naked capitalism

The Fed never met a bubble it wasn’t keen to reflate. The latest wrinkle is that it is trying to learn from its old behavior, although most of us would disapprove of the lessons it has drawn.

One of the cognitive biases in the readings of past crises is to attribute failure to official intervention, that is, the authorities either did not do enough, or they did the wrong thing. The result is a belief that correct action, if such a program had been divined, could have made the Great Depression a mild phenomenon, or tamed Japan’s post bubble malaise quickly.

The better question to ask is “How far can we go in short term intervention to alleviate pain and disruption without making things worse in the long run?” Admitting some dislocation is inevitable when you are in this big a mess is somehow verboten. And the “we can’t have too much visible distress” (tent cities are OK, it seems) plays right into the hands of the banksters, since “visible distress” seems to be measured more in asset values than human consequences.

For instance, in an oft-cited 2002 speech on deflation, Ben Bernanke cited a litany of things a central bank could do to create inflation. Nary a though was given to the possibility that if action as radical as he suggested was required, it could be a symptom that monetary policy had become ineffectual and doing more would yield little in the way of results. Or it might indicate that other problems were neutering monetary action, and addressing those issues would be more productive.

But no, the Bernanke default position on Japan was that its central bankers didn’t try hard enough. The Japanese, by contrast, believe their single biggest error was taking forever to take on and clean up the politically connected banking sector. Sound familiar?

So the latest of the “when in doubt, do more” syndrome is that the Fed is trying to get in front of an imminent commercial real estate bust by letting banks use the TALF for commercial real estate loans, thereby keeping credit cheap. The reason? That market is ready to go into free fall. Leon Black of Apollo Management, predicts a commercial real estate “back hole” that could deliver as much as $2 trillion in losses. to banks.

Ouch.

Ben, no matter how cheap the funding, is, if rent rolls collapse, commercial real estate prices and with it, commercial real estate debt values, will fall. Cash flow is king.

From Bloomberg:

The Federal Reserve is close to offering investors five-year loans to buy commercial mortgage- backed securities, granting an industry request, a person familiar with the matter said.

The decision on extending the term of such loans under the Fed’s Term Asset-Backed Securities Loan Facility isn’t final yet, said the person, who spoke on condition of anonymity. The Wall Street Journal reported the state of the decision earlier today. In December, the Fed lengthened the term of TALF loans to three years from one year.

Fed officials had been considering a compromise of charging higher fees after three years. That would be aimed at giving a greater incentive for investors to borrow from the Fed and helping restart markets for commercial mortgage-backed securities, while protecting the Fed’s flexibility to raise interest rates in the broader economy once consumer demand recovers.

“It continues to illustrate that it’s just a patchwork quilt of trying to shore up whichever asset du jour happens to be in trouble,” said Julian Mann, a manager of asset-backed bonds at First Pacific Advisors LLC in Los Angeles. In addition, “the taxpayer is encumbered for another few years,” Mann said.

In another disheartening development on the banking front, the Senate defeated legislation giving judges the authority to modify residential mortgages in bankruptcy.

Note that the popular description is often misconstrued in short form descriptions. Judges would not have had open-ended authority to make changes. The construct is that mortgages are collateralized loans. The mortgage balance is written down in bankruptcy to the value of the collateral, and the excess is added to the unsecured creditor claims.

This is also not an arcane process. It’s used in commercial bankruptcies and lending against boats, for instance. Ever hear any complaints about this practice in Chapter 11?

It was the best hope for cutting the Gordian knot of mortgage securitizations. First, it would allow for decisions on a case-by-case basis. Second, the servicer would get paid (fees are well established for court action in foreclosure). Third, the fact that a judge could force a principal writedown would give servicers air cover to do deep principal reductions, which Walter Ross, who owns the biggest third party servicer, has found do much better (in terms of borrowers paying on time) than the shallower mods coming out of government sticks and carrots.

This is not good news at all. It bodes ill for the housing recovery (the sooner prices bottom, the better; all these phony programs and fighting to find ways to suck more income out of hopelessly underwater borrowers is anti-recovery. The history of past bank crises shows that bankruptcies and debt restructurings are a necessary step to recovery. Trying to impede that puts the interest of the banksters ahead of the collective good. But why should we be surprised? This has been the modus operandi since the crisis began.

From Bloomberg:

The U.S. Senate rejected a measure that would let bankruptcy judges cut mortgage terms to help borrowers avoid foreclosure, a victory for banks and credit unions that said the legislation would increase loan costs.

The proposed “cram-down” amendment to a housing bill was defeated today in a 51-45 vote, with 12 Democrats among the 51 opponents. The measure needed 60 votes to pass over Republican objections. The House passed its version 234-191 on March 5.

“These bankers who brought us into this crisis are literally shunning and stiff-arming the people who are facing foreclosure,” said Senator Richard Durbin of Illinois, sponsor of the legislation and the chamber’s second-ranking Democrat.

The defeat is a setback for President Barack Obama’s administration, which included cram-down in the anti-foreclosure plan aiming to help 9 million homeowners. The mortgage industry has twice succeeded in helping to kill the proposal since Durbin first introduced it in 2007. The senator said today “this is not the last time” he will raise the issue.

Democrats led by Durbin had sought a compromise on the measure with JPMorgan Chase & Co., Wells Fargo & Co., Bank of America Corp., the American Bankers Association and Financial Services Roundtable. The lenders that scuttled the negotiations are “surviving today because of taxpayers’ dollars,” Durbin said. The three banks he named received $95 billion in U.S. aid.

“It’s clear that part of the mortgage industry was never interested in meeting us halfway, as negotiations went forward, they moved the goalpost back and back,” said Senator Charles Schumer, a New York Democrat.

An older trader’s saying is “little pigs get fed, big pigs go to slaughter.” In this case, the parasite is successfully sucking the life of of the host.

Submitted by Leo Kolivakis, publisher of Pension Pulse.

Following up on my last comment on CPPIB getting grilled in Ottawa, I received a few questions on benchmarks. I will elaborate on benchmarks in this post.

But first, CPPIB contacted me to tell me that they posted Ms. Warmbold’s opening remarks to the Standing Committee on Finance. I am still waiting for PSPIB to post Mr. Valentini’s remarks on their website, but given that the last press release dates back to October 2007, I doubt they’ll post his remarks on their website.

Anyways, back to Ms. Warmbold’s opening remarks (added notes are mine):

Good morning, Mr. Chairman and Members of the Committee.

My name is Benita Warmbold, and I am Senior Vice President and Chief Operations Officer of the CPP Investment Board. With me today is Mr. Don Raymond, Senior Vice President and head of Public Market Investments.

When the federal and provincial ministers of finance successfully reformed the Canada Pension Plan in the mid-1990s, they endowed the CPP – and the CPP Investment Board – with a number of advantages. Three of those advantages have proven invaluable in the recent economic environment.

