Possible new sources of the financial contagion

Roubini's RGE Monitor reports that EU banks are not looking so safe, and that their collapse will not be supported by their home countries, many of whom have smaller economies individually than the US.

• Daniel Gros/Stefano Micossi: The “overall leverage ratio” - a measure of total assets to shareholder equity - of the average European bank is 35 due to large in-house investment banking operations, compared with less than 20 for the largest U.S. banks. This means that relatively small writedowns on their assets could have a devastating impact on a bank’s capital--> some EU banks have become too big for any one European country to save while an official cross-border crisis management mechanism with ex ante burden sharing is not in place.
• The crucial problem on this side of the Atlantic is that the largest European banks have become not only too big to fail, but also too big to be saved. For example, the total liabilities of Deutsche Bank (leverage ratio over 50!) amount to about €2,000bn (more than Fannie Mae) or more than 80 per cent of the gross domestic product of Germany. This is simply too much for the Bundesbank or even the German state
  

What are the implications of RGE's analysis? A US bailout is useless if a world contagion can just as easily start in Europe. Maybe we need to start looking at the alternatives. Prof. Roubini gives his idea here.

Bank Capital and the law of unintended consequences

Economists make much use of the term “Law of Unintended Consequences”. In brief, unintended consequences are outcomes that are not (or not limited to) what the actor intended in a particular situation. The unintended results may be foreseen or unforeseen, but they should be the logical or likely results of the action.

There have been a lot of arguments lately that a lot of the factors that led to the subprime crisis have been unintended consequences of well-intentioned government policies and regulations. For example, Economist’s View links to this argument that summarizes how the repeal of the Glass-Steagall act, the Bush tax cuts, and the low Federal funds rate have led to the current financial crisis.

Building on a previous post I had on Basel capital adequacy standards, I’d like to add that this well-intentioned set of international standards also contributed indirectly to the current mess. Basel standards recommends banks to have at least a 10% capital-to-risky assets ratio. That means, a bank needs to have at least 10% as much in capital as the amount of risky assets it invests in. By risky assets, we mean all bank lending and investments in risk-weighted assets. By capital, we mean equity capital, and in no way includes funds coming from bank deposits or bank borrowings.

Generally, the riskier an investment is, the more risk-weight it is given by Basel. A credit-grade mortgage loan will be given 50% risk weight, while a credit-grade regular consumer or corporate loan will be risk-weighted at 10%. Only investments in relatively risk-free government securities are given zero risk weight. That means, the more a bank allocates its funds to risk-weighted loans, the more it needs to have in equity capital. The more loans in a bank’s books, the higher its equity capital needs to be to maintain a capital ratio deemed adequate by Basel standards.

But raising bank equity does not happen in a vacuum. Just because a bank has sufficiently high deposits to loan out doesn’t mean shareholders will be flocking to provide it with new capital. To attract these investors, the bank would have to provide a comparable return to other investment alternatives. But to maintain the capital adequacy, the bank would have to redeploy this equity capital in low risk weight assets.

Government securities have zero risk weight, but in the environment of low Fed funds rate, the liquidity that resulted ensured that government securities provided meagre yield. Certainly not enough to increase bank earnings sufficient to attract new equity holders. So a good number of banks and insurance firms chose to put these funds into the asset class available at the time that had the next to lowest risk weight , AAA-rated CDO bonds.

Of course, the fact that these toxic CDOs made up of sub-prime loans were ever rated AAA by ratings agencies has already been widely discussed in public forums. But the fact is, banks and insurance firms, compelled by international best standards to maintain adequate equity cover, for loans in the case of banks, or for cover liabilities in the case of insurance firms, but also compelled by equity holders to provide the highest possible yield at reasonable risk, investing in AAA-rated CDOs seemed like a reasonable thing to do. Granted, much more due diligence should have been done on the underlying assets backing up these securities, but then, the presence of a rating meant that reasonable due diligence had already been done by experts on these matters.

So here we are, with banks loaded up with toxic securities, and no willing market to buy them out. At least, nowhere close to what the banks think they should be worth. With no willing market, the reasonable value for these securities should be what they would fetch for, as Bernanke called it, “firesale prices”.

No bank would of course unload them at firesale prices when they in fact could hold on to them up to maturity, and earn a much higher yield. By how much more, nobody will know til maturity. But given the inevitability of equity writedowns a firesale will result to, holding on is the more rational choice to do.

A consequence of course, is the loss of credibility of banks among each other. No bank will lend to another bank that can, at an instant, need to liquidate at firesale prices, and default on its borrowings as a result.

