Tuesday, December 22, 2009

UK Finance, Basel blame-game, Climate failure

I have been teaching Basel II regulation to African bankers, in emerging market countries that had a good first half to the world credit crunch recession before also falling off the cliff. Returning via Uganda where an oil boom is about to disrupt a poor country with a half its 30m population is under 15, and the total is expected to triple in size by 2050, and via Dubai where the local upper echelon enjoys a socialism of free houses, guaranteed jobs and income, while the remaining 80% labour in construction, retail, and professional services without rights of abode (no family allowed in and expelled once unemployed), least of all citizenship -and much else, all of this amazingly to build a Manhatten dedicated to urban luxury in a coastal desert (200 futuristic skyscrapers) that briefly shook world markets because someone went on holiday and sought a 3-month maturity delay on $4bn of bonds - chump change payment for Abu Dhabi.
UAE has an economy the size of Scotland, which also enjoys socialist policies but applied to the other end of the economic food chain. Arriving back in Scotland, I find home snowed-up transport chaos, climate agreement failure in Copenhagen, and usual seasonal media summing up our world of the past decade and to year's-end.
Three ideas appear to stick out of the Christmas stocking. One, various theories to blame credit crunch illness on the cure, regulation. Two, as USA severely reduces its trade deficit, where will growth come from if not from emerging market countries dramatically increasing their trade deficits, the same countries that pleaded unfairness and acute sensitivety in growth prospects to Copenhagen climate change agreement? Three, dependency on Finance sector to reduce and we must rely less on asset gain versus actual net earned-income, while others argue that without finance sector red in tooth & claw and recovery in property prices what terms of trade advantage has the UK left to rely upon to recover lost ground other than very slowly? These issues in our globalized world are of course interconnected.
One emerging fashionable consensus is that in the financial crisis, banks’ equity was insufficient and quasi-equity could not absorb the losses. Basel Committee on Banking Supervision appears to agree and has proposed a comprehensive shake-up. From a banker's perspective, the impression is of a punitive regime, including increasing capital reserves by half, of which most is for liquidity reserves, and all of which must be of higher quality. Investors then hearing this sold bank shares round the world on fears that banks will have to continue to deleverage and raise oodles of fresh capital before they can restore share premiums, on top of taking off-balance sheet assets back on balance sheet, dilutive capital raisings on both sides of the Atlantic (to avoid the costs of government schemes), bonus caps and 'living wills'. The credit rating agencies, notwithstanding their own problems of mass-action compensation claims, are prowling like wolves round the winter campfires howling to downgrade any banks with living wills and any countries with rising deficits and debts. Also, matters are either so bad or so good that junk bonds look attractive and the dollar is rebounding as a safe haven, yet world economic growth continues looking liverish blotchy or blood-poison septicaemic!
It is a bit silly to focus on the idea that more reserves would have evaded the credit crunch problem. Bank writedowns and the lesser credit default losses have wiped out bank capital 100% and threatens to do so by another 100% before the crisis can have a final line drawn under it. What would have our economies and banks been like with 20-25% capital reserves ratio to asset exposures compared to 10%? For one thing losses would have been on a smaller scale anyway, but housing and office price bubbles and credit booms would have to have been severely curtailed with more bank lending to industry and far less to construction and property, but in a lower consumer spending environment with more savings diverted into longer term insurance and investment. The emerging markets poor countries would have been denied their boom of the past decade or so. We should not neglect what a boon that was to the world in shifting wealth and income from richest countries to poor countries. Now, it seems the idea (as set out by the Brookings Institute, for example) is that we should go back to a world economy driven by poor countries running rising deficits financed by aid. The FT says investors should welcome the Basel committee’s emphasis on beefing up banks' capital ratios so that "Funny money hybrids will be phased out". This is a blow to how hedge funds and private equity firms leverage their investors' capital via prime brokers and leveraged buy-ins etc. Banks will deleverage and should rebalance their lending away from finance (as they have been doing so enormously already that this triggered the credit crunch by denying banks' ability to roll-over funding gaps by borrowing from each other) and away from property towards industries that make tradable goods. The BCBS capital proposals are appropriately targeted: banks trading in derivatives, for example, will have to hold extra capital against counterparty risk. Furthermore, as the FT describes it, "a leverage ratio – the preferred measure in the US – will be introduced as a supplementary dial on the regulatory dashboard. While many European banks already report such a ratio, it will be harmonised internationally to cater for differing accounting treatments around the world". BCBS also wants to curb pro-cyclicality, requiring banks to bolster capital in good times. A minimum liquidity standard for internationally-active banks provides further protection, which will require a liquidity reserve equal to about one third more in capital reserves.
What is missing here is that governments stepped in to refresh banks' funding gaps (gap between loans and deposits previously filled by private sector intra-finance sector lending) equivalent to 100% of banks' capital reserves. Although governments have also widened their budget deficits to cope with falling tax revenues, the cause of much political hand-wringing, in fact this is more than covered by buying in government debt (nearly $2 trillions by UK and USA alone under Quantitative Easing financed by surplus margins between assets pledged by banks and government paper swapped in return). The profits that were previously private and are now public will in the recovery pay down at least half of governments' budget deficits. Governments (especially USA and UK) are showing that they can be and are being financial engines for growth. This is deeply unsettling for fundamentalists who believe in all government revenue and all growth only coming from private sector pockets and private sector's productivety efforts. The same fundamentalism lies behind emerging countries led by China sabotaging the Copenhagen Climate deal. They refuse to see green policies as just another business, and a growth business that they should be part of. The poorest countries see it as a reason for seeking more aid, more than the $100bn on offer by OECD countries led by UK & USA, while the richer emerging markets such as China especially merely see it as a cost like a green tax that will hold back economic growth and therefore China arm-wrestled 26 or so other poor countries to trade objection to Copenhagen for more investment and trade from China! This is 2-dimensional thinking. China ought to see green policies as another new business sector in which China should seek a large share. De-polluting and cutting global warming gases is no more a cost to industrial growth in general (regardless of whether climate warming science is right or wrong) than if 30 years ago the world had had resisted computerisation because it would add massively to business costs. Computerisation was, of course, sold as cost-saving. Computing became one of the biggest of all industry sectors. In hindsight we can see that the cost-saving argument was not true, but industrial groiwth did not thereby suffer. Instead a new industry formed. As experts will know, it is rare for new computer systems to generate cost savings before they have to be replaced again by a replacement technology.
The difference of environmental cost compared to computing is that climate warming counter-measures, emission-reduction targets and technology are not sold as cost-saving, only as 'saving the planet' when actually hey have more genuine chance of being a growth benefit in the long and medium term as was the case with computing. The argument can be extended to other industries such as health and education that were resisted by taxpayers and continue to be so resisted even if they have long since become self-financing parts of the whole economy. It is too easily presumed that moral reasons for doing anything must involve higher cost burdens while narrow business case reasons are assumed to be profitable efficiency gains. My own experience of over 30 years has taught me that such assumptions are generally wrong - that often the opposite is true.
Adam Smith's Invisible Hand should be understood by reversing the equation to recognise that by beginning with moral benefits economic benefits will usually follow. I don't doubt the same will be true of changing the culture in investment banking.