The first is the clarity of our investment mandate enshrined in legislation to maximize returns without undue risk of loss.

[Note: It is not that clear to me what is meant by "undue risk of loss". Specifically, how much active risk is CPPIB taking to generate 100 basis? Is it 400 basis points of active risk? 500 basis points?]

The second is a governance model that balances independence with accountability. The CPPIB operates at arm’s length from government and is overseen by an independent board of directors which approves investment policies and makes critical operational decisions. To balance that independence, the CPPIB is accountable to the federal and provincial finance ministers who act as stewards of the CPP. And we have a high degree of transparency so Canadians can see how their pension fund is managed.

[Note: CPPIB does have a high degree of transparency EXCEPT for stating what its benchmarks are in both public and private markets. This will be discussed below. As far as accountability, the stewards have not performed a comprehensive performance, operational and fraud audit of the CPP Fund. This will surely come in the next Special Examination.]

The third is stability, through the legislation that protects the CPP assets and governs the CPP Investment Board, which requires the cooperation of the federal and provincial finance ministers to change.

All of these advantages reinforce our ability to earn investment returns to help sustain future benefits for the 17 million Canadians who participate in the CPP.

To fulfill this objective, the investment strategy of the CPP Fund is designed to generate returns over decades and generations and as a result we have a long investment horizon.

That long-term focus is central to my remarks today.

[Note: Focus on the long-run but we should then have ten or twenty year rolling returns on your bonuses along with clawbacks and high-water marks in case you blow up in the short-run.]

The combination of our long-term focus and the funding structure of the CPP — in which contributions are expected to exceed benefits through 2019 — has proven extremely valuable in helping the CPP withstand a prolonged market downturn.

The assets of the CPP Fund have grown steadily as the portfolio has been diversified over the past 10 years. As at December 31, 2008, the CPP Fund had assets of $108.9 billion. That’s an increase of $71 billion as a result of investment returns and contributions from employees and employers.

The fund today is a broadly diversified portfolio of public equities, private equities, real estate, inflation-linked bonds, infrastructure and fixed income instruments.

[Note: Ms. Warmbold forgot to mention that CPPIB also invests in hedge funds.]

Just under half of the fund – about 49% — was invested in Canada and the balance was invested globally as of December 31.

As recent results have shown, the CPP Fund is not isolated from the storms buffeting financial markets and the global economies. Sharp declines in global equity markets have negatively impacted our recent results. For the first three quarters of the fiscal year, the fund declined $13.8 billionreflecting a return of negative 13.7 percent.

While we recognize that Canadians may be concerned about these short-term results, our long investment horizon creates advantages and opportunities.

First, the portfolio we manage today is not being used to pay benefits today. In fact, it will be another 11 years before money from the fund will be required to help pay pensions.

Secondly, as a result of new cash flows for the next 11 years, we have the opportunity to invest in quality assets at attractive prices, when many other investors cannot.

And thirdly, our portfolio reflects our long term mission and is designed to generate returns over 4 year periods, rather than focusing on a single year.

Appropriately, our policy on management compensation reflects our long term investment strategy, our portfolio design and our long-term outlook.

The key principles are that compensation rewards performance over the long term as measured in 4 year periods; that pay for performance is based on two factors — how the fund performs overall and whether we generate returns above a market-based benchmark.

[Note: There is a great deal of uncertainty regarding the long-run. Towers Perrin has today warned that the pensions industry will not recover from its exposure to the financial crisis for more than twenty years. Will you be around in twenty years if your long-term bets go sour? I doubt it, but you have no problem collecting millions in short-term and long-term bonuses based on four year rolling returns. Something does not add up there. Then there are reporters like Andrew Willis of the Globe and Mail who do not bother to analyze benchmarks in detail but just blindly shill on your behalf, stating that politics threaten CPP Investment Board's integrity. ]

Overall, the program balances pay-for-performance with the ability to attract and retain the best investment professionals to manage the fund.

[Note: It's a secular bear market in the financial industry. You can attract a lot of talent to CPPIB, paying them a fraction of what you are paying those senior VPs!]

In summary, the CPPIB is very confident that we have the investment strategy to generate the long term returns required to help sustain the CPP.

Given recent conditions, we know Canadians are placing an even higher value on a strong public pension system. We take very seriously our responsibility to help sustain one of Canada’s most important social programs for decades and generations to come.

Thank you.

As I stated in my last post, CPPIB does not disclose its benchmarks (read their latest investment policy; there is nothing on benchmarks), preferring to give returns of the broad asset classes and of the overall fund.

But without proper disclosure of all the benchmarks governing each and every investment activity, including hedge funds, private equity, real estate, and infrastructure, we simply do not know whether the managers are taking appropriate risks relative to their performance benchmarks.

So what is a benchmark? I take the following definition from PIMCO:

In most cases, investors choose a market “index,” or combination of indices, as their portfolio benchmark. An index tracks the performance of a broad asset class, such as the investment-grade bond market, or a narrower slice of the market, such as investment-grade corporate bonds. Because indices track returns on a buy-and-hold basis and make no attempt to determine which securities are the most attractive, they represent a “passive” investment approach and can provide a good benchmark against which to compare the performance of a portfolio that is actively managed. Using an index, it is possible to see how much value an active manager adds and from where, or through what investments, that value comes.

When talking about the stock market the typical benchmarks for large cap U.S. stock is the S&P 500. If your mutual fund is underperforming the S&P 500 (most of them do), then you are paying fees to someone who is not capable of returning “market” returns.

There are very few major disagreements when it comes to plain old stock and bond benchmarks. You might argue that the S&P 600 is a better index of small cap stocks than the Russell 2000, but they are both reflective of the performance of small cap stocks. Most institutions use the same indexes to track the performance of public markets.

Where things get tricky is in private markets and hedge funds, what we call alternative investments. There is no consensus on what constitutes the appropriate benchmark for private equity, real estate, infrastructure and hedge funds. It amazes me that global pension funds never got together to figure out what will be the pension industry’s benchmarks for private market assets and hedge funds.

Instead, each fund uses their own benchmarks. For example, in real estate, some funds use a spread (typically 500 basis points) over CPI while others gauge their performance using a benchmark like IPD Market Indices which better reflect actual property transactions in commercial real estate by region. Other funds will use a stock market real estate index like the Dow Jones REIT Index.

Being an economist, I like using benchmarks that reflect the opportunity cost of an invesment. If a pension fund is investing in large U.S. buyout funds in their private equity portfolio, then the benchmark governing these asset class should be some spread above the S&P 500 like S&P + 500 basis points and lag it by on quarter for valuation purposes. The spread is there to reflect the illiquidity of these investments and the embedded leverage of private equity deals where general partners borrow to finance their purchases of private companies.

If you are investing in private real estate or infrastructure investments, then try to benchmark these assets relative to some market index of real estate or infrastructure stocks that captures the “beta” of these investments and add a spread for illiquidity and lag it by on quarter for valuation purposes.

