A trend is a trend is a trend.
But the question is, will it bend?
Will it alter its course
through some unforeseen force
and come to a premature end?
-- Sir Alec Cairncross
I’ve had a lot of meetings this week, and very little time to reflect on fast moving events. This entry may be light on cites and hyperlinks as I’m in a bit of a rush today. It will also lack much in the way of perspective or insight as I find it impossible to distance myself just now from the swirling turbulence around me.
Here in Britain, several banks were offered partial nationalisation as an alternative to private recapitalisation. Strangely, this seems to have encouraged them to more strenuous efforts to recapitalise. The plan is now being held up as a model as it seems to force managements to confront their undercapitalisation as a problem that they can solve to their advantage or that will be solved for them to their heavy personal cost.
Iceland collapsed. It was more of a hedge fund than a country, with it’s 200,000 population supporting a massive leveraged position in financial markets via risk loving bankers and financiers. There were approximately 200,000 British depositors in accounts offered by Icelandic banks. Local authorities (municipalities) and charities were also big investors, exposed for more than £700 million. As a result, the government has frozen Icelandic-owned assets in the United Kingdom – using terrorism legislation, naturally – to provide the basis for a partial recovery of the losses likely to be incurred. This is causing more stress between the two island nations than they have known since the Cod Wars of the 1980s. Also causing tension is a rumour that Russia might bailout Iceland with $4.5 billion of credit, leading to speculation that the Russians may be eying the vacant airbase formerly used by Americans. This is problematic as Iceland is a member of NATO, and so has spurred efforts toward finding European alternatives.
Europe continues to call for collaboration while each country unilaterally defines and acts on its self-interest. That is the way it should be, and I approve heartily. I would rather not have the European Union making hasty decisions or holding such concentrated powers that it can force a uniform resolution across all member states. Either the EU builds consensus for action in the common interest, or it remains impotent. Either is preferable to too much concentration of power in Brussels.
In an attempt to shut just one stable door in a barn full of bolting horses, the Treasury has laid legislation before Parliament to reform the treatment of UK bank insolvencies and deposit insurance arrangements. Roughly described, the Financial Services Authority will decide if a bank is bust, the Bank of England will be responsible for overseeing its resolution and ensuring financial stability of the system, and the Treasury will oversee a new deposit insurance scheme that no one can currently describe but will make permanent the rise in protection to £50,000 per depositor. Despite the massive failure of Lehman, and the huge losses incurred by investors and hedge fund prime brokerage clients in London, the legislation is completely silent on the insolvencies of investment banks and broker-dealers and other institutions of systemic importance to financial markets. My fear is that the failure to address the systemic issues as a whole will be a vulnerability exploited by US banks and authorities as they try to undermine London as a financial centre, gaming the fragile global markets.
There is still a touching confidence among many in the City that the US authorities will provide the “leadership” to reinforce collapsing markets. As John Plender of the Financial Times quipped, “Gaul votes for Rome to take the strain.” This seems to me to display a total incomprehension of the way US authorities operate to externalise pain and loss to the greatest extent possible in times of crisis. Gaul, after all, was an occupied state that was militarily and economically exploited to Rome’s advantage for centuries before Rome’s collapse. Saving Gaul was never a high priority once Rome was threatened.
Elsewhere in the world, bureaucrats continue to show up at the office in the morning and check to make sure all boxes are ticked, all forms are correctly ordered, and all initiatives in progress continue their stately way forward unimpeded by global chaos. I find this comforting, although much of their efforts will ultimately prove futile and failed.
Finally, an optimistic note. I was reminded yesterday that the vast bulk of “wealth” created during the Greenspan/Bernanke bubble years accrued to the very top percentiles of population – with many in the OECD middle class and lower class either stagnating or getting poorer as they mired themselves in unsustainable debt. While opportunity and employment grew strongly in emerging countries, there too the elites gained disproportionately as income inequalities surged. The crash of global financial markets therefore will have disproportionate effect on the elites, impoverishing them to a far greater extent, although it will be felt throughout society as employment, pensions, investments and public services contract.
Once we hit bottom of this downturn, some years hence in all probability, we may experience a democratisation of wealth and opportunity like none seen since the end of World War II when education reforms and unionisation laid the groundwork for the rise of the American and OECD middle classes. Those who have lost economic and political power during the boom years, are likely to organise and retake authority within economic and political systems during the bust years. The collapse of concentrated wealth in Wall Street will spur more collaborative capital formation and investment throughout the economy. This could provide reorientation of economic progress toward more equitable, sustainable and democratic outcomes in coming generations. I hope so, it’s the only bright spot of the week.
