Monday, 29 September 2008


I had the following quote ready to publish when the bill passed. The vote against the bailout bill was a pleasant surprise, but the House still has until Thursday to be bought off or to cave to pressure. Or maybe democracy is still alive in America?

"The bank was saved, but the people were ruined."
- Henry M. Gouge, circa 1830

Friday, 26 September 2008

Learning from Rudi Bogni: The Thin Space of Financial Activity

Every good morality tale needs heroes as well as villains. In the past few weeks all we’ve seen are the villains raping and pillaging and despoiling all that we hold dear – rather like the first hour of the original and uncensored Mad Max.

I’ve made it pretty clear what I think about the villains that have got us into the current meltdown mess. Even I need a break from cynicism every now and then, however, to remind myself that better is truly possible. I thought I would take the opportunity of my post this week to reflect on a personal hero who epitomises what banking once was and whose philosophical writings can point us toward what banking should be again when the dust settles and we contemplate rebuilding our collapsed financial house of cards.

No one is perfect, and I’m sure he’s not either, but he’s shown consistently good judgement, intellectual curiosity and resistance to orthodoxy over the years. If we had a hundred bankers in the world like him, we wouldn’t have today’s crisis.

The bravest decision he took was in 1995, following the collapse of Barings Bank, as he explained in The Prospect:

I am a 47-year-old banker - chief executive of Swiss Bank Corporation in London, to be precise - and I have just decided that I need to go back to university for two years to study mathematics. Some of my friends think I am mad, and perhaps they are right. But perhaps something strange has happened to banking too.

It is hard to imagine that there is anything really new in banking. The tools of the trade have been around and in use, pretty much unchanged, for hundreds of years. Yet within the span of my own career, the world of international finance has enjoyed a renaissance-a spurt of creativity in the 1970s and 1980s, when new techniques emerged which have transformed the conduct of many banks and bankers. These techniques-collectively known as derivatives-have spawned a new jargon (would you know what to do with a Jellyroll, or an Alligator Spread?), huge new sources of profit, and mystifying new types of risk.

Imagine devoting yourself to the study of advanced mathematics in your mid-40s from the lofty heights of CEO of a Swiss bank! I wouldn’t be so noble, from more modest altitudes.

SBC had acquired O’Connor Associates, a Chicago derivatives trading partnership. The O’Connor partners were soon installed as senior executives throughout SBC, and changed it from a sleepy private bank to a powerhouse of aggressive power trading in the newly emergent global derivatives markets. Rudi needed to go back to school to know the business he was managing. He stepped down from the top job and got a degree in advanced mathematics at Imperial College, London.

That made Rudi an instant legend in the City and was the first I heard of him. He returned to finance as the Chief Executive of UBS Private Bank and Member of the UBS Group Executive Board. Since then I have followed his writings. For some years past I have enjoyed his friendship.

One year into the course, he emphasised again the importance of executives confronting the changing requirements of banking:

IC Reporter (10 February 1997)

Despite holding a degree in economics and business administration, Mr Bogni really did go back to basics under the tutelage of the Centre, sitting mock GCSEs and A levels in maths and statistics. Probability theory, calculus, algebra and stochastical modelling are also on the programme. “It’s a course not really designed towards a degree,” said Mr Bogni, “but towards the specific mathematics required for my type of business.”

Not all of those who share Mr Bogni’s business of derivatives are convinced of the benefits to be gained from the study of modern applied mathematics. However Mr Bogni believes that those who do not recognise its importance are avoiding the changing nature of financial markets. “Among the people that I respect there is a genuine understanding of what the issues are. It’s not a question of derivatives being a part of the financial markets, they are the financial market now.”

Rudi Bogni wasn’t afraid to admit that his bank had become unmanageable within the limits of his traditional banking background and understanding, and to take a hard look at his own qualifications to wager the bank’s capital on derivatives. If more CEOs had done that, then the proprietary dealing desks would never have gained the leverage that leaves the banking system so woefully undercapitalised today. If more CEOs pondered the philosophical basis for creating and allocating wealth, and the political means of asserting or coercing state power in the cause of more wealth accretion, then perhaps the destruction of jobs, savings and security would be less threatening to the investors, pensioners and taxpayers facing systemic financial failure this week.

In June of this year, Rudi published a piece in Wilmott Magazine (subscription only – the most expensive monthly on either side of the Atlantic, according to Forbes). At the risk of stretching fair use, and with the author’s consent, I’m going to quote it extensively here as it gets to the heart of the crisis we now face:

The Thin Space of Financial Activity

Those of you who may have read Bill Bryson’s A Short History of NearlyEverything will certainly recall his thesis that life on earth as we know it is an exceptional event and a possibility that materialized only within very small boundaries.

