy to heal our economy has to focus on the financial industry and its key agent, the Fed and how to reduce the exorbitant levels of debt they have accumulated. Yet, the subject was a paltry side-note in the President’s speech. Now, that might have been a political decision. Admittedly, more recently, the President has spoken with a new-found toughness in dealing with special interest groups and Wallstreet in particular, demanding a “fee” of more than 100 billion from the large banks as well as regulatory changes. A modern version of Glass-Steagall seems to be in discussion, finally! and Paul Volcker is given a stronger voice (he hits the nail on the head in the New York Times http://www.nytimes.com/2010/01/31/opinion/31volcker.html?).  Yet, shockingly, there is hardly any mention of the Fed and the fundamental reform that is needed to restore some semblance of sensible monetary management. In fact, Fed Chairman Bernanke has just been reappointed, which endorses the policies that have led us into this mess and assume that they have saved us from a further bigger mess. However, if that leaves us hopeful for any reform at all in our financial system, it will be half-hearted at best and while politics justifies half-heartedness as pragmatism, in this particular case, half-heartedness will most definitely make matters worse.

On the one hand, not splitting up our universal banks (into good banks and bad banks) means that the entire financial system that is visibly and predictably retrenching in deflationary mode will be forced into even greater cut-backs. On the other hand, the practices and risk models applied on Wallstreet will continue to distort our financial system’s processes, reinforce its detachment from the real economy and propagate the excesses of the past. All the while, the Fed will be allowed to continue to conduct its monetary policy of the most foolish sort, steering us straight into the abyss.

With absolute certainty the US (and much of the rest of the world) finds itself in the early stages of a deflationary de-leveraging process. There is no point in fooling ourselves, this will be painful for Wallstreet and Mainstreet. However, fighting inevitability with frantic activity, makes this much more painful for the real economy than is necessary. The President tells us about his conviction that he is absolutely sure to have done the right thing, the necessary thing even though it was “as popular as a root-canal” to everyone involved. Henry Paulson, one of the architects of these policies and former Chairman of Goldman Sachs admits today that they had “no idea what they had to do”. Listening to Larry Summers, giving interviews in Davos gives no indication that he knows any more, a year and a half on.

And so the big plan they came up was to save a number of large commercial banks, which had really become oversized hedge-funds. Although they had no idea what to do, they came to the conclusion they needed to “save” a few global financial superstores to save the world. But it was not the necessary thing to do, nor the right thing to do, it was the easy thing to do: there is no way back, hence full steam ahead, continuing in the tracks of the same policies that have arguably caused the crisis in the first place.

The necessary and courageous strategy fundamental to saving the financial system would have been and continues to be splitting off the commercial banking books from the mostly toxic and leveraged “asset plays”. This means removing the essential commercial banking businesses from the crushing weight of their often many times larger and more “profitable” hedge fund businesses. If we indeed want the economy to start creating jobs, it will not be without the help of a healthy commercial banking system. Saving the monstrous hedge funds that we have allowed to build achieves the opposite, as it inevitably paralyses lending further.  When we fight deflation, we have to fight the deflation of our commercial banking system and the subsequent deflation of our (still healthy) businesses and shield them as much as possible from the necessary and unavoidable deflation of the towers of debt we have built, mostly on non-cash flow generating bets. Most of these “too big to fail” bets are about as far removed from the real economy as we can imagine. We haven’t saved the system, we pumped air into it, jobless fluff.

Allowing our banks, i.e their hedge-fund books to be exposed to the market mechanism would certainly bring down asset prices in a hurry and would likely result in a bit of a shock to the system. Let us remember though, asset prices are a price tag of the economy, they don’t determine or create value, they price it. Who wants to argue the real economy would stop in its track and we would all go home and retire because assets are re-priced? Indeed, a continuance of current liquidity pumping and fiscal bail-outs is sure to paralyze the financial system, and over time deflate our (still) healthy businesses; then we can go home and retire.

Sisyphus is busy plugging the holes punched into the system over the past decades, frantically distributing “sand-bags” and “duct tape”. He is a well-meaning and hard-working fellow but we cannot close our eyes to the root problems of this crisis. Current policy lacks a clear strategy, it is an accumulation of tactical measures that is likely to create less jobs than are being destroyed by the lack of decisiveness and spine in dealing with the financial system. Job creation leads through the financial system!

Happy New Year!!!
Baron of Munchhausen {PDF}

And yet again this blogger was side-tracked by the intensity of starting up businesses. I sure hope to be able to write more in 2010. Although somewhat belated, I don’t want to miss wishing you and your loved ones great health, abundant wealth and happiness in the New Year ahead.