Wednesday, November 25, 2009

61.6 Billion, no shock, no horror, just secrets

Government is said to have loaned £61bn. No, it swapped c.£125bn assets of loanbook collateral, for £61.6bn of 3 month Treasury Bills probably. The deal was a Bank of England SLS type repo swap, not simply a loan as portrayed by the media and political comment. At no time was government or taxpayers money at risk because there was more than ample collateral. The value to the two banks was that they shored up their balance sheet balance by three times the treasury bill value i.e. c.£125bn came off balance sheet temporarily and c.£62bn liability came on, total £167bn, which may be approximately the funding gap that otherwise could not be filled. This redresses both banks end of year report of accounts. On capital reserves side, for example, Lloyds and HBoS announced in the same month (Oct.'08) £17bn capital raising of which £34bn would be government-owned preference shares, but ended up becoming much more. Their joint share value at the end of that month was only £18bn. RBS at same announced £20bn capital raising.
The Bank of England announced extending its SLS assets swap scheme for another 3 months. HBOS, I discovered had raised £45bn in securitisations, but without announcing the fact, keeping its identity secret in the regulatory news announcement to the Stock exchange. The Times discovered it had also received a secret £10bn loan from Lloyds TSB. It total therefore HBOS that quarter raised £80b in interbank wholesale liabilites and gotat least £100bn assets off balance sheet before year-end. It also had £35bn short-term liquidity drawing rights at the Bank of England for very temporary cash-flow smoothing.
It follows therefore that the interesting questions are:
1. why was this £61.6bn needed by RBS and HBOS? Answer: to fill the gap in 'funding gap' financing on liabilities side of the balance sheet. I surmise the banks were seeking to roll-over their maturing MTN programmes, but found their usual financing sources refusing to roll-over, many having been wiped out in the crisis themselves, and wanting their money back, that or at much higher rates e.g. LIBOR + 8%, a guess? The government (HMT & Bank of England) was simply providing paper (at a hefty fee) so RBS & HBOS continued to have balanced books. This was not I suggest about capital reserves or compensating the banks for credit risk losses and asset writedowns.
2. Bank of England say the RBS facility was repaid by 16 December 2008, and the HBOS facility by 16 January 2009 - how? Answer: simply the treasury bills run out, swap is reversed, banks take their assets back, not what people think 'repaying a loan' means.
3. Were the asset swaps rolled over or not? LBG and RBS announced in early '09 participation in Bank of England's APS, this time for c.£570bn assets in total as collateral, for which they might have received.
When treasury bills matured either the Bank of England could roll-over the swap and issue replacement treasury bills (and again without announcing the fact). There was revenue to pay from the assets to the Bank of England less interest on the treasury bills plus a fee, perhaps a total of £5bn? And HBOS it needed to find £25bn liability funding, and needed £3bn capital to take the assets back onto the books plus any other negative change in its liabilities to be funded. So, in HBOS case, instead of treasury bill roll-over, £15bn was converted into preference shares on 16th and became part of the newly merged LBG by 19th January (merger approved in Edinburgh Court of Session 12th January) and then LBG on behalf of HBOS had to only find £10bn, which neatly coincides with the figure claimed for both the cost and loss of buying HBOS.
In RBS case, it had to replace £36.6bn liabilities on 16 December. It also had a £28bn loss for the year. Government owned £11bn of RBS Ord. shares when bought at 49p, and it bought £5bn Pref shares. Note that by 19th january RBS shares had fallen to their lowest at 10p, re to 60p end of August and are today only 35p. On 8th January, RBS announced participation in the new Bank of England APS to replace SLS for £325bn (reducing RWA by £144bn and saving capital reserves about £13bn). This swap may have been executed or held in some holding form in exchange for Bank of England unencashable cheques until EU Commission approval - we don't know how precisely these assets are currently matched to liabilities? This is a murky area of enquiry.
Meanwhile the private financing of funding gaps is recovering with renewed appetite for Covered Bonds (like Germany's Pfandbriefe) backed by mortgages in place of RMBS e.g. LBG's £4bn CB issue sold in September. This confidence is why it seems ok to the bank of England and Government to provide more details now about the full extent of their support for UK banks.
I wrote the following to the FT letters: Sir, disclosure by Bank of England to Treasury Select Committee of £61.6bn loaned or swapped for assets wth RBS and HBOS (FT, Bank of England bailed out RBS and HBOS, 24 Nov.) should be no surprise since the sums involved were within the banks' respective liquidity window drawings rights with the Bank of England at the time, and fit with information I provided to Edinburgh Court of Session to approve the takeover of HBOS by Lloyds TSB. I stated then that asset securitisation sales of over £40 billions by HBOS without public announcement and questioned whether important information was witheld that was arguably critical to informing HBOS shareholders' before the takeover vote? Important information was witheld. Details and argument about the issues were entered into the court record. How much shareholders must be told about Liquidity problems and funding gap financing, a central problem of the credit crunch, is not sufficiently clear in FSA regulation and The Companies Act. Bank of England assets swaps with the banks under the liquidity window, SLS or APS schemes may be kept secret. This is allowed by the 2009 Banking Act. "...Treasury shall as soon as is reasonably practicable lay a report before Parliament specifying the amount paid (but not the identity of the institution to or in respect of which it is paid). If the Treasury think it necessary on public interest grounds, they may delay or dispense with a report under subsection (6)." Parliament discussed this. There were objections, but the Act passed. Liquidity assistance to the banks was expected to be reported in October. Therefore, there should be no political surprise when it is reported in November.

Wednesday, October 14, 2009

BANK LOSSES TO DATE

Top U.S. and European banks have lost over $1 trillion on toxic assets and from bad loans since the start of 2007. Losses from 2007-10 are expected to top $2.8 trillion, with roughly two-thirds from loans and the remainder on securities, according to International Monetary Fund forecasts. U.S. banks are expected to take a $1 trillion hit and European bank losses will reach $1.6 trillion, the IMF said last week. It said U.S. banks were about 60 percent through their needed writedowns, while British and eurozone banks had recognised only 40 percent of losses.Below is a list of estimated losses (in billions of dollars at current exchange rates):
(apology for formatting here)
BANK_______________2007_2008_2009YTD___TOTAL BILLIONS
Citigroup____________29.1_63.4_21.8_______$114.3
Wachovia Corp*_______4.0_73.4____________$77.4
Merrill Lynch**_______25.1_38.6____________$63.7
HSBC_______________19.3_30.3_13.9________$63.5
Bank of America______12.1_29.2_17.2________$58.5
Lloyds&______________6.8_28.9_22.3________$58.0
UBS_________________50.6__3.1____________$53.7
Royal Bk Scotland_____7.0_23.5_19.6_______$50.1
Fannie Mae__________4.7_26.9_15.4________$47.0
Freddie Mac_________5.2_24.4_12.8________$42.4
Washington Mutual***5.1_36.7_____________$41.8
Barclays____________7.0_16.5_13.1________$38.0
Lehman Brothers****12.5_14.0_____________$26.5
JPMorgan Chase______4.5_10.2_10.4________$25.1
Commerzbank/Dresdner3.9_13.3__4.5________$22.3
Morgan Stanley_____10.3_10.1__1.7________$22.1
Wells Fargo_________3.5__8.7__8.2________$20.4
Santander___________4.8__8.3__6.6________$19.7
Deutsche Bank_______4.0_11.2__3.6________$18.8
Credit Suisse_______3.5_11.9__1.5________$16.9
IKB &&___________________________________$14.7
National City*****_______________________$14.0
BNP Paribas+________2.4__8.0__2.5________$12.9
Unicredit___________3.5__5.1__2.4________$11.0
Fortis______________3.1__7.6_____________$10.7
C.Agricole+_________2.7__4.4__3.1________$10.2
ING_________________7.1__2.4_____________$ 9.5
Bayern LB___________1.1__8.0_____________$ 9.1
Intesa Sanpaolo_____1.6__4.5__2.6________$ 8.7
Societe Gen+________1.3__3.7__3.4________$ 8.5
Goldman Sachs_______1.7__4.9__1.9________$ 8.5
BBVA________________2.7__4.2__1.3________$ 8.1
Natixis+____________2.0__2.5__3.1________$ 7.6
Canadian Imp Bk Commerce_________________$ 6.5
Erste Bank__________0.8__2.5__1.3________$ 4.6
Standard Chartered__0.8__1.8__1.1________$ 3.7
Bear Stearns******__3.0__0.6_____________$ 3.6
WestLB___________________________________$ 3.0
Rabobank____________0.8__1.7_____________$ 2.5
=============================================
To be updated___________________Total $1,047.6
(Sources: Reuters/annual reports/company filings) Estimates based on writedowns and losses from subprime securities, mortgages, CDOs, derivatives and SIVs, and losses on bad loans, or non-performing loans. The definition of a bad loan is complex and can vary between countries and often includes a provision for future loan losses.
NOTES:
ACQUIRED BY WELLS FARGO AT THE END OF LAST YEAR.
* ACQUIRED BY BANK OF AMERICA ON JAN 1.
** ASSETS ACQUIRED BY JPMORGAN IN SEPTEMBER.
*** FILED FOR BANKRUPTCY IN SEPTEMBER.
**** BOUGHT BY PNC FINANCIAL SERVICES GROUP IN DECEMBER.
***** BOUGHT BY JPMORGAN IN MARCH 2008.
& Includes HBOS, taken over by Lloyds in January.
&& Bought by Lone Star in August after state-led

Wednesday, September 16, 2009

Tuesday, September 15, 2009

UK banks to lose 100% of capital ("horror, the horror?" ...er No)

