naked capitalism

Gretchen Morgenson has a fair number of critics among readers of this blog, which I think is a tad unfortunate. Most of her articles are in fact sound; she is very reliable on executive comp, anything in the equity markets, or where she is working form legal documents, generally lawsuits. It’s when she wanders into debt markets that her attempts to present material to a mass audience sometimes include nails on chalkboard slips.

This week, she has a pretty decent piece on how municipalities got hosed in various swap transactions. She is being savaged for a foot in mouth at the top of the piece, and this is the precisely the sort of thing that gets her in trouble: using Greece (a story in the headlines) to update readers on municipalities’ swaps woes, and worse, calling the Greek currency swaps “credit default swaps.” What completely mystifies me is why, after being repeatedly hectored on the blogosphere, she does not clean this sort of thing up. Josh Rosner is her co-author on an upcoming book. Why doesn’t she run her pieces by him to avoid obvious gaffes?

Yet the Gretchen-bashing for its own sake has gotten a life of its own. Another blogger criticizes Gretchen for allegedly only discovering muni derivatives fiascoes now. Huh? She wrote about this in 2008 as well. And I don’t see anyone yelling at Chris Whalen for addressing this supposedly stale topic when he wrote about muncipalities and derivatives this week.

I suppose I am more sensitive to this than most, since I regularly shred articles long form in the Times, Journal, and once in a very great while, the Financial Times. Yet Gretchen gets piled on when many of the articles I pummel (and readers typically agree with my harsh take) get a free pass from most other bloggers (including one on Goldman’s marks on AIG’s CDS….which happened to be by the very same Gretchen Morgenson).

As an aside, I’ve waded into this argument before. My first blog conversation of sorts with Felix Salmon was on the very subject of a 2007 Gretchen Morgenson piece, where I made the case in some detail that while I though a piece by Morgenson had been sloppily written, that some of his salvos were less than fair.

Now it is fair to say that municipal finance has long been an ugly nexus of incompetence, chicanery, and greed. Pay to play scandals are endemic. But even when you don’t have ugly combinations of venal officials meet underhanded financier, you routinely find its kissing cousin, chump officials hire venal advisor in cahoots with underhanded financier. The article cites Andy Kolaty, a fixed income expert:

“The basic problem is the swap adviser gets paid only if there is a transaction — an unbelievable conflict of interest,” he said. “It’s the adviser who is supposed to protect you, but the swap adviser has a vested interest in seeing something happen.”

Yves here. And that is as good as it gets. To put it politely, there are often other ways these advisors are compensated.

And it is also human nature to rely on assurances made by the salesman, when they in fact have no legal standing.

Some readers will no doubt say that governments should not get involved in complicated financial instruments. But they are under pressure to minimize costs to taxpayers, so when a banker peddles and approach that professes to do that, they feel duty bound to listen, particularly if they know other entities like them are doing the same (remember, there is no penalty for screwing up in an entirely conventional manner). And even sophisticated players like Harvard have been burned on swaps too, so it isn’t clear that even being a smarter buyer has produced better outcomes.

Nevertheless, as one reader pointed out in a recent post, the complexities are often not where they seem to be:

To me the other HUGE issue is that a lot of the deception was “hidden in plain sight”, to use a Sherlock Holmes metaphor. Relatively simple statements with non-intuitive meanings (or meanings requiring non-trivial parsing).

Examples:

1. ‘It can’t go up more than 2% a year’. “It” is the interest rate in this case, but a lot of unsophisticated borrowers would have been encouraged to assume (or certainly not corrected if they did assume) that “It” was their PAYMENT.
2. ‘The starter rate is (some ridiculously low number).’ Same as above. The borrower thinks this is the INTEREST rate, when in fact it is the (minimum) PAYMENT rate and the principal is thereby increasing.
3. ‘The loan will reset in X years’. Ignoring the fact that if the minimum payment schedule is followed, the loan will RECAST much sooner.

I have personally called BS within the last month on a young work colleague’s statement regarding the interest rate on his car loan. Got him annoyed enough to check his contract right through, in fact, because he wanted to prove the old fogey wrong. 20 minutes later he’s cursing under his breath, and is on the phone to his fiancee to work out how far they can accelerate the payment schedule.

Now this is a genuinely smart guy, who got taken in by the difference between flat (quite prominently displayed) and reducible (quietly hidden away, in small print) interest rates. He and his fiancee also earn enough so they can in fact blitz the loan and write off the interest paid to experience.

(And when he asked me why I was so sure of my contention, I told him I’d seen the same stunt pulled on a good friend of mine many, many years ago, and never forgotten it. From what he then said I suspect he’s not going to forget either, and also not going to forget that a ‘family friend’ brokered the finance for him.)

Yves again. While these examples are retail, the same principles and risks apply as far as not very sophisticated “institutional” customers are concerned.

Morgenson sets out a good bill of particulars on the swaps front. The ridiculous part of these deals is that the municipal market is sufficiently deep that most issuers can sell bonds that are a good fit with the life of the underlying project, thus circumventing the risk of maturity mismatching. But plain vanilla bond deals are not very attractive to Wall Street firms, so municipalities were pressed to enter into variable rate debt deals, usually in the auction rate securities market, and swap back into fixed rates.

However, these deals blew up when the auction rate securities market froze in early 2008, and Morgenson misses a line of attack here. The ARS market had been propped up by dealers for some time, with auctions that failed winding up being carried by the banks (as in the auctions were the way that investors could get their money back readily; the market was billed as a weekly auction, but in fact was an OTC market with a once a week trading window). That was a cost they had been willing to bear until the monolines started looking wobbly. Many of these ARS were rated AAA by virtue of a monoline guarantee; if the monoline was downgraded, so to would the insured bond. The dealers did not want to be stuck holding inventory, since if it was downgraded, they would show losses. They started aggressively trying to reduce their holdings, and en masse, quit supporting the auctions. Under the terms of the agreements, if an auction failed, the investors were due a penalty rate for the loss of liquidity, the investors got a penalty rate.

Some state attorneys general went after the banks (some investors had their funds effectively frozen, and while some were happy as clams with the penalty rates, many had been sold the product as being as safe and liquid as a money market fund) and got big settlements.

But what about the municipalities? Were they misled about the risks of auction failure too? Were they told that the market worked only thanks to active involvement of the dealers? Morgenson says the governments are not willing to cross the money types:

What is especially maddening to many in the municipal securities market is that issuers are now relying on the same investment banks that put them into swaps-embedded debt to restructure their obligations. According to those who travel this world, issuers are afraid to upset their relationships with their bankers and are not holding them accountable for placing them in these costly trades.

Yves here. Is this a variant of Stockholm syndrome?

Chris Whalen points out that swaps contracts have wound up being an exceptionally bad deal for municipalities, thanks to the Fed’s ZIRP de facto banking subsidy:

OTC derivatives are multiplying the economic pain that ZIRP is causing to interest rate sensitive investors.

The Fed’s current interest rate policy has caused the City of Los Angeles to go into the red to the tune of $10 million per year because of interest rate swaps sold to the city by Bank of New York Mellon (BK). That’s right, thanks to Chairman Bernanke and the FOMC, and an OTC interest rate swap, the City of Los Angeles must pay $10 million per year to BK so long as the Fed continues ZIRP — potentially until 2028.

By skewing interest rates down below the true rate of inflation, the Fed has levied a tax on all of the OTC interest rate counterparties that were trying to hedge against higher interest rates. And there are literally thousands of other cities, states, public agencies and insurers around the world which are caught in the unintended consequences of ZIRP. When you recall that the Fed has been and continues to be the chief cheerleader in Washington for OTC derivatives, the implications for the global economy are truly mind boggling.

But Los Angeles is starting to consider taking more aggressive moves, and that may embolden other government bodies to act:

Los Angeles is thinking about moving billions of dollars in municipal deposits as well as nearly $30 billion in pension assets away from the largest banks in order to redress the perceived wrongdoing by BK and other large banks. You can probably guess that the City of Los Angeles will be using…

But at IRA we believe that it is better to get even than to get mad, especially when there are billions of dollars in public funds at stake. This is why we have begun to assist public sector agencies in negotiating the repudiation of OTC derivatives positions that are causing unanticipated losses to customers like the City of Los Angeles. The message to the OTC derivatives dealers is simple: Take back the deceptive, unfair and misleading OTC contract or else the public sector client will pursues any and all options. Remember that defrauding a state agency is a felony in most jurisdictions.

This could get interesting, and for a change, in a good way….