I wish you to consider how much smaller those boundaries are for the existence of financial activity.

First of all, you need a thinking species that lives and prospers in a cooperative environment. Second, you need a reasonably developed economy. Third, you need the ability to save and do more than survive only hand-to-mouth on a daily basis. Finally, you need reciprocal trust and a framework of law, as well as accepted customs and rules.

. . .

We have just witnessed last year—and we are still witnessing this year—how a relatively minor breakdown in trust and information has brought two markets, the interbank money market and the CDO market, to either display strong anomalies or freeze. Worse could come if we do not all learn to respect the boundaries within which financial activity can exist and thrive.

Investment bankers have to learn that if you have ambitions to act as an agent for an issue of a financial product, you should also have the means to make a market in that very same product in good and bad times—and investors should hold you to that. Regulatory walls between origination and trading have solved some problems, but they have also become an easy alibi for not standing behind one’s responsibilities.

Furthermore, they must understand that a revaluation of financial assets because the cost of capital has sharply decreased is not due to their genius. It is a physical law as much as conservation of energy, and therefore they do not deserve bonus payments for that. They should also realize that when they push bonus expectations beyond the moral threshold of 50/55 percent of net revenue, they are forcing their employers to take unacceptable risks to meet such expectations and that such a course of action can only end in tears.

Rating agencies have to learn about financial history and free thinking, not only about ticking boxes. Furthermore, they have to learn that the theory of overcollateralization differs from the historical experience, if you dig long enough into the past.

Regulators must learn that any new rule is a starting point for regulatory arbitrage and the mother of unintended consequences. Hence, there should be a few good rules, not thousands aimed at covering each potential circumstance. Most governments seem to have understood the lesson that the pursuit of inflation as an easy solution will bring them down in due course and for a long period. They seem to be deaf, however, to the fact that corporate taxation above 30 percent and personal direct taxation

over 40 percent, as well as an overall tax take including indirect taxation of over 50 percent, will either cripple both financial and economic activity, force people to take excessive risks, or push them elsewhere.

Retailers of financial products and solutions must realize that they are dealing with people’s lives and families’ futures. They cannot behave as street peddlers. Clear ethical boundaries must be the first line of defense, even before any legal framework is considered, because the law is unlikely to be as clear-cut as morality.

Finally, investors must be realistic about expectations. The best you can hope through financial activity is to preserve your wealth. If you want to create it, become an entrepreneur. If you want to gamble, stop whining when you lose.

If we do not all learn to be guided by such simple principles, financial activity as we know and need it will be put at risk. Trust will be eroded, impossible expectations will be created, and we will look back to the past 60 years as a golden age of economic development and financial maturity that may not be replicated any longer.

. . .

Politicians and regulators must stop hectoring and accept responsibility for having unintentionally pushed financial activity beyond sound boundaries by meddling without really understanding. Basel 2 in particular requires a very critical new look, if not a recall, as you would do for a line of cars when you realize that the brakes do not work as expected.

. . .

An excess of CO2 may be a major threat to civilized life as we know it, but the malfunctioning or freezing of the financial system could happen much faster, and we would have no control over it, as it depends on the psychology of literally billions of individuals. The consequences of such a malfunctioning do not bear thinking: breakdown in trade and investments, freezing of savings and pensions, advent of totalitarian regimes, war, and so on.

The financial system is a delicate mechanism and an essential one. Let us all treat it with some respect.

The thin space of financial activity requires a carefully calibrated commitment to balance by all parties participating in defining the sphere and scope and framework for financial interaction. In trying to deliver ever-increasing profits all around by growing the pie with inflationary monetary policies, executive excess, heightened investor expectations, regulatory and rating agency forbearance and other unrealistic and unsustainable policies, we have each and every one of us contributed to the current collapse.

Soon we will be doing a forensic analysis of what went wrong, and then look to craft new policies as a basis for rebuilding. We could do worse than look to Rudi Bogni’s analysis of the thin space of financial activity as providing the template.


More excerpts from Rudi’s writing over the years:

Re: Excessive Liquidity, Self-Indulgence and Self-Deceit (1 March 2007)

I read Dr Malmgren’s submission to ATCA with great interest. As in the Middle Ages and early Renaissance, there is an increasing risk in our less and less enlightened and less and less educated societies for the financial operators to be blamed for all economic evils, the same way that unfortunately the Jewish and Lombard bankers used to be blamed for the disasters caused by the excessive indebtedness of the European monarchies of the time.

Reality is much simpler. Take a bathtub and fill it to 1/3, then throw a stone into it. It may cause waves, but it might not flow over. Take the same bathtub and fill it to the brim, then throw a stone into it. It is most likely to flow over.