During this reflective season the words of a wise friend of mine came to mind, “our dreams and aspirations are the blueprints to our lives”, a good thought to start my year.

As much as I believe in the basic truth of these words, there are some things that remain (for now) impossible for us humans, like teleporting or turning lead into gold.

As we begin a new year, markets, media, pundits and officials are united in celebration of a crisis behind us. The Economist calls it the “Great Stabilisation”. Mainstreet, small businesses and the growing rank of unemployed are asked to be patient, after all employment is never the first statistic to turn around. Demand will eventually return, somehow, as it always has, irrespective of the fact that in recent years it was driven entirely by an unsustainable credit expansion.

And there it is, the word “unsustainable”. Ben Bernanke along with the ruling interests disagrees, believing it is all a matter of liquidity and confidence, as they have “proven” for decades now. If everyone just believes that there are no limits to credit, it will make it true.

Consensus economic and stock-market expectations are far too optimistic. They limit their expectations to past “crisis” that were all “solved” by injecting liquidity into the system. The difference today is that this liquidity doesn’t flow through to the real system anymore. It stops at the banks and reverses flow into the central bank. The only life-blood that reaches Main street comes in the form of silly consumption driven programs such as “Cash for Clunckers”. TARP money spent on investment is almost negligible.

While the economy has become too risky for the financial gatekeepers, Ben Bernanke rides to the rescue in making financial  “investment” (once more) a sure bet, even at zero interest rates.

It created the dollar carry: “investors” (banks, in one form or another) are taking credit at zero interest in a currency (the dollar) that is driven down by the FED’s degrading balance sheet and fiscal debt expansion as it trades its pristine assets with the rubbish the market has accumulated during the heydays of the subprime mania. In essence, any hedge fund trading the rebound is paid to leverage itself up with what is effectively a net negative interest rate. As Bernanke promised in his infamous “Helicopter Speech” the game doesn’t stop at zero interest rate…. at least not as long as it holds.

Markets are up, risk indicators down, bonuses large, economy? Not as bad as it used to be, conclusion: crisis averted, hail Time Magazine’s man of the year Ben Bernanke.

Given the enormous interventions and consumption promoting activities in the US (and elsewhere), I find the scale of the “rebound” is rather disappointing.

Retail sales are still a good 10% below last year’s, durable goods orders in the US have hardly recovered, down 23% from last year, construction spending is down 13 percent and still sliding, housing starts are at minus 30% and flat-lining.

Whether signs of recovery are large, small or in-existing, Credit, the main driving force behind the demand that defined almost a decade of economic growth is contracting and will continue to do so. Consumer credit is contracting the fastest, delinquencies have exploded to 9% and credit card limits are cut almost across the board. The only party that is expanding credit is the government. The FHA (Federal Homeloan Agency) is underwriting mortgages as if there is no tomorrow with down-payments of as little as 3.5% while 25% of their loans given out just 2 years ago are delinquent. Maxine Waters, California Congresswoman, rightly points out “Let’s be clear. Without FHA there would be no mortgage market today.”

Unfortunately, as inflationary as the government’s intention much of its actions are deflationary by definition as total money (money plus credit) in the system as a whole continues to contract.

Re-regulating the financial system, no matter how benign, is deflationary. Although I do applaud the increasing popularity of bringing Glass-Steagall back, any form of it will be deflationary.

Far from signaling the end of the recession, the story of the financial markets in 2009 brings to mind the great Baron of Munchhausen, who, in one of his famous fantasies pulls himself and his horse out of a swamp by his own hair.

Liquidity propelled stock-markets are supposed to pull the economy out of its deleveraging mode with the gracious help of the FED and yet another carry trade.

Whatever the economic benefit or efficiency of this new credit, according to the Fed chief, fresh leverage is supposed to fix the economy. A formula that has been working for a long, long time but unfortunately, not unlike drug addiction, the system screams for every larger dosis  with ever increasing leverage needed to create the same effect.  In the 1960ies a dollar of debt taken on resulted in more than 60 cents of real economic growth. In the past 10 years one dollar of new debt meant no more than 14 cents of real growth. Shall we guess the efficiency of the current government driven debt expansion? Our debt is already 3 times the size it was before the Great Depression. What has gotten into us?

At the center of this financial madness are the large universal banks that have even increased their size and dominance since the crisis started not by lending but by swallowing smaller, less important institutions. And our financial superstores are largely left to continue as they were, managing huge balance sheets with the same silly risk models that are to a large extent responsible for this crisis.