Not a surprise, after already having lost 100% of capital, UK banks losing the same again, approx. £130bn, this time in credit risk losses over “next few years” i.e. rest of the credit cycle, according to Moody’s yesterday. Moody’s neglect to say this is equal to the total of UK banks’ capital reserves.
It is always a bit of a cheek to make breathless shock-horror news out of what anyone who looks into the matter (like me) knows anyway, by reading the Bank of England and or FSA stability review reports, or just working it out as anyone can withoiut even needing to use a spreadsheet. So what almighty specially insightful analysis has Moody’s got that others do not – answer none really!
But when the ratings agencies are under extreme pressure to undress and let the regulators check their health right down to DNA gene-pool level before prescribing severely unpalatable medicines, it makes them feel good to kick & struggle by issuing warnings and downgrades all round, everything from government & country ratings to threatening banks with loss of unsecured borrowing grades.
In this prognosis on UK banks, Moody’s are not making it clear they are referring to gross losses i.e. default rates, not net economic losses after recoveries. Ratings agencies do not take account of loan collateral & other security, though they do seem this time to take some account of government guarantees on liabilities side of the balance sheet how do they do that – who knows – the regulators don’t know?
US & UK banking sectors have both seen their collective capital reserves fall to half despite government capitalisation assistance and then rise again with more assistance to get to target minima. That was help over the short fat tail of credit crunch shock. Next comes the long fat tail of recession – much easier to cope with because there is more time to do so.
Moody’s said UK banking sector had already absorbed losses on loans of around £110bn since start of 2007 by the end of 2008 and it raised or arranged around £120bn of new capital by mid-2009. Actually, fact is, that this is no different from the experience of US banks collectively (FDIC stress-tests showed the US commercial banks (current total capital $1.1tn) will need another $285bn in Tier 1 capital + $140bn (possibly $160bn) in economic capital buffers over the rest of the cycle (of which, $75bn this year), and that’s just for 10 of the top 19 banks.
And, more serious, but not mentioned, was the much greater loss of share equity in banks (US, UK, and in rest of EU) so that many or most banks fell below even discounted book value. US & UK banks lost nearly 1.5 times capital in fall in share values, of which nearly a third has been recovered since touching bottom in March, many major and medium sized EU banks similarly.
Moody’s claim that UK banks & building societies losses (approx. £130bn) from their loan books (from start of 2009) is based on forecasts of performance of key asset classes i.e. forecasting credit risk default trends. This is a little ironic since Moody’s had to admit in June 2007 that its ratings models for asset backed securities were insensitive to credit default rates (some amazingly buggy models!) and had not updated default data in the models anyway, not since 2003 – and subsequently had to down-grade several $trillions of ABS, by up to 17 notches, including many from AAA straight to ‘junk’!
Moody’s goes on to say UK banks’ losses could reach £250bn in a stressed case scenario if UK economic performance is worse than expected, and then it indicatd that worst-case is what it expects, maybe? What is of course interesting about the timing of this is that we are awaiting results (that will not be published in detail) of the EU’s stress-testing requirement on the EU’s top 49 banks sometime this month. Somewhat stung already by the IMF’s hard to justify assertion (except by comparison with US data) recently that EU banks have under-estimated losses to date by about half! But then we expct a traditional lag to operate between US and Europe – at least I do (historical experience).
The result of this is that despite signs of recovery Moody's (Investors Service division) said its fundamental credit outlook for the U.K. banking system is negative (weak economy & likely effect on banks' financial performance). This is quite cute since we know that UK banks have a high exposure to foreign markets (HSBC, RBS, Barclays, & Standard C especially that together account for more than half of the domestic banking). How sophisticated is Moody’s model? My guess is not very.
“Negative outlook” is a view of credit conditions in for the next 12 to 18 months, not a warning that ratings will be downgraded. Moody's says it does not expect “a large number of downgrades” in the next 12 to 18 months, which again is a cute threat since how many downgrades are needed to denigrate the sector, less than 5.
One reason for ratings stability is support from government (large capital injections, credit guarantees, support for depositors, SLS, then APS, plus BoE’s liquidity window). APS is subject to EC approval. If that approval is subject to lead to significant changes in the franchises of large banks (which means requiring Lloyds Banking Group to sell business units o reduce its market share), Moody's says it will change ratings of individual banks. That is an obvious dog & fire hydrant threat – very cheeky, and crudely insensitive to the precise details of the matter – bit Colonel Blimp-style ideology I suspect!
In expecting U.K. banks to see higher loan defaults, requiring bigger loan loss provisions & more capital, Moody’s cannot be factoring in positive underlying performance in traditional banking or factoring in confidence about debt recoveries (typically expected by current through-the-cycle ratios to be at least 50%).
Moody’s numbers include in its estimates the benefit of the UK government’s APS scheme (still awaiting EC approval) to quarantine over half a £trillion of LBG and RBS impaired assets (including US assets in RBS case).
Elizabeth Rudman, Moody’s lead analyst for the UK banking system said the agency does not expect further ratings downgrades over the next 12-18 months because of the stability provided by government support. Moody’s also expect
raised cost of funding (self-fulfilling prophecy by ratings agency) related to uncertainity over the effect of tighter regulation. This is of course absurd since tighter regulation should secure lower riskiness.
Lower interest rates eased the burden for some corporates (which have also deleveraged) but Moody’s still expects to see a sharp increase in banks’ corporate bad debts which it says are “typically lumpy” in nature, which presumes to know what banks will do or not do to support corporate clients.
Moody’s said it expected some of the highest loss rates for banks to come from commercial property lending as real estate values have fallen by 37% since they peaked in the second quarter of 2007 and says it expects property values to continue falling through 2010. This is also hard to square with the past historical experience of property values always falling in a recession to long term gowth rate, which means maximum 35-40% i.e. we are there now. So, this negs the question, what sophisticated additional insight has the Moody’s macro-model?
Further insight into the bleeding obvious, Moody’s state that most heavily exposed are RBS and LBG which had around 10 per cent of their loan book exposed to construction & property sector (shome mistake shurely, the actual %ages are higher than that!). It added that the commercial property exposure at some smaller building societies was a “particular concern”. Moody’s are borrowing the UK watch to tell us the time, and not adding any value at all, except being doomier & gloomier (or dumber & glummer) without a good or exclusive basis for doing so. Moody’s say UK consumers have a high level of debt and unemployment is rising (golly, who didn’t already know that?) and (shock!) such factors are expected to feed into higher losses on secured & unsecured lending. Well, fact is UK households also have higher net equity. (for more see http://lloydsbankgroup.blogspot.com/)

Saturday, August 29, 2009

RECESSION ON/OFF - media spin or delusion?

The media is reporting central bankers and top regulators telling us, as in the words of the FT, "economic doctors have given their prognosis: the worst of the Great Recession has passed, but a full recovery will take a while." When the FT (LEX 'owner') refers to "economic doctors" leaving out the word "spin" for drip-dry humour effect - what do they really know? As we know, or should know, government officials avoid predicting recessions for fear that whatever they say becomes self-fulfilling; they believe in confidence factors.
When bankers do so it implies finance has an inside track, a superior map, for knowing where we are in macro-economics. There is no recent evidence to assume that, quite the contrary. Finance is, as we know, short termist, happiest when trading short-run volatilities. Easy for them to jump on latest quarterly figures to claim longer-run turning points. But, the truth is rather otherwise:
1) quarterly figures are not reliable - we have to wait for annual figures
2) there are several world region economic cycles, not one global cycle, however connected, the various main cycles do not move in synch, especially not C.Europe, Japan, and USA/UK.
3) official growth figures (GDP)are provisional and take several quarters to firm up during which they are subject to major revisions.
That said, the global economy did go into negative growth when all was added up together for 2008, but beneath the aggregate total were many disconnections. And there is little doubt that all OECD (developed) economies experienced quarters of negative growth together in the last year. That is unusual; it last happened in the oil shock of the early '70s (oil price hikes in response to Arab/Israeli war). After the shock, countries and regions rebounded to where they had been in their respective cycles before being so rudely interrupted.
This time we also had sharply rising oil prices, but just as potently, or more so, we had the Credit Crunch when much (not all) of global finance panicked, had an anxiety attack, dose of the vapours, seized up, became disorderly, stopped working as hitherto predicted. This was a downward spike in all major economies and many minor ones. The extremely one-sided pattern of world trade died and is being reformed. The USA as the world's major deficit country to which nearly everyone else became a creditor couldn't go on as before and is now acting as a slower steam engine, putting less coal and water into the boiler, when pulling the train of global activity behind it. It is also like a motorway pile-up; USA vehicles at the front stop suddenly but it takes a while before all other vehicles behind slow-up, and similarly as the USA gets going again it will take time before those behind get going.
This analogy is however too much one or two dimensional. The world system functions by having major regions acting in countervailing ways to each other. When USA peaks, Europe tends to be down and vice versa, just as the oil price was driven at times 90%by the $/€ exchange rate, and as much more by depressed demand.
What I expect to see when with better hindsight we can look back over the 2005-2012 period is that many economies experienced a temporary shock into recession before recovering back onto the poath they were following before the Credit Crunch shock. Hence I do not expect UK recession to end before 2Q '10 and C.Europe and the Euro Area that have receovered recently into possible positive growth have another recession coming in '11 and '12.
In the week when central bankers met in Jackson Hole, Wyoming, to express optimism, however circumspect (basically to validate each other's responses to the crisis when few others will), curiously the main media comment concerns the future of base rates? There is a theory that still prevails, however discredited by events, that central bank rates drive the credit & economic cycles by acting upon domestic inflation. Many have blamed an over-long period after 2001 of low base-rates for the Asset Bubbles that burst to create the Credit Crunch and that central banks in their monetary price settings focused only on consumer prices and failed to address asset prices (real estate & financial equity). The balance of media opinion seems to be that central banks are likely to err on the side of keeping interest rates lower for longer, necessitated by a longer recovery period, consumer price and continuing asset deflation, and to maintain a wider margin in which traditional banking can internally generate new capital reserves.
A question is how far and how quickly should policy seek to restore asset values to pre-Credit crunch levels? More on this question anon.

Thursday, August 27, 2009

JACKSON HOLE IN ONE?