What we are experiencing is an unusually long period of extreme liquidity. Whatever the motivations for it, they are essentially political motivations, driven by political intents. Whether it is to finance wars without increasing taxation, whether it is to make people feel good about the inflated value of their assets so that they are going to spend more and promote GDP growth, whether it is to buffer one country’s voters from the natural effects that working less should entitle them to a lesser share of global goods and services, there are political intents behind the excessive liquidity.

Politicians are shying away from telling the truth to their voters and a vicious circle of self-indulgence and self-deceit is being buttressed by excessive liquidity.

Blaming incorrectly the equivalents of the Jews and Lombards of today, ie hedge funds and private equity investors, is the modern version of the French kings locking up the bankers in order to avoid taking the due blame and repaying the debts.

Long term it is a strategy which can ultimately lead only to decline.

Turning difficult issues which require courage, like global warming or global competition, into a religion of fear is the novel way by which politicians aim and unfortunately short-term succeed in keeping the masses, and often even the intelligentsia, in the dark and unable to confront policy-makers on the rightful field of rationality.

Rudi Bogni

The Left and Right defined the 20th century. What’s Next? Prospect (March 2007):

Left vs Right was and is purely a nominal distinction between two strands of the same totalitarian posture. The real problem of the 20th century was that the demographic and economic pressures that fractured the empires gave rise to national states with leaderships ill equipped to face the nihilist challenge. The vacuum was filled by totalitarian regimes, whose ideologies set fire to Europe and the world. Remember that Hitler was a failed architected, Staline had studied for the priesthood an Mussolini was a schoolteacher. The heirs of the 19th and 20th century nihilists are today’s faith-based terrorists. If today’s democracies fail to win against the new nihilists on the intellectual and communication level, they will have no chance to win in the security space and will create another dangerous vacuum, ready to be filled. Nation states have proven a disastrous political experiment in the 19th and 20th century; they may well prove catastrophic in the 21st century, due to nuclear proliferation. Nevertheless, I hope that the 21st century will see a substantial reduction of political infrastructures. If a conglomerate is bad or indifferent at most of what it does, shareholders force it back to its core competences. Everything else has got to go. Why should it be different for governments? This is neither left nor right; it is common sense. Large countries’ politicians love to deride small countries’ direct democracies. Why? Because they fear their example and their nimbleness. The political systems inherited from the 20th century, whether democratic or totalitarian, are neo-feudal, incompatible with a 21st century when electors vote every so many years, but consumers vote and bloggers blog 24/7.

The Stars and Gripes (12 July 2002):

Curing hatred of America is not easy. The European intelligentsia, because of the value its educational system places on knowledge for its own sake, tends to develop a highly critical sense and a healthy scepticism. US elites, despite being trained to think for themselves, tend to be less self-critical, perhaps too focused on getting rich. This creates a big communication gap. I concentrate on Europe versus America because if there is anybody who can help America to shed its self-satisfied myths and treat the rest of the world as equals with whom it is OK to disagree, it is us Europeans. US and European interests often converge, even when our hearts and minds do not meet.

What is certain is that half-educated people, with puerile, dogmatic, self-centred half-knowledge, are the salt of tyranny. The greatest tyrants of the century we have just survived, Hitler and Stalin, were half-educated men of hatred. Only knowledge accompanied by self-deprecating critical spirit can dispose of hatred, whether of America or of the rest of the world.

But I must admit - and this is why this book created a sense of emotional release - that until now I have never seriously confronted my close American friends with what I did not like about their country. I used the same polite diplomacy to avoid taking to task my Jewish and Arab friends over Palestine. This is wrong. Discourse is the stuff of civilised life; complacency is the crystallisation of ignorance and the begetter of lost lives.

Raised by the Yankee Game (3 May 2002)

When I hear the debate as to whether capitalism won over communism, triggering perhaps the end of history, I get very annoyed. Capitalism did not win a thing. Thatcher and Reagan may have pushed down communism’s crumbling walls, but the revolution was elsewhere. It was in places such as the City of London, beacons of freedom, where young men and women of any nationality could go to work every day reporting to a person of different background and culture, working for shareholders perhaps of a different country, free to choose their career, employer, lifestyle, perhaps even work attire. Free to speak their mind and to pay the price for it if necessary. But what a small price in comparison to that of living in an autocratic society such as the Soviet Union.