Suggested modifications to the “Paulson-Bernanke plan” have included making bank shareholders pay the penalty for the sins of the banks in creating the current mess. This is reasonable given that taxpayers will be footing the bill of the bailout, and they had nothing to do with messing up the financial markets.

But an unintended consequence of wiping out all existing shareholders of the banks is that unless the government’s capital injection is sufficient to provide adequate capital cover, these banks will have to operate either at sub-standard capital ratios, or start providing loans at more prohibitive rates, to earn back their lost capital.

Morgan Stanley, Goldman Sachs to become bank holding companies

This Bloomberg news story announces that Morgan Stanley and Goldman Sachs have been approved to become bank holding companies.

What a difference a decade makes. A decade ago, everybody wanted to be an investment bank, and it was the commercial banks rushing to get in. It was the investment banks who could leverage their investments, thereby achieving superior returns. Now, this business model has been rendered inutile, and the name of the game is now being the fund source yourself.

It’s now way much better to be a commercial bank than an investment bank. You are funded by low-cost deposits, you have more boring but recurring income, and most importantly------you are first in line for a Fed bailout!

Hail to the new masters of the Wall St. universe, the commercial banks.

Arguments for and against the ban on ALL short selling

Is the outright ban on short selling a good move by the government? Does it make sense? Or is it a costly brake on a crucial market check and balance from launching the next “irrational exuberance”? There are good arguments for both sides, and many of these arguments can be found in both the main article, and in the comments section, of this post from the UK Telegraph.

Among the arguments against the ban:

From the author: "Liquidity will now dry up in these stocks so that any buying or selling of the affected companies will have massive ramifications on the prices of the companies concerned as dealers and Market Makers just pass the risk on immediately down the line, generating swathes of price action on limited business.

With limited ability to borrow stock, Market Makers will widen prices to reflect the increased risk and costs of transaction. With bank share prices now propped up artificially, it makes it even more difficult to decide on where to place funds as the information provided by share price movements is no longer available."

From the commenters: "Most short selling is done as part of a combined package of trades. The short selling part of which is usually a form of hedging i.e. to reduce risk in a financial position. e.g. convertible bond volatility trading requires the "equity option" element of the bond to be hedged. This is done by selling short enough shares to offset the implied long position in the option. Once hedged the trading position makes money when the price of the shares goes "up" OR "down". This trading strategy is indifferent to share price movements in either direction, only that they do move up or down (hence the name - volatility trading). The embargo on short selling is not only foolhardy, but will not give those seeking a convenient scapegoat a target for long. Sentiment is driving the lack of liquidity in the capital markets(not economic fundamentals or short selling)"

Arguments from those for the ban, all coming from the commenters:

“I’m a fervent believer in the increased market efficiencies of short selling. But, unlike “longs”, “shorts” can create a self-fulfilling prophecy of value destruction when a company needs capital - or when the shorts instil fear in an already fearful marketplace.

Thus, while short selling may well serve a wonderful purpose in nearly all market conditions, the market today is not “orderly”. Instead, it is getting dangerously close to a panic. In this environment, shorting is creating a market inefficiency (immediate business closures / sales based on incomplete information), whereas in normal times it creates a market efficiency. I am not an advocate the ban of all new short positions in the financials indefinitely. Had the regulators failed to do this, I believe that we really could have created a downwards spiral that could unwind both our financial system and our economy in a dangerous way.”

“There is always going to be moral dilemma in a society that has to be guided by 'common humanity' and promotes human rights that allows individual freedom and emancipation. But, we are part of a large society which must be sustained and given vitality. So like in times of great disaster where society is in danger, governments must intervene and regulate.”

“Free Markets are all very well, but when you see them stampeding about like great big herds of cattle that have been spooked, it's time to ask whether they should not be reigned in a little through regulation."

“Now free trading of stocks is an essential element of our society that should be safeguarded. However, borrowing gigantic amounts of stock and then leveraging this borrowed stock to create self-fulfilling market conditions (greatly exacerbated by automatic trading software that will dump stock that crashes through their pre-set minimum) seems to be good for little else than creating instability. In fact, it is most difficult to see how it contributes to equilibrium stock pricing, which is the first function of the stock market. Short-selling may "alert people to the weakness of a stock", but ordinary trading will do that just as well, and more gradually.”

My own opinion is that, though I generally agree with the principle that short selling is a good market corrector, banning it at this time is a crucial component of the government’s solution to the crisis.