FT's Krishna Guha writes on the meeting of central bankers (except Mervyn King) at their regular Jackson Hole, Wyoming, gettogether, "As central bankers from around the world queued on the terrace of Jackson Lake Lodge at the weekend to gaze at the stars above the Teton mountains through almost Nasa-sized telescopes, they must have wished they had as much clarity on the economic horizons they usually scan as they did on the constellations above... though they are now confident that the world has avoided an economic black hole." - a very non-Roubiniesque comment? I offer a vision photographed when the crisis was in meltdown in August 2007by Tyler Nordgren who captured this lunar eclipse sequence from his campsite in Grand Teton National Park on August 29. He took an exposure of the moon every 10 minutes until it disappeared and the sun lit up the mountains with alpenglow. I can do no better than to begin with krishna's text, "That is not an easy idea to sell to politicians, voters – or even regulators. After all, as Turner points out, world without a reliable compass is frightening, exhausting and time-consuming to navigate. “For the regulators of the world, once you have accepted that you don’t have an intellectual framework of “more market is always better” you’re in a much more worrying space, because you don’t have an intellectual system to refer each of your decisions.” And it remains crucially clear whether Turner will ever be able to actually turn any of his rhetoric into policies, given the scale of backlash that his comments will undoubtedly spark from the banking world. But I, for one, reckon he is to be applauded, for at least trying to think the unthinkable again - and move away from a crude reliance on creeds. The only question now whether other regulators will follow, not just in Europe, but, above all, in the US, where so many of the free-market dogmas first sprung to life?"
Free market may or may not be fairly described as "dogma" even if for many it is undoubtedly no better than this. The British alone running a trade deficit for free trade reasons for most of the 19th century that made the country rapaciously interested in finding gold to pay its creditors, is probably the better starting place for earmarking the origin of this 'dogma'. The USA was doing similar for most of the 20th century and there can be little doubt that while extreme imbalances in world trade led to the Credit Crunch (and other negative blips and major downturns from time to time) this also generated much that has been positive, if as in everything neither all negatives nor all positives. What now seems indubitable is the new central role for central banks who must now address problems with more empicism less dogmatic theory, more Keynesianism less Monetarism, more prudential macro- finance & macro-economics less micro-finance & supply-side theory; is Quantitative Easing supply-side finance or merely clearing the decks (debt restructuring) preparatory to massive issues of government bonds and ultimately replacing private indebtedness poorly collateralized (that grew to 3 times GDP in many countries when public sector debt stuck at half of GDP) with public debt (fully collateralized) that can profit for the taxpayer from interbank wholesale funding when private finance dried up (Credit Crunch)? Global finance appears to most peoplemore avant-garde puzzling abstractions than Cubist paintings seemed a century ago. Krishna reports, "Instead, much of the talk in the formal seminars and during the hikes in the lower slopes of the Tetons – although, ahead of his renomination on Tuesday as Fed chairman, Ben Bernanke opted to go (horse) riding instead – revolved around the lessons of the crisis for the future of central banking. Unease was widespread that even when the last asset they have had to purchase has been refinanced or sold off and the last unorthodox bank loan cleared, it would not be possible to go back to the pre-crisis status quo."
Well, indeed not for 5-6 years, by which time we might only be a year or two before the next set of global cyclical downturns? Macro-economics should now dominate in central bank analysis and prognosis, as it should do so too in banks' governing bankers thinking much thoroughly and ethically about their role in the global economy? "Central banking is going to change – in all cases, though more for some central banks than others – as policymakers seek to live up to elevated, and in some cases newly formalised, responsibilities for financial stability. It will become a broader, messier and more complex business, with objectives that may appear at times to be in conflict, new tools that are as yet largely untested and – at least at the margin – possible changes to the operation of monetary policy as well." As, central banks, especially the ECB, now realise it is not their remit and ideas only that have to change, but also undo how now discredited ideas are hard-wired into their constitutions; they need constitutional change?
Krishna says, "Although no one at Jackson Hole put it in such terms, there was a time when the life of a central banker was relatively straightforward, if not exactly easy. The job was to ensure economic stability by managing inflation, the monster that had ravaged the world economy in the 1970s. Most central bankers and academic economists were confident they knew how to do this: through some variant of inflation targeting, pioneered 20 years ago by the Reserve Bank of New Zealand and adopted by many others including the Bank of England. The Fed operates a de facto inflation targeting regime, which Mr Bernanke pushed to make more explicit, and academics claimed that even authorities such as the European Central Bank that deny being inflation targeters were so in practice. Implement such a regime successfully, the thinking went, and a central bank would not only achieve low and stable inflation but in doing so would ensure economic stability and the optimal platform for growth and prosperity. For a while it seemed to work. The 'great moderation' ensued – an era of low and stable inflation accompanied by long expansions and short and shallow recessions. But the credit crisis put paid to the idea that inflation targeting – at least as often practised, with a focus on consumer prices and a short policy horizon – was enough to ensure stability and growth." This was rather like finding a way through the thicket without worrying overmuch about what was living and what was dead wood, so long as general confidence was maintained about getting through. Now, the onus on central banks is to be far more comprehensive about the totality of economics + finance and to take fuller responsibility for systemic problems, which means being able to issue instructions that banks have to formally take full notice of and be made responsible for taking necessary actions - and that in turn means central banks no longer issuing complex double-sided advice like brokers, but actually issuing firm orders to banks to stop doing X and do more of Y etc.
Krishna reflects the Jackson Hole discussion, by reporting ""It is a good time to review the prevailing philosophy in the light of the current crisis," Masaaki Shirakawa, governor of the Bank of Japan, told his peers at the Jackson Hole conference. He said central banking before the crisis rested on three assumptions of "pre-established harmony", all of which now appear flawed. The first of these was that "macroeconomic stability can be achieved by monetary policy which pursues low and stable inflation" and that "price stability and financial stability are complementary". The other assumptions were that the authorities needed simply to keep an eye on individual financial groups rather than consider risks in a system-wide context, and that liquidity would be continuous in wholesale funding markets.
Inflation targeting did not fail, at least in the eyes of most central bankers, and it will continue to be the cornerstone for most. But policymakers now know that managing the outlook for consumer prices over horizons of a few years is insufficient to ensure financial and economic stability. "There is an emerging consensus that price stability does not guarantee financial stability and is in fact often associated with excess credit growth and emerging asset bubbles," said Mark Carney, governor of the Bank of Canada, which operates an inflation targeting regime.
Low inflation and moderate interest rates feed investor confidence and over time reduce conventional measures of financial risk, spurring financial groups to take on more leverage and fund longer-term investments with short-term funds. The crisis shows how disastrously that can end.
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What is being rethought is the idea that the macro-economy can be tracked and deemed ok by merely tracking some very broad indicators such as prices, stability and consumer confidence. Indeed, this was not unlike risk management by score-card; if the lid continues to fit the refuse bin we need not worry about the mess of waste inside it. Confidence was always a lunatic indicator centrally revered by banks. Commercial and consumer confidence was really a reflection of how easy they perceived it is to get bank credit i.e. banks lent more the more borrowers perceived it was easy to get loans - totally circular perception. Central bankers agree on a first line of defence against instability is tougher regulation of financial institutions, to make it harder to load up on debt funding mismatches in good times – caps on leverage plus new "macroprudential" powers to limit risk-taking system-wide. Jaime Caruana, head of BIS, said at Jackson Hole that these powers could come in two forms: tools to curtail concentrations of risk in the financial system, and policies that tighten requirements during an economic upswing, mitigating the extent to which risk-taking builds during booms. This all presumes a cyclical awareness and predictive modeling that central banks do not have, neither do governments. Central banks and government are not allowed to forecast downturns publicly. In economies with global banks, the regulators are also limited in the orders they can issue based on national economic concerns - and who other than the UN has global economic models, not the IMF or World Bank or BIS?
Krishna comments, "Like most of his peers, Mr Bernanke sees these macroprudential powers as providing the most promising way to ensure stability, in large part because they can be targeted at specific financial excesses. Awarding such powers to central banks is proving controversial, though, with Congress balking at proposals to make the Fed America's systemic risk regulator. While politicians mostly worry about the concentration of power in the central bank, some experts also worry that deploying macroprudential tools – for instance in a way that slowed the flow of funds to subprime borrowers – could drag the (central) bank into political controversy. Mervyn King, governor of the Bank of England... warned in June against placing the Bank in a situation where it had a formal mandate for financial stability but not the tools with which to achieve it. That would leave it "in a position rather like that of a church whose congregation attends weddings and burials but ignores the sermons in between"."The lack of models for analysis and lack of integrated finance sector data into macroeconomic models problem is alluded to by krishna, "But even if they win these powers, central banks know little about how to calibrate these tools or how they will interact with interest rates. On how to manage matters monetary, the core issue remains whether central banks should "lean against the wind" by running a tighter policy during asset and credit booms even if this means undershooting an inflation target for a couple of years – a debate that the crisis has revived with a vengeance." This raises a phenomenally big question, that of attempted or desirability of trying to banish by pre-empting cyclical events, and whether the emphasis has to be on equipping banks with sufficient capital reserve to ride out downturns - thereby acting anti-cyclically alongside fiscally-keynesian governments? Recessions easily wipe out 90% of bank reserves (at Basel Accord levels) and the current crisis is doubling this normal expectation. The implication could be that banks have to double their capital reserves, which of course would be an enormous motivation to push a great deal more of assets growth off balance sheet? Central banks have a lot of partial theories, but have failed to try to integrate them into a total system view - globally it is a bit like having to figure out how sunspots impact all of the earth's and humankind's infrastructure - less about pre-emption and prescription and more about understanding the interdependancies of our economic systems. I offer this interesting graphic, which I hasten to say is not a macro-economic or macro-financial model, but interesting none the less. Jean-Claude Trichet, president of the ECB, told the Jackson Hole symposium that the traditional objections to leaning against the wind are harder to sustain. As Krishna reports, "He said the ECB in effect leans against rising asset prices already – through its two-pillar approach that takes into account monetary and credit aggregates. "I trust that our own monetary policy concept is approximately this idea – that we should incorporate in a rules-based framework this leaning against the wind," Mr Trichet added. Some other central banks – including the Bank of Canada – put some direct weight on asset values by targeting a consumer price index that includes house prices. The Fed focuses on an index that includes a proxy for rent but not prices and has always rejected leaning against the wind on asset price. Although Mr Bernanke (who did not address the issue at Jackson Hole) has said he is open to reviewing the arguments, particularly if credit bubbles are involved, his instinct is that it is almost always better to use more targeted instruments to deal with credit excesses. Yet there may be common ground over the need to take a longer-term perspective on inflation. The ECB has always emphasised its focus on the medium term and Mr Bernanke has long argued in favour of a "flexible" form of inflation targeting that seeks to hit the spot over the medium term – as opposed to the formal two-year horizon at the Bank of England. In principle, this allows a central bank to set interest rates at a level that it thinks will result in inflation undershooting in two years' time, in order to reduce the likelihood of a bigger miss further down the line when a bubble may burst. That is hard to pull off in practice, because it is very difficult to forecast inflation many years out and virtually impossible to predict whether a bubble will burst soon on its own (in which case the central bank should be lowering rates, not raising them). Still, in at least one respect it may be easier than before for central bankers to exploit whatever flexibility there is in their legal inflation targeting regimes." There will always be at least two very different ways of seeing the same shapes. Krishna expresses this with, "...But in the aftermath of the crisis, the cost of not curtailing financial imbalances – even in a world of moderate inflation – is plain for all to see, even if how best to curb them remains rather more blurry a reality than the view of the stars through a high-powered telescope against the dark Wyoming sky."