And as to our monetary leadership, it seems ironic that a band of modern day Keynesians with their utter disregard for a coherent theory of capital and risk has been left in charge of a financial system that has become all about capital and risk.

Existing risk models had been discredited long before the crisis and have yet to be addressed by any of the new financial regulations announced.  Not in any of Mr. Bernanke’s analysis of the Great Depression have I found reference to the effects of leverage, the size and quality of debt as a major factor in both economic and monetary management. Why is everybody assuming investment during the past 30 years on the wings of modern financial theories was so immensely efficient? In many professional experts’ view quite the opposite is actuality.

It is no secret that liquidity stabilizes markets. That is its inherent quality, no magic!  However, we should not confuse market stabilization with a reduction of risk. Unless we are experiencing an historic break, the productive underbelly of our economy is driven by investments and cash flows and not fictitious asset valuations conjured up with ever-increasing leverage.  Unless Baron Munchhausen’s tale has a happy ending stockmarkets will eventually reverse south, possibly quite viciously.

Quite often I am being asked where to put money when everything is so gloomy. Indeed it is a bit tricky, gone are the days of buy and hold and everything is going up. The way down will be a bumpy ride. As a stock-picker I have always relied on company specific investments and cared less about the general environment. And that is what I am doing, but say you have excess funds, in the long-run, I would buy a lot of gold, physical Gold. Although, short term, I believe we will see a sizeable correction in Gold during the next 6 months as financial deleveraging accelerates. In a deleveraging environment generally liquid markets move highly correlated. I see that monetary push that pulled the carry trade is exhausted. The Fed will stop the mortgage train in March. What happens to the carry trade and markets when the long expected relief rally in the dollar takes off is clear. All asset markets correct, US treasury bills will be the safe haven >> ergo buy US 10 year T bills. No stocks, no fringe securitized paper, no commodities.

During the course of this probably quite long bear market (low in 2012/2013 as a guess), one will have to be nimble and reassess the risks on an ongoing basis. It could get wild.

Next to all this gloominess, I can see many reasons to be optimistic for our future. One of them is technological change that is visibly accelerating and is transforming our lives in many positive ways. When I find time next to write, I will share some of my thoughts on the bright future I see ahead.

Until then, keep safe and enjoy the moment. HsO

Reforming Banks II, United Kingdom

UK authorities have announced that they will break up two of its banks, the ones it now controls, Royal Bank of Scotland (RBS) and Lloyds. Back in 2006, RBS was the world’s largest bank as measured by the size of its balance sheet, which then amounted to $3’700 billion. RBS was also by far the fastest growing large bank in the years up to the crisis. No wonder it is in trouble, again. RBS and Lloyds are to be supplied with a total of $88 billion in capital, almost $50 billion from government funds.

Rightfully, the government should start to influence how these banks are run. However, the direction this influence takes doesn’t follow sound logic but advice from these banks’ competitors and supposedly pressures from the European Union competition authorities.

According to the Financial Times, RBS is held to sell its insurance businesses (Direct Line, Churchill and Green Flag), its small business operations in England and Wales, and its Global Merchant Acquiring business and Sempra, a commodities trading business. Lloyds will be forced to sell some of its retail banking operations and its Intelligent Finance online business.

Most everyone agrees that our financial superstores will have to be reduced with the goal to eliminate the hazard of businesses that are too big to fail. It is however preposterous to sell this effort with arguments of competitive policies which are nowhere near the center of our issues we have with banking today. Simplistically reducing bank’s size doesn’t change the fact that these banks run business lines for which they lack competence and institutional structures. The issue is not that that we have had commercial banks dominating a particular area or of commercial banking or too much concentration in any area of finance.

The issue is that our largest financial businesses try to run every kind of banking and financial service there is and are, not surprisingly, in over their heads.
Of course and without any delay, compatriot Joe Ackerman, CEO of Deutsche bank and supposed spokesman for our financial superstores has taken a stand against the “totally misguided” downsizing, calling it “unacceptable”.

He is right in one thing, the problem of too big to fail will not be solved by asking a bank with a $3’700 billion balance sheet to sell some branches and fringe businesses in which competitive authorities find “too much” concentration. It will still resemble an over-sized hedge fund, itself larger than the global hedge fund industry combined. RBS will remain intertwined and interconnected in the globally fungible world of finance. It will still run businesses for which it is utterly unqualified. And it will continue to do so with risk management tools that are sophisticated only to a non-mathematician and wholly inadequate, to put it very mildly.

Even though Mr. Ackerman is right, UK authorities are “totally misguided” in their action, his outrage only counters the advice given by his colluding peers across the aisle in a farcical charade that diverts attention from the real solutions, which would arguably be much more drastic for Mr. Ackerman and his peers.