Unfortunately, it’s not always possible to find the appropriate benchmarks that fits all pension funds in each of this alternative asset classes, but that is why you need a comprehensive performance audit to make sure they are not gaming their benchmarks to easily beat them.

Take hedge funds for example. Some strategies are liquid, others are illiquid, some use leverage, others use no leverage, and so on. Using an absolute return benchmark of T-bills + 500 basis points might seem appropriate, but what if your pension fund manager is investing in highly leveraged illiquid strategies? Up until last year, they would have trounced that benchmark, reaping huge bonuses, but then the music stopped and credit markets seized, effectively killing these strategies.

As I discussed before, it’s all about the benchmarks stupid! Unless the benchmarks reflect the risks, beta and leverage of the underlying investments, then you simply do not know if the value added your pension fund manager is claiming to add is really that or just a free lunch.

Let me end by looking at specific examples from pension funds. First, let’s look at PSP Investments’ Policy Portfolio from their latest investment policy:

You will notice that all the public markets indexes are properly disclosed but when it comes to private markets like private equity, real estate and infrastructure, PSP states that “for competitive reasons these benchmarks are not disclosed.”

What are these “competitive reasons”? Who is PSP Investments competing against? For crying out loud, it’s a public pension fund and a Crown corporation, not some secretive hedge fund! It is absolutely scandalous that they and CPPIB are refusing to disclose their private market benchmarks but see it fit to say that they added “significant value” in private markets when it comes time to collect their huge bonuses.

What’s a clear indication that a benchmark does not reflect the risks of the underlying investments? Again, take a look at the 2007 real estate returns from the large funds:

(Click to enlarge:)

You’ll notice that while OMERS, CPPIB and PSPIB “significantly outperformed” their real estate benchmarks, the Caisse underperformed it. This is because the Caisse policy benchmark for real estate is a lot tougher to beat because it accurately reflects the underlying beta, liquidity and leverage of their real estate investments.

The Caisse’s Policy Portfolio is clearly presented on page 32 of its 2008 Annual Report:

UK wages collapse at fastest rate in 60 years Telegraph

Timing of Goldman bond sale raises questions Financial Times

Why Congress Won’t Investigate Wall Street Thomas Frank, Wall Street Journal.

How Government Guaranteed Bank Debt May CRUSH Public Borrowing Clusterstock

Jobless Rate Rises In All US Metro Areas In March Huffington Post

Gagging on Google Willem Buiter

Unemployment Predictions: Why Reporters Must Use Caution When Listening to Economists Dean Baker

Antidote du jour (hat tip reader Barbara):

Polar bears Bill, right, and Lara seem to like each other at their first meeting at the zoo in Gelsenkirchen, Germany. Bill came from the zoo in Bruenn, Czech Republic, as a new partner for Lara.

The WHO has designated swine flu an “imminent” pandemic, and raised its alert to a level 5 out of a possible 6. The World Bank guesstimates the cost of a severe pandemic at 4.8% of world GDP (yikes!). Yet the US had a very nice day for equity investors yesterday, and the Japanese stockmarket is up handsomely as of this hour. What gives?

The usually dour Ambrose-Evans-Pritchard argues yes, in reporting that is less apocalyptic than his normal style, argues that investors are underestimating the possible repercussions:

Over the last couple of days I have been deluged by notes from City analysts and economists suggesting that H1N1 avian-swine flu poses no great threat to the global economy because the authorities showed during the 2003 SARS epidemic in Asia that outbreaks can be contained.

This is a misreading of the threat we face.

SARS is a coronavirus. It is extremely hard to catch. Just 8,000 people were infected worldwide during the entire epidemic (10pc died).

Today’s H1N1 outbreak is an influenza virus, which is far more contagious.

Dr. Keiji Fukuda, the WHO’s assistant director-general, said it is already too late to stop the spread of the disease. “At this time, containment is not a feasible option.

It is entirely possible that we may see a very mild pandemic. I think we have to be mindful and respectful of the fact that influenza moves in ways we cannot predict.

The worst pandemic of the 20th century occurred in 1918, and it also started out as a relatively mild pandemic that wasn’t very much noticed in most places. Then in time it became a very severe pandemic, one of the most severe infectious disease episodes ever recorded.

Perhaps because so few market players studied science, or have a current link to science, they seem not to realize that the world’s virologists and flu experts are in a state of nail-biting, ashen-faced, fear.

Rob Carnell, chief economist at ING, is one of the exceptions. “We believe fear of infection will lead to drastically altered behaviour. It may be that swine flu does not tip the human fear scale sufficiently, but if it did, with the economy already in tatters, the results could be catastrophic,” he said in a note today.

We may be lucky. The virus may indeed prove mild – like the Hong Kong flu in 1968 – or burn out altogether as it mutates.

The early cases in the US and Canada give hope. So does the apparent fall-off in the fatality rates in Mexico.

But as Dr Fukuda said, nobody can pre-judge the virulence of this pandemic. Least of all the markets.

Mexico City illustrates what can happen. People are avoiding discretionary outings. As the BBC reports:

What was once one of the noisiest, dirtiest, busiest places in the world, has become strangely sterile – a quiet city, where many people wear masks outdoors, and most don’t go out.

In Mexico City alone, the mayor, Marcelo Ebrard, has put the figure at $88m (£59m) a day

But how much will swine flu hit the wider Mexican economy?

Tourism, which represents 8% of Mexico’s gross domestic product (GDP), is the sector which will inevitably be hardest hit.
In the current environment, most people see little incentive to visit Mexico, and plenty of reason to leave.

The Mexican government has lobbied hard behind the scenes to prevent its borders being closed, or any formal quarantine being imposed.

But other governments and airlines are beginning to apply their own restrictions.

Cuba and Argentina have already stopped direct flights to Mexico. France is seeking a formal European ban on flights.
The real cost of swine flu depends on how long this crisis lasts.

UBS bank in Mexico City estimates the crisis could take out 0.2% of annual GDP if it subsides in the next two weeks, or 0.8% of GDP if it goes on for two months.

The New York Times reports that the Chrysler brinkmanship continues, with some small hedge funds acting as pigs in the hope of extracting yet more concessions from the government, as the bankruptcy deadline looms.

The reason the funds can play such hardball is that the Administration does not want to BK Chrysler. Despite all the cheery assertions of a speedy bankruptcy, there is no assurance that would indeed come to pass. Even in prepaks, where the creditors have a an arrangement they want a judge to bless. the process can become protracted. And a Chapter 11 filing with no creditor deal runs the risk of loss of customers as uncertainty hangs over the manufacturer, and a Chapter 11 could morph into a liquidation, with not only big job losses, but damage to significant suppliers who in turn may fail, causing problems for other US automakers and transplants..

The latest update on the negotiations from the New York Times:

Last-minute efforts by the Treasury Department to win over recalcitrant Chrysler debtholders failed Wednesday night, setting up a near-certain bankruptcy filing by the American automaker, according to people briefed on the talks.

