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.

Reforming Banks PDF

If you are interested in more background here are two relevant chapters of  Eye Of The Storm, (16) Asset Management, (17) The UBS Story

First, let me apologize for my long silence on my blog. It wasn’t a leisurely summer as some of you will have enjoyed: rising markets, lots of “Green Shots” and a couple of weeks at the beach, what more can you wish for. Not for me though.
Some of you know that I am not primarily an author and commentator. My entrepreneurial spirit has the tendency to take over and keep me busier than I bargain for. I am involved in a very exciting multimedia project produced by my wife Sandra (Yndico), that also uses the prototype of a, I dare say revolutionary, E-commerce  engine Yndico Store,  produced by a venture in which we have also become involved (facilitating the dawn of the much anticipated social commerce, you can get a little glimpse here:  Magnet).

Certainly, I have been following news and events, the return of the bulls, the inventory cycle, by many mistaken as the end of the economic crisis, and the sad tales and tragedies that gloomed up the summer while the political debate in the US grew beyond silly. Before I start; I have a pdf version of this post attached for all of you who like to read in two columns (I found that I am a much more efficient reader this way as my field of vision does just not cover the full width of a page).
After such a long time, there is much to talk about. Unfortunately, as you might have guessed, I cannot join in the cheerleading of the bulls amid the more than 50% rebound in stock-markets across the planet and all the economic “green shots”. Personally, I expect the next leg down to start any time now as hope gives way to facts and the reality of what we are up against. In the coming weeks I will try to address the important issues we face in our global economy. I will address the misguided fear and expectations of inflation that is taking hold in finance and media and explain why continuing deflation is so much more likely.
I will address the state of the economy and the inventory cycle that is being mistaken as a new dawn announced by the equity-markets’ rebound.
I will talk about China and emerging markets and why most of them are in for an even worse 2010 than the US economy.
I will address the rotten political process (we still call democracy), in which vested interests prevail over logic and facts, in which people who obviously failed are not only being left in charge of their businesses or posts but allowed to define the rules of the future: definitely not the change many voted for and an outright corporate governance night-mare.
And, I will write to you about the dire prospects of current policy direction that further impoverishes Main Street at the expense of Wallstreet that is driven by a misguided fear to take on the rotten structures in banking.
Although this all sounds very gloomy, I am in fact very upbeat about our long-term future. Technological change is clearly accelerating and is opening up huge opportunities. I believe in the ingenuity of people; we have always emerged stronger from any crisis. Today, the $50 trillion question is: who will pay for the mistakes of the past? Current policy direction would have Mainstreet footing the bill. This is glaringly unfair and given the scale of things, the resulting inequalities have the potential to become highly explosive.   There is much to cover indeed.
But, rather than concentrating on the negative, let us start with solutions. Last week, Mervyn King, the governor of the Bank of England took up ex-Fed Chairman Paul Volcker’s demand (voiced back in June) to split up our financial superstores along institutional lines (finally, I dare say). Promptly, Gordon Brown and Alistair Darling rebuked Mr. King, with the argument that the problems in the banking sector are more complex than Mr. King suggests, which is amusing coming from those two. Not surprisingly these two are pinning their hopes on more regulation. More regulation? Well, yes, rather smarter regulation is indeed necessary. Yet, it is precisely the complexity of the system that calls for a good dose of more market orientated measures.
Yes, agreed our regulators and financial “experts” were asleep at the wheel and that has to be changed. But we should not mistake the past 30 years in finance as a period of free-wheeling markets. In fact, quite the opposite is true. With regulators looking the other way, the “big and beautiful” took control and made finance their own, controlling the entire span of financial services in a happy hugely profitable oligopoly, rigging the market to their advantage and in the process distorting some of the most important price signals such risk or interest rates.
The financial industry is characterized by a variety of business structures with different risk profiles and functional dynamics that demand specific organizational and institutional structures, human resources and incentive systems. Described in detail in “Eye of the Storm” (www.eyeofthestormbook.com).
A commercial bank doesn’t have the institutional structures nor the functional abilities to advise anyone on investments (even less to manage assets themselves). HSBC, undoubtedly one of the most prudent and the most successful commercial bank on or planet, thrives on its strategic imperative that its core business doesn’t have the resources or structures to be successful in investment banking.
Yet today, virtually all globally leading commercial banks offer the entire span of services and products our financial industry has to offer and generate the bulk of their earnings in asset management and investment banking.
