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.

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

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.

William Black is uncovering some of the ugliest distortions in our financial system. It is quite clear that power and financial leverage create much opportunity to take more than seems appropriate and Black is right, no-one was looking.

I also agree with Black on having to reinstate Glass-Steagall and a proper regulation of derivative instruments.

However, William Black focuses mostly on the sub-prime example and the question he doesn’t address is why they got away with it. Wasn’t the market supposed to find out and punish unsound businesses and practices? Of course partly to blame is regulation itself but as I show in “Eye of the Storm” the demand side was entirely blinded by their institutional structures and risk management tools and gobbled up all that garbage. Regulation would not have been able to avoid Ninja loans (it would have to be the kind of regulations that the GOP is right to rail about) but since the market mechanism was broken, the market itself didn’t realise what it was doing (that is where we have to regulate, at the root).

Thus, the point of fraud is a very accurate description of what went on in subprime at the very end. However, ultimately the description is incomplete

Regarding Black’s emphasis on a system wide cover-up, it certainly sounds like a conspiracy theory. While I doubt grand scale conspiracies very much it has to be said that it is interesting to see that the same methods and policies continue to be applied by the very people that were responsible for the crisis while reasonable voices were shoved to the sidelines and still to a large degree are not consulted. Most of those experts would suggest quite different policies. I am personally disappointed by the plans Obama is presenting with a seasoned veterans John Volcker and Larry Summers on board.

Maybe something happens to people when they go to Washington, some sort of electromagnetic alterations of their brain circuits. An astonishing example of this is Alan Greenspan who changed his entire belief system when he ascended the Chairmanship of the FED in 1987. The Alan back in 1967 would have turned in his grave. The Alan Greenspan in 1967 analysed the mistakes made before the great Depression in a manner that would have flunked the Alan at the FED. The Alan in 1967 would completely disagree with what he did once in office and he would disagree with much of what Ben Bernanke says and does.

Black is of course right when he points to the Japanese experience as a very real path following current policies. And of course he is right when he points to the unbelievable conflicts of interests that are created by the very people in charge of bailing out their own businesses. The Bush administration was certainly immune to any decency and honesty. I have no reason to believe that the same would happen under an Obama Presidency. However, to date, his administration does certainly treat the financial sector with silk gloves. I would guess that is a result of insecurity about the inner workings of finance and a fear that everything would melt down. A fear however, that is unfounded.

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.

Some of the world’s biggest banks have
revealed they are victims of an alleged
fraud which has lost $50bn (£33bn).

Bernard Madoff (Mr Madoff is the former chairman of te Nasdaq stock exchange) has been charged with fraud in what is being described as one of the biggest-ever such cases.

Among the banks which have been hit are Britain’s HSBC and RBS, Spain’s Santander and France’s BNP Paribas.

One of the City’s best-known fund managers has criticised US financial regulators for failing to detect the alleged fraud.

Nicola Horlick, boss of Bramdean investments, told the BBC: “I think now it is very difficult for people to invest in things that are meant to be regulated in America, because they have fallen down on the job.”

“This is the biggest financial scandal, probably in the history of the markets – $50bn is a huge amount of money,” she said.

Counting the cost

Banks and financial institutions across the world had investments with Bernard Madoff, but not all have yet confirmed what their potential losses might be.

Among the potential losers is Spain’s largest bank, Santander, which owns the UK High Street banks Abbey, Alliance & Leicester and Bradford & Bingley.

The bank had a direct exposure of 17m euros ($23m; £15m), but clients of its Optimal fund management unit have another 2.3bn euros invested in the firm run by Bernard Madoff

Britain’s HSBC said it had investments of about $1bn, which could be affected.

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WHAT IS A PONZI SCHEME?

A fraudulent investment scheme paying investors from money paid in
by other investors rather than real profits

Named after Charles Ponzi who notoriously used the technique in the United States in 1903

Differs from pyramid selling in that individuals all tend to invest with the same person

Royal Bank of Scotland said it could potentially lose about £400m ($601m) if all its investments had to be written off.

The French bank, Natixis, a subsidiary of Caisse d’Epargne and Banque Populaire, said it could potentially lose up to 450m euros (£402m; $605m).

One of the world’s biggest investment groups, Man, said it had invested about $360m through its RMF institutional fund of funds business, representing 0.5% of its total funds

‘Systemic failure’

Meanwhile, some of the biggest private losers seem to have been members of the Palm Beach country club, where many of Mr Madoff’s wealthy clients were recruited.

According to some reports, the list of prominent victims include a New Jersey Senator, the owners of the New York Mets and the charities run by film director Stephen Spielberg and Nobel Prize winning writer Elie Wiesel.

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MAJOR POTENTIAL LOSSES

Santander, Spain – $3.1bn

HSBC, UK – $1bn

Natixis, France – $605m

Royal Bank of Scotland, UK – $601m

BNP Paribas, France – $460m

BBVA, Spain – $400m

Man Group, UK – $360m

Reichmuth & Co, Switzerland – $325m

Nomura, Japan – $303m

Mrs Horlick said 9% of Bramdean’s own funds were invested with Mr Madoff, but that even if the money was written off, the fund involved would be down just 4%.

“I just want to make it clear to investors that even after this, they would have done extremely well, relative to anything else they could have invested in,” she said.

In a statement, Bramdean said: “The allegations made appear to point to a systemic failure of the regulatory and securities markets regime in the US.”

However, some argued that the fund managers should themselves have done more.

“City figures cannot call for light touch regulation yet at the same time complain that regulators missed risks that the industry failed to spot,” said Simon Morris, a partner with City law firm CMS Cameron McKenna.

“It’s the unequivocal job of the fund manager to check out the bona fides of whoever they chose to pass their customers’ money onto,” he said.

Antonio Borges, chairman of the Hedge Fund Standards Board, said the scandal highlighted the need for “robust governance practices and oversight via independent boards, which will challenge management procedures and behaviour”.

Meanwhile one of the City’s watchdogs, the Serious Fraud Office (SFO) called on whistleblowers to come forward with evidence of corporate wrongdoing in the wake of the credit crunch.

The Serious Fraud Office said it wanted workers, former staff and shareholders to step up with information over suspected fraud in the current financial turmoil.

Director Richard Alderman said: “Our objective is to ensure that we can bring offenders to justice as quickly as possible.”

High returns promised

US prosecutors say Mr Madoff, a former head of the Nasdaq stock market, masterminded a fraud of massive proportions through his hedge fund and investment advisory business.

Mr Madoff is alleged to have used money from new investors to pay off existing investors in the fund.

A federal judge has appointed a receiver to oversee Mr Madoff firm’s assets and customer accounts, while the 70-year-old banker has been released on $10m bail.

Mr Madoff founded Bernard L Madoff Investment Securities in 1960, but also ran a separate hedge fund business.

According to the US Attorney’s criminal complaint filed in court, Mr Madoff told at least three employees on Wednesday that the hedge fund business – which served up to 25 clients and had $17.1bn under management – was a fraud and had been insolvent for years.

He said he was “finished”, that he had “absolutely nothing” and “it’s all just one big lie”, and that it was “basically, a giant Ponzi scheme”, the complaint said.

If found guilty, US prosecutors say he could face up to 20 years in prison and a fine of up to $5m.