Barring an agreement, which looked increasingly difficult, Chrysler was expected to seek Chapter 11 protection on Thursday, most likely in New York, these people said.

The automaker, which is in talks with the Italian automaker Fiat, would file for bankruptcy first. It subsequently would present an agreement with Fiat to the court for approval, possibly on Monday, these people said. They requested anonymity because they were not authorized to speak for the government.

A bankruptcy filing by Chrysler would be the first by one of Detroit’s three auto companies amid a devastating slump, and could serve as a preview of what a filing by General Motors might look like. G.M., which like Chrysler received federal assistance last year, faces a June 1 deadline for its own restructuring.

To win over several hedge funds, which have been holding out for better terms, the Treasury increased its cash offer to holders of Chrysler’s secured debt by $250 million, to $2.25 billion, these people said. If all of the secured holders would agree to the new deal, which would give them the cash in exchange for retiring about $6.9 billion of debt, Chrysler would still have a chance of restructuring out of bankruptcy court.

Several investment funds, however, continued to reject the Treasury’s sweetened offer at a vote of the lenders on Wednesday evening, people familiar with the talks said….

The Obama administration is adamant that every lender participate in the debt swap, according to people close to the talks. One reason is that the deal would face legal challenges.

The Wall Street Journal also sees a Chapter 11 filing as “imminent“

Talks between the Treasury Department and lenders aimed at keeping Chrysler LLC out of bankruptcy broke down Wednesday, making it all but certain the car maker will file for Chapter 11 protection Thursday, according to people familiar with the discussions.

Administration officials, who have been braced for a Chrysler bankruptcy filing for weeks, say all the pieces are in place to get the company through the court quickly, perhaps in a matter of weeks.

The talks with Chrysler’s lenders broke down after the Obama administration’s automotive task force worked into the evening to persuade several hedge funds and other lenders to accept a deal to reduce Chrysler’s debt, said people involved in the talks.

The Treasury boosted its most recent offer to lenders on Wednesday by $250 million to $2.25 billion in cash for the banks and hedge funds to forgive $6.9 billion in Chrysler debt, people familiar with the matter said.

J.P. Morgan Chase & Co., which leads the creditor group as Chrysler’s largest lender, gave the other 45 banks and hedge funds 90 minutes Wednesday to vote on the deal. A large number of the funds voted no and refused to budge, paving the way for an all but unavoidable trip to bankruptcy court, said people close to the talks.

How can the Administration spew such rubbish? Bankruptcies go quickly in the courthouse ONLY if there is a pre-negotiated deal with creditors. With no agreement, the fight with the lenders will continue in court.

James Kwak parsed the Administration’s dilemma:

I’ve been writing a lot about the game of chicken recently, most often in connection with the GM and Chrysler bailouts. On the Chrysler front, the game is in its last hours. Even after a consortium of large banks agreed to the proposed debt-for-equity swap, some smaller hedge funds are holding out for more money, and even the extra $250 million that Treasury agreed to kick in seems unlikely to keep Chrysler out of bankruptcy.

The problem is that bankruptcy is the only weapon Chrysler and Treasury have in this fight, and it’s a strategic nuclear weapon. Bankruptcy is the only threat that can get the bondholders to agree to a swap; but because a bankruptcy carries some risk of destroying Chrysler (because control will lie in the hands of a bankruptcy judge – not Chrysler, Treasury, the UAW, or Fiat), and taking hundreds of thousands of jobs with it, everyone knows that Treasury would prefer not to use it. The bondholders are betting that they can use Treasury’s fear of a bankruptcy to extract better terms at the last minute. (And it’s even possible that the large banks agreed to the swap knowing they could count on the smaller, less politically exposed hedge funds to veto it.) But Treasury may still press the button, because it needs to make a statement in advance of the bigger GM confrontation scheduled for a month from now.

So Treasury cannot win, If it calls the banks’ bluff, it risks a slow motion Lehman. The Times says “people briefed at the negotiation” believe Chrysler would emerge from Chapter 11. But bankruptcy, like war, has uncertain outcomes, and no automaker has emerged from bankruptcy (they have either been liquidated or sold in pieces or entirety).

Note Lehman was not rescued for essentially political reasons, that it was time to draw the line and show that there were indeed consequences for mismanagement. Here, again, some scalps ned to be harvested, since the banks are now completely out of hand in the utter shamelessness of their extortion. Kwak details their intransigence on other fronts in his post.

Revenge for behavior is often served cold. Recall Bear Stearns’ refusal to participate in the LTCM bailout created Ill will that caught up with it a decade later. But that’s no remedy in real time, when this rent seeking is taking place.

In the bad old days, you might have seen extra-legal measures. J, Edgar Hoover, then head of the FBI, was known to have dirt on pretty much anyone of consequence. People who take noisy political stands seem more subject than the average Joe to highly intrusive and costly IRS audits; uncooperative hedgies would seem ideal targets for that sort of harassment, and double goes for any entities that are subject to US regulations.

But I am concerned this behavior is setting the stage for another sort of extra-legal measure: violence. I have been amazed at the vitriol directed at the banking classes. Suggestions for punishment have included the guillotine (frequent), hanging, pitchforks, even burning at the stake. Tar and feathering appears inadequate, and stoning hasn’t yet surfaced as an idea. And mind you, my readership is educated, older, typically well off (even if less so than three years ago). The fuse has to be shorter where the suffering is more acute

But the banksters are eagerly, shamelessly, and openly harvesting their pound of flesh from financially stressed average taxpayers, and setting off a chain reaction in the auto industry which has the very real risk of creating even larger scale unemployment than the economy already faces. It’s reckless, utterly irresponsible, over-the-top greed.

And there is a tipping point, which I sense is closer than most imagine. Nassim Nicholas Taleb points out that thirteen centuries of peaceful ethnic coexistence in Lebanon exploded overnight into brutal, completely unexpected civil war. Everyone assumes America is too complacent for class warfare in the literal sense to erupt. The way the banksters are demanding to be disciplined, that assumption may prove naive.

Submitted by Edward Harrison of the site Credit Writedowns

This is an updated version of a post that I wrote yesterday at Credit Writedowns. Today we are going to see whether shareholders are going to back Ken Lewis, the embattled CEO of Bank of America, and his board. I see this as a watershed event in American corporate governance because, apparently the likes of Calpers are leading the charge to oust the board, or at a minimum Lewis (see articles on these efforts here and here at DealBook)

As Bank of America (BAC) prepares for its annual meeting, it is clear that things are coming to a head. At issue is the stewardship of Ken Lewis, BofA’s CEO. Over the past few days, I have written three posts regarding the increasingly acrimonious sparring surrounding Bank of America’s acquisition of Merrill Lynch.