By Edward Harrison

This is the third in a series of posts about ideas for financial reform generated by the “Make Markets Be Markets” conference I attended yesterday in New York City on 3 Mar 2010. You can download all of the written presentations here.

A century ago, anyone with a bathtub and some chemicals could mix and sell drugs — and claim fantastic cures. These “innovators” raked in profits by skillfully marketing lousy products because customers were poorly equipped to tell the difference between effective and ineffective treatments. In the decades following, the Food and Drug Administration developed some basic rules about safety and disclosure, and everything changed. Companies had greater incentives to invest in research and to develop safer, more effective drugs. Eliminating bad remedies made room for creating good ones.

Nearly every product sold in America today has passed basic safety regulations well in advance of being put on store shelves. A focused and adaptable regulatory structure for drugs, food, cars, appliances and other physical products has created a vibrant market in which cutting edge innovations are aimed toward attracting new consumers. By contrast, credit products are regulated by a bloated, ineffective concoction of federal and state laws that have failed to adapt to changing markets. Costs have risen, and innovation has produced incomprehensible terms and sharp practices that have left families at the mercy of those who write the contracts.

-Elizabeth Warren, 3 Mar 2010

After Elizabeth Warren had her chance to speak, the thought on my mind was ‘complexity is the handmaiden of deception.’  That wasn’t the only point of her presentation on consumer protection, but that was the takeaway for me. Her point was simply that contracts are the bedrock of the U.S. legal system in promoting law and order. The purpose of contracts is to support the ‘invisible hand’ by allowing both sides of the contract to walk away happy.

This purpose is thwarted when contracts are designed to promote an information asymmetry which enshrines into law the advantage of one party over the other. The expert understands but the layman does not – and the expert uses this fact to insert terms favorable to him and his associates to the layman’s disadvantage.  Ultimately, the system breaks down because of widespread distrust. Opaque and asymmetric contracts diminish from the free market and undermine the invisible hand.

Warren started out by detailing the rise in complexity of credit card agreements. She showed a Bank of America agreement circa 1980. It was one-page in large print and plain English with no hidden language buried within. Today, including riders, a Bank of America credit card agreement is 30 pages of dense legalese with all manner of disclaimers and hidden surprises. She says:

Study after study shows that credit products are deliberately designed to obscure the real costs and to trick consumers. The average credit-card contract is dizzying—and 30 pages long, up from a page and a half in the early 1980s. Lenders advertise a single interest rate on the front of their direct-mail envelopes while burying costly details deep in the contract.

Creditors try to explain away their long contracts with the claim that they need to protect themselves from litigation. This ignores the fact that creditors have found many other effective ways to insulate themselves from liability. Arbitration clauses, for example, may look benign to the customer, but their point is often to permit the lender to escape the reach of class-action lawsuits. The result is that the lenders can break and, if the amounts at stake are small, few customers would ever sue. Legal protection is only a small part of the proliferating verbiage.

This is deception, pure and simple. And you will notice the close relationship between deception and fraud in the definition below.

Etymology: Middle English decepcioun, from Anglo-French deception, from Late Latindeception-, deceptio, from Latin decipere to deceive

Date: 15th century

1 a : the act of deceiving b : the fact or condition of being deceived

2 : something that deceives : trick <a clever deception>

— de·cep·tion·al \-shə-nəl\ adjective

synonyms deception, fraud, double-dealing, subterfuge, trickery mean the acts or practices of one who deliberately deceives. deception may or may not imply blameworthiness, since it may suggest cheating or merely tactical resource <magicians are masters of deception>. fraud always implies guilt and often criminality in act or practice <indicted for fraud>. double-dealing suggests treachery or at least action contrary to a professed attitude <a go-between suspected of double-dealing>.subterfuge suggests the adoption of a stratagem or the telling of a lie in order to escape guilt or to gain an end <obtained the papers by subterfuge>. trickery implies ingenious acts intended to dupe or cheat <resorted to trickery to gain their ends>.

-Free Dictionary

The Credit CARD Act of 2009 was passed in part to crack down on this type of deception. But it is clear that the deception is still ongoing, even in credit cards (see here and here). The reason for the deception is clear: money. Banks increasingly rely on fees as a profit center, in part because of the rise of securitization.

But, the complexity and reliance on fees is not just about credit cards. Felix Salmon pointed out an interesting case today where a bank asked for and received authorization to post account debits largest-to-smallest, which allows them to collect overdraft fees for more transactions. Felix says:

On another post, RogerNegotiator finds an astonishing OCC letter, authorizing a bank’s request to adopt largest-to-smallest check posting, thereby maximizing overdraft revenue. (If you have $100 in your account, and put a $1 candy bar on your debit card, followed by a $15 t-shirt, both transactions will end up generating a $34 overdraft fee if a $90 check comes in later in the day: the bank will end up making over $100 in fees that day alone.)

The key section in the letter is the last one, entitled “The Bank’s Consideration of the Section 7.4002(b) Factors”. That section lays out four reasons to adopt the practice, and concludes that “the Bank’s process for deciding the order of check posting is consistent with the safety and soundness considerations set forth in section 7.4002(b) and that the Bank may therefore post checks in the order it desires”.

What are those four reasons for ripping off consumers so blatantly? The very first one is “projections showing that revenue is likely to increase as a result of adopting a high-to-low order of check posting”. That’s considered a reason to adopt the practice, in the eyes of the OCC.

As for the rest of the reasons, they’re mostly ridiculous on their face. I love this one, for instance:

The Bank concludes that it needs to adopt the high-to-low order of posting so that customers who frequently write checks against insufficient funds do not do business with the Bank primarily because the Bank’s fee for checks presented against insufficient funds is lower than its competitors’.

Essentially, the bank is saying that its competitors have high overdraft fees, and that it doesn’t want to compete against its competitors, so it needs high overdraft fees too.

And then there’s this beaut:

The Bank states its belief that a high-to-low order of posting is consistent with the majority of its customers’ preferences. The Bank surmises that the intended order, which will result in a customer’s largest bills being paid first, will have the consequence of the customer’s most important bills (such as mortgage payments) being paid first. The Bank thus concludes that a high-to-low order is aligned with the majority of its customers’ priorities and preferences.

This is accepted at face value by the OCC, instead of simply being laughed at. Of course, no one bothered to ask the customers, because they knew full well that customers would never say that they preferred this way of doing things. But so long as the bank simply says that customers prefer it, no problem.

This is predatory behavior, but it has been sanctioned by regulators.

Warren mentioned these overdraft fees specifically when she discussed complexity in financial contracts. The average overdraft in America is $17, while the average overdraft fee is $34. Don’t like it? It’s all there in the fine print – take personal responsibility!

She also mentioned the kickbacks hidden in car loan contracts that used car dealers often receive ($1000-$3800 per contract) for steering consumers to a particular lender.

As for mortgages, the same goals of opacity were in effect. A recent post on Baseline Scenario tells us:

First, lenders made loans that virtually invited default.  Thus, Countrywide’s manual approved the making of loans that left consumers as little as $550 a month to live on, or $1,000 for a family of four.  And lenders qualified borrowers for loans based on a temporary low teaser rate even though they knew that borrowers would not be able to make the higher payments required when the teaser rate expired.   Of course, when loans became unaffordable, lenders could anticipate that borrowers would refinance, triggering a new round of fees for lenders-but they gave too little attention to the possibility that the loans could not be refinanced.  Consumer protection laws failed to prevent this disaster-in-the-making.

Second, the Federal Reserve’s disclosure rules made it impossible for adjustable rate mortgage borrowers-and 80% of the subprime loans were adjustable–to understand the risks they faced. Since the eighties, the Fed has mandated that the disclosures for such loans state figures for monthly payments that are simply wrong.  That may have led consumers to believe their loans would be more affordable than they were.  One of us recently presided over a survey of mortgage brokers that revealed that many borrowers spent little time reviewing those disclosures and never changed what they did because of them-something that ironically makes sense when the disclosures are misleading.

Again, the borrower is told to take personal responsibility. But, of course, had regulators cracked down on these deceptive practices, the loans could not have been made. Warren’s desire is for a “cop on the beat” to enforce the rules and regulations that our laws have enshrined, rather than relying on personal responsibility and industry self-regulation, even in matters of fraud, as Alan Greenspan wanted to do.

The problem, of course, is bureaucracy. Below is a picture of the present regulatory infrastructure for consumer protection.

There are multiple regulators trying to accomplish a lot of different tasks.  Warren’s suggestion is that we need to streamline this, eliminating all the duplication and regulatory overlap, combining all of these mandates in one agency, the Consumer Financial Protection Agency.