Brad Setser: Extraordinary Times

Brad Setser has a fascinating insight to offer in his newest post, Extraordinary Times:

In the last two weeks — if I am reading the Federal Reserves’ balance sheet data correctly — the Fed has:

Increased “other loans” to the financial system by around $230 billion (from $23.56b to $262.34b);

Increased its “other assets” by about $80b (from $98.67b to $183.89b);

Increased the securities it lends out to dealers by $60b (from $117.3b to $190.5b);

That works out to the provision of something like $370b of credit to the financial system in a two week period. And that is just what I saw on a cursory glance.

The most that the IMF ever lent out to cash strapped emerging economies in a year?

$30b, in the four quarters through September 1998 (i.e. the peak of the 97-98 crisis).

The most the IMF ever lend out over two years?

$40b, in the eight quarters through June 2003 (this covered crises in Argentina, Brazil, Uruguay and Turkey)

This is a very real crisis. The Fed’s balance tells a story of extraordinary stress. I never would have expected to see the Fed lent out these kinds of sums over such a short-period.

My response:

Excellent and timely, Brad. I’ve been speculating all week that the pressure being used on the Congress to pass the Paulson Plan is the threat of Fed illiquidity. As of two weeks ago, the Fed had lent out more than $600 billion of its $800 billion balance sheet Treasuries against crap MBS collateral.

The Paulson Plan would have allowed the banks to unwind the repos putting the Treasuries back in the Fed, get cash for the crap MBS, and get more Treasuries from the issues financing the $700+ billion funding of the Plan. As a bonus, the Paulson mark-to-maturity price becomes the implicit Level 3 price for capitalisation of all the firms and banks in the system, giving them some breathing room to stay in business. Everyone wins except the poor American taxpayer.

The Fed is very close to being illiquid. That is the fear factor we are seeing at work, and the reason no one will discuss why the bailout is needed - only emphasise the urgency.

Wednesday, 24 September 2008

Did Buffett Just Give Us A Coded Warning?

Warren Buffett, new stakeholder in the megalithic survivor-biased Goldman Sachs, has referred to recent upheavals in the financial markets as "an economic Pearl Harbour". He is a very smart man who knows his history, having lived it and seen it up close. He will know better than most that Pearl Harbour is now understood in well informed circles to not only have been foreseen by FDR, but provoked by FDR in an orchestrated campaign to engineer a war with Japan dating from a plan adopted in 1940.

As yoyomo reminds us in an earlier thread, the book Day of Deceit: The Truth About FDR and Pearl Harbour provides dispositive documentary evidence.

Historians have long debated whether President Roosevelt had advance knowledge of Japan's December 7, 1941, attack on Pearl Harbor. Using documents pried loose through the Freedom of Information Act during 17 years of research, Stinnett provides overwhelming evidence that FDR and his top advisers knew that Japanese warships were heading toward Hawaii. The heart of his argument is even more inflammatory: Stinnett argues that FDR, who desired to sway public opinion in support of U.S. entry into WWII, instigated a policy intended to provoke a Japanese attack. The plan was outlined in a U.S. Naval Intelligence secret strategy memo of October 1940; Roosevelt immediately began implementing its eight steps (which included deploying U.S. warships in Japanese territorial waters and imposing a total embargo intended to strangle Japan's economy), all of which, according to Stinnett, climaxed in the Japanese attack.

Warren Buffet knows better than most just how dirty and mean this Bush administration plays. The politically motivated prosecutions of AIG after he endorsed Kerry in 2004 will have left scars, and his advising Obama puts him at huge risk if Rove succeeds with another GOP victory.

He is in the insurance business, isn't he? So think of his acquisition of a huge stake in Goldman Sachs and his endorsement of the Paulson Plan as insurance. Meanwhile, he may just be patriot enough to have provided a coded clue as to what he really believes you can expect.

Tuesday, 23 September 2008

Marcy Kaptur (D-OH): "Real reform now or nothing!"

Must see.

She rips Wall Street a new one.

Quotable: On Bank Balance Sheets

"The problem with financial institution balance sheets is that on the left hand side nothing is right and on the right hand side nothing is left."

Rep McDermott (D-WA): Paulson "able to catch a pass he threw to himself"

Rep McDermott gets it:

Mr Speaker,

The people in Washington State are very troubled by the fact that King George has been disposed of by King Henry.

We picked up Newsweek magazine today and we have a new King... King Henry?

We're supposed to give him 700 billion dollars of our money. He doesn't want any review. He wants to be able to do whatever he wants with it. He doesn't want any Congressional oversight. And worst of all, the new king is just like the old king: He doesn't want any sacrifice.

He says, "Oh we can't threaten the salares of the investment bankers who drove us into a ditch. We can't get anyone to pay for this."

This is the third time we've done it with this bunch. First the war, that didn't get paid for. Then the tax cuts, that didn't get paid for, and now King Henry takes over to distribute 700 billion dollars. He's going to be there for four months. And in four months he will make deals and then he'll go out and he'll be able to catch a pass he threw to himself.