I for one do not want to hear from Mr. Ackerman again until he explains how he manages his bank and its risks and tells us how his sophisticated models have failed him and his peers so miserably. I want him to explain the more than controversial concept of Value at Risk (VAR) to the public and why he believes he can be everything to everyone: an Investment Banker, an Asset Manager, a Private Banker, an Insurer, a Commercial Banker, a Derivatives Trader, a Broker and an Adviser on most everything the world of finance has to offer today.

Unfortunately, as long as government is being advised by the very banks it ought to reform, I guess we are fools to expect any independent logic in policy decisions. Even heads (and former heads) of central banks, i.e Mervyn King and Paul Volcker do not seem to have the gravitas to redirect the fateful course we are on.

Capital Requirements for Banks

On July 10, 2009, the Economist writes about the need for increased capital requirements for banks.
Interestingly, in all its writing about the financial crisis and its resolution the reputed weekly is shying away from tough questions. Ironically, it writes “politicians seem not to have the stomach for the fight” for more radical changes. Indeed political will is the main issue today with the tough love necessary for our financial businesses.
One of the main conclusions of my research is that a carving out and nationalization of commercial banking assets from our financial superstores is doable and necessary: never mind too big to fail, too big, period. Our large money-center commercial banks, cum hedge funds have to be broken up along institutional lines (Glass Steagall II). These banks are running different business models on one common platform, under one roof with distorted compensation structures, applying inadequate risk models, relying on meaningless internal risk management tools and are driven by enormous corporate and individual leverage.
Government has to reshape the structure of our financial system, it has to take over and restructure failed institutions, which does not mean that it needs to run these banks. It means government controls the board and drafts management and compensation contracts that are symmetric and measured. Ownership does not equal management. With new rules in place, these banks should be re-privatised almost immediately.
The Economist also bemoans that higher capital requirements will lead to higher interest rates. The point is completely off the mark. Why?
First, interest rates will rise eventually no matter what. By now it should have become clear to everyone that the interest rate environment of the past decade was the result of the extraordinary amount of liquidity provided to the system. A reversion to sustainable levels is not debatable, it is only a matter of time.
If borrowing rates are lower than the cost of equity capital, the higher the leverage, the lower interest rates will be in the system.  Part of the reason we enjoyed historically low interest rates was precisely the enormous leverage we built. Using it as an argument against reducing that leverage is quite silly, really.
Second, Banks’ assets have a very diverse risk structure. The conversion of interest rates amidst the collapse of risk differentiation was one of the main distortions in the system fuelled by its myopic treatment of risk. Commercial banking, by its very nature is low risk, direct relationship banking that thrives on scale and sound organizational structures (one reason why mortgage lending was assumed to be very low risk deep into the sub-prime mess). Ordinarily, these assets are the healthiest components of our banks’ balance sheets, even today. Commercial banking is the backbone of our financial system and, if managed prudently, has a much lower risk profile than the securitized investment businesses that are crushing our financial industry.
Commercial banking can be run at very low cost. There are great examples that have reached global scale while sticking to its knits. HSBC, without doubt one of the best run large commercial banks has for long followed the strategic maxim of not straying outside of its core business. The bank continues to thrive. HSBC is one of the few truly global commercial banks. Certainly, it is a saturated market, incurring low rates of growth and little opportunity for expansion. Get used to it!
By taking over failed commercial banks, cum hedge funds, the US taxpayer retains the crown jewels of the system and has a chance to re-establish sound structures and stability at the core of the financial system, all with a budget that is defensible. US commercial banking assets amount to approximately $6 trillion. Assuming government takes ownership of half of these assets, and assuming a 20% write-off (which may be on the high side), total costs amount to no more than $600 billion.
As described in “Eye of the Storm”, whichever way we look at the issue, $50 trillion of total debt, more than 3.5 times GDP, towers over any historical comparison. As an example, merely to shrink back to pre-Great Depression debt levels we would have to take out more than $25 trillion. With an estimated maximum discretionary budget of $5 trillion (excluding debt service payments and recessionary revenue shortfalls) over the next 10 years, the US taxpayer cannot afford anything but an orderly liquidation of these assets.
Given the practices with which this tower of debt was built, we have to assume that a significant portion of it will not survive the looming depression. So far, most of the money spent on this crisis has been taking up more debt, by the taxpayer, to unburden the banks from the worst of these assets. Authorities continue to operate on the assumption that we are in a crisis of confidence and liquidity, while in fact it is very clearly a crisis of over-leverage and mal-investment.
A split up of our banks is doable, it is necessary and it is indeed the only financially viable option. Apart from a reversion to the mean, it will not result in structurally higher interest rates but it will give us a chance to re-establish tested and trusted institutional structures in our financial system, from ground zero, preparing it for the economic pain of the inevitable deleveraging and large scale deflation of asset markets ahead of us. If political will for a tough and professional stance on bank regulation doesn’t materialize, the realities of this crisis will force much more drastic measures further down the line.
The lack of political spine should not be a reason for the Economist to chime in half-baked solutions. If we are to find the will to carry through necessary reforms, our media, in particular such industry heavyweights as the Economist (and others), need to start asking tougher questions. Otherwise we have to start asking some tough questions about their alignment of interests.