TT (TOBIN TAX)?

Gillian Tett, who recently presented and debated her new book at the Edinburgh Book Festival this week and who then participated at the Prospero conference where Lord Turner raised the prospect of TT. Gillian weighs in to the question too of “Does the world need a global Tobin tax? (see previous blog) that she finds is buzzing around London’s financial circles this week. She says, “the really interesting thing about Turner’s suggestion is the wider intellectual impetus behind it. For as the FSA chairman surveys the financial crisis, he is increasingly convinced that Western policymakers are at a crucial intellectual water-shed”… (saying) “the whole efficient market theory, Washington consensus, free market deregulation system…” (that it) was so dominant that it was somewhat like a “religion”. This gave rise to “regulatory capture through the intellectual zeitgeist”, enabling the banking lobby to swell in size and power. But now, he says, there has been “a very fundamental shock to the ‘efficient market hypothesis’ which has been in the DNA of the FSA and securities and banking regulators through-out the world.” Hence “the idea of that more complete markets were good and more liquid markets are definitionally good” is no longer trusted. “[This crisis] requires a very major reconstruct of the global financial regulatory system, [not] a minor adjustment.” John McFall MP, Chairman of the House of Common finance committee says TT is "impractrical" and possibly there speaks the voice of Gordon Brown too on this question? But the moral imperative behind this issue is not so easily gainsaid. Gillian rightly sees the possibility here of “…mere political posturing. The FSA, after all, has faced criticism for failing to get tougher in curbing banking bonuses, and if also fending off proposals to put it under the Bank of England.” To this I can add that the FSA was (with the SEC) entirely duplicitous over short-selling curbs, stock-lending, and calls for enquiries into misleading statements to shareholders attendant on capital-raisings in 2008, and to which longer term could be added indifference to quality of markets, markets per se, systemic risks, and failed to make the case for more resources to do the job they are statutorily obliged and expected to do. Both FSA and SEC, if not many other national regulators, are severely under-resourced, but also have been suspected of conflicts of interest in being as ruthless and authoritative as circumstances demand (see blogs passim).
Gillian says, “Turner’s comments are a striking sign of the times. And they raise a crucial question: namely what type of intellectual framework should Western regulators now use, if their prior bible – or compass – has now turned out to be so flawed? Sadly, Turner does not offer any pat answers. He has a long list of ideas he thinks that politicians and regulators should debate. Aside from the Tobin tax, he would like to consider more curbs on financial innovation, and a review of market dominance and pricing activity in the wholesale finance sector. But those ideas are not really a manifesto; instead, he stresses that regulators are “still trying to work out” what to do “after a fairly complete train wreck of a predominant theory of economics and finance.”” Gillian sees here a moral compass question on a global scale, which is of course fascinating since, as we all sort of know, even if money is morally-neutral, global finance surely is not even if global financiers are like arms-traders infamous for taking the moral low-ground of saying if I don’t do the deal all that happens is someone else does; “I was only following (buy/sell) orders”. This is reminiscent to me of Jonathan Swift’s Tale of a Tub written in the wake of South Sea Bubble, where he makes a na├»ve but morally-driven fool of himself in seeking to promote global solutions to the book of common prayer etc. (for which read the FSA’s Prudential Sourcebook), doomed to failure for the infinity of distractions into dead-ends amid acres of turpitudinous apologia. Gillian echoes that reminiscence, “No doubt, that agnostic stance will infuriate some (or confirm the impression that regulators are toothless). But that may be the wrong response. After all, the real problem with finance in the past few decades is not simply that policymakers and investors were using flawed economic and financial theories, but using them in such a blind way that they often disengaged their brains.”
To repeat my own refrain – the problem is that while we may have theories, but we lack comprehensive macro-economic-financial models in which to validate and test the theories, and by we I mean everyone including governments and central banks. At the book festival Prof. James Lovelock (90, and booked on Virgin Voyager) yesterday was making a similar point about “Global Heating”. He said Gaia (the term he invented for a self-adjusting global system) does not move in linear ways, and yet governments will sponsor computer models but not fund people to go out in ships and gather the data we need to validate the model-theories. Hence, our long-term forecasts are no better than short-term weather-forecasting. We will spend billions at CERN to find elusive bosons in neutron collisions to try and prove the standard theory of cosmology, but all oceanic research ships have been retired! Similarly, in credit crunch, we entertain policy-theories, but are not undertaking fundamental research to gather the data we need to answer the questions raised by what some describe as financial weapons of mass destruction.
Gillian says, “Bodies such as the FSA, for example, were so wedded to ideas of market efficiency that they only intervened when there was a clear case of market failure. Similarly, investors were so obsessed with narrow, short-term definitions of shareholder value, that they – like regulators – often appeared to be acting on auto-pilot. However, the unpleasant truth is that there is never going to be any complete intellectual system to explain how financial systems ‘should’ work.” Gillian concludes, "That is not an easy idea to sell to politicians, voters – or even regulators. After all, as Turner points out, world without a reliable compass is frightening, exhausting and time-consuming to navigate. “For the regulators of the world, once you have accepted that you don’t have an intellectual framework of “more market is always better” you’re in a much more worrying space, because you don’t have an intellectual system to refer each of your decisions.” And it remains crucially clear whether Turner will ever be able to actually turn any of his rhetoric into policies, given the scale of backlash that his comments will undoubtedly spark from the banking world. But I, for one, reckon he is to be applauded, for at least trying to think the unthinkable again - and move away from a crude reliance on creeds. The only question now whether other regulators will follow, not just in Europe, but, above all, in the US, where so many of the free-market dogmas first sprung to life?" Unlike Gillian Tett, I am confident, or at least hopeful, that a fairly complete intellectual system cannot be constructed is not true - it's my job, and not above my pay-grade; even Prof. Lovelock remains hopeful about Global Warming despite his realistic expectation that because Global Heating has progressed so far we are in for an inevitably terrifying time that he compares to WWII? In my view we can empirically determine how financial systems work, and do so at least as well as IPCC predicts global warming, and how macro-finance relates to the so-called “real macro-economy” globally; the ideas and most of the data exists and merely need the sponsorship to be brought together into useful analysis. But, I do not believe in the desirability or our capability to banish asset bubbles as critics of Bernanke suggest when they blame him and Greenspan for loose monetary policy leading to bubbles. We are in the 33rd credit & economic set of cycles since the 1850s, and I confidently expect many more in this century alone. And here I agree also with Gillian when she writes, “…ideologies are always rooted in shifting power structures and struggles. And just as the old intellectual model proved imperfect, any new ‘theory’ that might yet replace it – with or without a Tobin tax – will have limitations too. What is needed now, in other words, is not so much a new ‘creed’ or magic-wand policies, but policy makers, politicians, investors and bankers who are willing to engage their brains, and keep remaking policy, as the world evolves.”This brings us on to what are central bankers thinking at Jackson Hole? (next blog)

BUBBLE & TAX (squeak!)