Saturday, 20 September 2008

"Non-Reviewable" - Sometimes there really ARE conspiracies

The text of the proposed emergency markets legislation is now available. Just as expected, it will contain a provision to provide immunity from any review by any court or executive agency. Either get with the collaborationists or get with the insurgents. There is no other choice. The USA doesn’t exist as we once knew it.

The relevant text from the legislation:

Sec. 8. Review.

Decisions by the Secretary pursuant to the authority of this Act are non-reviewable and committed to agency discretion, and may not be reviewed by any court of law or any administrative agency.

Good luck, everyone. We’re in uncharted waters now. There is no rule of law if this passes - there are no markets. We’ve all been had, and the worst is yet to come.

Friday, 19 September 2008

The Unitary Federal Reserve - Crisis Choreography

Along with much of the world, I have watched with increasing disquiet as the United States of America morphed under President Bush into a lawless soft dictatorship more like the USSR than the USA.  Under his theory of the "unitary executive" the laws that Congress enacted were disapplied by signing statements and secret legal opinions.  The protections of the Constitution were eroded and marginalized by police powers and warrantless surveillance.  International treaties governing the protection of sovereignty, rules of war and the universal rights of man were distorted by unilateral interpretation and willfully hidden misconduct.  Court rulings and judicial review were avoided, and where forced, were ignored or overridden or negated by executive pardon.  Transparency and audit became a joke with refusals to cooperate with tribunals or to comply with supeonas or produce evidence.  This lawlessness has not made the world or the United States or its allies safer in the age of terrorism as it has degraded and confused what we might have hoped to defend.

Just as we here in the rest of the world hoped we might breathe easy with the end of the Bush administration in sight, and several creditable candidates for president coming forward, the lawless unitary executive has expanded to embrace the Treasury and the Federal Reserve, debasing and contaminating the financial markets globally with its spread to our own central banks and market authorities and destabilizing our banks and investment markets.  Once again in the name of crisis and expediency the laws are ignored, decisions are taken in secret, extra-judicial reapportionment of property and contract is mandated by executive fiat, and legislative review and judicial intervention are impossible. Over the past year every financial crisis has been met with lawless and Enron-esque innovation by the Federal Reserve and Treasury, and this week was arguably more extreme.

After this week's secret and unaccountable and extra-legal moves by the US financial authorities, I will not be holding any assets in the United States.  I do not understand the rules.  I doubt any rules will be applied fairly to all the players.  I cannot be sure who the umpire works for, or what principles the umpire thinks they should uphold.  I will not play the game.*

Let's look at a timeline of some of the decisions I would class as extra-legal or Enron-esque:

The (Selectively Leaked) Discount Rate Cut (August 2008)

Super SIV (October 2007)

Term Auction Facility (December 2007)

Bear Stearns/JP Morgan bailout and subsidy (March 2008)

Primary Dealer Credit Facility (March 2008)

Reverse MBS Swaps (April 2008)

Equity investment and collateral (September 2008)

Administrative Repeal of 23A (September 2008)

AIG nationalisation (September 2008)

Expansion of the Fed Balance Sheet through unprecedented Treasury refinance without appropriation by Congress (September 2008)

Central bank dollar liquidity draws (September 2008)

Resolution Trust Company/Super SIV Redux (next)

And that's just the list of actions we know about.  Much may have been orchestrated and influenced behind the scenes in  credit markets and traded equities and commodities.

At no stage have any of these significant enhancements to the prerogatives of the Federal Reserve, these derogations of explicit statutory limits, these stark departures from past authority and conduct, been the subject of democratic legislative proposal or review, or even public consultation and comment.  In the name of exigency, they have all been sprung as fait accompli on a shocked financial community, and since been treated as unquestionable and unreviewable.  Every initiative introduced as a temporary measure has become a permanent fixture.

The unitary executive of the Bush presidency eroded and disregarded the civil rights of Americans and others.  The unitary Federal Reserve disregards the property and contract rights of Americans and others.  Arguably the actions of the Federal Reserve over the past year represent the largest state confiscation of wealth in the history of man, dispossessing currency investors, equity investors, bond investors and taxpayers of literally trillions of dollars of current and future wealth by executive fiat.

The hypocrisy of the Bush administration criticizing Chavez while defending Paulson and Bernanke should be the stuff of late night stand up comedy.