I felt certain when I read the Financial Times headline, “Proposal sees consumer watchdog role for Fed,” that I must have woken up in a bizarre parallel universe (but that is probably unfair to pretty much all universes parallel to ours: I imagine it would be very difficult to have one more perverse than ours). But no, sadly, this headline is for real; the only possible good news in this account it that this dreadful idea is far from a done deal.

Putting the proposed consumer financial services watchdog in any existing agency, save perhaps the FDIC, no matter what the professed logic is, is really a plan to neuter it (ironically. Richard Shelby, who was the original moving force against having the proposed new agency be independent, wanted to house it at the FDIC; it is the Democrats who are now responsible for the further devolution of this plan). The Treasury, Fed, and Office of the Comptroller of the Currency are notoriously bank friendly. Think they are gonna do anything to seriously inconvenience their charges? Not on your life. The sole reason the FDIC could be a viable choice is that it is the only Federal bank regulator that is serious about enforcement. And that is due to the simple fact that if they mess up on enforcement, they wind up with more dead banks, which is embarrassing, costly, and a ton more work for them than preventing train wrecks in the first place (to the extent they can).

And as bad a choice as the Treasury was (the former planned place to bury the financial products consumer protection agency), it would be part of the Administration, and hence subject to political pressure. Although the Fed is in the process of getting its wings clipped a tad, has managed the neat trick of playing an increasingly political role (starting with Greenspan, in a break with the practice of past Fed chairman, of weighing in on policy issues) while remaining utterly unaccountable to anyone.

The concerns and realities of ordinary people have simply not registered with the Fed (in fairness, consumer protection has never been part of its charter). But the Fed was negligent in executing duties assigned by Congress on the consumer front. Congress did pass something called HOEPA (Home Ownership and Equity Protection Act) that defined subprime mortgages and called for subprime activity to be reported to the relevant regulators. The Office of the Comptroller of the Currency, which also oversees banks, used HOEPA to monitor subprime lending and rein in extreme behavior. The Fed could have done so, but chose not to. In June 2007, Congress was pressuring a resistant Fed to rein in abusive mortgage practices. And did that have any impact? This update, right before the storm burst, July 2007:

A good old-fashioned showdown is set for this week between the Congress and the Fed. Congressmen are hoppin’ mad at the Fed’s failure not only to act to stem overheated and sometimes predatory subprime lending, but also its patent lack of enthusiasm in doing anything to keep this and other predatory practices from recurring. And they have some justification for their annoyance. While admittedly the Fed regulates only a portion of the institutions that were involved in subprime lending, it failed to use the tools it had available, most notably the Home Ownership and Equity Protection Act (by contrast, the Office of the Comptroller of the Currency, made use of HOEPA and had relatively few abuses among the banks it supervises).

There is a reason the Fed has been so tone deaf on this issue. It does not see borrower protection as part of its job (it isn’t part of the original Fed charter) and the little we’ve seen directly also suggests the Fed is a staunch believer in free market ideology (remember, Greenspan was an acolyte of Ayn Rand and Bernanke hasn’t had the time to put his own stamp on the institution).

Congress is threatening aggressive moves, namely, moving some of its regulatory authority to other agencies, if the Fed doesn’t fall into line.

And consider this quote from Dodd himself:

“They had a job to do, and they didn’t do it,” said Senate Banking Committee Chairman Christopher Dodd, (D., Conn.), of the Fed’s performance. “A lot of people are hurt, and I’m angry about it,” added Mr. Dodd, who is seeking the Democratic presidential nomination.

Yves here. Do we have a single shred of evidence to support the notion that the Fed has undergone a miraculous conversion experience as a result of the crisis and will now act as staunch defender of the little guy? I certainly haven’t seen it.

In fact, the central bank already has broad authority to bar practices it sees as unfair and deceptive. The push to create an independent consumer financial services watchdog was precisely because the Fed and other regulators had been so hopelessly derelict in exercising these duties.

Congress was prepared to strip the Fed of some of its authority three years ago due to its abysmal failure to do anything about subprime abuses, even in the face of rising defaults, media coverage of fraud, and pressure from Capitol Hill. Now Dodd is prepared to reward the Fed for the very same conduct he roundly criticized three years ago. We can only assume he has already started serving his post-Congressional constituency.

Credit default swaps played a much more central role in the financial crisis than is widely understood, and they continue to get a free pass in financial reform proposals that they do not deserve. As we have discussed on this blog, and recount in more detail in the book ECONNED, central clearing and/or putting them on exchanges are inadequate remedies. Only a small subset of CDS contracts trade often enough for to be suitable for exchange trading. As for central clearing, the logic is that this would provide for consistent and sufficiently large margin to be posted (think of it as a reserve against the ultimate possible insurance payment required on the contract). But unlike real derivatives, CDS are subject to massive price moves (”jump to default’) when a reference entity (the entity on which the CDS is written) defaults or goes into bankruptcy. That large price movement, means that the margin already posted will be insufficient, and there is no guarantee that the counterparty will be able to pony up the amount now due.

But perhaps more important, the idea that CDS have legitimate uses is questionable. They are used to hedge credit risk (sometimes) yet their pricing, per Bloomberg or any of the common commercial models, price CDS based on volatility, which is not based on any assessment of the underlying credit. So the idea that the pricing reflects default risk is spurious; indeed, CDS failed abysmally in predicting financial firm default risk during the crisis (Lehman was a particularly vivid illustration). But they serve to perpetuate the erosion of proper credit analysis (why bother if you can just lay off the risk?).

In the last two days, Gretchen Morgenson of the New York Times and Wolfgang Munchau of the Finacial Times have both launched salvos at CDS. Munchau’s is even more vituperative than Morgenson’s, which given the sober sensibilities of the Financial Times, suggests that opinion on the other side of the pond may be coalescing against the product.

Morgenson points out that even Ben Bernanke has started to question the legitimacy of CDS, but peculiarly is not as hard on his remark as she should have been:

“Using these instruments in a way that intentionally destabilizes a company or a country is — is counterproductive, and I’m sure the S.E.C. will be looking into that.”

Yves here. Huh? How, pray tell, is the SEC, of all regulators, going to look into CDS? CDS are specifically exempt from SEC regulation. If anyone has (or could decide it has) jurisdiction, it’s the Office of the Comptroller of the Currency, and the Fed. So saying that swaps are a problem, and saying that someone who cannot possibly look into them will handle them, is just a fancy form of regulatory three card monte.

And if anyone had any doubts that the CDS market is officially backstopped, look no further than the Bear Stearns and AIG rescues. To put not too find a point on it, the industry understands full well who is the ultimate bagholder:

United States commercial banks, those with insured deposits, held $13 trillion in notional value of credit derivatives at the end of the third quarter last year, according to the Office of the Comptroller of the Currency. The biggest players in this world are JPMorgan Chase, Citibank, Bank of America and Goldman Sachs.

All of those firms fall squarely into the category of institutions that are too politically connected to fail. Because of the implicit taxpayer backing that accompanies such lofty status, derivatives become exceedingly dangerous, said Robert Arvanitis, chief executive of Risk Finance Advisors, a corporate advisory firm specializing in insurance.

“If companies were not implicitly backed by the taxpayers, then managements would get very reluctant to go out after that next billion of notional on swaps,” he said. “They’d look over their shoulder and say, ‘This is getting dangerous.’”

Morgenson is positively tame compared to Munchau. I’m quoting him more liberally, because the tone of his remarks are remarkably pointed for him and the FT generally. Notice that he explicitly, and repeatedly, says the use of naked credit default swaps looks an awful lot like a crime:

I cannot understand why we are still allowing the trade in credit default swaps without ownership of the underlying securities. Especially in the eurozone, currently subject to a series of speculative attacks, a generalised ban on so-called naked CDSs should be a no-brainer…. Unfortunately, it is legal…

A naked CDS purchase means that you take out insurance on bonds without actually owning them. It is a purely speculative gamble. There is not one social or economic benefit. Even hardened speculators agree on this point. Especially because naked CDSs constitute a large part of all CDS transactions, the case for banning them is about as a strong as that for banning bank robberies.

Economically, CDSs are insurance for the simple reason that they insure the buyer against the default of an underlying security. A universally accepted aspect of insurance regulation is that you can only insure what you actually own. Insurance is not meant as a gamble, but an instrument to allow the buyer to reduce incalculable risks. Not even the most libertarian extremist would accept that you could take out insurance on your neighbour’s house or the life of your boss.