This was primarily made possible by the abundant tool box of Modern Finance that became wholly accepted, then mis-applied by bankers and cheered on by regulators and central bankers during the past 30 years. With the fall of Glass Steagall in 1999 in the USA, the last bastion of restrictions was lifted, with devastating consequences.
In the three years up to the summer of 2007 alone the top 20 global commercial banks increased their balance sheets by $20 trillion, 150% of US GDP.
Take the case of UBS, a swiss bank. At the end of 2006, UBS was the world’s 7th largest bank with $2’000 billion in assets on its balance sheet (Royal Bank of Scotland was the largest bank with a balance sheet of $3’700 billion). Of these assets straight loans amounted to $260 billion. UBS’ non-core business therefore was (and continues to be) a multiple of its core business. UBS also advised a total of $2500 billion of client assets for a fee.  Thus, in total, this commercial bank exerted influence on $4’500 billion in assets, roughly 10 times its host country’s GDP, 17 times its own core business and 110 times its equity capital. UBS became a hedge fund much larger than the total estimated size of the global hedge fund industry (approximately $3’000 billion).
During the past two decades, UBS and its peers crowded out smaller and better suited firms to handle the risks they ended up taking with misguided inadequate management tools. Smaller, entrepreneurial firms had no chance in the face of the balance sheets and market power of our commercial banks.
In order to even justify being able to manage these astronomical sums, UBS and its peers rely on the mathematical risk models spawned by Modern Finance. These models allowed them to boil down complex and diverse fields of businesses, investments and risks into simple and “precise” formulas. The inadequacies and dangers of the wholesale application of these models had been proven long before 2007. The irresponsibility with which they were applied and condoned by auditors, boards, regulators and central bankers is not open to subjective interpretation. The dangers were clear to everyone yet the money train was simply too big and too strong for anyone to stop.
When it was finally brought to a halt by ever more ridiculous practices, we had amassed the largest pile of credit in human history. In relative terms the USA’s outstanding credit today is 3 times the size it was at the beginning of the Great Depression. Worse, this credit was accumulated to a very large extent by institutions that were as ill-qualified as they come, using tools as unsuitable as anyone could imagine.
Yet, it would be wrong to blame securitization or derivatives for this crisis. Modern Finance and its tools have brought much efficiency and progress to finance, yet in the wrong hands they are wreaking havoc.
Now, as the chickens have come home to roost, these same bankers who mismanaged and rigged the market on a grand scale ask the taxpayer for a bailout. They then turn around and pay themselves large bonuses (based on such ridiculous arguments as to retain top talent), instead of accumulating capital reserves. In addition, not only are they being left in charge of their businesses but also of their own industry’s restructuring. Even Mr. King says he would allow bankers to “write their own will”.  Don’t we all hate men without spine?
It is a corporate governance night-mare that no private business would ever get away with. Our representatives, our politicians need to finally wake up to the monumental risk that commercial bankers pose, a risk that has become even larger in the 2 years since the crisis broke. It is dishonest and shamefully irresponsible to point the finger at hedge funds and non-bank financial institutions, while the truly responsible are declared too big to fail, too delicate to touch and too powerful to replace.
Central bankers, auditors, boardrooms and politicians alike need to finally drop their irresponsible attitude towards the theories of Modern Finance and how they are applied within our banking system.
Restricting commercial banks to commercial banking doesn’t mean the end of Modern Finance or securitization. It means that we are able to nurture a more nimble, fragmented, specialized institutional landscape that functions within a framework of proper incentives, checks and balances and businesses able to properly take and manage risks. Our financial system is indeed too complex for any one institution to handle the entire array of products on offer, in particular commercial banks. Properly framed and managed no institution in our financial industry will be too big to fail.
In closing let me say it again: this crisis was not an unforeseeable “Black Swan” event. We were headed towards the abyss for years with warnings ignored at the levers of power the world over. It is shameful to now stand in front of cameras and say “no one saw this coming” and feed the media and the people half truths and confusing, ill-informed garbage on the workings of the financial system. If you don’t understand it, admit it and step aside! There are enough independent professionals who understand exactly what is going on. This crisis was glaringly obvious to a great many people who have been ignored by greed and arrogance at the expense of every decent hard-working taxpayer.
Whatever self-serving politicians proclaim Mervyn King and Paul Volcker ought to be taken serious. It is our duty to act decisively. It is certain that most bankers wont like it. But everyone else will.
Mervy King Speech
Reaction by Brown and Darling