And the answer to the crisis so created, according to those in authority in Washington and Wall Street, is to give more concentrated power with less review and less oversight to the Federal Reserve.  The reforms now being discussed in Washington are aimed at (1) gutting the SEC so that it can no longer challenge the Fed's primacy in investment bank and financial conglomerate prudential supervision, oversight of clearing and settlement systems, market integrity and stability and introducing “principles based” regulation so that no one well connected need ever worry about prosecution or conviction ever again; (2) gutting the FDIC so that it can no longer challenge the Fed's determination of capital adequacy or prudential supervision at insured banks or restrain cross-affiliate financing or excessively risky activity within bank holding company groups; (3) gutting the CFTC so that the Fed has primacy to oversee risk management in all OTC and exchange-traded derivatives clearing and margin; and (4) providing explicit powers to the Federal Reserve to promote "market stability" by means which shall be secret, unreviewable, and above challenge in the courts; and (5) making the Federal Reserve the prime global regulator for review of the regulatory and prudential supervision arrangements everywhere else in the world through mandated “harmonization” of global standards as a quid pro quo for foreign market recognition and access.

Stalin couldn’t have drafted a better plan for central control of the global economy after wreaking such havoc and devastation.

Up until this week I thought the gold bugs a bit mad.  I couldn't see the sense of holding something that couldn't be spent but could be seized (as gold was seized in the 1940s).  I still think they are a bit mad, but I am actively looking for any alternative to currency and market investments as a medium of exchange and store of value.  Given the very public concerns now being expressed in China and Russia, I am keeping company I would have once thought very surprising indeed.

For now the ECB, Bank of England and others are content to cooperate with the Fed, but as the chaos deepens and it becomes clear that the losses are to be allocated principally outside the US borders to those foolish enough to hold assets the Fed’s policies degrade and debase, they will begin to question and to look to each other for common interest and alignment.

The loss of 1200 lives on the Lusitania was deliberately allowed to justify US entry into World War I.  The attacks on Pearl Harbour were known in the White House three days before the bombs fell, but were ignored to justify entry into World War II.  Tonkin Gulf was a fraud.  WTC hijackers were financed by US allies and WTC 7 was . . . whatever.  Saddam’s weapons of mass destruction were fabricated in the forgery shop of Ahmad Chalabi’s Iraqi National Congress.  You get the idea.

Not all catastrophic events were willful or anticipated, but all were used to force through an agenda that was pre-agreed by a powerful elite that stood to profit from a preferred course of policies that could only be pursued in the undemocratic atmosphere of crisis.  Crisis prevents objective determination of the public interest.  Crisis undermines both markets and democracy.

I no longer believe that every financial collapse is unanticipated or without behind the scenes orchestration of effects.  I no longer trust the authorities to act fairly, honestly, in the public interest.

In the past year and just this past week, trillions of dollars of wealth have been allocated or misallocated, preserved, appropriated or destroyed by central bank fiat.  If we really have nations of laws and not men, capitalist markets and not command economies, then it’s essential we peek behind the curtain to ask by whom and why and hold them accountable.

Lawlessness has not enhanced our security as citizens, and lawlessness will not enhance our security as investors or depositors either. Banks and markets require regulation in the public interest, and determination of the public interest requires transparency, accountability and the rule of law.


* For those cynics out there, let me remind you I gave up trading in January this year. I had a small amount of cash in a US dollar account. That account is now closed.

Hat tip to Joe Mason, for expressing similar views here on RGE Finance and Banking yesterday: Crisis Policy is Redrawing the Boundaries of our Financial System - and not necessarily in productive ways

And, as ever, thanks to the courageous Professor Roubini for providing a forum for views challenging the orthodoxy.

Thursday, 18 September 2008

Denninger warns of US political failure

Every now and then I have enjoyed reading Karl Denninger's Market Ticker on current events. His most recent video, which he warns may be his last, warns that the line crossed by the Treasury and Federal Reserve in creating new money to bail out Wall Street will - if unchallenged - lead to the political failure of the United States and its constitutional government as a representative democracy. He makes some very good points.

Unlike most people, I knew in 2002 and early 2003 that the United States was determined to attack and occupy Iraq because I have a long memory for bank failures. I knew that Ahmad Chalabi was the same forger, embezzler and fraudster who had looted Bank Petra of $300 million before fleeing Jordan, almost causing the collapse of the Jordanian economy. Since all the intelligence fabricated for the war emanated from Chalabi's Iraqi National Congress, I knew the whole thing was being orchestrated by authorities.

I get the same queasy feeling today about events on Wall Street, and like Denninger, I wonder what the plan really is for the nation as more and more lines are crossed with extra-legal executive authority. I did not expect in 2002 and 2003 that war for oil in Iraq would lead to black sites, renditions, torture, Blackwater deployed in New Orleans, and other proximate results of a lawlessness and unaccountability that remained unchallenged and unchecked. I do not know what to expect of the USA in the years to come. That worries me deeply.