Technically, CDS are not classified as insurance but as swaps, because they involve an exchange of cash flows. The CDS lobby makes much of those technical characteristics in its defence of the status quo. But this is misleading. Even a traditional insurance contract can be viewed as a swap, as it involves an exchange of cash flows. But nobody in their right mind would use the swap-like characteristics of an insurance contract as an excuse not to regulate the insurance industry. The fact that, unlike insurance, CDSs are tradeable contracts does not change the fundamental economic rationale…

Yves here. The “tradeable” aspect is exaggerated. While standardization of contracts has helped, most CDS are not traded; dealers lay off their risks by entering into offsetting swaps. Back to Munchau:

Another argument I have heard from a lobbyist is that naked CDSs allow investors to hedge more effectively. This is like saying that a bank robbery brings benefits to the robber. A further stated objection to a ban is that it would be difficult to police. There is no question that a ban of a complex product, such as a CDS, involves technical complexities that commentators like myself probably underestimate. It is conceivable, for example, that the industry might quickly find a legal way round such a ban. Then again, we would not consider legalising bank robberies on the grounds that it is difficult to catch the robber.

So why are we so cautious? From conversations with regulators and law-makers, I suspect they are not always familiar with those products, to put it kindly, and that they may be afraid of regulating something they do not understand. They understand, or think they do, what a hedge fund is. Restricting hedge funds is something they can sell to their electorates. Hedge funds were not at the centre of the crisis, but they are a politically expedient target. Banning products with ugly acronyms that nobody understands seems like unnecessarily hard work…

Yves here. Hedge funds and Wall Street prop desks replicating certain structured arb strategies that relied on CDS were far more important in the crisis than is widely understood. You’ll be hearing more about that in due course. Back to Munchau:

But naked CDSs have played an important and direct role in destabilising the financial system. They still do. And banks, whose shareholders and employees have benefited from public rescue programmes, are now using CDSs to speculate against governments.

Where is the political response? The Germans want to bring it to the Group of 20, but they hesitate to do anything unilaterally. Christine Lagarde, the French finance minister, was recently quoted as saying: “What we are going to take away from this crisis is certainly a second look at the validity, solidity of sovereign [credit default swaps].”

A second look? I wonder what they saw when they looked the first time.

Yves here. The other defenses of CDS I’ve heard are equally dubious. One is they add to liquidity. Ahem, were corporate bond investors ever suffering from a lack of liquidity? That paper doesn’t trade much because most investors are buy and hold. Even when I was a kid, in the early 1980s, when there was as much appetite for corporate bond trading as are likely ever to see due to high uncertainty over interest rates. Yet no one complained about illiquidity in the corporate bond market (as in yes, it may not have been that liquid, but no one felt inconvenienced, dealer spreads were not seen as problematic). And as CDS drain liquidity in crises. As bond yields rise, intermediaries and hedge funds, both of whom are leveraged and normally serve as liquidity providers, have to tie up of their scarce cash and collateral in posting margins on CDS positions. So they suck liquidity out of markets are precisely the worst possible moment.

The more we can to to contain this product the better, but I am afraid it will take another meltdown to teach us the lesson we should have learned from the last one.

Consider: if we are starting to see signs of resistance to austerity measures in the US, it would suggest that they are not going to go over too well in other countries that have debt overhangs either. Defaults and/or restructurings are usually more palatable, politically.

And before suggesting that bondholders won’t stand for it, guess what, they can and do. Our Chapter 11 regime is widely praised and admired among the economically orthodox. That is a system for organized partial default and restructuring. Banks and investors are happy to lend to companies post Chapter 11.

Note we are not endorsing violence, and perhaps more important to note, the destruction that occurred at UC Berkeley was not planned, but instead grew as tensions spun out of control.

The outbreak appears to result from two sources of discord: one, the student objections to tuition increases and program cuts, the second a series of racist incidents: first a “Compton Cookout” on President’ Day in protest of Black History Month, followed by a noose on display in the UC San Diego Library. Students objected to the university’s failure to respond to these incidents, which led to a series of dance parties to show solidarity being organized at other UC campuses to show support. The blog Occupy California claimed the dance parties were followed by the occupation of several university buildings t UC Santa Cruz.

The Daily Californian describes the outbreak at UC Berkeley and notes that the police believe that many of the rioters were not students (via Raw Story, hat tip reader John D):

A crowd of more than 200 people swarmed the streets of Southside early Friday morning in a riot involving seven law enforcement agencies, runaway dumpsters, flaming trash cans, shattered windows and violent clashes between rioters and police.

What began as a dance party on Upper Sproul Plaza led to an occupation of Durant Hall at around 11:15 p.m. Thursday to raise support for the March 4 statewide protest in support of public education…

UCPD Captain Margo Bennett said the occupiers “cut a lock to get into the construction area and then cut a lock to get into the building [Durant Hall]” before vandalizing the area.

“There were windows broken, there was spray painting and graffiti on the interior, there was construction equipment that was tossed around,” she said.

The occupation evolved into a riot as it moved onto streets south of campus…

Bennett said the occupiers were able to leave Durant Hall without police confrontation because UCPD did not have adequate staffing and the Berkeley Police Department had not responded to the scene per UCPD request before the occupiers left.

She added that UCPD believes many of the occupiers were not UC Berkeley students….

The tone of the gathering changed at about 1:55 a.m. when a dumpster was pushed into the center of the intersection and set on fire by members of the crowd. The Berkeley Fire Department responded as people danced on top of the dumpster and shouted, “Whose street? Our street!”…

Officers physically pushed the crowd back so that Berkeley fire personnel could extinguish the flames. Sporadic fights broke out within the crowd, causing police to advance their line on the growing mob and use batons to push it back…

Members of the crowd hurled glass bottles, plastic buckets, pizza and other objects at the police line. The crowd’s size and intensity fluctuated as the police and protesters clashed and multiple members of the crowd were detained by police..

Bloomberg reports that former Treasury Secretary and Citigroup board member Robert Rubin will be summoned before the Financial Crisis Inquiry Commission in April, with Alan Greenspan and Chuck Prince likely to be tapped as well.

On the one hand, it’s a welcome sign that the FCIC will be interviewing many of the major figures responsible for the crisis. On the other, the Q&A format is almost certain to prove mighty unsatisfying. Although Angelides has been more effective a questioner than expected, none of the committee members is a litigator (as in practiced in dealing with witnesses in public forums) and it shows. Imagine what these hearings would be like if David Boies, who was devastatingly effective in the Microsoft antitrust trial, had a go at the likes of Bob Rubin, who bears far more responsibility for the crisis than most realize.

Greenspan, while a key actor, is unlikely to provide new information. He has been grilled repeatedly over his record; he has defended it verbally and in print; he therefore has already been subjected to every major line of attack and has practiced responses. Prince never seemed up to the task of managing Citi; a year into his tenure, he was having difficulty asserting control over the sprawling bank.

But Rubin was either the architect or the moving force behind so many of the flawed policies and practices that fed the crisis that it is difficult to come up with a complete list. For starters, he was an advocate of a finance-centric view of the economy and ultimately of US interests (notice how often trade negotiations have made opening financial markets a priority item. It’s due to the near certainty that American firms would easily secure a significant share. Just look at the inroads they made in the UK and Europe). He was a persistent advocate of a strong dollar policy (and he meant it; his stance represented a 180 degree change from earlier Clinton Administration efforts to weaken the dollar to put pressure on Japan). One of the reasons is that prolonged currency weakness was believed to be unfavorable to the standing of financial centers.

Rubin also pioneered covert banking bailouts. US financial firms were heavily exposed to the 1994 peso crisis. Congress rejected a rescue package for Mexico. Rubin then raided the Exchange Stablilzation Fund, a large kitty created in the Depression and under Treasury’s control, to do exactly what Congress had nixed, which was help the banks (a motive not openly discussed) by assisting Mexico.

Surprising as it amy seem, Rubin also bears considerable responsibility for global imbalances. In the 1997 Asian crisis, Japan wanted to lead a rescue effort within Asia, relying primarily on Asean. Rubin and his protege Larry Summers beat that back aggressively and insisted the IMF lead the rescue efforts (which by the way, all called for greater opening of capital markets, when hot money inflows had been the proximate cause of the Thai and Indonesian booms and busts). And the overly aggressive, inappropriate measures imposed on Thailand, Indonesia, and South Korea left a strong impression on all countries in the region: never never get in the position where you might need help from the IMF. That led them all to peg their currencies low in order to build up large foreign exchange reserves. If you look at charts showing the level of private debt to GDP in the US, the increase goes parabolic starting roughly in 1999.

Rubin was also famously the leader of the successful fight against Brooksley Born’s efforts to regulate credit default swaps.