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

The U.S. Government’s Financial Stability Plan

Comments by Stephan Olajide-Huesler

The Obama administration is tackling the financial crisis with a Financial Stability Plan.

“To address the financial crisis, the Financial Stability plan is designed to attack our credit crisis on all fronts with our full arsenal of financial tools and the resources commensurate to the depth of the problem. To be successful, we must address the uncertainty, troubled assets and capital constraints of our financial institutions as well as the frozen secondary markets that have been the source of a significant portion of our lending for everything from small business loans to auto loans.”

Unfortunately, the plan does not address the crisis at its root but instead tries to fight the symptoms with interventionist tools that are not only ineffective but merely expand the distortions within the market. Below you will find comments in blue on the various tools and procedures described in the plan. In order to fully grasp the background of some of these comments it may be necessary to read parts of the book “Eye of the Storm” where the dynamics are laid out in detail.

Efforts to Improve Affordability for Responsible Homeowners: The treasury has implemented
programs to allow families to save on their mortgage payments by refinancing; to assist responsible
homeowners in avoiding foreclosure through a loan modification plan; and, alongside the Federal
Reserve, to help bring mortgage interest rates down to near historic lows. This past month, the 30%
increase in mortgage refinancing demonstrated that working families are benefiting from the
savings due to these lower rates.
An analysis that goes to the roots of this crisis concludes quite clearly that the haircut should ultimately be taken by the investors and not the mortgage holders. However, forcing the pricing mechanism in the markets (interest rates) is unsustainable (and unnecessary).
Consumer and Business Lending Initiative to Unlock Frozen Credit Markets: The treasury and the Federal Reserve are expanding the TALF (Term Asset-Backed Securities Facility) in conjunction with the Federal Reserve to jump-start the secondary markets that support consumer and business lending. Last week, the treasury announced its plans to purchase up to $15 billion in securities backed by Small Business Administration loans.

Business stimulation sure, but do you really want to stimulate consumption? Can we not agree, finally, that consumption north of 70% of GDP is unsustainable? It is very simplistic and flat out false to assume that if we all just continued to consume we are going to be fine. In any case consumption is very far from the root cause of this crisis, it was merely the ultimate manifestation where the distortions found an outlet.
Capital Assistance Program: The treasury has also launched a new capital program, including a
forward-looking capital assessment undertaken by bank supervisors, to ensure that banks have the
capital they need in the event of a worse-than-expected recession. If banks are confident that they
will have sufficient capital to weather a severe economic storm, they are more likely to lend now—making it less likely that a more serious downturn will occur.

I doubt this very much. Banks will, if healthy, lend to some extent, but in conjunction with their changed perception for risks and a slowing business environment in their models; lending will not reach pre-crisis levels for a very long time (more than 10 years).
The Challenge of Legacy Assets: Despite these efforts, the financial system is still working against
economic recovery. One major reason is the problem of “legacy assets” – both real estate loans held
directly on the books of banks (“legacy loans”) and securities backed by loan portfolios (“legacy
securities”). These assets create uncertainty around the balance sheets of these financial institutions,
compromising their ability to raise capital and their willingness to increase lending.

The greatest fallacy of the current debate is this segmentation into “legacy assets” and the rest, which appears in good health. We have to start dividing the assets up differently. In my view it would be much more helpful to separate out assets along functional lines. Specifically, we have to carve out traditional relationship-banking assets. They constitute the bedrock of our financial system, they account for a fraction of total banking assets today and are most definitely much healthier than most of the troubled assets that we are dealing with and will keep on growing as the deleveraging process takes its course.