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The economy shows signs that it has stopped from falling and markets are up sharply from their low earlier in the year.
Does this mean the crisis is over?
In my last blog “Is this Crisis Over?” you can read about a few reasons why that is highly, highly unlikely. And there is more…
Good friend and brilliant economist Jim Walker has just published an article that brings evidence to the dynamics I am describing in “Eye of the Storm”.
Dr. Jim (as he is lovingly called in the investment community) explains and shows that all that money created by the FED since this crisis started (approximately $2 trillion) has immense trouble finding its way into the real economy but instead sloshes around asset markets, pushing up asset prices.
Despite a more than doubling of base money since early 2008, the US economy has not found any traction and continues to contract. Jim shows that the transmission mechanism is broken. The creation of M1, which is the base of money influenced by central bank action is not even translating into growth in M2, which includes parts of the private sector’s decisions in uses of  money.

Thus, as expected, the Fed is creating a lot of liquidity that does not translate into economic activity.

Loan growth is (and will remain for some time) negative.

One of the key characteristics of this crisis is that it was built on credit. The levels of credit outstanding are unprecedented and unsustainable. The FED continues to believe that creating base money will eventually restart the credit mechanism. I agree, but the cost is very high, in particular for main street. The Fed will have to print a lot of money. Its balance sheet has been expanded to approximately $2.5 trillion. This compares to a total US debt outstanding of $50trillion. All the additional money has been doing was finding a way to become profitable, and no matter what the Fed would like it to do it is not finding its way into the real economy and thus needs to flow into asset markets.
This is evidence that the US economy is not nearly as sound as markets and media are portraying. Markets are celebrating the end of the crisis with taxpayer’s money while hardly any of it is flowing into the real economy. In the meantime still sound businesses and most of all smaller local banks will be watching their loan books deteriorate on falling commercial property and a generally worsening business environment.
These banks and businesses we thought safe and sound because they didn’t engage in all the fancy financial engineering are going to be hit hard in the next round of collapse.
Unfortunately, international dynamics are exacerbating the situation… but this is a subject for another letter.

First posted Feb 17, 2009

This question was subject of an article in the Swiss Daily “Tagesanzeiger” , February 12, 2009
For those who don’t read German. In essence the article is talking about an exposure of Swiss banks to eastern European Residential mortgages in the amount of USD 200 billion, that may bankrupt the country.
The situation is in fact much worse than that. Here is an excerpt from “Eye of the Storm” that sums up the situation for Swiss financials.
…, consider Switzerland, a rock-solid country with a GDP of $400 billion, a positive budget, and a public debt of $200 billion, none of it foreign. Switzerland has a very strong economy and a great variety of businesses, small and large, with global size and reach despite their miniature launching pad. We’re talking about Nestle (one of the largest consumer goods brands in the world), Novartis and Roche (the chemical giants), ABB (the global capital equipment giant)—not to mention numerous specialized niche businesses, particularly in mechanics and electro-mechanics. The country, with one of the most efficient public services and a truly world-class infrastructure, is at the forefront in environmental technologies. And let us not forget finance, with UBS and Credit Suisse among the largest global banks. Swiss Re is Munich Re’s main global rival in reinsurance, and Zurich Insurance is one of the largest global financial services companies. It is a splendid, rich, rock-solid economy that punches far above its weight-class on a global level. But now it could be crushed by the punch that is about to land.
At the end of 2006 the assets of the two largest banks in Switzerland alone by far outstripped the size of its host economy. Together they combined an equity base of $80 billion, with outstanding commercial banking loans of $460 billion (mostly domestic commercial banking assets) and other managed assets (mostly foreign leveraged engagements) on their book of $2.8 trillion. Moreover, both banks advised clients for assets in the amount of $4 trillion. In total, Credit Suisse and UBS have managed and influenced assets in the amount of $7.25 trillion, almost 15 times the size of Switzerland’s GDP. Should 20% of noncommercial business go bad and have to be written off (i.e. 20% of $3.25 trillion) by the Swiss government, taxpayers would have to foot a bill of approximately $650 billion for the rescue of these two banks alone. Together with the outstanding debt of $200 billion, total Swiss debt would rise to $850 billion (not counting revenue shortfalls during the crisis)—almost twice its GDP. In a global recession where tax revenues ($150 billion in 2007) are sinking, this would easily turn an $8 billion surplus into an unsustainable deficit. Debt service would increase the bill by $40 billion at a conservative interest rate of 5%. Together with falling tax revenues, the budget deficit could easily explode to $60 billion or more, or 15% of GDP.
It is clear that this and even tamer scenarios would raise the specter of a debt spiral in Switzerland. Think: Switzerland, a country that looks rock solid, with a currency that is still a beacon of stability and safety, could be torn to shreds by a necessary monetization of debt. Yet government and central bankers still seem relatively unconcerned and are grudgingly supporting the two giant banks.