Friday, 12 September 2008

Ring Fences, Rustlers and a global bank insolvency

In this week which has seen so much speculation on the fate of Lehman Brothers, it seems only sensible to review how an international insolvency of a major bank works and what it might mean for international creditors. The insolvency treatment of international banks has remained one of the stubbornly difficult areas of law to harmonise and huge uncertainty and complexity remains. For excellent background, see Cross-border bank insolvency by Rosa Maria Lastra of Queen Mary, University of London.

Although markets are global, and Lehman Brothers operations span the globe, all insolvency is local. The basic premise is that each jurisdiction buries its own dead and keeps whatever treasure or garbage it finds with the corpse. Local creditors get to recover their claims out of the locally available assets. If, and only if, there are any assets left over will international creditors be invited to make a claim for the rest. Europe has managed to harmonise cross-border insolvency for banks under directives and local law to embody principles of universality and unity within the EU, but that only works equitably if enough assets are in the EU when the bank fails, and local insolvency law still applies in all its divergent complexity.

Claims against a bank are deemed located wherever the contract creating the claim is undertaken. If it is under US law then the claimant must look to the liquidator in the United States and assets under his control for recovery. If the claim is in Hong Kong, then the claimant looks to the Hong Kong receiver and assets.

The key to having a happy insolvency, if such a thing exists, lies in ensuring that when a globalised bank goes bust, all the best assets are inside your borders and subject to seizure by your liquidators on behalf of your creditors. Everyone else outside your borders is on their own. As the US dollar is the reserve currency of banking and US Treasuries, Agencies and other assets are the highest preferred asset class, the US is almost always in a good position in an international bank failure.

The principle of using local assets for local recovery is known as the “ring fence” – the idea being that insolvency drops an invisible “ring fence” around any valuable assets at the borders to meet claims arising within the borders. No country is more assiduous in weaving the ring fence than the United States of America. It is a very successful strategy for US creditors. US creditors of failed international banks tend to recover disproportionately relative to creditors anywhere else. The ring fence contains all these choicest assets for US creditors, and all the international creditors are forced to pick among the dross of foreign assets to eke out a recovery, only receiving any residual US assets remaining after US creditors get 100 percent recovery.

Lehman has been deeply troubled and subject to speculation since the early spring. That was just about the time that we started to see a marked sell off in foreign markets where Lehman has long been a major player. Recently, along with intensification of that sell off, we have seen a strengthening of the US dollar and US asset markets.

If one were cynical, and one believed that Lehman was going to be allowed to fail pour encouragement les autres one might wonder if Lehman was quietly bidden – or even explicitly ordered – to sell off its foreign holdings and repatriate the proceeds to asset classes within the US ring fence. This would ensure that US creditors of Lehman received a satisfactory recovery at the expense of foreign creditors. It would also contribute to a nice pre-election illusion of a “flight to quality” as US dollar and assets strengthened on the direction of flow.

If one were really cynical, one might even think that a wily bank supervisor might arrange to ensure 100 percent recovery for its creditors with a bit of creative misappropriation thrown in the mix. Broker dealers normally hold securities and other assets in nominee name on behalf of their investor clients. Under modern market regulation, these nominee assets are supposed to be held separately from a firm’s own assets so that they can be protected in an insolvency and restored to the clients with minimal loss and inconvenience. Liberalisations and financial innovations have undermined the segregation principle by promoting much more intensive use of client assets for leverage (prime brokerage and margin lending) and alternative income streams (securities lending). As a result, it is often very difficult to discern in a failed broker who has the better claim to assets which were held to a client account but reused for finance and/or trading purposes. The main source of evidence is the books of the failed broker.

On the wholesale side, margin and collateralisation in connection with derivatives and securities finance arrangements mean that creditors under these arrangements should have good delivery and secure legal claims to assets provided under market standard agreements. As a result, preferred wholesale creditors could have been streamed the choicest assets under arrangements that will look above suspicion on review as being consistent with market best practice.

If Lehman were to go into insolvency, I will be interested to discover whether US creditors achieve a much higher proportion of recovery than their global peers in other locations where Lehman did business. If so, it will likely be because of the US ring fence and the months of repatriation of assets and funds back into the confines of the ring fence before the failure was finally orchestrated. It will also be because the choicest assets were preferentially delivered to preferred US creditors under market standard margin and collateral arrangements.

Unfortunately, the pace of an international insolvency means that any retrospective evaluation will be so far down the road that I will likely be almost alone in looking backwards to see what the final distribution effects are and what they mean for equitable principles of international banking practice.