Breaking off commercial banking assets should be relatively straightforward, since these assets can be quite clearly identified and separated from “investment assets” most of which were securitized and traded throughout the system. .

Commercial banking books are the assets we should be concerned with and the amounts are manageable. If the U.S. government would annex, (for the cost of $1.00) 50% of all commercial banking assets in the U.S., i.e. approximately $3 trillion, the maximum ultimate cost for the taxpayer would probably be no more than $500 billion.

Government can then also influence, from within, the various regulative structures that will have to be rebuilt from scratch, including audit, Sarbanes-Oxley, and financial market oversight. The theory and the tools of Modern Finance will not go away but they have to be applied much more prudently and intelligently.

• Origins of the Problem: The challenge posed by these legacy assets began with an initial shock
due to the bursting of the housing bubble in 2007, which generated losses for investors and banks.
Losses were compounded by the lax underwriting standards that had been used by some lenders
and by the proliferation of complex securitization products, some of whose risks were not fully
understood. The resulting need by investors and banks to reduce risk triggered a wide-scale
deleveraging in these markets and led to fire sales. As prices declined, many traditional investors
exited these markets, causing declines in market liquidity.

It is understandable that when the analysis of the origin of the problem missed the point and does in fact not even touch the root cause, the result will be a confused and unhelpful plan.

• Creation of a Negative Economic Cycle: As a result, a negative cycle has developed where
declining asset prices have triggered further deleveraging, which has in turn led to further price
declines. The excessive discounts embedded in some legacy asset prices are now straining the
capital of U.S. financial institutions, limiting their ability to lend and increasing the cost of credit
throughout the financial system. The lack of clarity about the value of these legacy assets has also
made it difficult for some financial institutions to raise new private capital on their own.
The representatives of government have got to stop listening to the banks, who are at the core of the crisis and develop some original thought.
I get the impression that these people do not believe that we have climbed a huge mountain and are just starting our descent. Does anyone believe that 350% debt to GDP can and should be surpassed, in the name of a little economic growth? In the 7 years leading up to the crisis, every dollar of credit merely created 14 cents of real economic growth, all of it driven by mortgage equity withdrawals.
To address the challenge of legacy assets, the treasury – in conjunction with the Federal Deposit Insurance Corporation and the Federal Reserve – is announcing the Public-Private Investment Program as part of its efforts to repair balance sheets throughout our financial system and ensure that credit is available to the households and businesses, large and small, that will help drive us toward recovery.

Three Basic Principles of the Public-Private Investment Program: Using $75 to $100 billion in TARP capital and capital from private investors, the Public-Private Investment Program will generate $500 billion in purchasing power to buy legacy assets – with the potential to expand to $1 trillion over time. The Public-Private Investment Program will be designed around three basic principles:

1. Maximizing the Impact of Each Taxpayer Dollar: First, by using government financing in
partnership with the FDIC and Federal Reserve and co-investment with private sector investors,
substantial purchasing power will be created, making the most of taxpayer resources.

So, in essence, the government has learned from the markets and is opening its own hedge fund with a leverage of 5 times (with an option to increase it 10 times). What are they going to do with 1 trillion, which is a drop in the ocean compared to the size of the likely size of bad assets? What are they going to buy, and at what prices?

2. Shared Risk and Profits with Private-Sector Participants: Second, the Public-Private
Investment Program ensures that private-sector participants invest alongside the taxpayer, with
the private-sector investors standing to lose their entire investment in a downside scenario and the
taxpayer sharing in profitable returns.

OK, so 50/50 partnerships? Capital and ownership? That can’t be right. Under this plan a well-run hedge fund can come in and spend 0.5 dollars for a purchasing power of 10 on the back of the government’s provision of 9.5 dollars for the purchase? Returns are split 50/50. Who would not take that offer? In reality this looks more like a 9.5-to- 0.5 (19 to 1) partnership, where the government takes 95% of the risk and 50% of the upside.