One of my Summer breakfast specials is bubble & squeak. Adair Turner (head of FSA) threw into the political frying pan (of our credit crunch dog’s breakfast) the idea of Tobin Tax, a sizzler conceived in 1972 by Prof. Jimmy Tobin at Princeton to reduce exchange rate volatility. 1972 was 17 years before the first BIS survey data of world FX markets collected triennially over 2-3 weeks that remains today only way we know roughly how much FX trading there is). In case you don’t know, there is roughly $3.5tn in daily FX transactions, $1tn a day in money markets, $0.5tn per day in bonds, and $0.25tn per day equities trading world-wide (total turnover divided by 2+ to get a single-counted value of transactions). These are my figures only, for the egregious fact is no-one knows exactly as none of the major wholesale markets are entirely “on exchange”; FX & MM not at all, bonds only slightly, equities mostly, but not entirely. They do not have to report. BIS surveys FX periodically (in Springtime every 3 years) but not MM or Bonds?
For a tax on wholesale financial market transactions to work at all, requires all the taxable transactions to be undertaken within regulated exchanges. Free market liberalism has resisted this for over a century and continues to do so. Now, in policy debates dragged up from muddy ocean depths by the Credit Crunch, it has been stated by many decision-takers that credit markets should be brought “on exchange”, but progress is stymied and slow. What underpins this is the question of quality of price discovery, quality of markets, long ago kicked into the long grass when stock exchanges became private corporations able to denationalize by merging across borders and pursue global relevance, and when any number of competitor systems were allowed, and when cost of transactions became more the competitive focus than quality. In arguable fact, ever since Tobin Tax, the world’s wholesale markets pursued a directly opposite goal of cheaper easier trading.
Therefore Tobin’s idea was only ever a theory proposition – it never had a snowball’s chance. His idea was also structural; to tax financial exuberance of the first world to fund a transfer of money to the third world. Well, the one benefit of Credit Crunch and asset bubbles was surely to deliver unexpectedly prolonged high growth for third world exporting countries, for which they may be ever grateful.
Tobin Tax (TT), as an idea was raised many times in the ‘80s and ‘90s when folks could not understand how it is that financial markets can apparently trade the equivalent of world GDP every 6-8 weeks, and that’s before we consider the same again in nominal value of derivatives trading, which is at least mostly on-exchange? In theory, TT might discourage speculation by making currency trading more costly, but that would only ever have been a first-order effect, most likely dissipated as the tax is passed on. FT reporting on this posited the theory that the volume of destabilizing short-term capital flows would decrease, leading to greater exchange rate stabili. But, of course, there is as yet no global tax authority to impose global taxes on global financial transactions, no monitoring, no formal reporting, global or otherwise, and no academic or other theory to explain how must is genuine need to trade and how much is speculation; old data suggests roughly a 20%/80% split before we consider market-makers who merely churn the market. TT is a speculation tax, but FX is a zero-sum game. Therefore, the global tax has to be on turnover, not profit.
And anyway, which currency should all be measured in, and at what moments in time. When FX margin spreads go to the 4th to 6th decimal places, how many decimal places further on should the tax be exerted, and could trading systems accounting be trusted to measure that? Even if a tax on FX turnover was say 0.05% or 5bp at both ends of the deal the result is $one trillion or more than the total GDP of the African continent. To be complete about this TT should apply to all derivatives and to MM, Bonds and equities, in which case the tax would equate to the total GDP of China plus India. Sounds great, but a global tax on this scale would undoubtedly reduce the volume traded enormously - and derivative or other measn found to emulate or track without actual cash-market trading i.e. the tax would be avoided and evaded!
So why is the clever Adair Turner suggesting this as an alternative to “swollen” financial sector paying excessive salaries grown too big for society. He says debate on bankers’ bonuses is a “populist diversion” and more drastic measures are needed to cut the financial sector down to size.
He adds that FSA should “be very, very wary of seeing the competitiveness of London as a major aim”, claiming the city’s financial sector has become a destabilising factor in the British economy. Mayor Boris Johnson discounts this as an aberration view that Lord Turner should rethink since the Mayor wants London’s wonderful competitiveness to emerge even stronger from the crisis!
Turner’s question is actually sensible and legalistic. It is against EU law for the UK to support its financial sector for competitiveness gains. It is not really, as FT surmises, that “Britain is becoming increasingly sceptical about the perceived advantages of being a leading financial centre”. Lord Turner’s suggestion that a “Tobin tax” is a reproach to the debate over bankers’ bonuses (BB) is something of a blind. BB we can all do something about, however problematic. TT is another matter entirely! The question of BB is linked to London as a financial centre insofar as BB is defended as being competitively necessary on the grounds that there would be a business flight to centres where BB would not suffer any capping. This is baloney in my view, for reasons I shall not enumerate here, not this time, save to say that bonus earners are 1. not nearly so valuable as is pretended and 2) they don’t all want to go live in tax-havens, or they’d all have done so long ago.
Lord Turner is sensibly worried too about a return to “business as usual” (mentality and/or actuality) in the banking sector, suggesting that new taxes may be necessary to curb excessive profits and pay in the financial sector. Indeed, correct, but this has a complex aspect, which is that bankers do not know their value or their riskiness other than what they can get away with. They are as star-gazing as those who cannot explain how it is that the world’s income appears to be traded ever couple of months, who cannot understand where all this niagra of finance money flow comes grom and goes to and how it is they have a pool ticket to swim in such deep fast flowing waters.
None of the academic instituites, governments or central banks have macro-economic macro-financial models to answer this question either. Despite our computer-data rich world the truth is that for almost everyone, including bankers, today’s science on the matter remains somewhere in the medieval world of astrology; it is definitely not astro-physics. Most bonus-bankers are clear about one thing, they prefer it that way, to be priests of voodoo-finance, not economists!

Monday, May 18, 2009

Accounting Basics: Current Assets - Accounts Receivable

 Almost as common a term as cash nowadays, accounts receivable is an accounting term meaning amounts owed to a business by other business or customers (individuals or otherwise). An accounts receivable arises anytime when goods are sold but cash is not received immediately; thus when you purchase something for cash at Walmart you are not creating an accounts receivable. If you commit to purchase something (say a lawnmower) and you are offered the option to pay next month, now you have created an accounts receivable on the retailers books.

Unlike a note receivable (to be discussed next), there is generally no signed agreement beyond an invoice for an accounts receivable. They are generally short term in nature (less than a year, if not only a couple months). Because of their short term nature, they are generally listed as a current asset on the balance sheet next after cash.

Thursday, May 14, 2009

Accounting Basics: Current Assets - Cash

 Cash is normally the first item listed under Current Assets on the Balance Sheet. What does cash include? Cash includes any deposits available in the bank as well as anything on-hand which might include bills and checks or money orders to be deposited.

Monday, May 11, 2009

Accounting Basics: Current Assets

 We've previously discussed what Assets are. In an unclassified balance sheet where you only have 3 major classifiations (assets, liabilities and owners equity) that would be in the story. A much more useful report is the Classified Balance Sheet. Here, the three major categories are subdivided to provide readers of the financial statements with much more detailed information. The first such subdivision under assets is Current Assets.

Current Assets are defined as those assets which will either be converted into cash or otherwise 'used up' by the business in a relatively short period of time (generally one year or less). On the balance sheet, they are generally presented in order of liquidity; thus cash is generally listed first.

Other examples of current assets include accounts receivable, notes receivable (which often have a current and a non-current portion) and prepaid expenses. These will be examined in future entries.

Edinburgh economist predicts toxic debt boon

From Sunday Times business section, 10 May, 2009, page 1
"Robert McDowell says UK Treasury will finance recapitalisations and pay off many budget deficits through troubled banks" by Ian Fraser
The UK government should comfortably claw back at least half of forecast budget deficits in 2010-12 because of higher-than-expected returns from its ownership of shares in troubled banks and profits from bank bailouts, according to an Edinburgh-based economist.
Robert McDowell, a banking economist and risk-management consultant, said: “The UK and US Treasuries are charging substantial fees and exerting 25-30% haircuts, leaving themselves with more than adequate headroom to generate substantial medium-term profit which, I calculate, will finance both their bank recapitalisations and pay off half of medium-term government budget deficits, thus relieving taxpayers of the risk of sharply higher future tax rates.”
The British and American Treasuries have been criticised for their programmes to purchase billions of pounds of “toxic” and“legacy assets” from the banks, including impaired mortgage-backed securities, collateralised debt obligations, credit card bonds and student loans.
However, McDowell, who advises governments as well as banks, said such criticism is unjustified. He believes that, while asset-backed securities were arguably the cause of the credit crunch, they are also going to play a part in bringing it to an end.
McDowell said the UK government’s support for the banking sector, including the special liquidity scheme and the asset protection scheme, will generate a net profit of about £185 billion, and possibly more than £200 billion, “which is a substantial three-year gain from off-budget financing worth about £900 billion currently”. He said £200 billion would eradicate 45% of future budget deficits.