«Der Schweiz droht der Bankrott»
Interview: Claudio Habicht; Aktualisiert am 17.02.2009
Schweizer Banken haben Milliardenkredite nach Osteuropa vergeben – nun können die Kunden die Gelder nicht zurückzahlen. Der Schweiz drohe das Schicksal Islands, sagt Wirtschaftsexperte Artur P. Schmidt.
«Die Schweiz könnte vielleicht gezwungen sein, den Euro zu übernehmen»: Artur P. Schmidt.
Nationalbank sieht keine Gefahr
Laut Nationalbank (SNB) sind in Zentral- und Osteuropa Frankenkredite in der Höhe von 75 Milliarden im Umlauf. Die Nationalbank glaubt nicht, dass die Frankenkredite in Osteuropa einen Einfluss auf die Stabilität der Schweizer Währung haben. Sie stützt sich dabei auf zwei Studien: Diese kommen zum Schluss, dass die Risiken im Zusammenhang mit Frankenkrediten im Ausland kleiner sind als befürchtet.
Die Kredite seien in Haushalten und Firmen konzentriert, die entweder eine hohe Risikofähigkeit besässen oder Einkünfte in fremder Währung aufwiesen. Die Schweizer Banken sind laut SNB im Detailgeschäft mit Krediten in Osteuropa kaum aktiv. Die Frankenkredite werden durch lokale Banken vergeben.
In Ländern wie Polen, Ungarn und Kroatien ist der Franken zur wichtigen Fremdwährung geworden. Tausende Haushalte und Kleinfirmen nahmen ihre Kredite wegen tieferen Zinsen in Franken auf, und nicht in den Landeswährungen Zloty, Forint oder Kuna. In Ungarn sind 31 Prozent aller Kredite in der Schweizer Währung ausgestellt, bei den privaten Haushaltskrediten sind es fast 60 Prozent.
Kreditnehmer in Nöten
Nun hat die Finanzkrise die Ära der günstigen Kredite beendet: Die Ostwährungen sacken ab. Ende September musste man für 100 polnische Zloty noch 46 Franken bezahlen, heute sind es 30 Franken. Das heisst: Immer mehr Kreditnehmer kriegen Probleme mit den Zinsen und bei der Abzahlung. Die Frage ist also, wie sich das auf den Schweizer Finanzplatz auswirkt. Einer, der für die Schweiz schwarz sieht, ist der Wirtschaftsexperte Artur P. Schmidt*: Er glaubt, dass die Schweizer Währung wegen der Frankenkredite in Osteuropa in Gefahr ist.
In Polen, Ungarn und Kroatien ist der Schweizer Franken zur wichtigen Fremdwährung geworden – sozusagen zum Dollar Osteuropas. Tausende Haushalte und Unternehmen haben Franken-Kredite aufgenommen. Warum?
Das rasante Wachstum in vielen Ländern Osteuropas wurde durch Kredite in Schweizer Franken angekurbelt. Schweizerische Banken und Offshore-Institute haben den dortigen Banken Franken geliehen, die diese an ihre Kunden weitergaben. Die Kredite waren attraktiv, weil die Kreditnehmer viel tiefere Zinsen zahlen mussten als bei Krediten in der jeweiligen Landeswährung.
Nun ist dieses System ins Wanken gekommen.
Ja, das System hat nur so lange funktioniert, wie die Wechselkurse zwischen Franken und diesen Währungen einigermassen stabil waren. Das ist aber zurzeit nicht mehr der Fall: So haben der ungarische Forint und der polnische Zloty in den letzten Wochen gegenüber dem Franken über ein Drittel an Wert verloren. Wegen der Abwertungen der Landeswährungen haben sich die Schulden gegenüber der Schweiz um mehr als einen Drittel gesteigert. Viele der osteuropäischen Länder haben ernste Zahlungsschwierigkeiten und stehen quasi vor dem Staatsbankrott.