Friday, 10 October 2008
Friday, 3 October 2008
Financial Eugenics: The Paulson Plan for Survivor Bias
As I write this I don’t know the outcome of the attempt to ram through legislation for looting the US Treasury of $700 billion before the end of the Bush administration. I suspect that Congress will force the passage of the bill in some form because the media and political narrative on the necessity of the measure is unremitting and so horribly biased.
No alternatives will be considered.
No constraints on the unilateral executive authority of Hank Paulson will be considered.
No assurances that funds will be used to unlock credit markets or promote lending to the real economy (as opposed to the financial robber barons) will be considered.
Instead, the bill will get laden with an additional 300 pages of pork to sway the dissenters, adding to the tab imposed on the American taxpayer.
Having listened to all 42 minutes of the late night Treasury briefing of investment banks on Sunday, there is no doubt in my mind that this legislation represents the sort of federal largesse for Goldman Sachs, Morgan Stanley, Citibank and JPMorgan Chase that the Iraq war provided for Halliburton and Blackwater.
The most cynical moment in the call is when the Treasury official confirms, ”our preference would be to help the healthy banks become even healthier” rather than helping troubled banks or illiquid banks.
America is now a centrally planned economy where the Treasury will determine which firms survive and prosper through allocation of scarce capital to an undercapitalised financial sector.
Clearly what is going on here has nothing to do with kick starting the credit markets or stabilising the equity markets or restoring depositor confidence in banks. (Treasury official: “No provision in the legislation that mandates re-lending.”) What is going on here is a blatant attempt to provide government funds to a select cadre of firms (not all banks) which are chosen to be the survivors feasting off the carcasses of their less fortunate and less well-connected brethren as the downturn intensifies in the years to come.
The crash in equities will still happen. The debt deflation of the economy leading to mass commercial and consumer credit defaults will still happen. The collapse of many national, regional and local financial institutions will still happen. The bankruptcy of many municipalities and shortfalls in state budgets will still happen.
This bill is about engineering survivor bias to friends of the Bush administration so that they profit disproportionately from the collapse of these markets using the funds provided by the taxpayer via the unreviewable and unconditional authority of the Secretary of the Treasury.
The basic plan is to set up a federal money laundering operation. Bad assets come in, get laundered by the Treasury and put in a new AAA “wrapper” (as it’s termed on the call), and good assets go out, issued as Treasury guaranteed securities. Whether the final value of the legislation this week is $700 billion or $150 billion is irrelevant as long as the laundering operation can accommodate the throughput, as that number is only a cap on total extensions at any one time.
The SEC will support the plan and survivor bias by relaxing FASB 157 on mark to market accounting. If there is no agreement on what an asset is worth, it is worth whatever the firm holding it says in its Level 3 accounts or the Treasury Secretary accepts in buying it.
The Federal Reserve will support the plan by relaxing the definition of “control stake” in US banks and bank holding companies to allow secretive cabals to hold through private equity and offshore hedge funds. No one knows the beneficial owners of these ill-transparent private equity investors, and so it is the ideal way to reward loyal and helpful insiders, legislators and officials – as well as cede further ownership of American assets to foreign stakeholders who would be politically unacceptable if publicly acknowledged. Many foreign creditors are irate at the losses their funds, banks and pensioners have sustained from investments in the United States, and this plan provides a secret way to buy them off and keep them lending and investing as their own economies are roiled by the deflation to come.
For the past year the survivor bias has been orchestrated from the Federal Reserve, with its extension of innovative credit facilities and selectively engineered rescues or forced mergers. That has been very useful, but that well is now dry. The Fed has no more good assets to trade for the bad assets the banks can offer. And the supply of bad assets just keeps growing as market illiquidity spreads further from the core of the mortgage backed securities market. Instability is now leading to a realistic threat that the Fed and Treasury could lose control of the deflationary process.
Part of the reason the Paulson Plan is so attractive is that it recapitalises the Fed by promoting the unwinding of repos and lending facilities which left the Fed holding toxic assets. As the repos and credit facilities gradually unwind, these toxic assets can now be taken back by the banks and exchanged for good cash. The Fed gets its balance sheet Treasuries and cash back to restore its flexibility to intervene anew.
Favoured private equity and insiders who swap US dollars for equity in the banking system will presumably be aware of the survivor bias being engineered on their behalf. Sovereign wealth funds, investment funds and private equity investors ripped off in the first round of recapitalisation may be willing to come back in once it is clear to them that the next round will benefit from official favouritism. Warren Buffett’s timely stake in Goldman Sachs is clearly linked to his confidence the Paulson Plan will benefit them disproportionately.