Yet Rubin somehow has the aura of being untouchable. From Bloomberg:

Rubin, 71, has been perceived as “bullet-proof” because his Citigroup job was “framed as if he was only there to give advice,” said Charles Geisst, author of “Wall Street: A History” and a finance professor at Manhattan College in Riverdale, New York. “Unless they’ve actually got some stuff where he advised on some surreptitious deal that went bad or his advice was purposely misleading, they’re going to have a very difficult time with him.”

Yves here. Ahem, the problem isn’t that there probably isn’t dirty laundry, it’s that Rubin normally limits his interventions to those at a similarly lofty level who will therefore never rat him out. And no one will go in and demand a data/e-mail dump. Rubin did call Treasury to try to get it to intercede to avoid a downgrade of Enron, and the press for the most part politely ignored this hot potato. Similarly, Rubin repeatedly pushed Citi management to take MORE risk in the credit markets. So even the little we can see of Rubin’s record at Citi is far from clean.

Mind you, I am not suggesting he did anything criminal, and that it the problem with the standard that the FCIC and SIGTARP seem to be using. Reader Andrew Dittmer describes why “Were crimes committed?” is the wrong question to be asking:

A substantial fraction of financial services industry activity over the last couple of decades has been directed toward “financial innovation” in the sense of Martin Mayer: “finding legal
ways to do things that used to be illegal under the old rules.” The periodic blowups have been dealt with by producing a scapegoat whose misbehavior was so blatant that it could be punished under the criminal code. The result is actually to support a framework in which enormous rewards are granted to people
who devote their lives toward freeing corporate organizations from the pain of democratic supervision. I don’t think any compromise is possible on this point – if Congress resolves the tension through symbolically punishing a couple of egregious offenders, that would signify a step backwards on the road towards a non-predatory financial system.

The only way to get out of this trap is to focus attention on what it means to maintain a sector that is addicted to finding ways to turn the rules that bind it into dead letter, and to supplying this skill to others as a paid service.

Yves here. In other words, we need to come up with standards of what should be unacceptable behavior. Rather than focusing on what was legal, which gives an industry that devised overly lax rules an easy out, we need to identify what products and practices were destructive. If they happened to be legal, that is prima facie evidence that we need new rules.

The Wall Street Journal is not the first to comment on the magnitude of the wagers against the euro (the Financial Times took note nearly two weeks ago: “Speculators raise record bets against euro“). But the Journal offers a spectacle sure to inflame sentiment in Europe: that of major hedge funds feasting first on lemon-roasted chicken and filet mignon and later the euro:

During the dinner, hosted by a boutique investment bank at a private townhouse in Manhattan, a small group of all-star hedge-fund managers argued that the euro is likely to fall to “parity”—or equal on an exchange basis—with the dollar….

An SAC manager, Aaron Cowen, who pitched the group on the bearish bet, said he viewed all possible outcomes relating to the Greek debt crisis as negative for the euro.

Yves here. The article contains some comment that I consider to be misleading:

There is nothing improper about hedge funds jumping on the same trade unless it is deemed by regulators to be collusion. Regulators haven’t suggested that any trading has been improper.

Through small gatherings, hedge funds can discuss similar trades that can feed on each other, in moves similar to those criticized by some investors and bankers in 2008. Then, big hedge-fund managers, such as Greenlight Capital Inc. President David Einhorn, who also was at this month’s euro-dominated dinner, determined that the fortunes of Lehman Brothers Holdings and other firms were dim and bet heavily against their securities, accelerating their decline.

Yves again. The first paragraph gives the mistaken impression that foreign exchange markets are regulated. They aren’t. Spot and forward markets in foreign exchange in the major currencies are close to unsupervised (for instance, there is no mechanism for collecting transaction activity, which would be a critical way to look for odd transaction patterns and volumes), so the notion that there are growups that are supervising that trading or prepared to intervene is oversold. Now there are currency futures that trade on the IMM, Euronext, and ICE and these traders may well prefer to use exchange traded futures (options are largely traded OTC). Those trades would be subject to meaningful oversight.

Using Einhorn as an example in this context is also peculiar. First, Einhorn shorted Lehman’s stock, which meant he was operating in a highly regulated market, which is very different than some of the avenues open for wagering against the euro. Second, given his history (the SEC investigated Einhorn for possible market manipulation when he shorted Allied Capital, when Einhorn’s stance was ultimately vindicated, and the SEC later launched an internal probe in response to Einhorn’s charge that it mismanaged the situation, and appeared to discover some irregularities) my impression is Einhorn went to some lengths to make his case against Lehman in a highly public way. So while there is nothing inaccurate, narrowly speaking, about mentioning Einhorn, conflating his short of Lehman with a currency short is disingenuous. The standards for collusion in SEC-land are very different from those in the wild west of OTC markets.

But then we get to a more complicated dynamic. Truth be told, eurozone members should want a cheaper euro. A favorite crude measure, the Economist’s Big Mac index, suggests that fair value would be 1.1 versus the dollar, well below its current level of 1.35. Of course, the old nostrum that a cheaper currency is better for growth generally (by helping export competitiveness) does not mean that a shift would not be disruptive and leave many individuals worse off (particularly since energy imports in particular would become more pricey).

But a fall now, particularly a sudden one, would be seen a a repudiation of the euro. There is more at stake than just the level of the euro; many observers see this as a test that was inevitable when the euro was established, that a number of crucial issues were finessed and now have to be resolved. But some go further, and argue that while the eurozone will not break up, that it includes too many heterogeneous nation-stated to be viable. FT Alphaville (hat tip reader Richard Smith) quotes Paul Donovan of UBS:

That the Euro area is not an optimal currency area is generally agreed upon. The European economies are sufficiently diverse that external shocks hit different economies with differing degrees of severity. The asymmetrical nature of any shock is also likely to persist for longer. This is something that has been well understood for some time. Indeed, fourteen years ago UBS economists concluded that “a monetary union extending beyond the core six [European] economies would not work properly in economic terms.” The analysis identified those economies that could realistically be called an optimal currency area, those economies that could satisfy the Maastricht criteria (on a relatively liberal interpretation), and those economies for which there was a strong political will in favour of monetary union. The analysis suggested that Greece, Spain, Italy and Portugal failed to meet real economic or financial criteria. Ireland and Finland were felt to meet the financial and political criteria, but also failed to meet the real economic test. The Venn diagram UBS originally published is replicated [here], for the benefit of those with an interest in economic history….

The most optimistic scenario for the Euro probably lies in some kind of parallel to the experiences of the US in the 1930s. Then, a fragmented banking system, with powerful regional central banks, failed to deal properly with an asymmetric shock to the economy (and to the financial system). The problem fostered significant regional differences in economic performance. This motivated financial reform, and a greater fiscal transfer mechanism to turn a sub-optimal currency area into a sub-optimal currency area with the mechanisms to smooth the consequences of shocks.

Yves here. So see, it IS possible to be a “sub optimal currency area” if you can muddle through devising the right mechanisms. And the analogy to the US in the Great Depression is apt in another way: a complicating feature is that a sovereign default or restructuring will hit European banks, many of which have fragile balance sheets.

It is important to note that while the symptoms may show up as a “Greece problem” or a “Spain problem”, the root cause is a one-size fits all monetary policy (that is not to say that country-level monetary policy guaranteed good outcomes, individual governments can still make poor choices).

Reader Richard Kline’s remarks in comments yesterday illustrate the considerable variations among the eurozone members the top of most worry lists (and as some readers correctly point out, the UK also has a looming external debt problem, but is not in the firing line right now):

Protests: By whom and to achieve what? Those to me are the principle questions. It would appear that the protests were primarily organized by unions and in particular by public employee unions. That is understandable because theirs are the jobs most likely to be lost, but if they are protesting in isolation—and it would appear to be so—their cause is already lost. Without broader support in their countries, they can make a lot of sound and fury, but the flutter of a redundancy slip will have the final word. I take that as the undercurrent of some of the well-intentioned pushback in comments in this thread. Part of me wants to be sympathetic to part of the problem, but the fact is the context has changed, and strategy needs to change.