Was bedeutet das für die Schweiz?
Es ist anzunehmen, dass ein beträchtlicher Teil der insgesamt 200 Milliarden Dollar Osteuropa-Kredite in Schweizer Franken ausgestellt wurden. Gemäss einem Bericht der Bank für Internationalen Zahlungsausgleich sind weltweit Franken-Kredite im Gegenwert von rund 675 Milliarden Dollar im Umlauf – davon wurden etwa 150 Milliarden direkt von der Schweiz, 80 Milliarden von Grossbritannien sowie rund 430 Milliarden Dollar über Offshore-Finanzzentren vergeben. Wieviele dieser Kredite faul sind, ist nicht bekannt. Doch schon wenn die Ausfallrate 20 Prozent beträgt, würden die Banken viel Geld verlieren.
Muss nun der Bund eingreifen?
Wenn die Banken einen massiven Abschreibungsbedarf durch solche Kredite haben, muss ab einer bestimmten Grössenordnung der Staat eingreifen. Dies geschieht bereits durch die Schweizerische Nationalbank: In Polen hat sie der dortigen Zentralbank mehrere Milliarden Franken zur Verfügung gestellt, damit polnische Banken die Kredite decken können. Zugleich hat die schweizerische Nationalbank bereits bei der Europäischen Zentralbank angefragt, ob ihr diese im Notfall Geld ausleihen könnte. Dies ist ein klares Warnzeichen, dass der schweizerische Franken in Bälde unter einen enormen Abwertungsdruck geraten könnte.
Waren die Schweizer Banken zu unvorsichtig bei der Kreditvergabe in Osteuropa?
Ja, in der Tat. Viele Banker wollten zu viel verdienen und haben dabei die Risiken vernachlässigt. Schuld ist auch die Nationalbank, die nicht eingegriffen hat. Zudem haben die Aufsichtsbehörde und die Politiker völlig versagt.
Was muss die Schweiz nun tun?
Nun müssen die möglichen Verluste durch diese Kredite auf den Tisch; vor allem müssen alle möglichen osteuropäischen Risiken lückenlos offengelegt werden. Zusammen mit den Kreditausfällen von UBS und Credit Suisse könnte der gesamte Abschreibungsbedarf für die Schweiz die Grössenordnung des Schweizer Bruttosozialprodukt übersteigen.
Das heisst?
Der Schweiz droht wie Island der mögliche Staatsbankrott. Eine Folge davon wäre, dass die schweizerische Währung massiv an Wert verlieren könnte, möglicherweise sogar crasht. Eine andere wäre, dass die Schweiz in ihrer Kreditfähigkeit massiv zurückgestuft würde. Das wäre ein Trauma für das Land: Die Schweiz galt immer als Hort der Stabilität. Der Franken könnte zu einer instabilen Weichwährung werden. Dann würde die Schweiz vielleicht gezwungen sein, den Franken aufzugeben und den Euro zu übernehmen.
*Artur P. Schmidt ist promovierter Wirtschaftskybernetiker und Herausgeber der Finanzportale www.wallstreetcockpit.com sowie www.bankingcockpit.com. Er hat elf Bücher verfasst, sein aktuellstes Buch «Unter Bankstern» ist im EWK-Verlag erschienen. Schmidt schreibt zudem Fachartikel und Kolumnen für die Nachrichtenportale moneycab.com und telepolis.de. (Tagesanzeiger.ch/Newsnetz)
Erstellt: 12.02.2009, 13:22 Uhr