• The horrible self-dealing of Ken Lewis and the principal-agent problem
• BofA CEO Lewis investigated by SEC
• BofA saga continues as John Thain calls Lewis a liar

The latest news is stunning: Bank of America’s MAC clause could probably never have been invoked because it had a specific exclusion for the deteriorating prices of legacy assets on Merrill’s books.

Here’s what it says. All you need to do is read the highlighted parts:

3.8 Absence of Certain Changes or Events. (a) Since June 27, 2008, no event or events have occurred that have had or would reasonably be expected to have, either individually or in the aggregate, a Material Adverse Effect on Company. As used in this Agreement, the term “Material Adverse Effect” means, with respect to Parent or Company, as the case may be, a material adverse effect on (i) the financial condition, results of operations or business of such party and its Subsidiaries taken as a whole (provided, however, that, with respect to clause (i), a “Material Adverse Effect” shall not be deemed to include effects to the extent resulting from (A) changes, after the date hereof, in GAAP or regulatory accounting requirements applicable generally to companies in the industries in which such party and its Subsidiaries operate, (B) changes, after the date hereof, in laws, rules, regulations or the interpretation of laws, rules or regulations by Governmental Authorities of general applicability to companies in the industries in which such party and its Subsidiaries operate, (C) actions or omissions taken with the prior written consent of the other party or expressly required by this Agreement, (D) changes in global, national or regional political conditions (including acts of terrorism or war) or general business, economic or market conditions, including changes generally in prevailing interest rates, currency exchange rates, credit markets and price levels or trading volumes in the United States or foreign securities markets, in each case generally affecting the industries in which such party or its Subsidiaries operate and including changes to any previously correctly applied asset marks resulting there from, (E) the execution of this Agreement or the public disclosure of this Agreement or the transactions contemplated hereby, including acts of competitors or losses of employees to the extent resulting therefrom, (F) failure, in and of itself, to meet earnings projections, but not including any underlying causes thereof or (G) changes in the trading price of a party’s common stock, in and of itself, but not including any underlying causes, except, with respect to clauses (A), (B) and (D), to the extent that the effects of such change are disproportionately adverse to the financial condition, results of operations or business of such party and its Subsidiaries, taken as a whole, as compared to other companies in the industry in which such party and its Subsidiaries operate) or (ii) the ability of such party to timely consummate the transactions contemplated by this Agreement.

(b) Since June 27, 2008 through and including the date of this Agreement, Company and its Subsidiaries have carried on their respective businesses in all material respects in the ordinary course of business consistent with their past practice.

(c) Since June 27, 2008 through and including the date of this Agreement, neither Company nor any of its Subsidiaries has (i) except for (A) normal increases for or payments to employees (other than officers subject to the reporting requirements of Section 16(a) of the Exchange Act (the “Executive Officers”)) made in the ordinary course of business consistent with past practice or (B) as required by applicable law or contractual obligations existing as of the date hereof, increased the wages, salaries, compensation, pension, or other fringe benefits or perquisites payable to any Executive Officer or other employee or director from the amount thereof in effect as of June 27, 2008, granted any severance or termination pay, entered into any contract to make or grant any severance or termination pay (in each case, except as required under the terms of agreements or severance plans listed on Section 3.11 of the Company Disclosure Schedule, as in effect as of the date hereof ), or paid any cash bonus in excess of $1,000,000 other than the customary year-end bonuses in amounts consistent with past practice and other than the monthly incentive payments made to financial advisors under current Company programs, (ii) granted any options to purchase shares of Company Common Stock, any restricted shares of Company Common Stock or any right to acquire any shares of its capital stock, or any right to payment based on the value of Company’s capital stock, to any Executive Officer or other employee or director other than grants to employees (other than Executive Officers) made in the ordinary course of business consistent with past practice under the Company Stock Plans or grants relating to shares of Company Common Stock with an aggregate value for all such grants of less than $1 million for any individual, (iii) changed any financial accounting methods, principles or practices of Company or its Subsidiaries affecting its assets, liabilities or businesses, including any reserving, renewal or residual method, practice or policy, (iv) suffered any strike, work stoppage, slow-down, or other labor disturbance, or (v) except for publicly disclosed ordinary dividends on the Company Common Stock or Company Preferred Stock and except for distributions by wholly-owned Subsidiaries of Company to Company or another wholly-owned Subsidiary of Company, made or declared any distribution in cash or kind to its stockholder or repurchased any shares of its capital stock or other equity interests.

Translation: If the market tanks and assets already on the books when this deal is consummated are marked down, then this is NOT grounds for Bank of America to renegotiate or pull out.

Look, here’s the story:

• Ken Lewis rushed into a terrible deal for Merrill Lynch at a grossly inflated price because he desperately wanted Bank of America to be a top notch franchise across the full spectrum of products. Merrill has a very good franchise and had a good brand until recently.
• The deal terms specifically excluded poor market conditions as a MAC clause. I should add that this is standard operating procedure in many mergers as I have been witness to countless MAC clauses with this very exclusion in mergers when I worked in Leveraged Finance and Corporate Development.
• John Thain was doing his duty in getting the best deal for his shareholders and protecting the 60,000 jobs of Merrill Lynch from a Lehman cataclysm. Ken Lewis was arguably not worried enough that he was overpaying and wasting shareholder money.

So, if Ken Lewis says that he told Hank Paulson and Ben Bernanke on December 21st that he was invoking the MAC clause, then this was a hollow statement because the MAC clause could not be invoked. Whether Lewis knew/knows that is unclear.

As for John Thain, the man has been pilloried publicly, in particular because of the bonus scandal and the office re-design. But, let me ask you this: was BofA going to underpay its vaunted Merrill money-makers in a one-off bonus round and risk their exiting the company? No. If you went to a Fortune 500 company with a new CEO, what would you guess the average amount spent for office renovations would be?

All of the Thain theatrics were bread and circuses, distracting us from the real issues: is our financial system safe yet and, if not, how can we most prudently ensure it is.

Bank of America was once one of the safe banks. It is no longer. And yet, to date no one has paid the price. However, now a movement is underway to oust Ken Lewis and the entire Board of Directors, something Hank Paulson allegedly threatened to do in December. Giant pension fund Calpers is leading the charge. To my mind this is an important moment in American capitalism. The pendulum had swung too far in favor of insiders, managers, and corporate executives with disastrous results and shareholder value destruction. It is time shareholders have more say over how things are run in Corporate America.

For more on this theme see a Fora TV video of Vanguard founder John Bogle decrying the growing failure to observe fiduciary responsibilities in America at Credit Writedowns.

Source
Definitive Proxy Statement (Schedule 14A), Merrill Lynch – BofA Merger – SEC Website

Submitted by Leo Kolivakis, publisher of Pension Pulse.

The third meeting of the Standing Committee on Finance focusing on pensions took place on Tuesday morning, placing more senior pension executives on the hot seat.

Before I continue, let’s recap what happened at the two first meetings. I went to Ottawa last week to expose the bogus benchmarks pension fund managers were using in private markets and hedge funds to justify their outrageous bonuses.