Greece’s problems aren’t a result of the financial crisis. Greece has run unsustainable deficits for decades, finally turning to accounting chicanery. Greece has had do-little public sector jobs as buy-offs for social peace, too many jobs, and these wealth-transfer posts can’t be funded, now. The political counterweight for those jobs was a tax system which more or less allowed there significant domestic wealthy elite to live in a domestic tax haven, paying virtually nothing. All of this was possible while phoney ‘growth’ was happening due to the credit bubble making Greece’s sovereign debt fundable on capital markets without qualm—once it was euro-denominated. (Greece had financial crises in the recent past before the currency union.) Greece’s problems have been, in fact, made in Greed. —So it would be a good thing if those who live in Greece got on the stick and came up with some solutions. The solutions at present appear to be, ‘Shaft the common man, and bill him for the surgery.’ That proposed VAT is brutal . . . but then that’s one of the few taxes which is relibably collected there. And the rise in the retirement age hits the poorest with particular force. What is not on the table are effective tax enforcement upon the wealthy, and at higher rates. This, too me, is what protestors should be protesting, not the evaporation of do-little jobs which the country can only afford if someone else is picking up the tab. Then too, another goal of a demonstration which would be reasonable would be to demand a ‘renegotiation’ of existing debt over longer terms at lower rates; ‘reasonable’ because the banks who snapped up Greek sovereign debt in the good times did it in full knowledge of the situation but were quite willing to leap in as ‘enablers’ as long as they got their money rent on it. French, Swiss, and German officials would find if hard to defend against a demand for renegotiation in a situation where they are insisting that the Greek citizenry work two, four, seven years more of their lives to pay that debt off. To me, the point is as you say, Yves, to keep the impacts of necessary changes from being excessively and unfairly taken out of the hides of the poorest.

Portugal’s problems are also not caused by the financial crisis. PJM above sums them up well. Portugal joined the euro, and this was both necessary and good as it brought cross-border investment from within Europe, gave increased access to markets there, and (in normal times) gave increased access to capital markets there. But the export sector, and overall productive sector there is too small yet to support services and government at a ‘European’ level, all efforts to expand them notwithstanding. Just as PJM says, remittances from abroad are still a very important part of the local financial system, a real indication of production imbalances. What has happened is not that Portugal has ‘overspent’ or ‘overborrowed’ but that the borrowing they have done was only possible at the excessivly low rates of the credit bubble: Portugal can’t afford a rate spike, and so services are squeezed with funding becoming dear. The alternative to that are long-term development funds from within the EU, but that was controversial (as a matter of competitive advantage) even before now, and will be very difficult if not impossible to get funded in present conditions. Portugal’s economy is small and weak relative to stresses around it, and is getting bruised. That is not their ‘fault,’ even if it is their pain.

And so on, and so on. The points to me are: a) the immediate crises are by-products of lending squeezes, and b) stink of predatory instigation by third-parties speculating against the weak countries involved. If the poor in the affected countries aren’t to take the hit for everyone, they need to get out in front with solutions rather than just saying no. I think most in those countries know this better than I do.

Update 3:30 AM: From Eurointelligence:

FT Deutschland leads the paper with the story that leading German banks announced that they would not be buying Greek bonds at a forthcoming auction (very unhelpful such an announcement, but this is what happens once a panic starts). Eurohypo, Hypo Real Estate and Postbank are the banks mentioned in the article, and Deutsche Bank will only get involved in its role as an investment bank. The paper quoted sources from two Landesbanken as saying that investments in Greece are hardly thinkable. So, these banks are already distrusting any possible guarantees they might receive from the German government as part of a rescue package. Die Hypo Real Estate is the German bank most exposed to Greek debt, with about €10bn.

Jean Quatremer says in his blog that a monetary union with full fiscal independence is not going to be sustainable in the long run. He also writes that Athens is threatening to borrow unilaterally from the IMF if the euro area is not helping – or attaching further pre-conditions – which would a massive embarrassment for the EU.

Martin Wolf, the Financial Times’ highly respected chief economics commentor, weighs in with a pretty pessimistic piece tonight. This makes for a companion to Peter Boone and Simon Johnson’s Doomsday cycle post from yesterday.

Let us cut to the chase of Wolf’s argument:

Now, after the implosion, we witness the extraordinary rescue efforts. So what happens next? We can identify two alternatives: success and failure.

By “success”, I mean reignition of the credit engine in high-income deficit countries. So private sector spending surges anew, fiscal deficits shrink and the economy appears to being going back to normal, at last. By “failure” I mean that the deleveraging continues, private spending fails to pick up with any real vigour and fiscal deficits remain far bigger, for far longer, than almost anybody now dares to imagine. This would be post-bubble Japan on a far wider scale.

Yves here. Notice he associates success and failure with polar options. But how can you “reignite the credit engine” when the financial system is undercapitalized even before allowing for the need to take further writedowns? The IMF has found the converse in its study of 124 banking crises, that purging bad debt is a painful but necessary precursor to growth. So I fail to understand how Wolf envisages that “skip Go, collect $200″ of releveraging quickly comes about. And in fact, it turns out that Wolf’s “success” is a straw man:

Unhappily, the result of what I call success would probably be a still bigger financial crisis in future, while the results of what I call failure would be that the fiscal rope would run out, even though reaching the end might take longer than worrywarts fear. Yet the big point is that either outcome ultimately leads us to a sovereign debt crisis. This, in turn, would surely result in defaults, probably via inflation. In essence, stretched balance sheets threaten mass private sector bankruptcy and a depression, or sovereign bankruptcy and inflation, or some combination of the two.

I can envisage two ways by which the world might grow out of its debt overhangs without such a collapse: a surge in private and public investment in the deficit countries or a surge in demand from the emerging countries. Under the former, higher future income would make today’s borrowing sustainable. Under the latter, the savings generated by the deleveraging private sectors of deficit countries would flow naturally into increased investment in emerging countries.

Yet exploiting such opportunities would involve radical rethinking. In countries like the UK and US, there would be high fiscal deficits over an extended period, but also a matching willingness to promote investment. Meanwhile, high-income countries would have to engage urgently with emerging countries, to discuss reforms to global finance aimed at facilitating a sustained net flow of funds from the former to the latter.

Yves here. Unfortunately, not only does it require “radical thinking” but also political consensus in a US that is badly divided, and not simply along party lines. Class warfare is in the air, and the idea of any large scale spending program will raise even more acute “But what about my share?” problems than usual.

We see a stark reminder of outcomes that will strike ordinary people, correctly, as unfair in the Wall Street Journal’s “Lending Falls at Epic Pace“:

U.S. banks posted last year their sharpest decline in lending since 1942, suggesting that the industry’s continued slide is making it harder for the economy to recover.

While top-tier banks are recovering at a faster clip, the rest of the industry is still suffering, according to a quarterly report from the Federal Deposit Insurance Corp. Banks fighting for survival, especially those plagued by losses on commercial real estate, are less willing to extend loans, siphoning credit from businesses and consumers.

Besides registering their biggest full-year decline in total loans outstanding in 67 years, U.S. banks set a number of grim milestones. According to the FDIC, the number of U.S. banks at risk of failing hit a 16-year high at 702. More than 5% of all loans were at least three months past due, the highest level recorded in the 26 years the data have been collected. And the problems are expected to last through 2010.

FDIC Chairman Sheila Bair said banks are “bumping along the bottom of the credit cycle” and that the number of bank failures in 2010 will likely eclipse the 140 recorded last year.

Yves here. There are a few problems with this picture. First, consider the throwaway “top tier banks are recovering faster” remark. Ahem, the 19 banks subjected to the stress tests hold 70% of deposits, which somewhat confounds the picture. However, it also fails to factor in the role of the implosion of the securitization market (although Freddie and Fannie have moved in a massive way as a stopgap on the housing front). So the actual contraction in credit extension, when the impact of the fall in securitization is factored in, is almost certain to make the picture even worse. And securitization, while it did include riskier corporate lending (collateralized loan obligations), the bulk of the volume was consumer and small business credit (recall that home equity and credit cards were a significant source of small business financing).

So the little guy is hit disportionately, and in cases, unfairly (I’ve heard stories of both very affluent people who used credit minimally who had credit lines cut, as well stories both in the press and recounted personally of people who were simply in the wrong zip codes, who were treated as credit risks due to the severity of area housing price declines even if they had largely or entirely paid of mortgages).

And of course, we have the elephant in the room, the seeming inability to come up with sensible mortgage modification programs (again, to a significant degree, due to the shift to securitization making it virtually impossible for the newfangled mortgage machinery to do anything on an individual basis, like assess creditworthiness, plus seemingly insurmountable intercreditor obstacles for borrowers who have second mortgages or HELOCs). The wee bit of bright light here appears to be that banks are getting more amenable to short sales.

