Gonzalo Lira: What do BP and the Banks Have In Common? The Era of Corporate ...

I've often thought that my generation is like the turn-of-the-Nineteenth-century British generation. We were all born into the World's greatest country near its inevitable decline. It's said watching the fall from grace. Can you say nǐ hǎo?

 

 

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Gonzalo Lira: What do BP and the Banks Have In Common? The Era of Corporate Anarchy

via naked capitalism by Yves Smith on 6/16/10

By Gonzalo Lira, a novelist and filmmaker (and economist) currently living in Chile

On the occasion of the BP oil spill disaster, President Obama's delivered an Oval Office speech last night—a masterpiece of milquetoast faux-outrage. The speech was all about "clean energy" and "ending our dependence on fossil fuels". Faced with the BP oil spill—likely the most severe environmental disaster ever—this was President Obama's response: Polite outrage, and vague plans to "get tough", "set aside just compensation" and "do something".

President Obama missed what the BP oil spill disaster is really about. Though unquestionably an environmental disaster, the BP oil spill is much much more.

The BP oil spill is part of the same problem as the financial crisis: The BP oil spill and the banking crisis are two examples of the era we are living in, the era of corporate anarchy.

In a nutshell, in this era of corporate anarchy, corporations do not have to abide by any rules—none at all. Legal, moral, ethical, even financial rules are irrelevant. They have all been rescinded in the pursuit of profit—literally nothing else matters.

As a result, corporations currently exist in a state of almost pure anarchy—but an anarchy directly related to their size: The larger the corporation, the greater its absolute freedom to do and act as it pleases. That's why so many medium-sized corporations are hell-bent on growth over profits: The biggest of them all, like BP and Goldman Sachs, live in a positively Hobbesian State of Nature, free to do as they please, with nary a consequence.

The added bonus to this, though, is that the largest corporations have convinced the governments and the people of the "Too Big To Fail" fallacy—they have convinced the world that if they cease to exist, the sky will fall atop our collective heads. So if they fail, they must be saved—without argument, without penalty, and without reform.

Let's take BP: British Petroleum caused the Deepwater Horizon oil spill in the Gulf of Mexico. There were various Federal Government agencies charged with supervising their operations—but all of those agencies deferred to BP, before the accident. As a large corporation—one of the largest oil companies in the world—BP operated more or less without any Government supervision. As is emerging, because of this lax and toothless supervision, safety rules and procedures were ignored. Insane risks were taken. No safety contingency plans were drawn up.

From what some memos are saying, disaster was inevitable.

Once the accident happened, BP controlled the information it released concerning the disaster. BP unilaterally decided not to proceed with an immediate top-kill of the well—instead, BP risked a wider disaster, in order to save the oil field by drilling a "relief well". BP's reasoning was simple: By implementing an immediate top-kill, BP would have sacrificed the oil field (and lost its investment) in order to save the environment. BP did not do this. Instead, it tried to stretch out the process, so as to salvage the oil field (and the profits) with the "relief well". But when it became impossible to hide the extent of the damage—when the smell of oil permeated the clear skies of Louisiana a hundred miles from the site of the spill—BP tried to implement the top-kill. We know how that ended.

Where was Authority? Where was Someone In Charge? The fact was, there was no one in charge. There was no one supervising—or at any rate, the ones who were supposed to be supervising had had their teeth yanked. And BP knew it—so they did whatever they wanted, regardless of the risks, or the costs.

Worst of all, BP realizes that, if it finally cannot get a handle on the oil spill disaster, they can simply fob it off on the U.S. Government—in other words, the people of the United States will wind up cleaning BP's mess. BP knows that no one will hold it accountable—BP knows that it will get away with it.

No one was holding the banks accountable either. It's no accident that American and European banks nearly went broke, but banks here in Chile sailed along smoothly: That's because banks here are regulated up the wazoo. They literally can't fart without an independent banking inspector supervising them, and then getting a stamped form in triplicate. When Chile's banks went bust in the crisis of 1980, it put paid to any illusions that the banks knew what they were doing—the government bailed out the banks then, but kept them under glass ever after.

But in Europe and America, the story was the Greenspan Put. Easy Al was so convinced that the banks would "self-regulate" that he pulled the teeth of the Fed, the banks regulatory agency, and let the "free market" have its way.

With this free pass, what do you think the banks did? They went anarchic—they invented all sorts of clever "financial products" that exponentially increased risk, rather than mitigating it. We all saw how that movie ended. When Lehman busted and the credit markets froze, a slap-dash improvised "rescue package" was drawn up, then the $700 billion TARP, then Quantitative Easing, all of these efforts lubed up with a lot of talk to "strengthening the regulatory environment" and "protecting the financial markets".

The upshot? The banks did whatever they pleased—with no supervision. And when their recklessness led inevitably to the catastrophe in the Fall of '08, the banks got bailed out—with no repercussions. The biggest ones even managed to turn a profit off the tax payer-funded bail-outs!

Even after the worst of the crisis—when the effects of no regulation and no supervision were clearly understood—nothing happened. The zero-regulation, zero-supervision regime continued.

This isn't the case for people, for individuals: People are regulated, people are controlled. Individuals are supervised and limited in what they can do and say—and no one complains. On the contrary—everyone is relieved, because it protects us all from the unreasonable behavior of an individual.

As an individual, I am limited in countless ways, from the trivial, like jaywalking, to the severe, like murder. I can't even speak up and yell "Fire!" in a crowded theater—I would be arrested for inciting a panic, the general good of avoiding a potentially lethal stampede overriding my need to express myself by yelling "Fire!" when there is none.

Curiously, individuals—ordinary people—are being supervised and regulated more and more stringently. Yet at the same time, corporations are becoming more and more free to do as they please. No one notices how strange this is—we have even lost the social framework to even talkabout regulating and supervising corporations, because too many foolish pundits equate supervision and regulation with Socialism. Yet curiously, personal freedom is being chipped away, day by day, without a peep from these pundits.

Meanwhile, the banks run amok.

Meanwhile, BP runs amok.

We can look at other industries—Big Pharma, for one—but there's no real need: Big Pharma will fit the same pattern as BP and the banks. Get so big that you can do whatever you want, and no one will challenge you, not even the government. Carry out practices that will inevitably create a crisis—like unsafe drilling, like toxic bonds—and be confident that you will be bailed out.

Bailed out, and allowed to continue, unfettered. "Allowed" to continue, unfettered? I'm sorry, I mis-spoke: Encouraged to continue, unfettered.

This era of corporate anarchy is reaching a crisis point—we can all sense it. Yet the leadership in the United States and Europe is making no effort to solve the root problem. Perhaps they don't see the problem. Perhaps they are beholden to corporate masters. Whatever the case, in his speech, President Obama made ridiculous references to "clean energy" while ignoring the cause of the BP oil spill disaster, the cause of the financial crisis, the cause of the spiralling health-care costs—the corporate anarchy that underlines them all.

This era of corporate anarchy is wrecking the world—literally, if you've been tuning in to images of the oil billowing out a mile down in the Gulf of Mexico.

I think we are at the fork in the road: One path leads to revolutionary change, if not outright revolution. The other, appeasement and stasis, as the corporations grind the country down.

My own sense is, there will be no revolutionary change. The corporations won. They won when they convinced the best and brightest—of which I used to be—that the only path to success was through a corporate career. No necessarily through for-profit corporations—Lefties never seem to quite get how pernicious and corporatist the non-profits really are; or perhaps they do know, but are clever enough not to criticize them, since those non-profits and NGO's pay for their meals.

Obama is a corporatist—he's one of Them. So there'll be more bullshit talk about "clean energy" and "energy independence", while the root cause—corporate anarchy—is left undisturbed.

Once again: Thank God I no longer live in America. It's too sad a thing, to watch while a great nation slowly goes down the tubes.