To this I add: The 2009 Budget authorises the bank of England to engage in up to £150 billions in Quantitative Easing, which means buying in outstanding gilts (government bonds) early. No-one has questioned where the financing originates to buy back the gilts. It has to come from net balance between assets and liabilies on the Bank of England's balance sheet. last time I looked the BoE balance sheet was £500bn, considerably more than the IMF which is seeking to grow to that level and equivalent to that of the Bank of International Settlements. Not all of the nearly £600bn assets being bought in by the BoE have yet transacted and its quantitative easing programme is somewhere in the £25-50bn range so far. I view the £150bn authorisation as an indicator of the net profit medium term that the government expects roughly to generate from its investment in saving the banks including majority ownership under UKFI Ltd.
BoE said it would spend a further £50bn of newly-created money to buy bonds. Note that the ECB has so far expanded its balance sheet much less than the BoE despite being responsible for a much bigger eceonomic areas. It has pledged to buy €60bn (£53.4bn) of covered euro bonds though the size of its asset purchase scheme is still small in comparison to those operated by the Federal Reserve or BoE with HM Treasury. This is something of an indictment of the Euro Area system whereby all the money market liquidity windows of the 16 constitutent central banks are vested and centralised in the ECB. It has a board of 16 central banks' representatives plus 6 ECB'ocrats, but among the central bankers are 9 economists and this bodes well for its gathering responsiveness. ECB President Jean-Claude Trichet said the bank would buy covered bonds, typically backed by mortgages, but did not rule out other purchases, which may let the ECB buy government bonds, although this has by political convention about fairness been resisted so far. The ECB will double the maximum term of its loans to banks to 12 months and loosen the rules on the assets which can be used as collateral to lessen the financial strain throughout the eurozone. 12 months is however much shorter than the 3 years offered by the BoE and similar medium term support from the US Treasury and Federal Reserve.
Details of the Bank of England's Special Liquidity Scheme (21.4.08) and its successor Asset Protection Scheme and Asset Purchase facility (19.01.09) - both organised by BoE as 'agent for HM Treasury and the Debt Management Office) do not have to be revealed until October 2009, and at the government's discretion not even then. This is according to the 2009 Banking Act (http://www.opsi.gov.uk/acts/acts2009/pdf/ukpga_20090001_en.pdf). What we do know is the following asset swaps for treasury bills and Bank of England cheques, where the bank assets are securitised as asset banked bonds and purchased as collateral for up to three years for: SLS - £245bn assets pledged as collateral, swapped for £185bn in treasury bills, with a roughly 3% fee. The assets are securitised as bonds paying about 3% above LIBOR, averaging say 5% net after the coupon on the T-bills over 3 years = £6bn + £28bn.
The difference between the assets pledged and the T-bills they were swapped for provides backing for the £37bn of preference shares bought from Lloyds TSB, HBoS and RBS paying 9% (subject to the banks' profitability). We can assume they will pay and average of 6% over 3 years = £7bn.
The APS scheme has we know taken in £325bn and £245bn from RBS and LBG plus another £15bn in exchange for Bank of England cheques left as deposits with the Bank of England, for a £22.1bn fee paid partly in preference shares and converted into common stock, and 2% insurance, plus very importantly, the banks agree to make no tax claim for losses for "several years!" (see http://www.hm-treasury.gov.uk/statement_chx_260209.htm)
It is not possible to gauge the exact value of all this, but investment in bank shares of £37bn plus £34.6bn (£71.6bn) and becoming worth more. (see p.59 of Budget Report http://www.hm-treasury.gov.uk/d/Budget2009/bud09_completereport_2520.pdf).
These shareholdings were paid for off-budget i.e. not at taxpayers' expense. This plus about £30bn a year on average over 3 years in coupons and dividends i.e. £150-200bn say over 3 years, but can become considerably more.
There is also the BoE's Asset Purchase Facility. "Following a request from the MPC, the Chancellor authorised the Bank of England to use the APF for monetary policy purposes and increased the total scale of the fund to £150 billion, up to £50 billion of which could be used for private sector asset purchases. Asset purchases since then have been financed by the issuance of central bank reserves at the Bank of England". (page 60, Budget Report)
'Central Bank Reserves' means BoE cheques as per the Asset Protection Scheme. This has the advantage that the recipients cannot sell the payment they receive and must keep this as a financial reserve. It avoid issuing treasury bills that could be sold and may be represented at unexpected times rather than simply rolled over.
Thus from these schemes the government should gain a net profit of about £185bn, and very possibly over £200bn, which is a substantial 3 year gain from off-budget financing worth about £900bn currently. If part or all of this is used in the Quantitative Easing scheme for buying in £75bn of government bonds and then up to £150bn in total, and I judge there could be another £50bn, this is about half of the government's likely Budget Deficit of £175bn deficit in 2009, then say £160bn and £125bn in 2010 and 2011 respectively.
Given that long term interbank funding that UK banks require to finance their funding gaps remains very hard to get from private sources, we can expect the Bank of England to add several £100bn more to the Asset Protection Scheme during the remainder of this year, which would mean we can be even more confident that there will be a £200bn three-year gain or more, sufficient to cover half of government budget deficits. The agreements with the banks will also ensure about £50bn in new lending into the economy by the banks.
Chancellor Darling in his Budget report 2009 highlights in red on p.25, "Reflecting the principle of transparency, the fiscal forecasts include a provisional estimate for the high end of a range for the net impact of unrealised losses on financial sector interventions, equal to 3½ per cent of GDP." The budget deficit is about 12.4% ratio to GDP for 2009/10, then 11.9% and 9.1% in the next two years. The Chancellor is therefore indicating that a substantial part the deficit is required, at least roughly half most probably,assuming a 4:1 multiplier, to compensate the economy for the banks' and possibly may not be needed if the government's financial sector interventions pay-off.
In the case of the ECB there is now tacit admission that the policy of leaving interest rates relatively high and quietly talking down the prospect of quantitative easing has been abandoned.
There remains considerable fear and uncertainty about how the chips will fall. The BoE's MPC recently stated: “The world economy remains in deep recession. Output has continued to contract and international trade has fallen precipitously. The global banking and financial system remains fragile despite further significant intervention by the authorities.”
The BoE's QE has prompted a sudden jump in the price of government bonds, or gilts. Though this may not be sufficient to close the gap so that the BoE will not still be buying the higher coupon outstanding gilts cheaply on the secondary market. It will no doubt use other banks to do the buying for it. we can see this in that despite the higher QE, the benchmark bond yield remains above the level it was before QE was announced and began.

Sunday, May 10, 2009

Accounting Basics: Assets

 As hinted in my previous entry, the balance sheet is comprised of three basic sections: assets, liabilities and owners equity. Assets are resources or items of value owned by the business. They are items of value which can be used or exchanged in the production or delivery of services of the business.

Typically, the most common asset people think of is cash. Cash can be exchanged to purchase office supplies, raw materials used in production, pay employees, etc.; thus it is an asset of the business. Machinery is another asset; it is used in the production of the goods or services delivered by the business.

Substantial effort is made by accountants in valuing assets; some of which may not have a clear current value. For example, a piece of equipment purchased five years ago for $100,000 and used daily in the operation of the business is not worth $100,000 today (in the same way that a five year old car is not worth the price paid for it when it was new). In this instance, accountants use depreciation to adjust the value of a 'fixed asset' such as this (to be discussed later).

Thursday, May 7, 2009

STRESS TESTS TO CLIMB UP OUT OF CRUNCH CRISIS RECESSION?