The taxpayer could agree to increase the stake of the private partner if performance is good. For example, if the taxpayer makes his money back (all of it), the funds share could be increased to 10%, or 20% of the upside. Otherwise the taxpayer takes most of the risks and shares only 50% of the glory.

3. Private-Sector Price Discovery: Third, to reduce the likelihood that the government will overpay for these assets, private-sector investors competing with one another will establish the price of the loans and securities purchased under the program.

I am not convinced that this will be an orderly mechanism that fosters true price discovery, in particular since private hands don’t share the downside risks.
The Merits of the Public-Private Investment Program: This approach is superior to the alternatives of either hoping for banks to
gradually work these assets off their books or of the government purchasing the assets directly. Simply
hoping for banks to work legacy assets off over time risks prolonging a financial crisis, as in the case of
the Japanese experience. But if the government acts alone in directly purchasing legacy assets, taxpayers
will take on all the risk of such purchases – along with the additional risk that taxpayers will overpay if
government employees are setting the price for those assets.

Two Components for Two Types of Assets: The Public-Private Investment Program breaks down into two essential sections, addressing both the legacy loans and legacy securities clogging the balance sheets of financial firms:
• Legacy Loans: The overhang of troubled legacy loans stuck on bank balance sheets has both made it difficult for banks to access private markets for new capital and limited their ability to lend.
• Legacy Securities: Secondary markets have become highly illiquid and are trading at prices
below where they would be in normally functioning markets. These securities are held by banks
as well as insurance companies, pension funds, mutual funds, and funds held in individual
retirement accounts.
The Legacy Loans Program: To cleanse bank balance sheets of troubled legacy loans and reduce the
overhang of uncertainty associated with these assets, the Federal Deposit Insurance Corporation and
the treasury are launching a program to attract private capital to purchase eligible legacy loans from
participating banks through the provision of FDIC debt guarantees and treasury equity co-investment.
The treasury currently anticipates that approximately half of the TARP resources for legacy assets will be
devoted to the Legacy Loans Program, but our approach will allow for flexibility to allocate resources
where we see the greatest impact.
• Involving Private Investors to Set Prices: A broad array of investors are expected to
participate in the Legacy Loans Program. The participation of individual investors, pension
plans, insurance companies, and other long-term investors is particularly encouraged. The
Legacy Loans Program will facilitate the creation of individual Public-Private Investment
Funds, which will purchase asset pools on a discrete basis. The program will boost private
demand for distressed assets that are currently held by banks and facilitate market-priced
sales of troubled assets.
• Using FDIC Expertise to Provide Oversight: The FDIC will provide oversight for the
formation, funding, and operation of these new funds that will purchase assets from banks.
• Joint Financing from the Treasury, Private Capital, and FDIC: Treasury and private capital
will provide equity financing, and the FDIC will provide a guarantee for debt financing issued
by the Public-Private Investment Funds to fund asset purchases. The treasury will manage its
investment on behalf of taxpayers to ensure the public interest is protected. The treasury
intends to provide 50 percent of the equity capital for each fund, but private managers will
retain control of asset management subject to rigorous oversight from the FDIC.

What if they start to realize that their “hedge fund” will need to grow beyond $10 trillion?

At least private involvement is gearing it toward going concerns. But what will be done with those assets that no one wants to buy? How do we auction off everything, without regard to losses? As long as these assets are on bank’s balance sheet, that are so highly leveraged, these banks will be unable to sell these assets at seriously discounted prices. This plan may look good in theory, but in practice we will see that very little will actually happen.

Instead, we should strip the banks of all their noncommercial banking assets and just auction them off. Ask the bank—completely rid of all investment assets—how much capital it needs to survive on its own and provide it. That would mean 100% ownership by government of nearly all banks. Government sets the rules, the regulations, and rehires executive with all new contracts.

Clearly the financial world, and in particular the banks, have run this thing into the ground. They must be expropriated and start new with compensation packages and management options that accrue for long-term performance.