Two days later, PSP Investments’ (PSPIB) CFO, John Valentini, was on the hot seat, getting grilled for refusing to answer some basic questions on performance and bonuses.

You’d think that after watching that grilling the folks at the Canada Pension Plan Investment Board (CPPIB) would be wise enough to come to Ottawa better prepared to answer some very tough questions.

Apparently not. The two representatives of the CPPIB that appeared this morning were Don Raymond, Senior Vice-President, Public Market Investments and Benita Warmbold, Senior Vice-President and Chief Operations Officer.

You can read more about them and other senior executives at CPPIB by clicking here. Notice that prior to joining CPPIB, Mr. Raymond worked at Goldman Sachs for seven years and Ms. Warmbold worked eleven years as a Managing Director and CFO of Northwater Capital Management Inc., a well known fund of hedge funds in Canada. This is important information to keep in mind as I review today’s hearing.

You can view the entire meeting in English by clicking here (note French only version and floor version in both languages are also available and the transcripts will be available on this site).

There were other witnesses speaking today including:

• Jean-Claude Ménard, Chief Actuary of Canada from the Office of the Chief Actuary which is independent but situated within the Office of the Superintendent of Financial Institutions of Canada.
• Keith Ambachtsheer, President of KPA Advisory Services and founding director of the Rotman International Center for Pension Management (ICPM). Mr. Ambachtsheer has written books, including The Pension Revolution, and more recently an article for the C.D. Howe Institute, The Canada Supplementary Pension Plan (CSPP).
• Shirley-Ann George, Senior Vice-President, Policy at the Canadian Chamber of Commerce.
• Serge Pharand, Vice-President and Corporate Comptroller, Canadian National Railway
• Renaud Gagné and Germain Auclair, Communications, Energy and Paperworkers Union of Canada.

I enjoyed listening to all speeches. Mr. Ménard immediately made his speech available on the OCA’s website. He is a consummate professional who has profound respect for Parliamentary institutions which why he and his team take transparency and accountability seriously.

I have said it before and I will say it again: The Office of the Chief Actuary of Canada is THE model for transparency and accountability. If only other government departments and Canadian Crown corporations were run like the OCA, we’d have a lot less waste and a lot more accountability.

For his part, Mr. Ambachtsheer raised several excellent points on the The Canada Supplementary Pension Plan (CSPP). Where I disagree with Mr. Ambachtsheer is on how he blindly defends the governance of the large Canadian pension funds, including their outrageous bonuses based on bogus benchmarks in alternative investments.

[Note: Mr. Ambachtsheer should come clean and say who pays for his services at KPA Advisors: the pension funds or the beneficiaries who those pension funds invest on behalf of? If the pension funds are his clients, it's hardly surprising he defends their governance model, ignoring some of the weaknesses in their compensation structure.]

Mr. Gagné and Mr. Auclair rightly noted that while the auto sector and banks are getting bailouts, the forestry industry has been getting decimated and is being ignored by the federal government.

Let me add something here. I read an article today about a Newfoundland man and his wife facing financial ruin because of troubled newsprint giant AbitibiBowater’s decision to suspend his pension:

“Devastated, really,” said Wilson Pike, 61, a former seasonal woodsworker for AbitibiBowater in Grand Falls-Windsor who opted to leave his job three years ago for a type of early retirement program.

AbitibiBowater, which has applied for bankruptcy protection in Canada and the U.S., said Friday it cannot maintain such programs.

“I figured I was set until I was 65. But now I don’t know where to turn, really,” said Pike, who had worked for Abitibi for 41 years.

Wilson and his wife Beverly lead a modest life on a budget of $1,200 per month.

Because the Abitibi payments have stopped, the two are using Canada Pension Plan payments to cover this month’s rent, and have about $200 left to pay for groceries and cover their other bills.

“I know that seems a little to some, but it’s our survival,” said Beverly Pike, who is legally blind and has no income of her own.

“My husband has enough on his shoulders to worry about, taking care of me. We didn’t need this extra stress.”

Beverly’s medical bills last year reached $9,000. Abitibi had allowed them to buy into the company medical plan for about $100 per month.

“Canada Pension is not going to cover it. So what we’re going to have to decide to do is either we have medical insurance, or if we eat,” she said.

“It’s just as simple as that, ’cause there’s not enough money to go around.”

The Pikes said they are hoping that a court challenge planned by the Communications, Energy and Paperworkers Union will force AbitibiBowater to restart its payments.

If that doesn’t work, Pike said he will have to re-enter the job market to make ends meet.

Keep Mr. and Mrs Pike in mind as you listen Mr. Raymond and Ms. Warmbold defend the outrageous bonuses that were handed out to the senior executives at the CPP Fund.

The table below was taken from page 54 of CPPIB’s 2008 Annual Report

(click to enlarge:)

In case you can’t read it clearly, let me go over the top four compensation packages doled out in fiscal year 2008 which ended March 31st, 2008 (same fiscal year as PSPIB):

1) David Denison, President and CEO: total compensation 2008: $4,163,966 (his base salary is $475,000)

2) Mark Wiseman, Senior VP, Private Markets: total compensation 2008: $3,107,840 (his base salary is $325,000)

3) Don Raymond, Senior VP, Public Markets: total compensation 2008: $2,626,073 (his base salary is $325,000)

4) Graeme Eadie, Senior VP, Real Estate Investments: total compensation 2008: $2,515,431 (his base salary is $300,000)

During question period, Ms. Warmbold evaded a direct question asking her to disclose the performance for fiscal year 2009 which just ended on March 31st. (I guess they are not finished valuing those private market investments!).

Mr. Mulcair noted that Mr. Raymond has a higher base salary than the Prime Minister of Canada and the Chief Justice of the Supreme Court of Canada.

I would argue that the Prime Minister of Canada and the Chief Justice of the Supreme Court of Canada are grossly underpaid, especially when you compare their responsibilities to those of the senior executives at CPPIB.

But that’s not the point. The point is that Canadian public pension fund managers are paid too much for what they claim to be delivering. And what are they doing to justify these outrageous bonuses? They are increasingly shifting assets into private market investments and hedge funds where it’s easier to game performance benchmarks so they can continue to scam the system and claim “significant value added”.

[Note: Read Steven Chase's article in the Globe and Mail, Curb CPP managers' bonuses, opposition urges.]

When pressed to diclose the performance benchmarks for private markets, Mr. Raymond remarked that they do account for leverage (news to me), but he did not disclose what these benchmarks are composed of so we cannot verify his claims.

My question to both CPPIB and PSPIB is if the Caisse discloses all their benchmarks, including those of private markets (private equity, real estate, and infrastructure) then why do they refuse to disclose them?

PSPIB cites “competitive reasons” (what the hell does that mean?) and CPPIB does not properly disclose their private market benchmarks in their annual report or investment policy.