Now the little guy versus big business distinction (where credit is more freely available) might be acceptable if there were evidence of shared sacrifice. But there is none. Wall Street bonuses are the most egregious offense, but there has been perilous little in the way of serious cuts in executive pay (John Mack’s zero bonus for three years running is a welcome and rare bit of symbolism, but even so, with the rest of the industry at the feeding trough, the austerity does not go very deep into the firm overall). And the financial press recounts on almost a daily basis the desperate efforts of banks to find new ways to fleece customersextract fees, which further stokes the resentment of an aggrieved public.

With the private sector debt overhang as great as it is, I doubt there is a way out of our mess that does not involve a period of debt restructuring and writeoffs. That process, no matter how adeptly handled, results in dislocation and has a chilling effect on bystanders (think of what it does to your mood to watch your neighbor’s house burn, even if you are unscathed. And mind you, I said neighbor, as in immediate neighbor, not the schadenfreude of seeing banksters or others seen as undeserving get their comeuppance).

Back to Wolf:

Unfortunately, nobody is seized of such a radical post-crisis agenda. Most people hope, instead, that the world will go back to being the way it was. It will not and should not. The essential ingredient of a successful exit is, instead, to use the huge surpluses of the private sector to fund higher investment, both public and private, across the world. China alone needs higher consumption.

Let us not repeat past errors. Let us not hope that a credit-fuelled consumption binge will save us. Let us invest in the future, instead.

I had a little e-mail chat with Swedish Lex, who offered his take:

The implicit conclusion of what Wolf and Johnson write is that we going forward need dirigiste economies and national and regional scale of types and magnitude that we have not seen before (or at least not in a very long time). In addition, the dirigisme would have to be closely co-ordinated globally.

I agreed with his reading of their views and noted:

I don’t see how we get close coordination. I had a talk with someone in from Hong Kong today, he is quite alarmed at China’s bullheadedness, wanting what it wants and devil take everyone else.

Plus we will not get dirigisme until the hold of the banking sector is broken. It will take a bigger bust to do that.

Swedish Lex interestingly sees another possible brake that may become operative prior to another bubble/bust cycle. He believes that the EU has much less tolerance for underwriting zombie banks than the US. The EuroBanks have written off less in the way of losses than their US peers, are also exposed to any EU sovereign debt defaults, and yet the biggest are still crucial parts of the international capital markets infrastructure (and therefore still tightly coupled to the very biggest US/UK firms). While any EU sovereign debt defaults could morph into a full blown crisis, the EU responses to the joint sovereign/bank debt overhang could lead to more radical changes in EU banking rules and practices that could blow back to the very biggest US banks in unexpected ways.

Kenneth Rogoff, former IMF chief economist warned that a series of sovereign debt defaults is likely to be in the offing. From Bloomberg:

Following banking crises, “we usually see a bunch of sovereign defaults, say in a few years. I predict we will again,” Rogoff,…said at a forum in Tokyo today.

He said financial markets will eventually drive interest rates higher, and European countries such as Greece and Portugal will “have a lot of troubles….

“It’s very, very hard to call the timing, but it will happen,” Rogoff, 56, said in the speech. “In rich countries – - Germany, the United States and maybe Japan — we are going to see slow growth. They will tighten their belts when the problem hits with interest rates. They will deal with it.”…

Rogoff said Japanese fiscal policy is “out of control.” Japan has the world’s largest public debt, with gross liabilities that are approaching twice the size of the economy.

Rogoff is far from alone in seeing sovereign defaults as likely, but so far, the chorus of concern comes mainly from analysts and investors rather than well-known economists (Willem Buiter was notable exception in that regard). One correspondent said that one of his sources, with impeccable contacts, anticipates 12 sovereign debt defaults in the EU. And while Rogoff puts Greece and Portugal as top of his hit list, a recent Bridgewater report (no online source) took a hard look at Spain, and did not like what it saw:

On net, Spain owes the world about 80% of GDP more than it has external assets. As a frame of reference, the degree of net external debt Spain has piled up in a currency it cannot print has few historical precedents among significant countries and is akin to the level of reparations imposed on Germany after World War I. We don’t know of precedents for these types of external imbalances being paid back in real terms.

In the Great Depression, the debtor countries, who both defaulted and devalued their currencies by leaving the gold standard fairly early, did better than creditor countries (as in they suffered smaller drops in GDP and recovered faster). But it is not clear how this will play out in the EU, where the debtors cannot depreciate their currencies (and as we also noted, the recent example of Sweden v. Norway also suggests that currency devaluations are not always the tonic they are assumed to be).

Another complicating factor is that European bank will need to refinance over €1 trillion of debt in the next two years. This not only will pressure spreads on sovereign credits, but conversely, will lead to higher bank borrowing costs. Since banks in the eurozone on the whole are even more thinly capitalized than those in the US (they are even less are along in writing down dud assets), this will at a minimum dampen lending and has the potential to put pressure on particularly weak institutions. From Ambrose Evans-Pritchard at the Telegraph (hat tip reader Swedish Lex):

Roughly €560bn of EU bank debt matures in 2010 and €540bn in 2011. The banks will have to roll over loans at a time when unprecedented bond issuance by governments worldwide risks saturating the debt markets. European states alone must raise €1.6 trillion this year.

“The scale of such issuance could raise a significant ‘crowding out’ issue, whereby government bonds suck up the vast majority of capital,” said Graham Secker, Morgan Stanley’s equity strategist. “The debt burden that prompted the financial crisis has not fallen; rather, we are witnessing a dramatic transfer of private-sector debt on to the public sector. The most important macro-theme for the next few years will be how easily countries can service and pay down these deficits. Greece may well prove to be a taste of things to come.”

This is going to be an interesting next couple of years, and the odds are pretty high that it may not be interesting in a good way.

By Marshall Auerback, a fund manager and investment strategist and L. Randall Wray, a Professor of Economics at the University of Missouri-Kansas City

In recent weeks there has been much discussion about what to do about Greece. These questions become all the more relevant as the country attempts to float a multibillion-euro bond issue later this week. The Financial Times has called this fund-raising a critical test of Greece’s credibility in financial markets as it battles with a spiraling debt crisis and strikes. (http://www.ft.com/cms/s/0/463b205e-1d93-11df-a893-00144feab49a.html ) The “credibility” of the financial markets is an important consideration in a country which has functionally ceded its sovereign ability to create currency, and thus remains dependent on the vagaries of the very banking institutions which helped create the mess in the first place.

Maybe Greece should secede from the European Union and default on its euro debt? Or go hat-in-hand to the International Monetary Fund (IMF) to beg for loans while promising to clean up its act? Or to the stronger Euro nations, hoping for charitable acts of forgiveness? Unfortunately, all of these options are going to mean a lot of pain and suffering for an economy that is already sinking rapidly.

And it is questionable whether any of them provide long term viable answers. Polls show that given the perception of fiscal excesses of Greece and the other countries on the periphery, the public in Germany opposes a bailout of these countries at its expense by a significant margin. Periphery countries such as Ireland that have already undertaken harsh austerity measures also oppose the notion of a bailout, despite—nay, because of–the tremendous pain already inflicted on their own respective economies (in Ireland’s case, the banks are probably insolvent as well). The IMF route is also problematic, given that Greece probably doesn’t qualify under normal IMF standards, and many euro zone nations would find this unpalatable from an ideological standpoint, as it would mean ceding control of EU macro policy to an external international institution with strong US influence.

The Wall Street Journal recently highlighted an article by Simon Johnson and Peter Boone, lamenting that the demands being foisted on Greece and other struggling Euronations would “massively curtail demand, lower wages and reduce the public sector workforce. The last time we saw this kind of precipitate fiscal austerity—when nations were tied to the gold standard—it contributed to the onset of the Great Depression in the 1930s” (http://online.wsj.com/article/SB10001424052748703525704575061172926967984.html ). Where we disagree with Johnson and Boone is the suggestion that the IMF be brought in to craft a solution. Any help from this organization will come with tight strings attached—indeed, with a noose around Greece’s neck. Germany and France would be crazy to commit their scarce euros to a bail-out of Greece since they face both internal threats from their own taxpayers and external threats from financial vampires who are looking for yet another nation to attack.

Here’s a more appropriate action: declare war on Goldman Sachs and other global financial firms that created this mess. Send the troops, the planes, the tanks, and the ships. Attack every outpost of the saboteurs on European soil. Blockade the airports and ports. Make Wall Street traders and CEOs fear for their lives, or at least for their freedom to travel. Build some Guantanamo-like facility to hold these enemy financial combatants until they can be tried, convicted, and properly punished.