• The Process for Purchasing Assets Through The Legacy Loans Program: Purchasing
assets in the Legacy Loans Program will occur through the following process:

o Banks Identify the Assets They Wish to Sell: To start the process, banks will decide
which assets – usually a pool of loans – they would like to sell. The FDIC will
conduct an analysis to determine the amount of funding it is willing to guarantee.
Leverage will not exceed a 6-to-1 debt-to-equity ratio. Assets eligible for purchase
will be determined by the participating banks, their primary regulators, the FDIC
and the treasury. Financial institutions of all sizes will be eligible to sell assets.

o Pools Are Auctioned Off to the Highest Bidder: The FDIC will conduct an auction
for these pools of loans. The highest bidder will have access to the Public-Private
Investment Program to fund 50 percent of the equity requirement of their purchase.

o Financing Is Provided Through FDIC Guarantee: If the seller accepts the purchase
price, the buyer would receive financing by issuing debt guaranteed by the FDIC.
The FDIC-guaranteed debt would be collateralized by the purchased assets, and the
FDIC would receive a fee in return for its guarantee.

Guarantor? Meaning taxpayer…

o Private-Sector Partners Manage the Assets: Once the assets have been sold, private
fund managers will control and manage the assets until final liquidation, subject to
strict FDIC oversight.
Sample Investment Under the Legacy Loans Program
Step 1: If a bank has a pool of residential mortgages with $100 face value that it is
seeking to divest, the bank would approach the FDIC.
Step 2: The FDIC would determine, according to the above process, that they would
be willing to leverage the pool at a 6-to-1 debt-to-equity ratio.
Step 3: The pool would then be auctioned by the FDIC, with several private sector
bidders submitting bids. The highest bid from the private sector – in this example,
$84 – would be the winner and would form a Public-Private Investment Fund to
purchase the pool of mortgages.
Step 4: Of this $84 purchase price, the FDIC would provide guarantees for $72 of
financing, leaving $12 of equity.
Step 5: The treasury would then provide 50% of the equity funding required on a
side-by-side basis with the investor. In this example, the treasury would invest
approximately $6, with the private investor contributing $6.
Step 6: The private investor would then manage the servicing of the asset pool and
the timing of its disposition on an ongoing basis – using asset managers approved
and subject to oversight by the FDIC.
What does the seller actually get? Treasuries?
The Legacy Securities Program: The goal of this program is to restart the market for legacy securities,
allowing banks and other financial institutions to free up capital and stimulate the extension of new credit.
The resulting process of price discovery will also reduce the uncertainty surrounding the financial
institutions holding these securities, potentially enabling them to raise new private capital. The Legacy
Securities Program consists of two related parts designed to draw private capital into these markets by
providing debt financing from the Federal Reserve under the Term Asset-Backed Securities Loan Facility
(TALF) and through matching private capital raised for dedicated funds targeting legacy securities.

These should be independent programs run under an umbrella of capital but with varying strategies and partnerships. So-called Chinese walls are important; units should not collude. The overall strategy, however, has to be driven by the awareness that this is the taxpayer’s money. Much of what is likely offered by the banks is completely infected by the virus of Modern Finance and some of it will be worth no more than 20 cents on the dollar. Who is going to represent the taxpayer properly? The current structure clearly favours banks and the private partners in the purchase program.

1. Expanding TALF to Legacy Securities to Bring Private Investors Back into the Market:
The treasury and the Federal Reserve are today announcing their plans to create a lending
program that will address the broken markets for securities tied to residential and commercial
real estate and consumer credit. The intention is to incorporate this program into the
previously announced (TALF).
• Providing Investors Greater Confidence to Purchase Legacy Assets: As with
securitizations backed by new originations of consumer and business credit already
included in the TALF, we expect that the provision of leverage through this program
will give investors greater confidence to purchase these assets, thus increasing market
liquidity.
• Funding Purchase of Legacy Securities: Through this new program, non-recourse
loans will be made available to investors to fund purchases of legacy securitization
assets. Eligible assets are expected to include certain non-agency residential
mortgage-backed securities (RMBS) that were originally rated AAA as well as outstanding
commercial mortgage-backed securities (CMBS) and asset-backed securities (ABS)
that are rated AAA.
• Working with Market Participants: Borrowers will need to meet eligibility criteria.
Haircuts will be determined at a later date and will reflect the riskiness of the assets provided as collateral. Lending rates, minimum loan sizes, and loan durations have not been determined. These and other terms of the programs will be informed by discussions with market participants. However, the Federal Reserve is working to ensure that the duration of these loans takes into account the duration of the
underlying assets.