 

 

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SEC Investigation of Goldman Trading Against Its Clients Widens

The FT had a front page story (link below) about the SEC investigating another Goldman CDO called "Hudson."  Apparently Hudson was the focus of the Senate hearings.  The situation is a little different than ABACUS.  In the Hudson transaction, Goldman was not acting as a market maker for third-party counterparties (unlike the Paulson v. IKB deal in ABACUS) but was THE actual counterparty.  Goldman disclosed both a long and a short position in Hudson that turned out to be 0.4% long and 99.6% short.  (BTW, the $8 million long position was less than half the $17 in fees Goldman collected on the deal!)  It looks like Lloyd needs to have another conference call.

 

The post below discusses the story, cites to some of the Senate references, and mixes in another FT story hypothesizing why the SEC is investigating Goldman and Merrill, but not Deutsche Bank.  The conspiracy theorist think the SEC is using Goldman to establish the template before it goes after DB b/c Khuzami could not participate in a DB matter.    

 

 

 

 

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SEC Investigation of Goldman Trading Against Its Clients Widens

via naked capitalism by Yves Smith on 6/10/10

 

The latest shoe to drop on the Goldman front is the report on Wednesday that the SEC was investigating yet another one of its synthetic CDOs, this one a $2 billion confection called Hudson. It isn't clear whether the SEC will file charges, but this one has the potential to be particularly damaging in the court of public opinion, since this CDO was created solely as a proprietary trading position to help the firm get short subprime risk in late 2006, when the market was clearly on its last legs.

By way of background, the assets in a synthetic CDOs are credit default swaps. In the case of Hudson, they referenced $800 million of BBB subprime bonds, 2005 and 2006 vintage, and $1.2 billion of the ABX. The deal was a wipeout.

What makes Hudson different from the Abacus CDO that is the subject of an SEC lawsuit is that it was not even arguably intermediated between customers. Goldman was not only the initial short counterparty (as was indicated in the contract as standard verbiage), it was every and always intended to be the ultimate short counterparty. Why does this matter?

Synthetic CDOs were sold to investors as the economic equivalent of cash CDOs, ones whose assets were subprime bonds rather than credit default swaps. That was always more than a bit disingenuous. Cash CDOs had for some time been the way that underwriters would dispose of the pieces of subprime bonds they were unable to sell, namely the riskier tranches. Conceptually, it was like taking unwanted parts from (presumably) healthy pigs, grinding it up with a little bit of better meat plus some spices and turning it into sausage.

But the short players like Goldman set out to create sausage from pigs known to be sick because that would be more profitable for them, and this was a zero sum game: their profit came at the expense of their customers. Note that this is NOT inherent to investing, that the dealer's gain is necessarily the customer's loss. A dealer might exit a trade that he sees as unprofitable because he expect the price to fall in the next few days. The customer may have a completely different time horizon, and the success of his investment will not be affected much by what would be for him trading "noise" over the next few days.

Let's put it more simply: how many of you would knowingly choose to be on the other side of a Goldman prop trade, particularly if you knew Goldman had designed the instrument to enable it to go short? Answer: probably zero.

There is an (in theory) less culpable scenario, but it does not get Goldman out of the SEC's crosshairs. The initial motivation for its Abacus program (25 synthetic CDOs in total) was to lay off long CDS positions it took. Let us say a hedger like a bank wanted to reduce its subprime exposure. It could sell the loans or bonds, or simply hedge it by entering into a CDS with Goldman. From time to time, Goldman would flatten its position by bundling these exposures into a synthetic CDO. This was hardly unusual; a similar process was well established in the corporate CDS market.

So if that is the case (big if, one will have to look at Goldman's intent, as revealed by internal messages, as to whether it was merely laying off exposures in a routine manner or cherry picking particularly drecky exposures to establish a profitable short), Goldman's "we're just acting as a market maker" argument is not a complete fabrication. But it still appears to have a legal problem. See this statement in its marketing documents (p. 346 of the Goldman documents released by the Senate):

Goldman Sachs has aligned incentives with the Hudson program by investing in a portion of equity and playing the ongoing role of Liquidation Agent.

Yves here. This is a flat out misrepresentation. The equity position is a Trojan horse for the much larger short position. The equity was at most 5% of an ABS CDO; Goldman was at least 95% net short this deal (if p. 401, which shows Goldman had a $8 million equity position, is correct, it was 99.6% short! And since per p. 402, it reported $17 million in P&L on the deal, so it took more out in fees than its equity stake. Nice work.). It most certainly did NOT have incentives aligned with its investors

Goldman may argue that the disclaimer language in itty bitty print on the next page gets it off the hook, but I have my doubts that that will be viewed with much sympathy. There is a notion of good faith and fair dealing that underlies all contracts. It is such a bedrock concept that it is not clear that Goldman can try to disclaim its way out of it.

Goldman has more language that is misleading (p. 357):

Goldman Sachs' objective is to develop a long term association with selected partners that can adapt to and take advantage of market opportunities

• The goal is to create attractive proprietary investments by leveraging expertise of both Goldman Sachs COO and Mortgage Desks while maintaining a consistent approach and creating a unified issuance program across multiple transactions

Yves here: Translation. We want to sell you more deals like this, so trust us, we won't fleece you.

Note that Goldman explicitly says it is NOT laying off its own exposures, and by implication based on the body language thus far, it is pickin' good stuff for this deal (p. 358):

• Goldman Sachs' portfolio selection process:

• Assets sourced from the Street. Hudson Mezzanine Funding is not a Balance Sheet COO
• Goldman Sachs COO desk pre-screens and evaluates assets for portfolio suitability
• Goldman Sachs COO desk reviews individual assets in conjunction with respective mortgage trading
desks (Subprime , Midprime, Prime, etc.) and makes decision to add or decline
• All CDS use rating agency approved confirms (pay as you go)

It appears this deal was not an easy sale (p. 803, from an October 2006 e-mail by Michael Resnick):

do we have anything talking about how great the BBB sector of RMBS is at this point in time … a common response I am hearing on both Hudson' HGSl 1s a concern about the housing market and BBB in particular!

We need to arm sales with a bit more – do we have anything?

Now Goldman defenders may argue that the investment bank is being unfairly singled out. However, that is hard to take seriously. There were very few banks in the business of synthetic CDO programs for their own account : Goldman, who is being investigated, Morgan Stanley, ditto, and Deutsche Bank….not. One industry source has also told us that Citigroup did deals along similar lines, but we have not gotten independent confirmation (update: aha, some new G2 in a very good article at the Financial Times tonight).

Some cynics may contend that the failure to go after Deutsche Bank is due to the fact that the head of SEC enforcement, Robert Khuzami, not only comes from Deutsche, but was involved in its CDO business. But the reality is more complicated. Getting someone like Khuzami, who is also a former prosecutor, was a coup for the SEC. He would clearly have to recuse himself from any cases involving his former employer. Insiders can correct me if I am wrong, but not only does the SEC not appear to have anyone who could step into Khuzami's shoes (in terms of having both the product knowledge and the litigation experience), but it would be difficult to hire someone with a similar profile. Thus the fallback may be to perfect the litigation strategy on Goldman and Morgan so it then can then be deployed against Deutsche and not require someone as high powered to lead the effort.

Just because the wheels of justice seem to be grinding a bit slowly does not mean that in the end, they will not grind exceedingly fine.

 

 

 

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European Interbank Markets Stress Rises Over Counterparty Fears

In March 2009 I had an optimistic attitude about the global economy (i.e. I was bullish). I thought stocks were underpriced and the economy would recover, albeit at a slow pace. Over the past month, however, I've become bullish. I now think the current recession will double-dip. The first dip was the plummeting global real estate market that caused bank assets to plummet, which in turn led to a credit crisis. I think the second dip will be caused by a sovereign debt crisis in Europe that causes bank assets to plummet along side a currency free fall, which in turn will cause a credit crisis. This Naked Capalism post explains the European Crisis in better detail.