Bank stocks have been rising well internationally. Wednesday (yesterday) was especially good for US financial stocks as investors expressed relief the capital shortfalls identified by the government’s “stress tests” at large banks such as Citigroup and Bank of America were not as big as feared.
The bank rally occurred as news of the capital needs of the 19 banks involved in the tests leaked out during the day, ahead of the official release of the results on Thursday.
Citi, BofA and Morgan Stanley were among the big names that will have to raise equity following the completion of the tests, while JPMorgan Chase, Goldman Sachs and American Express are among those that will not need additional capital, people familiar with the situation said.
Citi and BofA emerged as the banks with the biggest capital shortfalls, with Citi’s equity needs projected to be more than $50bn and BofA requiring about $34bn in fresh equity.
However, BofA’s capital deficit is more pressing because Citi has already agreed to bolster its balance sheet by converting preferred shares owned by the government and other investors and selling non-core businesses.
People close to the situation expect Citi to have to raise no more than $6bn through the expansion of its planned conversion of preferred shares – less than the $10bn-plus the market had feared. The move could decrease the government’s stake in Citi, which was expected to be 36 per cent to about 33 per cent.
New equity ratio rule
US banks will be required to hold enough equity to ensure that they would still have a common equity ratio of at least 4% of risk-weighted assets at the end of 2010 even if the adverse scenario set out in bank stress tests were to materialise, the authorities said on Wednesday 6th May. I suggest that they should consier applying an equivalent of the Dutch National Bank’s Liquidity directive.
Banks are required to report on a consolidated level on their liquidity position to the DNB monthly, on the basis of the liquidity supervision directive. The liquidity directive seeks to ensure that banks are in a position to cope with an acute short term liquidity shortage under the assumption that banks would remain solvent. In principle, the DNB liquidity directive covers all direct domestic and foreign establishments (subsidiaries/branches), including majority participations. The regulatory report also takes into consideration the liquidity effects of derivatives and the potential drawings under committed facilities.
The directive places emphasis on the short term in testing the liquidity position over a period of up to one month with a separate test of the liquidity position in the first week. For observation purposes, several additional maturity bands are included in the liquidity report (one to three months, three to six months, six months to one year and beyond one year).
Available liquidity must always exceed required liquidity. Available liquidity and required liquidity are calculated by applying weighting factors to the relevant on- and off-balance sheet items, i.e. irrevocable commitments. The liquidity test includes all currencies. Compliance reports concerning liquidity requirements of foreign subsidiaries are submitted to the appropriate foreign regulatory authorities as required. At a consolidated level, and in every country in which a bank operates, the banking group must adhere to the liquidity standards imposed by the applicable regulatory authorities.
The use of a common equity ratio – even if as a benchmark rather than a formal future standard – is a departure from normal bank regulation. It is intended to ensure that banks have good quality capital, providing permanent capacity to absorb losses and flexibility over cash distributions.
The US authorities also said that the 19 biggest US banks will also be required to hold enough overall tier one capital to ensure that they would still have tier one capital equal to at least 6% ratio to RWA. This allows their reserve capital to operate as a cushion that can depress by half.
Banks will have 30 days to present a plan to meet the demands identified by regulators. They will also be required to outline steps they will take to “address weakness, where appropriate” in their own processes for capital planning. They are tasked to outline how they will, over time, repay existing government capital injections (e.g. in payment or in preferred shares) and reduce reliance on debt issued under a government-guaranteed programme. Up to 10 of the 19 banks are likely to need fresh equity, according to various unnamed sources. Morgan Stanley is said to need $1.5bn in new equity, as a result of its buying a majority stake in Citi’s Smith Barney brokerage.
Tim Geithner, the US Treasury Secretary, said last night on PBS: “I think the results will be, on balance, reassuring.” Investors concur, with shares in BofA, Citi and Wells Fargo – expected to need $10bn-plus in new equity – rising by over 15%.
The tests aim to ensure that even in an adverse economic scenarios, such as obviously the current crisis, banks can retain tier one capital of at least 6% of risk-weighted assets RWA – loans and other exposures less collateral, with both the assets and liabilities risk-weighted and risk-graded) and tangible common equity of at least 4% at the end of 2010 (when economic recovery should be 1 year old). Each bank told to raise additional equity has until June 8 to present a plan to regulators explaining how it intends to do so. The concern here is to have clarity in time for planning the administration’s budget for budget year starting 1 October. This is required even though further government financing will be off-budget via Federal Reserve balance sheet of T-bills, and only on-budget if requiring longer term Treasury Bond issues.
These banks will also be required to remedy any “weaknesses” (governance, systems, data quality, reporting process, risk management controls, and risk mitigation measures) in their internal capital planning (liquidity risk management) and to outline how they eventually intend to buyt hemselves out of government-sponsored aid.
The revelation that BofA needs about $34bn in extra capital will increase pressure on Ken Lewis, its embattled chief executive. The banks and the regulators declined to comment to news sources such as FT or Reuters or were unavailable.
The stress tests overseen by the FDIC involved more than 150 senior bank supervisors, analysts and economists being interrogated (subject to Geneva Convention or Basel Accord Rules) in the top 19 US banks about their likely losses in the event of a deeper-than-expected recession. This is somewhat complicated and relieved by FASB relaxaion of fair value mark-to-market valuations that takes the illiquid temporary turbulence effects out of market pricing. It is also helped that 3 month LIBOR has fallen to its lowest level since the ‘80s even if longer term funding from private sources remains a desert.
Following the policy (announced February 10) these banks were asked to estimate their short term future losses against capital to meet those losses, under adverse conditions that reflect a view of current conditions shaded on the relatively more benign side of the possible range of outcomes, as defined by the FDIC.
The teams of bank supervisors – specialising in specific types of assets, bank earnings capacity and reserves – then evaluated the banks’ submissions and asked for further information. They tested banks’ projections against independent benchmarks of their own tailored to the portfolio mixes of each bank. The problem here is that the authorities do not have complete macoeconomic models with sufficient financial sector detail to produce and adequatelyrobust and complete benchmark. It is easier to benchmark the banking sector to the economy than to directly correlate any one bank to the economy. The latter is almost impossible. The problem therefore is that whatever macro-prudential and macro-economic modelling the supervisors have to check with is not availabl to the banks themselves. There is, of course, considerable scope for judgement in these matters, but the all tolled the liklihood of the banks assessments agreeing directly with that pre-calculated by the supervisor team is zero! Hence, there will be considerable interative toing and froing between supervisor team and the bank. It may take until end of June to reach consensus agreement.
Taking into account likely losses, operating earnings (repeatable and one-offs) and own-capital reserves, the supervisors make a judgment about on whether each bank requires additional capital to guard against the risks represented by the stress test, with particular concern for whether that capital may be obtained from private sources or must be sought from the Federal Reserve, US Treasury, FDIC, and/or Congress and the White House.
There was both an overall tier-one capital test (which virtually every bank met easily) and a common equity test (which identified the need for many banks to hold economic-capital cushions against wider market and economy risks).
Supervisors did at least tell the banks about their assessment headline terms shortly in advance of visits, i.e. only last week – giving them a few days to crunch through their spreadsheets and challenge the findings. One immense difficulty of all this is that spreadsheets are not powerful enough to turn the handle on all of banks books and do not facilitate audit-trail drill-downs. We are dealing with macro- views top-down applying credit risk, market risk and liquidity risk assessments of large portfolios, large asset classes, where the magins for error greatly exceed the margins that the supervisors ant to have precision on i.e. increments of 0.25% of ratio to RWA or 0.125% of assets. Liquidity funding covers typically 30% of assets (the funding gap) and this is a larger ‘call’ on authorities financial resource than incremental top-up to Tier capital.
With assets of say $30tn of which $20tn are less than AAA, the funding gap is say $6-9tn that will require most of it rolling over perhaps within 6 months. Federal Reserve, US Treasury and FDIC balance sheets probably already have secured half of the requirement. The government is anxious not to let the banks deleverage to satisfy the remainder, and yet reluctant to be seen delivering yet more support in the $1+ trillion region, which would severely damage confidence just when the recession is hopefully in its last 2 quarters. The FDIC had also said in advance that relaining TARP and other sources of $150bn should be more than enough to see out this year. Hence, there is concern to keep the outcome of new funding requirement to below this, hence too Geithner’s plan to leverage the hedge funds into this role by offering them cheap loans to buy toxic assets. The hedge funds know they have political leverage here despite their general unpopularity (only a few notches adrift of the mistrust of the banks, except that at least bank shares are currently rising). This leverage resulted in their generous ‘exit’ clauses should they sometime down the track doubt their ability to make double-digit returns from buying up to $500bn of the banks ‘impaired’ assets.
Bankers say the authorities were willing to update their assessments in the light of changes to asset portfolios from the fourth quarter to the first quarter (reflecting FASB dispensation), but refused to put much weight on very strong first-quarter operating earnings when reaching their judgment on future revenues (which neatly agrees with maket sentiment that at first welcomed the record profits before recognising that these were mainly accounting changes and one-off gains).
Today’s announcement will in effect put banks into one of four categories: those (if any) that need extra tier-one capital; those that need to increase their equity buffer; those that have an adequate capital buffer under the stress test standard; and those that have surplus capital and could be eligible to repay bail-out funds subject to further conditions.
Nouriel Roubini and others, who with the credit ratings agencies, share one outlook in common, which is that there are no penalties just now for being excessively gloomy, advocates in good populist manner the dstruction of some banks to allows others to flourish in their place, a kind of fast-forward Darwinianism. Roubini complains that the tests have no precise insolvency threshold. In my view this is only sensible. Insolvency for banks is not a fixed moment in time event and there are at least six different ways of assessing insolvency. And, in any case, when government stands behind the banks, more so when it owns them, the normal regulatory and insolvency critieria no longer apply as before! Quoting the IMF estimates of losses, which actually added nothing we did not know already, Roubini reiterates that since losses have doubled in six months, the stress test results cannot “be credibly interpreted as a sign of bank health”. My response is, no of course not; these are not yet healthy patients. That is not the issue. The question is have they died or are the vital signs good enough, with evidence of at least near-normal brain-function not to turn off the life support?
Roubini is like a camp-doctor. These banks are cripples, let’s top them if they need “extra capital have, in fact, failed. As a result, these institutions will not be able to raise outside capital and will immediately require government help. Once again, the question will be how the near-insolvent banks can be kept afloat, to avoid systemic risk. But the question we really should be asking is: why keep insolvent banks afloat? We believe there is no convincing answer; we should instead find ways to manage the systemic risk of bank failures.” Good luck to that as a policy prescription: the complexity is mind-boggling.
Like a Eugenicist, Roubini says simply, “Trillions of dollars have been thrown at the system, just so that we can avoid the natural process of creative destruction that would take down these institutions’ creditors. Why shouldn’t the creditors bear the losses?”
He cites as counter-arguments, the “Lehman factor” and counterparty risk, the fear of being on the other side of a transaction with a failed bank”. But this includes the fact that Government is now a major counterparty and cannot risk the banks going under and all those T-bills being presented suddenly for redemption payments. Perhaps mindful of that, he suggests “a new insolvency regime for systemically important financial institutions is passed on a fast-track basis by Congress. Problem nearly solved.” Fast-tracking anything through Congress is an operational risk. I see the problem also that instead of allowing the vacuum of major failed banks to be filled by those with unreconstructed ethics, the government and regulators should continue with supporting the troubled banks in order to clean them up and ensure the country has better, ethically sounder banking. This is economically as important as anything else for the long term. Roubini has a fond belief that there is sufficient spring in the rest of the financial markets for them to rebound even if those big banks fall over. This I very much doubt. I judge that the interconnectedness of financial institutions is far far more complex a network than Roubini realises. Finance is not a competitive market mainly. The banks chased alpha unrealistically, fooling themselves into believing they are their on performance drivers. The difference in performance among banks is minor. The major factors are the economy, nationally and globally. I think Roubini should abandon a micro-theory view and get back to macro-economics.
The stress-tests, from which bankers have to learn this is how they must manage in the future, concern managing through the vicious circle between economic and financial weakness plaguing the economy, paving the way for a reliable recovery. Once that is achieved then other tinkering, Shumpeterian perhaps, is open to debate, not before.
Just now the focus is on narrowing the information gap between what bankers think banks are worth and what investors think banks are worth, they hope to enable many banks to raise the equity they need from the private market. Banks must clean up their balance sheets to attract more equity but not at the expense of the underlying economy.
Officials privately agree that the stress test is not a worst-case assessment but they argue that by intervening relatively early by the standards of past crises they can help ensure such an outcome does not materialise. The assessments are, however, based on a banker’s rather than an economist’s analysis of losses and that is their gross realism failing. They should though avoid the accountant’s snapshot view of solvency by allowing banks to value assets held to maturity at higher than current market prices, and gives them credit for their ability to earn their way back to health over time, taking account of time to generate debt recoveries.
The Federal Reserve tries to narrow the gap between the banker’s view and the economist’s view (two disttinctly different cultures) by taking a broad view of risks and a more forward-looking assessment of loan losses and recoveries. If the strategy succeeds in restoring confidence and drawing in additional equity, it should result in a decline in risk spreads on bank debt, reducing their funding costs and encouraging them to be more aggressive in lending to households and businesses. This correlates well with UK policy that has exceeded even the total support for banks of the rest of the EU. The other OECD countries will be under pressure to follow suit with publishing stress tests of their own. The EU is seeking stress tests on 47 banks, now reduced to the top 25. But these are late. This is because everyone under-estimated the difficulties of assessing scenarios and building models across so many national economies, and the lack of models appropriate to doing this work at a pan-EU level as well as individual country levels.