Given that the painful solution involves bailing out institutions that are deemed too big and inter-connected to fail, allowing short selling to continue would have only made the bailout more expensive for the taxpayer. Short selling was making it even harder for the financial institutions to raise needed capital. It would have been another form of privatizing gains (for the short sellers) while socializing losses (to the taxpayers). Looking at the larger picture, it is not about rewarding the reckless behavior of the banks.

So I agree that banning short selling made sense, and I also agree that it should be only until this crisis has been resolved. I trust that the government, with the guidance of the market, should know when that ban has had its run.

Similar-themed post here.

A visual diagram of inter-connectedness

Mark Thoma of Economist's View posts this useful diagram that visually captures how an inter-connected entity can affect the network of entities connected to it. Imagine each entity in such a network functioning as nodes. If one node in the network malfunctions, then each spoke connected to it is affected, and if these in turn function as nodes themselves to other spokes, it doesn't take long before the malfunction of one node short-circuits the entire system.

Prof. Thoma says: Since measures of connectedness exist, and I presume physicists also have such measures (of complexity), I'm wondering if financial market regulators should start developing measures along these lines. Can we measure the connectedness of financial institutions econometrically? If so, can we also follow along the lines of the Hirfandahl index for monopoly power and develop guidelines for when a firm is too interconnected with other firms, so interconnected that it's failure threatens the overall system? Couldn't we then "break-up" the firms the way we do monopolies, "disconnect" the firm until it's failure wouldn't be so devastating?

As pointed out above, size alone isn't the key feature, the degree of connectedness (complexity) is also important, and regulators - as far as I know - don't have good empirical tools for assessing this aspect of financial markets.

Perhaps a way to easily "disconnect" firms is for regulators to emulate what competent electricians have been doing all along - require that firms create alternate connections along crucial nodes in the circuit. Might just add more complexity in the case of financial firms though.

The most sensible containment plan for the credit crisis - so far.

Senator Charles Schumer just now proposed probably the most sensible containment plan for the credit crisis. He suggested the setting up of an entity similar to the Resolution Trust Corporation during the S&L crisis of the '80s.

The plan calls for the government to set up an entity that will take out the toxic CDOs from the books of the financial institutions, warehouse these securities while the banks re-build their balance sheets and start lending again, and at some point in the future, resell the CDOs to the market.

The most potent force propagating the deleveraging in the financial sector is a crisis of trust and confidence among the banks. Because many of them are holding sub-prime CDOs, they are now no longer lending to each other. And because these CDOs keep being written down, the banks who own them have had to take repeated hits on their capital. With each capital hit, banks have had to sell more assets at lower prices, causing the next wave of writedowns.

George Soros has a term for this vicious cycle – reflexivity. Downturns causing panic causing more downturns. But this panic is actually being fuelled by the mark-to-market accounting rule. This rule forces banks to mark the value of ALL their asset,s based on the clearing price of the last transaction, regardless whether they had planned to sell all these assets at a foreseeable future time.

The planned warehousing of CDOs can do the job of short-circuiting this reflexivity. With CDOs no longer in banks’ books, they will no longer have an asset class with a continuously declining value. They can then focus on re-building their asset base, confident of the stability of their remaining assets.

Who knows, at some point in the future, when we have fully determined how much of these CDOs will really default, a market for them will return and the government entity holding them can sell them at a profit.

So here are my two $64,000 questions: How will the government value these CDOs, and how will it raise the funding to buy them? Senator Schumer plans to discuss the plan in detail later today.

If you happened to be a shareholder of AIG, Lehman, Fannie, Freddie or Bear, too bad your firm didn’t make it till today, before all the value of your holdings went down the drain. Such is life.

Update: Senator clarifies that, unlike the RTC solution of the '80s, his plan does not call for acquiring the pool of CDOs from the banks. It calls for acquiring stakes in the banks, in exchange for taking these out of their books. Therefore, it will be cheaper than an outright buyout of the securities, which do not have an alternate market right now, and hence, have no verifiable market value. The money will come from the Fed's reserves, which he says, is enough to acquire the stakes.

New $64,000 question: How will this change Wall St., now that the government is poised to become a minority stakeholder in practically all the financial institutions?

How to avoid financial crisis in the future? Decrease the number of banks

So the Fed finally decided to help AIG out. It’s true, as I pointed out in my last post, AIG, an insurance firm not under the regulatory jurisdiction of the Fed - is too big to fail. The Fed had no choice but to come to the rescue.

Unfortunately, nowadays, we do have an abundance of globally inter-linked institutions that are now too big to fail. And they are all prime candidates for a government bailout should any of them end up with unlucky trades. Theoretically, we could have an endless line of institutions who can “privatize profits but socialize failure”.

So what’s a regulator to do?