I will repeat it once again: unless you disclose all the benchmarks governing public market and private market investments, you simply do not know whether the reference portfolio used to compensate pension managers accurately reflects the liquidity risk, leverage and beta of the underlying investments.

I can show you 100 ways of how to scam pension plans by using bogus benchmarks in private markets and hedge fund investments. I can also show you how some accountant can write up or write down assets by one single magical stroke of a pen.

What’s a clear indication that a benchmark does not reflect the risks of the underlying investments? Well, take a look at the 2007 real estate returns from the large funds:

(Click to enlarge:)

Whenever a fund is handily beating a benchmark in “private markets” or “hedge funds”, year in and year out, you can bet your taxpayer dollars there are shenanigans going on. I have never in my life seen such incredible outperformance in the public markets (does your mutual fund outperform the Dow or S&P 500 every single year by 10%, 20% or 30%?!?!?)

Bottom line: Unless we augment financial audits by comprehensive performance, operational and fraud audits, our large public pension funds are vulnerable to further abuses. It is a scandal.

And let’s call a spade a spade: the compensation packages at these large Canadian public pension funds is a scandal. All upside, no downside. If they screw up, most of these guys walk away with a golden parachute.

Again, while Mr. Raymond and Ms. Warmbold defend their compensation based on a “four year rolling return”, there are people like Mr. and Mrs. Pike struggling to get by on next to nothing.

My eyes rolled behind my head when I heard Mr. Raymond claiming the reason they avoided non-bank asset-backed commercial paper (ABCP) at CPPIB is that their compensation allowed them to attract bright people to analyze these investments.

Give me a break! Do you really think the folks over at CPPIB are that much brighter than the pension managers at the Caisse? I can assure you they’re not, and in many areas, they are a much weaker.

Mr. Raymond said the “focus on short-term results” is not in the best interests of beneficiaries. Agreed, but when you are losing billions and claiming value added in private markets without properly disclosing the benchmarks of those private markets, you are scamming the system.

I had lunch today with a former colleague of mine who was a senior public market pension manager. He knows all about the nonsense surrounding the benchmarks in private markets. He never had a free lunch trying to beat public market benchmarks.

He also had a great idea. “They should scrap the four year rolling returns, keep long-term incentives in escrow and use clawbacks if the fund or a particular portfolio suffer a hit. They should all get decent salaries, but not these outrageous salaries, bonuses and generous retirement benefits.”

Let me end this comment by asking CPPIB to post their remarks on their website. I find it inexcusable that those remarks are not already posted there for public scrutiny. You claim to be transparent but all I see is “selective transparency” as long as it suits you and your compensation.

And one final thought on compensation. Nobel-prize winning economist, Paul Krugman wrote a excellent op-ed column in the New York Times called Money for Nothing.

I quote the following:

Still, you might argue that we have a free-market economy, and it’s up to the private sector to decide how much its employees are worth. But this brings me to my second point: Wall Street is no longer, in any real sense, part of the private sector. It’s a ward of the state, every bit as dependent on government aid as recipients of Temporary Assistance for Needy Families, a k a “welfare.”

I’m not just talking about the $600 billion or so already committed under the TARP. There are also the huge credit lines extended by the Federal Reserve; large-scale lending by Federal Home Loan Banks; the taxpayer-financed payoffs of A.I.G. contracts; the vast expansion of F.D.I.C. guarantees; and, more broadly, the implicit backing provided to every financial firm considered too big, or too strategic, to fail.

One can argue that it’s necessary to rescue Wall Street to protect the economy as a whole — and in fact I agree. But given all that taxpayer money on the line, financial firms should be acting like public utilities, not returning to the practices and paychecks of 2007.

Furthermore, paying vast sums to wheeler-dealers isn’t just outrageous; it’s dangerous. Why, after all, did bankers take such huge risks? Because success — or even the temporary appearance of success — offered such gigantic rewards: even executives who blew up their companies could and did walk away with hundreds of millions. Now we’re seeing similar rewards offered to people who can play their risky games with federal backing.

So what’s going on here? Why are paychecks heading for the stratosphere again? Claims that firms have to pay these salaries to retain their best people aren’t plausible: with employment in the financial sector plunging, where are those people going to go?

No, the real reason financial firms are paying big again is simply because they can. They’re making money again (although not as much as they claim), and why not? After all, they can borrow cheaply, thanks to all those federal guarantees, and lend at much higher rates. So it’s eat, drink and be merry, for tomorrow you may be regulated.

Or maybe not. There’s a palpable sense in the financial press that the storm has passed: stocks are up, the economy’s nose-dive may be leveling off, and the Obama administration will probably let the bankers off with nothing more than a few stern speeches. Rightly or wrongly, the bankers seem to believe that a return to business as usual is just around the corner.

We can only hope that our leaders prove them wrong, and carry through with real reform. In 2008, overpaid bankers taking big risks with other people’s money brought the world economy to its knees. The last thing we need is to give them a chance to do it all over again.

I sincerely hope that the leaders who sat in on these hearings at the Standing Committee on Finance heed my advice and further investigate the activities at these large public pension funds.

It is time to have special hearings focusing exclusively on public pension funds. Bring in the CEOs and chairs of the boards of PSPIB and CPPIB and ask them some very tough questions on how they added value in public and private markets. It’s public monies they are managing so they should be held accountable for their decisions.

Chemical ‘caterpillar’ points to electronics-free robots New Scientist.

Rudd sides with the bigots Larvatus Prodeo.I had found Australians to more tolerant of gays than Americans (you see a gay angles played up in advertising, which is inconceivable here) so this is surprising.

The Last Temptation of Risk Barry Eichengren (hat tip reader Dave)

Fed Is Said to Seek Capital for at Least Six Banks After Tests Bloomberg

Milan Police Seize UBS, JPMorgan, Deutsche Bank Funds Bloomberg

Green shoots: grounds for cautious pessimism Willem Buiter

Sticky Leverage Wall Street Journal (hat tip reader Don)

Days could be numbered for BofA and Citi CEOs Reuters

Bronte Capital with a Major Scoop on Alleged Fraudster Columbia Journalism Review (hat tip reader Tim S) and Fraudulent hedge fund associated with the Vice President’s family harasses blogger John Hempton

Antidote du jour (hat tip reader Martin):

Well, that isn’t exactly how the Financial Times’ Martin Wolf put it, but his comment today does carry a sobering message. Bank balance sheets need a tremendous amount of additional shoring up.

Some not too pretty factoids:

We appear to be less than halfway through writedowns, and the fundraising and recapitalizations to date are falling short of the equity hits. Wolf thinks the ability to raise funds privately is nada.