European Interbank Markets Stress Rises Over Counterparty Fears: "

It’s starting to fell like 2007 and 2008 all over again: banks suddenly cautious about lending to each other, with the stress spilling into other markets. Per Bloomberg:

The cost to hedge against losses on European bank bonds is 63 percent higher than a month earlier. Investment-grade corporate debt sales in the region plummeted 88 percent last week to $1.2 billion from the prior period…

The rate banks say they charge each other for three-month loans in dollars is the highest in nine months…

The three-month London interbank offered rate in dollars, or Libor, rose to 0.445 percent last week, the highest level since August, from 0.428 percent on May 7 and 0.252 at the end of February…

Concerns have spilled into the market for commercial paper, debt used by companies and banks for their short-term operating needs. Rates on 90-day paper are more than double the upper band of the federal funds rate, about twice the average in the five years before credit markets seized up in mid-2007.

“The list of banks able to tap the three-month market remains extremely limited with access spotty and expensive,” Joseph Abate, a money-market strategist at Barclays in New York, wrote in a May 14 note to clients…..

Rates on commercial paper for 90 days are 24 basis points above the upper band of the Fed’s zero to 25-basis point target rate for overnight loans among banks. While far below the 245- basis point gap reached in October 2008, the spread is more than double the 10-basis-point average in the five years before credit markets seized up in the middle of 2007. As recently as February, financial CP rates were below the federal funds rate.

Except for banks with little exposure to European sovereign risk, banks “have found liquidity to be scarce, securing funding only one month and shorter and mostly concentrated inside one week,” Abate from Barclays wrote in the report.

Yves here. The Bloomberg piece highlights Royal Bank of Scotland and Barclays as the banks hit with the biggest rise in funding costs.

Where this all gets a bit nasty is the worries re MTM losses, not just on sovereign debt, but on other risky assets as well (and don’t underestimate the ability of a bank to have wrongfooted their currency exposures). Remember, most observers believe banks generally, and UK/European banks in particular, have not recognized the full extent of their losses from the last crisis (cheap liquidity has enabled a lot of dubious assets to be marked at levels that are questionable given their long-term prospects).

While all eyes have been on the plummeting euro, sterling hasn’t fared too well either, and a lot of my UK contacts expect it to be decline (the powers that be presumably hope that Mr. Market will take care of that, but they think a formal devaluation is not out of the cards). But the open question is whether a desired slide in the value of the pound could morph into a currency crisis. As Willem Buiter warned in 2009:

The risk of a triple crisis – a banking crisis, a currency crisis and a sovereign debt default crisis – is always there for countries that are afflicted with the inconsistent quartet identified by Anne Sibert and myself in our work on Iceland: (1) a small country with (2) a large internationally exposed banking sector, (3) a currency that is not a global reserve currency and (4) limited fiscal capacity.

The argument is simple. First consider the case where the banking sector is fundamentally solvent, in the sense that its assets, if held to maturity, would cover its liabilities…There is no such thing as a safe bank, even if the bank is sound. Without an explicit or implicit government guarantee, there is always the risk of a bank run (a withdrawal of deposits or a refusal to renew maturing credit and to roll over maturing debt) or a sudden market seizure or ’strike’ in the markets for the bank’s assets bringing down a fundamentally sound bank.

To prevent a fundamentally sound bank succumbing to a deposit run or to asset market illiquidity, the central bank has to be able to act as lender of last resort, providing funding liquidity and as market maker of last resort, providing market liquidity to liquidity-constrained banks…

The UK banking sector’s balance sheet is about half the size of the Icelandic banking sector as a share of annual GDP: just under 450% at the end of 2007 as compared to Iceland’s almost 900%…. If we exclude the Bank of England, the latest observation on the balance sheet of the banking sector and a percentage of annual GDP would still be around 420 percent. The deleveraging of the banking sector, visible at the very end of the sample period, has much further to go…..foreign currency assets and liabilities of the banking sector are very evenly matched….

While there is no net foreign exchange exposure of the banking system in the UK, banks are banks. The foreign currency liabilities of the banking system are therefore likely to have shorter maturities than the foreign currency assets. The foreign currency assets are also likely to be less liquid than the liabilities….With foreign currency assets of longer maturity and less liquid than foreign liabilities, the banks and the country would still be vulnerable to a foreign currency run on the banks (a refusal to renew foreign currency credit) or a seizing up of the markets in which the banks’ foreign currency assets are traded. The Bank of England’s foreign currency reserves are puny and the government’s foreign currency reserves are small – around US$43 billion, pocket change, really.

Yves here. You can see where this is going…the UK cannot credibly backstop its banks if they have trouble rolling their short term foreign currency borrowings. Not a pretty line of thought.

"

Should a Stock Market Decline Stop Us From Breaking Up the Giant Banks or Fu...

Interesting post from "Washington's Blog." Briefly discusses how the rich are getting richer and, by the way, they control Congress and run both the private sector and the government to build and protect their wealth.

 

 

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Should a Stock Market Decline Stop Us From Breaking Up the Giant Banks or Fully Auditing the Federal Reserve?

via Washington's Blog by George Washington on 5/6/10

As of 2007, the bottom 50% of the U.S. population owned only one-half of one percent of all stocks, bonds and mutual funds in the U.S. On the other hand, the top 1% owned owned 50.9%.

From the San Francisco Chronicle:

Half of America has only 0.5% of the stocks and bonds

Source: Institute for Policy Studies

(Of course, the divergence between the wealthiest and the rest has only increased since 2007.)

As I noted in January:

Vincent Deluard - a strategist for TrimTabs Investment Research (25% of the top 50 hedge funds in the world use TrimTabs' research for market timing) - says:

We've never seen this before – such a huge rally, and the little guy is out.

In other words, the stock market rally is due almost entirely to hedgies, pension funds, banks and other institutional investors, and not every day investors.

***

TrimTabs notes that small investors pulled out $14 billion net from stock mutual funds from the beginning of last year through mid-December, on top of a net $245 billion withdrawn in 2008.

Given that, at the end of September, individuals held 80% of the $19 trillion in stock in U.S. companies, both private and public - according to the Federal Reserve (see this, for example)- recovery will not happen so long as the little guys are sitting on the sidelines.

TrimTabs notes that most of $592 billion taken out of money market mutual funds last year has gone into bond and bond-hybrid funds instead.

No wonder David Rosenberg is saying:

• "People have been lured into two bubbles seven years apart, and for a lot of them it's over."

• "The bulls say if the market is up this much without retail investors, just watch when they come in, but it isn't going to happen."

• Investors who have not been spooked or angered by the market are probably too poor to buy anyway.

Many people say that keeping the stock exchange up is important to maintaining people's wealth. But since the bottom 50% of Americans don't have much skin in the game, and the giant prop desks are probably doing most of the trading, the stock market really doesn't affect most Americans very much.

After Hank Paulson initially asked for $700 billion to bail out the banks, Congress refused. Then the stock market tanked (and Paulson said there would be martial law unless TARP was approved), and Congress gave Paulson his bailout. They said they had to do it, because their constituents were being hurt by the stock market downturn.

As I pointed out last November, there are a lot of millionaires in Congress:

A report by University of California, Berkeley economics professor Emmanuel Saez concludes that income inequality in the United States is at an all-time high, surpassing even levels seen during the Great Depression.

The report shows that:

• Income inequality is worse than it has been since at least 1917

• "The top 1 percent incomes captured half of the overall economic growth over the period 1993-2007"
  

• "In the economic expansion of 2002-2007, the top 1 percent captured two thirds of income growth."