Ok, if a literal armed attack on Goldman is too far-fetched, then go after the firm using the full force of the regulatory and legal systems. Close the offices and go through the files with a fine-tooth comb. Issue subpoenas to all non-clerical staff for court appearances. Make the internal emails public. Post the names of all managers and traders on Interpol. Arrest anyone who tries to board a plane, train, or boat; confiscate their passports; revoke their visas and work permits; and put a hold on their bank accounts until culpability can be assessed. Make life at least as miserable for them as it now is for Europe’s tens of millions of unemployed workers.
We know that the Obama administration will not go after the banksters that created this global financial calamity. It has been thoroughly co-opted by Wall Street’s fifth column—who hold most of the important posts in the administration. Europe has even more at stake and has shown somewhat more willingness to take action. Perhaps our only hope for retribution lies there.
Some might believe the term “banksters” is too mean. Surely Wall Street was just doing its job—providing the financial services wanted by the world. Yes, it all turned out a tad unfortunate but no one could have foreseen that so many of the financial innovations would turn into black swans. And hasn’t Wall Street learned its lesson and changed its practices? Fat chance. We know from internal emails that everyone on Wall Street saw this coming—indeed, they sold trash assets and placed bets that they would crater. The crisis was not a mistake—it was the foregone conclusion. The FBI warned of an epidemic of fraud back in 2004—with 80% of the fraud on the part of lenders. As Bill Black has been warning since the days of the Saving and Loan crisis, the most devastating kind of fraud is the “control fraud”, perpetrated by the financial institution’s management. Wall Street is, and was, run by control frauds. Not only were they busy defrauding the borrowers, like Greece, but they were simultaneously defrauding the owners of the firms they ran. Now add to that list the taxpayers that bailed out the firms. And Goldman is front and center when it comes to bad apples.

Lest anyone believe that Goldman’s executives were somehow unaware of bad deals done by rogue traders, William Cohan (http://opinionator.blogs.nytimes.com/2010/02/18/the-great-goldman-sachs-fire-sale -of-2008) reports that top management unloaded their Goldman stocks in March 2008 when Bear crashed, and again when Lehman collapsed in September 2008. Why? Quite simple: they knew the firm was full of toxic waste that it would not be able to continue to unload on suckers—and the only protection it had came from AIG, which it knew to be a bad counterparty. Hence on March 19, Jack Levy (co-chair of M&As) sold over $5 million of Goldman’s stock and bet against 60,000 more shares; Gerald Corrigan (former head of the NY Fed who was rewarded for that tenure with a position as managing director of Goldman) sold 15,000 shares in March; Jon Winkelried (Goldman’s co-president) sold 20,000 shares. After the Lehman fiasco, Levy sold over $6 million of Goldman shares and Masanori Mochida (head of Goldman in Japan) sold $56 million worth. The bloodletting by top management only stopped when Goldman got Geithner’s NYFed to produce a bail-out for AIG, which of course turned around and funneled government money to Goldman. With the government rescue, the control frauds decided it was safe to stop betting against their firm. So much for the “savvy businessmen” that President Obama believes to be in charge of Wall Street firms like Goldman.

From 2001 through November 2009 (note the date—a full year after Lehman) Goldman created financial instruments to hide European government debt, for example through currency trades or by pushing debt into the future. But not only did Goldman and other financial firms help and encourage Greece to take on more debt, they also brokered credit default swaps on Greece’s debt—making income on bets that Greece would default. No doubt they also took positions as the financial conditions deteriorated—betting on default and driving up CDS spreads.

But it gets even worse: An article by the German newspaper, FAZ, (“Die Fieberkurve der griechischen Schuldenkrise”, Feb. 20, 2010) strongly indicates that AIG, everybody’s favorite poster boy for financial deviancy, may have been the party which sold the credit default swaps on Greece (English translation here).

Generally, speaking, these CDSs lead to credit downgrades by ratings agencies, which drive spreads higher. In other words, Wall Street, led here by Goldman and AIG, helped to create the debt, then helped to create the hysteria about possible defaults. As CDS prices rise and Greece’s credit rating collapses, the interest rate it must pay on bonds rises—fueling a death spiral because it cannot cut spending or raise taxes sufficiently to reduce its deficit.

Having been bailed out by the Obama Administration, Wall Street firms are already eyeing other victims (and for allowing these kinds of activities to continue, the US Treasury remains indirectly complicit, another good reason why one shouldn’t expect any action coming out of Washington). Since the economic collapse is causing all Euronations to run larger budget deficits and at the same time is raising CDS prices and interest rates, it is easy to pick off nation after nation. This will not stop with Greece, so it is in the interest of Euroland to stop the vampires now.

With Washington unlikely to do anything to constrain Goldman, it looks like the European Union, which is launching a major audit, just might banish the bank from dealing in government debt. The problem is that CDS markets are essentially unregulated so such a ban will not prevent Wall Street from bringing down more countries—because they do not have to hold debt in order to bet against it using CDSs. These kinds of derivatives have already brought down an entire continent – Asia – in the late 1990s (see here), and yet authorities are still standing by and basically doing nothing when CDSs are being used again to speculatively attack Euroland. The absence of sanctions last year, when we had a chance to deal with this problem once and for all, has simply induced even more outrageous and fundamentally anti-social behavior. It has pitted neighbor against neighbor—with, for example, Germany and Greece lobbing insults at one another (Greece has requested reparations for WWII damages; Germany has complained about subsidizing what it perceives to be excessive social spending in Greece).

Of course, as far as Greece goes, the claim now is that these types of off balance sheet transactions in which Goldman and others engaged were not strictly “illegal” under EU law. But these are precisely the kinds of “shadow banking transactions” that almost brought down the global financial system 18 months ago. Literally a year after the Lehman bankruptcy – MONTHS after Goldman itself was saved from total ruin, it was again engaging in these kinds of deals.

And it wasn’t exactly a low-level functionary or “rogue trader” who was carrying out these transactions on behalf of Goldman. Gary Cohn is Lloyd “We’re doing God’s work” Blankfein’s number 2 man. So it’s hard to believe that St. Lloyd did not sanction the activities as well in advance of collecting his “modest” $9m bonus for last year’s work.

If these are examples of Obama’s “savvy businessmen”, then heaven help the global economy. The transaction highlighted, if reported that way in the private sector, would be accounting fraud. Fraud – “Go to jail, do not pass Go” fraud. That senior bankers had no problem in structuring/recommending/selling such deals to cash-strapped governments should probably not surprise us at this point. However, it would be interesting to know if the prop trading desks of those same investment banks, purely by coincidence of course, then took long CDS (short the credit) positions in the credit of the countries doing the hidden swaps. A proper legal investigation by the EU could reveal this and certainly help to uncover much of the financial chicanery which has done so much destruction to the global economy over the past several years.

In this country, we have had a “war on terror” and a “war on drugs” and yet we refuse to declare war on these financial weapons of mass destruction. We all remember Jimmy Carter’s “MEOW”—the attempt to attack creeping inflation that was said to sap the strength of the US economy in the late 1970s. But Europe—and indeed the entire globe—faces a much more dangerous and immediate threat from Wall Street’s banksters. They created this mess and are not only profiting from it, but are actively preventing recovery. They are causing unemployment, starvation, destruction of lives, and even violence and terrorism across the world. They are certainly more dangerous than the inflation of the 1970s, and arguably have disrupted more lives than Osama bin Laden—whose actions led the US to undertake military actions in at least three countries. That should provide ample justification for Greece’s declaration of figurative war on Manhattan.

However, in an ironic twist of fate, it was just announced that Petros Christodoulou will take over as the head of Greece’s national debt management agency. He worked as the head of derivatives at JP Morgan, and also previously worked at Goldman—the firm that got Greece into all this trouble!

Dimitri Papadimitriou has recently made what we consider to be an important plea for moderation of the hysteria about Greece’s debt. Writing in the Financial Times, he complained that

The plethora of articles in your pages and others, some arguing in favour and other against a bail-out, contribute to market confusion and drive the country’s financing costs to record levels. It is not yet clear that a bail-out is even needed, but this market confusion is rendering the government’s ability to achieve its deficit goals ever more difficult.

Indeed, we suspect that the same financial firms that helped to get Greece into its predicament are profiting from—and stoking the fires of—the hysteria. He goes on, “what Greece really needs now is a holiday from further market confusion being created by contradictory, alarmist public commentary”.

Greece, Euroland in general, and the rest of the world all need a holiday from the manipulation and destruction of our economies by Wall Street firms that profit from speculative bubbles, from burying firms, households, and governments under mountains and debt, and even from the crises that they create. Governments all over the globe should use all legal means at their disposal to ferret out the bad faith and even fraudulent deals that global financial behemoths are foisting on us.