Banks also have significant maturing debt in 2010 and 2011. If they can’t roll it at an attractive price, that means balance sheet shrinkage. And believe it or not, the myriad of lending support programs represents only 1/3 of the IMF’s estimate of total needs. Yes, the US has the FDIC guaranteeing bank bond issues; it will probably expand that program further. But if that continues (likely) it again continues the dangerous pretense that banks are private concerns that claim the need to give employees decent pay, when they are in fact wards of the state and should be regulated as utilities. or put into receivership and restructured.

The gloomy calculus does not include the implosion of the shadow banking system, a bigger source of credit than the banking system. Unless private securitization can be restored (ahem, no progress on the needed reforms), even more capital in the banking system is needed.

One thing that Wolf does not allow for is that some shrinkage in credit is necessary, if nothing else due to the fact that people who were not creditworthy got loans. But that presumably shows up mainly in the contraction of non-bank credit.

Wolf is nevertheless optimistic that the fiscal cost (13% of US GDP) is manageable. But is it politically viable? The restructuring of Japan’s banks was delayed nearly a decade due to popular hostility. Continued rescues of banks are more and more difficult to sell politically as the unwashed public keeps being reminded that we pay for the losses but the perps get to keep the gains.

And the finesses are running into opposition too, although at this point it’s just a rumble. For instance, the Senate version of the budget resolutions contained language calling for the Federal Reserve to identify banks and other financial institutions that have received more than $2.2 trillion in taxpayer-backed loans and other financial assistance since March 24, 2008. A letter to John Spratt signed by Alan Grayson, Ron Paul, Walter Jones, Corrine Brown, Michelle Bachmann, and Peter Defazio asked for the Senate language to be incorporated in the House version:

Under Chairman Bernanke, the central banking system has opened a range of extraordinary funding facilities that are providing additional credit to banks, large financial institutions, and primary brokers, as well as guaranteeing commercial paper. All of this activity is happening in secret, with the Federal Reserve disbursing money and credit to the large financial institutions that have put our credit markets and economy at risk. The Federal Reserve has resisted FOIA requests, and will not make public even the terms of payment for the contractors it is using to run these extraordinary programs.

At the very least, Congress and the public should have knowledge about which banks are receiving taxpayer money, what they are doing with the money, and the credit risk taxpayers are taking on through the Federal Reserve. The Senate language encourages such transparency, allowing for audits and public disclosure of secret loans and financial assistance from the Federal Reserve to these large institutions.

The more the Fed acts as what Willem Buiter calls “a quasi-fiscal agency of the Treasury”, the more turf struggles we will see over its role and accountability.

From the Financial Times:

The International Monetary Fund’s latest Global Financial Stability Report provides a cogent and sobering analysis of the state of the financial system. The staff have raised their estimates of the writedowns to close to $4,400bn. …

To put this in context, the writedowns estimated by the IMF are equal to 37 years of official development assistance at its 2008 level…

The IMF estimates the additional equity requirements of the banks as well. It starts from total reported writedowns up to the end of 2008, which come to $510bn in the US, $154bn in the eurozone and $110bn in the UK. The capital raised to the end of 2008 is, again, $391bn in the US, $243bn in the eurozone and $110bn in the UK. But the IMF estimates additional writedowns in 2009 and 2010 at $550bn in the US, $750bn in the eurozone and $200bn in the UK. Against this, it estimates net retained earnings at $300bn in the US, $600bn in the eurozone and $175bn in the UK.

The IMF points out that the ratio of total common equity to total assets – a measure investors burned by more sophisticated risk-adjusted ratios increasingly trust – was 3.7 per cent in the US at the end of 2008, but 2.5 per cent in the eurozone and 2.1 per cent in the UK. The IMF concludes that the extra equity needed to reduce leverage to 17 to 1 (or common equity to 6 per cent of total assets) would be $500bn in the US, $725bn in the eurozone and $250bn in the UK. For a 25 to 1 leverage, the required infusion would be $275bn in the US, $375bn in the eurozone and $125bn in the UK.

In current dire circumstances, the chances of raising such sums from markets are zero. Part of the reason is that they could still prove to be too little…..

Yet these are not the only sums required. Governments have so far provided up to $8,900bn in financing for banks, via lending facilities, asset purchase schemes and guarantees. But this is less than a third of their financing needs. On the assumption that deposits grow in line with nominal GDP, the IMF estimates that the “refinancing gap” of the banks – the rollover of short-term wholesale funding, plus maturing long-term debt – will rise from $20,700bn in late 2008 to $25,600bn in late 2011, or a little over 60 per cent of their total assets (see chart below). This looks like a recipe for huge shrinkage in balance sheets. Moreover, even these sums ignore the disappearance of securitised lending via the so-called “shadow banking system”, which was particularly important in the US.

The IMF also provides new estimates of the ultimate fiscal costs of rescue efforts (see chart below). At the high end are the US and the UK, at 13 per cent and 9 per cent of GDP, respectively. Elsewhere, costs are far lower. These, happily, are affordable sums. Indeed, compared with the recession’s impact on public debt, they look quite manageable…

A better reason for refusing to bail out banks is its dire effect on incentives. The alternative must then be bankruptcy. Jeremy Bulow of Stanford University and Paul Klemperer of Oxford University have advanced a scheme that would do this neatly. Valuable banking functions of each institution would be split off into a new “bridge” bank, leaving liabilities (apart from deposits) in the old bank. Creditors left behind would be given equity in the new bank. Governments could “top up” some creditors beyond this level, without making all creditors whole, as now.

Respectable opinion assumes that it would be best to provide full bail-outs of creditors in systemically important institutions. The rationale for this is that it is the only way to eliminate further panic. The objection is not the fiscal cost. It is that a limited number of large, complex and “too-big-to-fail” institutions would then emerge. Their creditors would naturally believe they were lending to governments. This would be a recipe for yet bigger catastrophes in future years.

Yet imposing large losses on creditors is indeed risky. It would probably have to be done simultaneously everywhere. Only after it was obvious that surviving banks were sound would anybody be willing to lend to them without guarantees.

Even worse than this choice between grim alternatives is the fact that the path to recovery is likely to be slow, whichever is chosen. As the latest World Economic Outlook notes in an important chapter, recessions that follow financial crises are unusually severe. So, too, are globally synchronised recessions. But now we are living through a globally synchronised recession that coincides with a huge financial crisis that emanates from the core countries of the world economy, particularly the US. This is a recipe for a long recession and a weak recovery. Whatever is done about the financial system, “deleveraging” is the order of the day (see chart). The UK’s position in this looks dire. But that of the US looks quite bad, too, even compared with that of Japan in the 1990s.

For better or worse, the authorities have decided to bail out their financial systems with taxpayer money. Almost all the affected countries should be able to afford to do this, at least on the IMF’s numbers. So now, having made the fundamental decision to prevent bankruptcy, they must return their financial systems to health as swiftly as they possibly can.

Even so, that will prove to be a necessary, not a sufficient, condition for a return to robust economic health. The overhang of debt makes deleveraging inevitable. But it has hardly begun. Those who hope for a swift return to what they thought normal two years ago are deluded.