As others have pointed out, the average wage of Americans, adjusting for inflation, is lower than it was in the 1970s. The minimum wage, adjusting for inflation, is lower than it was in the 1950s. See this.

On the other hand, billionaires have never had it better (and see this).

Of the 535 members of Congress, over 44% - 237 to be exact - are millionaires. Fifty have net worths of at least $10 million, and seven are worth more than $100 million. By comparison, around 1% of Americans are millionaires. There is no other minority group that is as overrepresented in Congress. See this.

Indeed, Herbert argues that the real reason that Congress approved the TARP bailouts is that their money was on the line. In other words, they had a lot of skin in the game, and so they voted to bail out their own assets. But they just pretended it was for the good of the American people.

Whether or not Herbert is right (Paulson did pull a bait-and-switch), the information discussed above makes for valuable background for looking at proposed reform legislation and the stock market.

Specifically, I have seen many questions on well-known financial sites asking whether today's plunging stock market is related to top Senators' decision today to audit the Federal Reserve and break up the giant banks (and see this).

I have no idea whether there is anything to this question. But I do know that the economy can only be stabilized if the history of what happened is fully revealed.

And the Fed is an important part of what happened.

And I know that the economy can only recover long-term if the giant banks are broken up.

So ignore the short-term stock market scares. Fully audit the Fed and break up the mega-banks ... or the economy will never really recover.

 

 

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Market Update

 

 

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Market Update

via Calculated Risk by CalculatedRisk on 5/6/10

There are two rumors: The first is that there was a trading error (fat finger of a E-mini SP future order), the second is that Euro banks are having a liquidity problem of some sort. Neither is confirmed.

Click on graph for larger image in new window.

The first graph shows the S&P 500 since 1990 (this excludes dividends).

The dashed line is the closing price today. The S&P 500 was first at this level in April 1998; over 12 years ago.


The second graph is from Doug Short of dshort.com (financial planner): "Four Bad Bears".

Note that the Great Depression crash is based on the DOW; the three others are for the S&P 500.

 

 

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Yes, Virginia. There is a Difference Between Greece and the US

 

 

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Yes, Virginia. There is a Difference Between Greece and the US

via New Deal 2.0 by Marshall Auerback on 5/6/10

If we learn the wrong lessons from Greece, our social safety net may wind up in tatters.

Many market analysts, commentators and economists claim to be having a hard time finding a metric in which the US is in better financial shape than Greece. Ken Rogoff, for example, recently warned that a Greek default would usher in a series of sovereign defaults, and suggested recently on NPR that the crisis also had implications for the US. The historian Niall Ferguson made a similar claim a few months ago in the Financial Times. The cries of the deficit hawks grow louder: Repent all ye fiscal profligates, before the "day of reckoning" comes.

Let's dial down the Biblical hysteria a wee bit while there's still time for rational debate. The market's recent response to the intensifying pressures in the euro zone suggests that investors are beginning to differentiate between countries that are sovereign issuers of currency, such as the US or Japan, and non-sovereign issuers, such as Greece or any other nations in the euro zone. The US dollar is rising in value, notwithstanding the federal deficit, while debt distress in the so-called "PIIGS" countries, especially Greece, are intensifying, thereby driving down the euro to fresh 12 month lows against the dollar.

The relative performance of various currencies against the US dollar is highly instructive in this regard. Over the past 3 months, the Australian, New Zealand and Canadian dollars have all registered gains of some 4% against the greenback. The worst performer? Not surprisingly, the euro, down 6.3% over that period. Whether consciously or not, the markets are demonstrating that they understand the distinctions between users of currencies (who face an external funding constraint), and those nations that face no constraint in their deficit spending activities because they are creators of currency.

That the US has the reserve currency is an irrelevant consideration here. The key distinction remains user vs. creator. The euro zone nations are part of the former; Canada, Australia, the UK, Japan and the US are representatives of the latter.

Using "PIIGS" countries as analogues to the US or the UK, as Rogoff, Ferguson and countless other commentators do, is wrong. Their faulty analysis comes as a result of the deficit critics' failure to distinguish between the monetary arrangements of sovereign and non-sovereign nations. Any sovereign government (none within the EMU enjoy that status any longer) can deal with a collapse in revenue and an increase in outlays from a financial perspective without invoking the sort of deadlocks that are now crippling the EMU zone. That is why, for example, the Japanese yen is not in freefall against the dollar, despite having a public debt to GDP ratio in excess of 200%, almost 2.5 times that of the US. In fact, over the past few days the yen has actually appreciated against the dollar. Now why would that be, if the lesson we were supposed to learn was the evils of "unsustainable" government deficit spending?

Fiscal sustainability has no relevance in a system where there are no operational constraints on the ability of a government to spend. US Social Security checks will not bounce. Nor will the Canadian or Japanese equivalents. Similarly, their bonds will always be able to pay out interest.

Note that this doesn't mean that there are no real resource constraints on government spending. Let's be clear: anyone who advances the use of fiscal policy as an effective counter-stabilization tool is always careful to point out that these interventions can come at a cost. That cost could well be inflation if, as a result of the fiscal expansion, we reach full employment, resource constraints begin to appear, but the government continues to spend. But if the economy recovers, tax revenues will increase and safety net spending will fall. In the US, that means we will likely be back to "normal," with deficits around 2-4% depending on the state of the economy, which is where we've been for the past 30 years aside from 1998-2001.

Why won't these deficits be inflationary? As Professor Scott Fullwiler noted in a recent email correspondence with me, once the recovery is underway and the economy gets to a significantly higher capacity utilization where price pressures could emerge, the deficit will be declining substantially. It will also be at least a partially offset by a fall in discretionary spending on social welfare. It's axiomatic that the faster the economy grows, the smaller the deficit becomes, unless the government continues to spend recklessly–which we certainly do not advocate.

And by the time we get to a point where we might have inflation, the deficit is back to 2-3%, which again is where we've been for the past 30 years, while average inflation has been about 2%. Note: inflation does not equal default. You and I could well buy credit default swaps on any country in the world, but we are unable to collect if any of the relevant countries register a positive rate of inflation — even a double digit rate of inflation — because inflation is not tantamount to default. Nor do the ratings agencies recognize default in this manner. Default is defined as a failure to perform a task or fulfill an obligation, especially failure to meet a financial obligation. Inflation is not incorporated into the definition when it comes to questions of national insolvency.

By contrast, the talk of Greek default is prevalent across the markets, and that is a reasonable concern in the context of the euro zone. The default option is considered a foregone conclusion, even allowing for the massive 110 billion euro bailout, which was designed to inspire "shock and awe" among investors but instead has simply engendered shock. If Greece costs 110 billion euros to bail out, how much next time for Spain, Italy, or even France?

If the markets have concerns about national solvency, they won't extend credit. And that is the problem facing all of the euro zone countries. Greece, Portugal, Italy, France, and Germany are all users of the euro-not issuers. In that respect, they are more like any American state or municipality, all of which are users of the US federal government's dollar.

And deficits per se will not create the conditions for default in the US. If the US continues to run net export deficits (all the more likely given the ongoing fall in the value of the euro), and the private domestic sector is to net save, the US government has to net spend–that is, run deficits. That is a basic accounting identity, nothing more, nothing less. If the US government tries under these circumstances to run surpluses, it will first of all force the private domestic sector into deficits (and increasing debt) and ultimately fail because the latter will eventually seek to increase their saving ratio again.

And the same logic applies for Greece. The call is for the IMF/EU package to reduce its budget deficit as a percentage of GDP from the current 13.6% to 8.1% in 2011. How will they achieve that? Trying to engineer a reduction in the deficit via austerity programs (or freezes or whatever else one might like to call them) at a time when private spending is still insufficient to maintain adequate real GDP growth is a recipe for disaster. It will increase the deficit.