2. Partnering Side by Side with Private Investors in Legacy Securities Investment Funds:
The treasury will make co-investment/leverage available in order to partner with private capital providers
to immediately support the market for legacy mortgage- and asset-backed securities
originated prior to 2009 with a rating of AAA at origination.
• Side-by-Side Investment with Qualified Fund Managers: The treasury will approve up
to five asset managers with a demonstrated track record of purchasing legacy assets,
though we may consider adding more, depending on the quality of applications
received. Managers whose proposals have been approved will have a period of time
to raise private capital to target the designated asset classes and will receive matching
treasury funds under the Public-Private Investment Program. Treasury funds will be
invested one-for-one on a fully side-by-side basis with these investors.
• Offer of Senior Debt to Leverage More Financing: Asset managers will have the
ability, if their investment fund structures meet certain guidelines, to subscribe for
senior debt for the Public-Private Investment Fund from the Treasury Department in
the amount of 50% of total equity capital of the fund. The Treasury Department will
consider requests for senior debt for the fund in the amount of 100% of its total
equity capital, subject to further restrictions.

Sample Investment Under the Legacy Securities Program
Step 1: Treasury will launch the application process for managers interested in the
Legacy Securities Program.
Step 2: A fund manager submits a proposal and is pre-qualified to raise private capital
to participate in joint investment programs with Treasury.
Step 3: The government agrees to provide a one-for-one match for every dollar of
private capital that the fund manager raises and to provide fund-level leverage for the
proposed Public-Private Investment Fund.
Step 4: The fund manager commences the sales process for the investment fund and is
able to raise $100 of private capital for the fund. The treasury provides $100 equity co-investment
on a side-by-side basis with private capital and will provide a $100 loan to
the Public-Private Investment Fund. The treasury will also consider requests from the
fund manager for an additional loan of up to $100 to the fund.
Step 5: As a result, the fund manager has $300 (or, in some cases, up to $400) in total
capital and commences a purchase program for targeted securities.
Step 6: The fund manager has full discretion in investment decisions, although the fund will
primarily follow a long-term buy-and-hold strategy. The Public-Private
Investment Fund, if the fund manager so determines, would also be eligible to take
advantage of the expanded TALF program for legacy securities when it is launched.
And how are these fund managers compensated, incentivized, overseen? Are we really going to make those who have driven us into this mess immensely rich by sorting out their own mess? Sounds grotesque.
I must repeat, the risk here is entirely on the taxpayer. Somehow the assumption seems to be that all this shuffling back and forth may actually be profitable. As a taxpayer, I don’t want to have any capital at all in the rubbish that the banks will be stripped of. Now, as it stands, not only have I got all the risk and get the worst of the rubbish (80 to 100% write-down?) but if, for some magical reason, I should make a profit on a project, I have to share it with private hedge funds. Ultimately, the plan is nothing but a smoke-and-mirrors version of bailing everyone out, with the additional insult of sharing the crummy spoils with the very people who caused the mess. It is quite hard to believe that they are actually going ahead with this. It will generate the ultimate worst-case scenario. This plan looks just about as bad as the Bush Administration’s, if not worse.
This is what I would call Super Bailing.
I must also repeat that in the entire document there is—possibly purposefully—no mention of financial markets regulation, which is at least as important as an actual auction. The plan describes an auction process in which we are actually paying banks something for their rubbish, but there is so much more to financial stability than just an auction that obscures the fact that the taxpayer ends up holding the bag.
1. Commercial banking has to be re-established as a specialist business.
2. Glass-Steagall has to be reinvented. Both points 1 and 2 will assist the restructuring of risk management in the financial industry and inform the discussion on proper treatment of real economic risks in the market place.
3. Those financial-market instruments long hidden in the shadows must be made more transparent and be listed.
4. Global monetary policy coordination is necessary.
5. The Fed needs to be completely overhauled and an independent financial authority of oversight needs to be established.

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.