Friday, 5 September 2008

Weaning the banks off the Old Lady's teat

There is a warm sense of security that comes from suckling liquidity from the teat of the central bank rather than foraging for capital and earnings in a harsh world full of threats and predators. Nonetheless, there comes a time when a good mother pushes away her importunate young and forces them to fend for themselves subject to her stern guidance and supervision.

Central banks have been suckling their broods of commercial banks since the credit crunch first exploded on the scene in August 2007. Now there are signs that the Bank of England and European Central Bank, at least, are keen to push their broods toward self-sufficiency, even at the risk that not all survive independently.

The Old Lady of Threadneedle Street has announced that she really, really means it when she says that the Special Liquidity Scheme introduced to enable banks to draw her gilts against mortgage-backed collateral will be closed down 20th October. The SLS was opened as a “one-off operation with a finite life” and was never intended to do more than bridge the liquidity gap created by the collapse of the mortgage-back securities market while banks adjusted their business models to changed market conditions.

The banks, led by UBS, are throwing temper tantrums, stamping their little feet, screaming in the financial press, but so far the Old Lady is holding firm. Mervyn King said last month:

"The SLS was introduced as a measure to deal with a legacy problem of liquidity of the stock of assets which banks owned last year when the crisis hit. So that window will close in October. The longer-term issue of tightening of credit conditions is much wider. That is to do with the health of the capital position of the banking system, and it's very important not to confuse the two".

Mr King’s determination to husband what remains of the Old Lady’s resources may have something to do with profligate abuse of them when opened to her brood. What started out as a scheme to extend up to £50 billion (a bit less than $100 million) in liquidity to shore up the UK credit markets during a surprise credit dislocation may have been drawn for as much as £200 billion in total as crunch turned to constriction. The Bank will only publish the true scale in October after the SLS closes. The SLS has been hungrily drained by banks keen to swap whatever unmarketable dross remained on their books for good central bank gilts.

The abuse has been made plain in numbers reported by the BIS.

Banks issued a record £45bn in mortgage-backed bonds in the three months to the end of June - more even than at the very height of the housing boom in 2006 - according to figures from the Bank for International Settlements. . . . . The Quarterly Review added: "Most of the UK issuance followed the Bank of England's announcement in April 2008 of a Special Liquidity Scheme (SLS) that enables UK banks to swap illiquid assets such as mortgage-backed securities against UK Treasury bills."

This record mortgage-backed issuance comes at a time when new mortgage lending in the UK has contracted very sharply, down 71 percent year on year for the month of July. That indicates a cynical abuse of the Old Lady’s generosity. Rather than be left with dry dugs dangling to her waist, the Old Lady would prefer to wean the banks while she retains ample bosom and sufficient other assets to shore up her public stature.

Over at the European Central Bank, a rule change this week will increase haircuts (discounts to stated market value) for collateral provided under that liquidity scheme from next February. The ECB has made available over EUR 367 billion (a bit less than $700 billion) under very liberal terms.

According the Financial Times:

The changes, which take effect from February 1, include increases in the average “haircuts” applied to asset-backed securities. A haircut is the amount deducted from the market value of a product when judging its value as collateral. In future, a blanket 12 per cent haircut will apply, replacing a previous sliding scale of between 2 per cent and 18 per cent. There will be penalties for asset-backed securities valued using models and for unsecured bank bonds.

Restrictions already in place on banks using assets they themselves had formed were extended to stop banks using assets from issues to which they had offered currency hedges or liquidity support above a certain level.

Analysts at Barclays Capital said the extra haircuts would mean banks might have to post an additional €25bn-€45bn of securities for collateral purposes. “That could cost €375m to €450m annually to banks ... Not in­significant, but probably bearable,” said Laurent Fransolet, analyst at Barcap.

The normally politic Yves Mersch made explicit reference in his remarks to "dangers of gaming the system".

Nonetheless, with house purchases falling to new lows and credit getting progressively tighter, the Labour government and the Council of Mortgage Lenders are wild to have another source of cheap liquidity if the Old Lady denies them. A new scheme for taxpayer-subsidised mortgage finance is in the offing. It is clearly bad public policy to have the government subsidise further borrowing for the housing sector after such a destructive bubble, but the scale of vested interest and the unpopularity of the Labour incumbents as the house prices fall make a new scheme a certainty all the same.

Rather like a mother who loves her young no matter how ill-bred, destructive and abusive they are to their peers or the community, the Old Lady of Threadneedle Street is unlikely to mind very much if British banks prosper by depredations on the politicians, taxpayers, market counterparties, corporate treasurers, hedge funds and others so long as they are out of the house. Having proved they have no sense of gratitude or duty to the Old Lady that preserved them in time of need, the others who will become their new targets can expect even less consideration.