Consider Ireland as Exhibit A in this regard. Ireland began cutting back deficit spending in 2008, when its banking crisis began to spread and its budget deficit as a percentage of GDP was 7.3%. The economy promptly contracted by 10% and, surprise, surprise, the deficit exploded to 14.3% of GDP. We would wager heavy odds that a similar fate lies in store for Greece, given the EU's inability to understand or recognize basic financial balances and the interrelationships among the various sectors of the economy. Neither a government, nor the IMF, can predict with any certainty what the outcome will be–ultimately private saving desires will drive the outcome, as Bill Mitchell has noted repeatedly.

Why do we have huge budget deficits across the globe? It's not because our officials have all suddenly become Soviet-style apparatchiks. It is largely because the slower global economy has led to lower revenues (less income=less taxes paid, since most tax revenue is based on income, and lower tax brackets) and higher spending on the social safety net. Gutting this social safety net because we extrapolate the wrong lessons from the euro zone's particular (and self-imposed) predicament constitutes the height of economic ignorance. It also reflects a transparently political agenda, which the US would be ill advised to embrace. The rescue packages, the IMF intervention and all the talk about orderly defaults cannot overcome the EMU's fundamental design flaw. Let neo-liberalism die with the euro.

Roosevelt Institute Senior Fellow Marshall Auerback is a market analyst and commentator.

 

 

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Goldman’s public purpose and problems with the Abacus deal

This is a guest post on the blog "Naked Capitalism." If you've been following the SEC v. Goldman Sachs, then this post will help explain some of the issues behind the Commission's case.


Goldman’s public purpose and problems with the Abacus deal: "

This is a post I wrote earlier today at Credit Writedowns.

As I said yesterday, investment banks are institutions which do fulfil a useful role in society. I would define their role as companies where large institutions and governments receive financial advice and raise capital. Goldman Sachs is an investment bank. As such, Goldman must offer financial advisory services, capital markets origination, and secondary market support to maintain an orderly market in the markets in which it originates deals. That is what a full-service investment bank does and has always done.

In my view, the advisory business and the sales and trading functions are black and white issues.

Advisory Business

When Goldman gives financial advice to a client and executes a transaction or deal on the back of this advice, it must do so only in the best interests of the client. There are no ifs ands or buts here. The client comes first. I went into the moral and ethical obligations in my post "Inside the mind of an investment banker: Greece, Goldman and derivatives," so I will let you read that post to get a full picture there. I will just reiterate that this is a black and white issue. You simply cannot execute transactions or do deals that you know are not in your client’s interests. Full stop.

Sales & Trading

On the sales and trading side, Goldman Sachs is a market maker. That means their traditional role is to buy and sell securities principally to facilitate liquidity in the market. They are not a principal actor in this regard. As such, caveat emptor applies to their counterparties. Goldman is under no obligation to reveal its positions to counterparties in the market it makes. In fact, doing so compromises a firm’s ability to make a market. If you want to do a trade, Goldman’s only obligation is to show you a price because that’s what broker/dealers do. Lloyd Blankfein said as much in his Senate testimony. I see this as a black and white issue. They have no obligation to reveal their positions. Full stop.

Capital Markets

Then there is origination, an area where I have worked. Origination is what many firms call their ‘Capital Markets’ group. Here is where the problems begin because the origination groups are at once advisors and market-makers in their function. Your role as Capital Markets professional is to originate equity, debt, or structured product (derivative) deals for institutional clients, sell those deals to ‘buy-side’ clients, and to make a market in those instruments in the after market.

So, the capital markets guys must do deals that are in the best interests of the institutions, originating those deals. But, do they have an obligation to inform ‘buy-side’ clients of the pitfalls of those deals? Yes. 100%. This is where the problems lie in the Abacus AC1 deal that is the subject of alleged fraud. This was not a deal without a client. Paulson was the client. The synthetic CDO never would have been created had Paulson & Co. not asked for its creation. Goldman originated this Abacus deal at the behest of its institutional client, Paulson & Co. Therefore, Goldman’s obligation in the deal was to structure a deal which was in Paulson’s best interest.

The problem, therefore, is that in originating this transaction, Goldman was obligated to disclose to its initial buy-side clients what Paulson’s role in the deal was. Goldman was not selling a structured product without a client nor was it making a market in a security already originated. It was originating a deal purposely put together for a specific institution, Paulson & Co.. If Goldman did not fully disclose Paulson’s exact role – and all indications are it did not – then, at a minimum, it was not fulfilling its public purpose. The SEC has indicated this goes further – to fraud i.e. making ‘material’ misrepresentations to its buy-side clients and the company structuring the deal.

Proprietary Positions

Moving to a different track, let’s talk about ‘proprietary trading’ and the Volcker Rule for a second. What is novel in financial services is what is known in the business as "risking one’s own capital as a principal." Every major bank now is not just in the business of servicing clients in the ways I described above but also in making money as a principal actor.

This began during the 1980s when firms would risk their own capital in making bridge financing to corporate raiders like Carl Icahn during the Predator’s Ball days. One reason investment banks became so leveraged is that commercial banks had a natural advantage in this business due to their enormous balance sheet. So you saw firms like UBS, Deutsche Bank and JPMorgan muscling their way into mergers and acquisition and origination via this channel.

At some point, the banks realized that deregulation meant they didn’t have to risk their capital just for other people. They didn’t have to do deals where the profit accrued only to their clients. They could become principals, taking what they deemed to be prudent risks for their own benefit. In essence, the banks all became hedge funds and private equity groups, often competing with their clients for business.

Now, the capital markets business already presents an ethical dilemma because of the opportunity for duplicity i.e. flogging off garbage as AAA to sell-side clients just to make a buck. This goes as far as getting bad assets off the bank’s balance sheet and sticking it with buy-side clients.

But, proprietary activity raises the potential conflicts to a new level by pitting a potential client against the bank for the very same business. The bank goes from market-maker or advisor to rival who cannot be trusted. This is why the Volcker Rule has been posited. The goal of the Volcker Rule is to fashion a way to separate these proprietary activities which are replete with conflicts of interest from the more public purpose role of banks. I don’t think the legislation based on the rule drafted makes a lot of sense given how difficult it is to define what a proprietary trade is. But the concept is grounded in the knowledge that these conflicts of interest pose a risk to the financial system.

My own view is that none of this will be resolved because banks make too much money in proprietary activities. They will lobby Congress until they get legislation more palatable to their interests. Only when the financial system does collapse will Congress be forced to turn away from the banking special interests. And at that point, with populist fervour against banks much greater than it is today, much more draconian remedies will be in store.

Of course, between now and then, there will still be a lot of money to be made by individual bankers.

"

Will Greece's fall change the current world order?

Default scares are spreading through Europe and current predictions suggest there is little, if anything, that the IMF can do about it. Germany will offer some help, but politically it is limited to what it can offer. Think about this, what do you think Americans would say if they were asked at this point to loan $54 billion to Canada, $120 billion to Mexico, and $475 billion to Argentina? NO WAY!

At this point I'm not sure if Europe has the political capital to supply these three countries with the money necessary to save them. Maybe if the IMF maxed out its contribution the rest of Europe could cover the tab, but even that is not clear. Any organized bailout would probably require a combined effort from Europe, the IMF, the U.S. and at least some of the BRIC (Brazil, Russia, India, China) countries.

Watch to see if Russia and China get into the fray. Both would love to exert greater influence in Europe (particularly as leverage against the U.S.). And what better way to exert influence then to own a portion of Europe.