An Answer to the Soros Policy:
How to Value Troubled Assets?

Comments by Stephan Olajide-Huesler

The buzz at the World Economic Forum was all about building good banks and bad banks, seemingly inspired by a George Soros article that had appeared in the Huffington Post.
But determining how to do this would mean distinguishing among assets and valuing them. Hence the question: How can we distinguish and ultimately value troubled assets? The short answer is we can’t—and really, we dont need to. The approach and therefore the nature of the questions asked continue to miss crucial points. We need to split banks along functional, institutional lines.
Government has become the central go-to place for sorting out any troubled situation in this crisis. Ultimately, however, the value of these assets must be and will be determined by the marketplace.
It may be possible to estimate the overall size of the problem, but it is unfeasible if not impossible to weed through the granular structure to determine which assets are in effect bankrupt or establish values appropriately. It means chasing a moving target in a deleveraging cycle.
It is true that carving out bad assets has generally worked in the mini-crises that occurred before the leveraged boom of the past 60 years. The difference today is that throughout the boom, the leverage accelerator found traction every time monetary authorities opened the liquidity valves and thus swiftly reaccelerated the economy. But today it is the centre that is sick, too sick to lift itself. And the periphery of our global monetary system has relied on export driven policies, leaving it at its mercy. It must have been clear to at least some people that this could not go on forever, yet today authorities continue to search for the next big thing to inflate in an effort to reignite economic growth.
Instead, the question that must be answered first is, how much leverage is prudent. Is debt in the amount of 350% of GDP sustainable, even expandable? Before the Great Depression the level of debt was barely at 160% of GDP. Any debt level of more than 200% of GDP is extremely rare. It seems many feel today that the “sophistication” of the world’s largest economy, fully furnished with the tools of Modern Finance can bear much higher debt levels than was historically the case.
This is however a great misconception. It isn’t simply a case of lack of regulation and missing capital reserves. The all-pervasive application of Modern Finance in investment and risk management has dissociated markets from real economic risks. This dissociation not only created a false sense of – mathematically calculated – security in the marketplace but also greatly affected the choices that were made. Financial markets were corrupted from their core function: the allocation of risk and capital.
Hence, the system’s efficiency has in fact deteriorated drastically from the times before Modern Finance. Not only is the current debt level unsustainable, most of this debt was created with false assumptions and misleading models.
Therefore, it is not so far-fetched to assume that the market-place will eventually, one way or another, force an adjustment to sustainable debt levels. To bring U.S. debt back to pre Depression debt levels we have to anticipate a reduction of more than $25 trillion.
This brings us back to the attempt to value distressed assets today, in fact how should we value any asset, any cash flow? What will happen to all those asset prices that were carried by that debt that will have to be reduced by more than half?
How in the world can we even speculate on values when we are riding down a deleveraging cycle of this magnitude and have merely started the process?
Ultimately, the solution lies in being tough and realistic, especially with our bankers, who so far have only shown us contempt (by continuing to pay or collect extraordinary bonuses) and displayed a great measure of ignorance, seeming to be primarily interested in extricating themselves from responsibility and saving their hides.
It is important that we secure the commercial banking assets of our large banks that have gorged themselves on leveraged assets. The fate of these leveraged assets can only be some sort of market liquidation via some sort of bidding mechanism. We have seen it done quite successfully in recent Asian crises, but it entailed the worst of those assets going for no more than 20 cents on the dollar. Governments have to realize that outside of the commercial banking assets they cannot bail out anyone without running the danger of ruining the finances of their country.
Commercial banking is the backbone of our economies, and once the government safely has its hands on these businesses, it can become more relaxed about the prospect that the markets will likely significantly deflate asset prices, even those of healthy businesses.. The main obstacle to swift and bold action by government today is the fear that the economy will implode if we allow assets to deflate. It is believed that allowing assets to deflate will bankrupt and incapacitate the financial system, which will bring economic activity to a standstill.
That is unjustified fear-mongery by those affected (bankers and asset owners) that has no base, in particular if governments were to carve out and own the crucial commercial banking businesses. On the other hand, it is sheer lunacy to risk financial ruin of the country by trying to keep up appearances of a bubble gone by.
Monetary policy is, in my humble opinion equally misguided. The strategy of quantitative easing (QE) will not work, not this time. It is true that in past crisis quantitative easing, i.e. competitive currency devaluation has always worked. In fact, QE is just another name for the global currency system that we have been running for decades with the US as the reserve currency and the Fed pumping liquidity. Of course it lifted everyone quickly from any slowdown in growth. Furthermore, these financial crisis were to a large extent isolated to certain areas or industries with in the global economy. Today, the entire planet is in the same boat. QE is a competitive devaluation race to the bottom. Ben Bernanke still feels that he knows what he is doing and trusts that he will be able to mop up all this liquidity when the engines are jump-started again. That may be possible to a large extent, although we will have to see how financial regulation will be able to restitute the Fed’s control over liquidity generation. To make sure that the system is provided with ample liquidity is a good thing but it would be naïve to assume that this provision of liquidity will have any significant real effect. Monetary policy has lost its grip a long time ago. In the current situation it should be facilitatory and get out of the way, trying not to do make embarrassing decisions. The current policy direction clearly signals the persistance of the message that this is a crisis of liquidity. The facts speak against this notion, clearly. In fact, setting interest rates to zero is more harmful that helpful. Zero interest rates indicate that things are bad, and interest rates near zero prompt market participants to assume a negative future and lead to increased risk aversion.