A factor which is probably critical but has received little discussion is that literally thousands of Bush administration apparatchiks will need jobs come January, and a fair selection of GOP House and Senate legislators and their aides too. What better way to enahance their CVs in their final months in power than to distribute $700 billion or so in pre-Christmas largesse to the most remunerative employers in the world? And what better way to ensure the corporate largesse is returned to the GOP to win back the White House and Congress in 2012 as the recession fuels public anger?
And then there is a huge arbitrage opportunity as well so that everyone makes money for years to come. According to the conference call, the pricing on offer from the Treasury will be a bit below Level 3 pricing. The toxic assets will be repackaged and resold with a new AAA wrapper, possibly priced well below what the Treasury paid, assuring a huge profit on both immediate liquidation by the banks and ultimate maturity by investors. The Fed gets its cash and Treasuries back; the banks make huge profits; the foreigners and off-shore tax avoiders get disguised ownership of the American financial system; the taxpayer gets ripped off. What’s not to love?
Think back to Fisher’s Theory of Debt Deflation in Great Depressions. Dollars become “bigger” as deflation takes hold because each dollar can buy more assets as assets deflate. That means that as these clowns crash the markets, their $700 billion of liquid cash funnelled to their friends and recycled through the Treasury laundrymat can progressively buy up the rest of the pieces on the gameboard at low discount prices. Game over with those who caused the crash and robbed the bank winning.
Deflation is going to happen – globally. Either we can use the course of deflation to shape healthy economies that will provide growth and employment and productive returns on investment in future, or we can allow deflation to further enrich those miscreants whose irresponsible policies led to the violent financial collapse we are about to experience.
There is a fundamentally healthy economy in America – somewhere underneath all the financial excess and chicanery and all the financial/oil/military/healthcare/developer corruption of local, state and federal politics. It will be a painful and slow process to kill off the metastasising cancerous growths on the economy, but if Americans achieved that, they could embrace a healthier and more productive and more prosperous future.
I would like to believe Americans expressed the courage to change over last weekend when they 25 to 1 rejected an unconstrained and unconditional bailout of Wall Street in favour of cold turkey deleveraging of the economy. I wish I could believe that it mattered in the political calculus, but the result of the House vote on the bill will tell us that.
Fight the survivor bias. It’s not your survival they’re engineering.
No alternatives will be considered.
No constraints on the unilateral executive authority of Hank Paulson will be considered.
No assurances that funds will be used to unlock credit markets or promote lending to the real economy (as opposed to the financial robber barons) will be considered.
Instead, the bill will get laden with an additional 300 pages of pork to sway the dissenters, adding to the tab imposed on the American taxpayer.
Having listened to all 42 minutes of the late night Treasury briefing of investment banks on Sunday, there is no doubt in my mind that this legislation represents the sort of federal largesse for Goldman Sachs, Morgan Stanley, Citibank and JPMorgan Chase that the Iraq war provided for Halliburton and Blackwater.
The most cynical moment in the call is when the Treasury official confirms, ”our preference would be to help the healthy banks become even healthier” rather than helping troubled banks or illiquid banks.
America is now a centrally planned economy where the Treasury will determine which firms survive and prosper through allocation of scarce capital to an undercapitalised financial sector.
Clearly what is going on here has nothing to do with kick starting the credit markets or stabilising the equity markets or restoring depositor confidence in banks. (Treasury official: “No provision in the legislation that mandates re-lending.”) What is going on here is a blatant attempt to provide government funds to a select cadre of firms (not all banks) which are chosen to be the survivors feasting off the carcasses of their less fortunate and less well-connected brethren as the downturn intensifies in the years to come.
The crash in equities will still happen. The debt deflation of the economy leading to mass commercial and consumer credit defaults will still happen. The collapse of many national, regional and local financial institutions will still happen. The bankruptcy of many municipalities and shortfalls in state budgets will still happen.
This bill is about engineering survivor bias to friends of the Bush administration so that they profit disproportionately from the collapse of these markets using the funds provided by the taxpayer via the unreviewable and unconditional authority of the Secretary of the Treasury.
The basic plan is to set up a federal money laundering operation. Bad assets come in, get laundered by the Treasury and put in a new AAA “wrapper” (as it’s termed on the call), and good assets go out, issued as Treasury guaranteed securities. Whether the final value of the legislation this week is $700 billion or $150 billion is irrelevant as long as the laundering operation can accommodate the throughput, as that number is only a cap on total extensions at any one time.