From Washington's Blog: Greek 2 Year Yields 20 Percent, Italy Up 6 Basis Points, Portugal Up 7 Basis Points, Spain Up 27 Basis Points: "

It's not just Greece and Portugal.
As Simon Johnson reports:

This is not now about Greece (with 2 year yields reported around 20 percent today) or Portugal (up 7 basis points) or even Spain (2 year yields up 27 basis points; wake up please) or even Italy (up 6 basis points). This is no longer about an IMF package for Greece or even ring fencing other weaker eurozone economies.
This is about the fundamental structure of the eurozone, about the ability and willingness of the international community to restructure government debt in an orderly manner, about the need for currency depreciation within (or across) the eurozone. It is presumably also about shared fiscal authority within the eurozone – i.e., who will support whom and on what basis?

(In related news, Eurozone sovereign credit default swaps widened somewhat Tuesday, but tightened again after the German finance minister said that Germany will rush through a disbursement of funds to Greece.)

Standard & Poor's downgraded Spain's sovereign credit rating today from AA+ to AA, after recently slashing Greece's rating to junk and lowering Portugal's rating two notches from A+ to A-.

David Rosenberg notes:

Portugal’s stock market has traded down to a 12-month low and it’s so bad in Greece that the government has banned short selling for two months. (Hey, it worked in the once-capitalistic U.S.A. didn’t it?) We see in the NYT that Barclay’s analysts believe that Greece needs €90 billion to see them through, €40 billion for Portugal and €350 billion for Spain!That is €480 billion of refinancing help, which dwarfs the latest €45 billion EU-IMF joint aid announcement by a factor of TEN (according to Ken Rogoff, the IMF is maxed out after €200 billion)! Do euros grow on trees as fast as Bernanke-bucks? Would the ECB, modeled after the Bundesbank, ever resort to the printing press for a fiscal bailout? Where exactly is this money going to come from?

***

Yesterday was really as much, if not more, about Portugal than it was about Greece. Contagion risks are spreading as they were amidst the turmoil around Bear Stearns in early 2008 ...

[Spain's] combined fiscal and current deficits are the highest in the industrialized world, save for Iceland (and we know what shape it is in). The amount of debt it has to refinance in the coming year is as large as the entire Greek economy ...

***

If the other two major rating agencies follow S&P’s lead and cuts Greece to “junk”, then the ECB would be in a real bind for it cannot hold below-investment-grade bonds on its balance sheet. If the ECB does accept junk-rated Greek debt as collateral, then the sanctity of its balance sheet will be seriously undermined; though this ostensibly didn’t matter too much to the Fed in the name of saving the system.

It is tempting to assume that this is just a Eurozone problem.

But that might be a very erroneous assumption. See this, this and this.

"

S&P Downgrades Spain

First Greece and Portugal, and now Spain. The bad news keeps coming from Europe.


S&P Downgrades Spain: "

S&P cut Spain’s long term rating to AA today with a negative outlook. From Bloomberg:

S&P said in a statement today that the outlook on Spain is negative, reflecting the chance of a possible further downgrade if the “budgetary position underperforms to a greater extent than we currently anticipate.” Spain was last cut by S&P in January 2009.

The risk premium investors demand to hold Spanish bonds surged to the highest in more than a year today and the price of insuring Spanish bonds against default reached a record as doubts about Greece’s ability to pay its debt spilled over into Spanish and Portuguese markets…

“We now project that real GDP growth will average 0.7 percent annually in 2010-2016,” S&P said.

From the Wall Street Journal:

The ratings agency said that the Spain is likely to have an extended period of subdued economic growth, which weakens its budgetary position. The move sent equities in Spain the U.S. broadly lower, while the euro fell back to a one-year low against the dollar of $1.3131….

In addition, S&P took into account the possibility that Spanish public and private sector borrowing costs could remain elevated this year and next and further slow Spain’s recovery from the current recession.

S&P warned that “additional measures are likely to be needed to underpin the government’s fiscal consolidation strategy and planned program of structural reforms.”

Main factors dampening Spain’s medium-term growth prospects include private sector indebtedness, which S&P estimates is higher than that of many of Spain’s peers, as well as high unemployment, a fairly low export capacity, and an unwinding of the government’s fiscal stimulus as part of its current efforts to reduce general government deficit to 3% of GDP by 2013.

"

Ka-Boom: Yield on Greek two-year notes increases

The Greek economic bomb just exploded. Investors have completely abandoned any hope that Greece can make it on its own. Either the EU/IMF needs to take drastic action or Greece is going to default within two weeks.

How bad is it getting, Greece is viewed as worse than Pakistan, and some are saying it will need a bailout of up $100 billion (with a big "B"), see here. That's nearly double the initial estimate of $59 billion.

Yield on Greek two-year notes increases: "From Bloomberg: Stocks Drop as Sovereign-Debt Crisis Spreads; Greek Bonds Slump

[Y]ields on Greek two-year notes jumped to a record 26 percent ... The yield soared almost 600 basis points at one stage today. Ireland’s jumped 90 basis points to 4.64 percent, Portugal’s increased 93 basis points to 6.24 percent and Spain’s rose 20 basis points to 2.26 percent.

The IMF, ECB and German officials are meeting today. They have scheduled a press conference at 9 AM ET, to be followed by a press conference with German Chancellor Angela Merkel at 10:45 AM ET."

Raj Date on Resolution Authority, Conservative Arguments on Bailouts

There are two things I would like to point out about this post.

First, the article is much more detailed and more in depth than this post. In my opinion, this is the best article I've read about the proposed Dodd Bill and the effect it would have had on the 2008 crisis (P.S. it also hints at how close Goldman Sachs was to defaulting).

Second, I want to reieterate the irony in the Republican party's current position. The GOP is arguing that this bill would legitimize the "to big to fail" mentality of the big financial institutions. Does the GOP really take the American public for a bunch of fools. Deregulation and other GOP sponsored theories allowed much of the crisis causing behavior. And it was a GOP President and Treasury that provided the 2008 bailouts (although the Democratic Congress is also responsible). How quickly the GOP has forgotten its previous posturing on financial reform.

 

 

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Raj Date on Resolution Authority, Conservative Arguments on Bailouts

via New Deal 2.0 by Mike Konczal on 4/27/10

First up, Raj Date has a new paper out, titled: The Killer G's: Resolution Authority, Financial Stabilization, and Taxpayer Bailouts. It's definitely worth your time, as it explains how, if the Dodd Bill was in place in January 2008, our response to the Killer G's - Goldman Sachs, GMAC and GE Capital - would have gone differently. It's great on the topic, and pulls back to show the three types of bailouts we are worried about and what the bill does well and doesn't do well. Highly recommended if you want to learn more.

The Bailout We Just Had

Second, we need to talk about if there are bailouts in the Dodd Bill because conservatives are not going to let this go. But before we dive into that, here's what is incredibly important to remember: the major, serial bailouts of 2008 were not the result of some unelected, socialist technocrats hidden away in a government basement somewhere exploiting a loophole. They were the results of GOP-appointed Hank Paulson, GOP-appointed Sheila Bair and GOP-appointed Ben Bernanke, all with the support of a Bush White House-sponsored EESA going to Congress and asking that an emergency bill be passed to allow for TARP.

The Dodd Bill cannot stop this. If this all happens all over again, and it could, there's nothing in this bill to stop GOP Team Paulson et al Version 2.0 from going to Congress and demanding more money for the financial system. Congress can always pass new laws in an emergency, even if it means overturning old laws. The only way to stop this is through prudential regulation on the front end and a resolution mechanism that is earlier and reduces uncertainty on the backend, which the Republican oppose, or by dramatically shrinking the size of the largest and most risky firms, segmenting business lines to de-risk critical infrastructure from that which can fail with less damage, and/or bringing some of the more dangerous business lines like derivatives into market-based sunlight.

The Republicans oppose all that too. I'm not trying to be a jerk - I actually read the GOP House Bill on Financial Reform and there's nothing in it that does any of that. When the Senate GOP drops their version I imagine it will look the same - let's just redo the problem with more bankruptcy law.

I've never really heard of this working and it's predicated implicitly on the conservative's argument that Lehman's bankruptcy wasn't that big of a deal (an argument that usually gets demolished by the blogosphere whenever it peeks its head). But if Keith Hennessey or other Bush administration officials who oversaw the bailouts would like to argue that in retrospect their mistake was to not do an overnight bankruptcy law change and force AIG and Bear into a bankruptcy court, and that the economy would be better off for it right now had they done so, I really hope they make their case. I'd really want to read it.

Is There a Bailout in Resolution Authority?

With that in mind, section 210(b)(4)(B) of the Dodd Bill is being called out as the bailout provision conservatives are alluding to as allowing extra payments to certain creditors. See, for instance, Nicole Gelinas, and I think this provision is what is being alluded to in this unsourced accusation by Phillip Swagel. I'm going to kick it to Raj's paper:

4.1.3 Removing moral hazard

The mere existence of a special resolution regime for certain large firms, and not others, could in theory create its own difficulties. Orderly liquidation almost certainly preserves more franchise value than an uncontrolled de-leveraging followed by bankruptcy. Absent counter-measures, that would create a perverse preference by creditors to lend to the largest and most systemically risky firms, like Goldman, as opposed to smaller rivals.

In light of that risk, the Senate Bill crafts a strikingly punitive resolution regime. The Bill requires that the FDIC, as receiver, act "not for the purpose of preserving the covered financial company"; ensure that shareholders are paid only after all other claims are paid; require that unsecured creditors bear losses; and terminate "management responsible for the failed condition".

Crucially, the Bill also sets out a cap on the amount that a creditor can receive from the resolution of a systemically important firm. No creditor can receive more than it would have received in a regular-way chapter 7 bankruptcy liquidation.(23) Creditors cannot be better off because of the existence of the resolution authority. Thus, the Bill effectively severs the potential feedback loop from the existence of a special resolution regime to moral hazard among creditors.

(23) - Id. at section 210(d)(2). Note that this maximum recovery also serves as a minimum recovery in those instances that the FDIC wishes to use its discretion to pay certain creditors more than similarly situated creditors, to minimize aggregate losses. In other words, the FDIC can preferentially pay a creditor, but only if similarly situated creditors are at least receiving what they would have received in a chapter 7 bankruptcy. Id. at section 210(b)(4)(B).

The repayment waterfall specifies that taxpayer money has to get returned before creditors get paid. If some creditors are paid more than similarly situated peers it can only occur if those peers get at least what they would have gotten in liquidation which occurs only if, by definition, the FDIC has already gotten its money back too. Not a bailout.

And as Raj points out in his conclusion, the real worry is twofold - that Federal Reserve expanded access to healthy firms in a crisis will disproportionately benefit larger and riskier firms, and that regulatory forbearance (that regulators will not want to pull the trigger to close a firm that is gigantic and has a huge political presence) hasn't really been solved by this bill. These are the real problems outstanding with the current sense of resolution authority, and would make for an excellent debate on the floor.

Mike Konczal is a fellow with the Roosevelt Institute.

 

 

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S&P Downgrades Greece and Portugal

Greece has just entered a free fall and taken Portugal with it, although they only have themselves to blame. This downgrade along with souring investor confidence in Greece and Portugal is certain to lead to the first major soveriegn defaults of the 2008 Recession. In other words, the global economy is in for another shake-up. Prepare your emergency shelters because who knows where this one is going.

 

 

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S&P Downgrades Greece and Portugal

via Calculated Risk by CalculatedRisk on 4/27/10

From MarketWatch: S&P cuts Greece ratings to junk status

Standard & Poor's said Tuesday it cut Greece's ratings to junk status. The ratings agency lowered the long-term sovereign credit rating on Greece to BB+ from BBB+. The outlook is negative.

From CNBC:

S&P downgraded its rating on Portugal's debt by two notches to A-minus.

 

 

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Bad news getting worse: "Yield on Greek Two-Year Bonds jumps to 13.5%"

As posted by Calculated Risk, the spread on Greece notes continues to rise despite the "reassurance" from the Greek government, the IMF, and the European Union. At this point it appears Greece is definitely going to default unless the European Union completely bails out the Aegean nation. I doubt this will happen.

 

 

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Yield on Greek Two-Year Bonds jumps to 13.5%

via Calculated Risk by CalculatedRisk on 4/26/10

From the Financial Times: Greek bond markets plunge again

The yield on two-year Greek government bonds ... jumped 3 percentage points ... to close at 13.522 per cent.

This is the highest yield on short-dated government debt in the world ...
excerpt with permission

This is now higher than Venezuela at 11%.

The yields jumped for some of the other PIIGS too (Portugal, Ireland, Italy, Greece and Spain). For Portugal the two-year yield increased more than 3/4 of a point to 3.98%.

 

 

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Keeping the CDO Machine Rolling

This post from Naked Capitalism explains how CDOs infected our economy in a short amount of time without warning. Basically, the banks created a complex cycle in which they and their counterparts made a ton of money on phantom fees while vomiting huge amounts of risk into the economy.

 

 

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CDO Market – Rife With Collusion and Manipulation?

via naked capitalism by Yves Smith on 4/22/10

By Tom Adams, an attorney and former monoline executive, and Yves Smith

Despite extensive credit crisis post mortems, many of the widely accepted explanations of what happened are at odds with facts on the ground. These superficial explanations are hard to dislodge because they tally with widely held beliefs about how the real estate and securitization market operate. The waters have been muddied even more by self-serving PR from various market participants.

The consensus reality of the credit crisis appears to be: it was the result of a complex combination of factors, no one can be blamed all that much (save maybe greedy borrowers and complicit rating agencies) and almost no one saw it coming.

We've argued that many of the arguments that support that view are myths. In particular, the more we have dug into the CDO market, the more we are convinced that it was central to the crisis. Furthermore, we believe that this market did not operate on an arm's length basis, that many of the practices that were widespread in the industry amounted to collusion.

Collusion and resulting price distortions serve as the most likely explanations for behaviors that are consistently glossed over in the consensus accounts of the crisis. By early 2006, many mortgage market participants felt that the housing market was overheated and unsustainable. Many felt that mortgage rates should be higher, but despite interest rate tightening by the Fed, mortgage rates were not increasing. Even more distressing, credit spreads remained narrow despite widespread concerns that mortgage risk was increasing and deals were weakening.

Many economists and academics described this as a conundrum at the time and tried to come up with theories to explain it, none of which were terribly satisfying. None of them looked at a more likely culprit – the securitization market and, specifically, the CDO market.

CDOs distorted the mortgage market because they undermined the normal processes for pricing risky assets. For subprime debt, demand for the lower rated tranches had served to constrain market growth. If investors started to shun the BBB to AA rated tranches of subprime mortgage bonds, dealers were not willing to retain them, no new deals would be sold, and the market would need to find better quality mortgages or grind to a halt. But CDOs were the dumping ground for these tranches. A 1990s version of mortgage-related CDOs proved ultimately to be a Ponzi scheme (unsold risky CDO tranches were rolled into new CDOs), but even then, that CDO market imploded early enough that the damage was comparatively minor.

This time, the CDO market distortions were more significant and wide-ranging. In particular:

1. Demand for CDOs came not from long investors, who would be concerned about credit losses, but primarily from (a) short investors who wanted to bet aggressively against the housing market and needed a tool to allow them to do so without disclosing their real intentions (b) investment banks who created the CDOs so they could generate fees and bonuses by putting the CDO bonds in their trading portfolios (negative basis trades) and off balance sheet vehicles (SIVs) without regard to risk and (c) correlation traders who were indifferent to credit risk

2. The normal mechanisms for pricing risk were upended because of manipulation of the demand for mortgage and CDO bonds by a consortium of banks and CDO managers who masked the real appetite for the bonds and fabricated pricing for the bonds

3. By creating the illusion of demand for the mortgage and CDO bonds, the CDO managers and arranging banks operated under a well disguised conspiracy that allowed a massive housing bubble to be created which only exploded when the shorts became impatient for realizing their gains.