The SEC will support the plan and survivor bias by relaxing FASB 157 on mark to market accounting. If there is no agreement on what an asset is worth, it is worth whatever the firm holding it says in its Level 3 accounts or the Treasury Secretary accepts in buying it.
The Federal Reserve will support the plan by relaxing the definition of “control stake” in US banks and bank holding companies to allow secretive cabals to hold through private equity and offshore hedge funds. No one knows the beneficial owners of these ill-transparent private equity investors, and so it is the ideal way to reward loyal and helpful insiders, legislators and officials – as well as cede further ownership of American assets to foreign stakeholders who would be politically unacceptable if publicly acknowledged. Many foreign creditors are irate at the losses their funds, banks and pensioners have sustained from investments in the United States, and this plan provides a secret way to buy them off and keep them lending and investing as their own economies are roiled by the deflation to come.
For the past year the survivor bias has been orchestrated from the Federal Reserve, with its extension of innovative credit facilities and selectively engineered rescues or forced mergers. That has been very useful, but that well is now dry. The Fed has no more good assets to trade for the bad assets the banks can offer. And the supply of bad assets just keeps growing as market illiquidity spreads further from the core of the mortgage backed securities market. Instability is now leading to a realistic threat that the Fed and Treasury could lose control of the deflationary process.
Part of the reason the Paulson Plan is so attractive is that it recapitalises the Fed by promoting the unwinding of repos and lending facilities which left the Fed holding toxic assets. As the repos and credit facilities gradually unwind, these toxic assets can now be taken back by the banks and exchanged for good cash. The Fed gets its balance sheet Treasuries and cash back to restore its flexibility to intervene anew.
Favoured private equity and insiders who swap US dollars for equity in the banking system will presumably be aware of the survivor bias being engineered on their behalf. Sovereign wealth funds, investment funds and private equity investors ripped off in the first round of recapitalisation may be willing to come back in once it is clear to them that the next round will benefit from official favouritism. Warren Buffett’s timely stake in Goldman Sachs is clearly linked to his confidence the Paulson Plan will benefit them disproportionately.
A factor which is probably critical but has received little discussion is that literally thousands of Bush administration apparatchiks will need jobs come January, and a fair selection of GOP House and Senate legislators and their aides too. What better way to enahance their CVs in their final months in power than to distribute $700 billion or so in pre-Christmas largesse to the most remunerative employers in the world? And what better way to ensure the corporate largesse is returned to the GOP to win back the White House and Congress in 2012 as the recession fuels public anger?
And then there is a huge arbitrage opportunity as well so that everyone makes money for years to come. According to the conference call, the pricing on offer from the Treasury will be a bit below Level 3 pricing. The toxic assets will be repackaged and resold with a new AAA wrapper, possibly priced well below what the Treasury paid, assuring a huge profit on both immediate liquidation by the banks and ultimate maturity by investors. The Fed gets its cash and Treasuries back; the banks make huge profits; the foreigners and off-shore tax avoiders get disguised ownership of the American financial system; the taxpayer gets ripped off. What’s not to love?
Think back to Fisher’s Theory of Debt Deflation in Great Depressions. Dollars become “bigger” as deflation takes hold because each dollar can buy more assets as assets deflate. That means that as these clowns crash the markets, their $700 billion of liquid cash funnelled to their friends and recycled through the Treasury laundrymat can progressively buy up the rest of the pieces on the gameboard at low discount prices. Game over with those who caused the crash and robbed the bank winning.
Deflation is going to happen – globally. Either we can use the course of deflation to shape healthy economies that will provide growth and employment and productive returns on investment in future, or we can allow deflation to further enrich those miscreants whose irresponsible policies led to the violent financial collapse we are about to experience.
There is a fundamentally healthy economy in America – somewhere underneath all the financial excess and chicanery and all the financial/oil/military/healthcare/developer corruption of local, state and federal politics. It will be a painful and slow process to kill off the metastasising cancerous growths on the economy, but if Americans achieved that, they could embrace a healthier and more productive and more prosperous future.
I would like to believe Americans expressed the courage to change over last weekend when they 25 to 1 rejected an unconstrained and unconditional bailout of Wall Street in favour of cold turkey deleveraging of the economy. I wish I could believe that it mattered in the political calculus, but the result of the House vote on the bill will tell us that.
Fight the survivor bias. It’s not your survival they’re engineering.
Monday, 29 September 2008
Quotable
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
"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:
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:
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 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)
The Left and Right defined the 20th century. What’s Next? Prospect (March 2007):
The Stars and Gripes (12 July 2002):
Raised by the Yankee Game (3 May 2002)
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:
My response:
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.
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.
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
Subscribe to:
Posts (Atom)