If traditional cash investors and insurers were avoiding the mortgage securities market, who was driving the yields and spreads lower? Many industry participants agreed that the "CDO bid" was distorting the market.

The mechanism was the CDO managers, who assembled the assets for cash or hybrid deals (ones like Magnetar's that used a combination of mortgage bond tranches and credit default swaps). They were effectively extensions of investment banks, dependent on substantial credit lines from them. Perhaps more important, it appears that many of the larger CDO managers bought much, perhaps all, of the AA to BBB tranches of entire subprime mortgage bond issues to be placed into CDOs. Having a single affiliated party take down the riskiest layers of subprime deals means that normal arm's length pricing was not operating, and the profit potential of CDO issuance, rather than investor demand, was driving the market.

Consider this series of interconnected transactions:

A "sponsor" indicates an interest in creating a CDO to an investment bank. In combination, the sponsor and the bank would select the CDO manager who would buy the mortgage bonds for the CDO at start up and oversee the portfolio after closing. The sponsor would typically provide the CDO manager with an investment objective and find a manager that could achieve these aims.

Since the CDO deals were typically over a billion dollars, the CDO manager didn't usually have the capital to purchase the mortgage bonds. As a result, the investment bank for the deal would offer the manager a line of credit to use to purchase the bonds that the manager selected. When the CDO closed, the CDO would repay the line of credit.

The bank for the CDO would not offer the line of credit to a thinly capitalized CDO manager casually. They were sure to get an attractive rate of interest plus a security interest in the bonds being financed to protect them in case the CDO manager ran into trouble. In addition, the CDO manager would work hard to find investors in the CDO to pay of the loan from the investment bank.

Many CDO managers were repeat issuers and many had a fairly systematic approach to how they covered the market. For instance, in a particular period, a CDO manager might be responsible for a mezzanine deal and a high grade deal or two. This would mean that the CDO manager had multiple lines of credit active

This execution strategy meant that the CDO manager had significant capital at its disposal for the purpose of buying mortgage bonds. Normally, the process of bidding on newly issued mortgage bonds while trying to meet the eligibility criteria of the proposed CDO transaction can be timing consuming and arduous for the CDO manager. The clever ones with more influence and access to generously termed lines of credit, could use their capital to tremendous advantage. Rather than face the competition of multiple bidders on a particular bond of a new mortgage deal, the CDO manager, armed with multiple upcoming deals and lines of credit, could offer to buy the entire stack of subordinated bonds that the issuer was bringing to market: BB all the way up to AA. This would be very attractive to the issuer, since it made it easier to get his deal sold. It was attractive to the CDO manager, since they could slot the bonds into both their mezzanine deal and their high grade deal at the same time, saving them a considerable amount of work. In addition, it could be very attractive for the bank on the mortgage transaction, particularly if they were the same bank that was issuing the CDO. A bank that knew it would be able to sell its mortgage deal and supply bonds to its CDO deal at the same time would take comfort that it was not terribly exposed to market risk.

One additional feature that some CDO managers might employ is to have a line of credit established for an upcoming CDO squared. A CDO-squared is made up of other CDO bonds, rather than MBS bonds. Putting aside how ridiculous the concept sounds now, this type of deal served a tremendous importance at back in 2006 and 2007. Since the riskier tranches of a CDO were more expensive to the issuers and harder to place, a CDO manager who knew that he had a home for these slices of his upcoming mezzanine or high grade CDO could certainly sleep easier. If managed properly, a CDO manager working with a friendly bank could pre-place the all of the sub bonds for a number of mortgage deals into their mezzanine and high grade deals and also pre-place all of the sub bonds from their mezzanine and high grade deals into a CDO squared transaction.

This example illustrates that pricing was often not based on market demand. Is there any real price discovery if one buyer (the CDO manager) is snapping up all of the risky tranches from a mortgage deal, and the bank on the mortgage deal is the same bank on the CDOs where the bonds will end up? Similarly, if all the risky tranches of a CDO were all pre-placed into another CDO, did anyone even bid on them? And since all of these pieces fit so nicely together, wouldn't getting competitive bids really have been rather inconvenient?

Consider the role that a company like TCW played in the market. TCW was the biggest CDO manager in the ABS CDO market. In 2006, TCW acted as manager on about $9.5 billion worth of CDOs over 7 transactions.

The deals have an interesting pattern – alternating between high grade ($5.5 billion) and mezzanine ($3.4 billion) and across four banks, Goldman, Merrill, Wachovia and Morgan Stanley. The high grade deals included not just A and AA MBS bonds but also similarly rated bonds from other CDOs, including potential the mezzanine and high grade deals managed by TCW during this period.

During this same time 2006, those four bankers owned or acquired subprime lenders who typically securitized most of their originated loans. By rotating among the lenders owned by these banks, TCW could achieve decent diversity in their CDOs without ever having to pursue other lenders for their bonds. While they certainly mixed the bonds of other lenders into the mix to achieve better diversity scores from Moody's (and lower rating agency cost of issuance, TCW may have offered to take all, or nearly all, of the mortgage bonds issued by the acquired lenders of Merrill Lynch, Wachovia, Morgan Stanley and Citigroup when they brought a subprime or Alt A mortgage deal or perhaps even the occasional deals where the banks had offered the bonds of third party mortgage lenders. If so, it's likely the offer was received well.

Consider the systemic impact. Lower costs on for the CDO translated into lower, more aggressive bids for the mortgage bonds, which translated into lower mortgage rates – all of which were potentially being set between just 4 or 5 traders

But the risky tranches represented only a relatively small portion of the mortgage or CDO transactions. What happened to the biggest portion of the transactions – the senior (AAA) bonds? The bond insurers insured a decent amount of the market in 2006 (about a third), but even the many of the insured bonds needed a buyer and the uninsured senior bonds still needed a home. As we learned last week when Citigroup testified at the FCIC, Citigroup were big buyers of their own CDOs. Just like with the mezzanine and high mortgage deal, it was probably much more convenient for bank who was selling the senior CDO bonds, to convince management to acquire the bonds themselves rather than try to sell them in a messy, time consuming bid process. Similarly, Yves discussed in ECONNED that Eurobanks frequently retained AAA tranches because Basel II rules gave them considerable latitude in how much (as in how little) capital to charge against them.

As a result, from the top of the structure – the senior bonds of a high grade or mezzanine CDO, all the way down through the mortgage bonds and into the price of the mortgage loans – third party assessments of the risk and rewards of the loan appear to have been limited to non-existent.

The result was that riskier and riskier loans were being originated at effectively lower costs for issuers with little outside feedback. In one big happy family among the mortgage issuers, CDO managers and CDO investors, there would have been little motivation to worry about increasing risk or wider spreads. They were all keen to keep the great fee machine rolling.

Finally, if you throw the shorts into the equation, you complete the picture. Hedge funds who wanted to short subprime were pushing for more and more CDS on MBS, which led to the creation of more CDOs, which in turn, bought more cash and synthetic MBS bonds, helping to keep spreads low. The tight spreads on the mortgage deals created a great buying opportunity for the shorts, who were getting to bid on what we now know were extremely risky loans at bargain basement prices. Once the risks in the mortgage loans began to emerge, spreads on the bonds finally started to widen, sometime in mid 2007. By then it was too late – the deals were already created. Since the bonds had never really been distributed very widely and sat with highly leveraged firms that could not take much in the way of losses, the result was systemic risk and financial crisis.

 

 

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