The Fed need not end up regulating all “non-bank” financial institutions that come into existence. That will only end up giving the Fed responsibility for their viability as ongoing concerns. What the Fed needs to do is to come up with a more stringent framework for regulating the largest counterparty transactions of those institutions that do come under its umbrella – the banks.

Unfortunately, that can amount to endless reams of transactions to review for each bank under the Fed’s purview.

A possible solution? Decrease the number of banks. This lessens the network effects of a larger population of banks inter-dealing with one another. That might still leave us with fewer banks that get to grow even bigger, and definitely too big to fail. But at least, among these few, the level of regulatory scrutiny can be deeper.

Think about it. Less banks. Less unbridled greed. Less destructive maneuvering for profit. Less to bail out. But greater oversight over the few.

Hedge funds and independent broker-dealers can go on being unregulated. But if they enter into a significant transaction with a regulated bank as the other party, the Fed can and will know all the details.

Mr. Bernanke, what about incentivizing more consolidation?

Update: As of mid November, I may have changed my mind.

If AIG collapses, the meltdown will really be global

Back in July, we said that it was now becoming evident that the greatest threat to the global economy was not rising core inflation, but the US credit crisis.

Now here comes the biggest kahuna in the financial markets to possibly fail – AIG. While a bankruptcy by Lehman will shake the US financial system to its tethers, a failure by AIG will be globally catastrophic. To give perspective on the extensive list of countries where AIG has a major presence as an insurer or financial counterparty, click here.

With AIG now on the line, the financial crisis will no longer be just tied to the US housing crisis, it will extend to all economic activities in the world that function on the confidence of insurance coverage. Imagine how much more insurance coverage will cost if it fails. Imagine how many pension accounts will be lost.

The tumble in equities and derivatives in various markets worldwide that will be caused by an AIG asset liquidation will be huge, that otherwise healthy banks operating in still healthy economies could suddenly find themselves severely undercapitalized.

Good-bye Lehman, good-bye Merrill

Lehman Brothers declared bankruptcy last night, and Merrill Lynch, feeling that it would be the next to be attacked by speculators, has agreed to be acquired by Bank of America.

With Lehman’s bankruptcy proceedings expected to unleash a torrent of asset sales, many smaller investment banks and hedge funds holding similar assets will likely be toppled over by the riptide, even the 2 remaining independent bulge bracket investment banks, Goldman and Morgan, are likely going to be severely affected.

Insurance giant AIG is also on watch as it is today the biggest threat to the market. If it does a Lehman, the riptide of asset sales might even be big enough to sweep Goldman and Morgan.

Welcome to the nadir of the US financial market perfect storm.

When this is all over, there could be only 5 global one-stop banking powerhouses remaining and viable, while the rest will be reduced to becoming niche players. It was meant to happen this way anyway. After all, it was too many firms chasing after too few good deals that got these firms taking on undue risk and closing deals that did not make sense anymore.

By allowing Lehman to fail, the US Fed finally indicated that it has had enough of bailouts. Market forces will be taking it from here in resolving the crisis. It won’t be pretty, but at least, we know how it will end. Only the strongest and most viable will remain.


Update: Calculated Risk has a running thread covering news on this front as it breaks, if you're interested.

Prescriptions for a Globalized Economy

Now that I have passed the 50 posts mark, let me go back and reiterate some recurring themes that flow through much of the posts that have lined this site so far. These themes, you might say, form much of the philosophy of the Rogue Economist, as brought about by the current global economic condition.

Foremost in my economic thoughts is always the idea of sustainability. You might say that this is the core idea that runs in practically all of the posts. In fact, I’ve mentioned it ever since the first post. Nothing will go on unless it is sustainable. So the next time you think about the current level of use of resources, of public funds, or personal funds, ask yourself if it is sustainable. If it isn’t, then it’s likely to level off, or stop altogether, at some point in time.

Then there is the idea of uneven effects of globalization in various locations and industries in one single market or country. A falling currency can favour one industry and punish another. Similarly, a rising currency will benefit the other while disadvantaging the former. You can no longer say that a rising or falling currency is favourable to a country. Favourable for which of the country’s citizens?

All countries and economies are now inter-linked, that anything that happens is one country will likely have an effect on many others. This includes one country’s domestic economic decisions and policies. So if you’re a policy maker, particularly if you’re from a small country, how much can you really decide your own country’s economic future, unless you coordinate your policies with those of your neighbours?

A country whose people are experiencing severe credit problems likely do not have to worry much about inflation. During financial crises, consumers consume less, investors stop investing, and many businesses cease doing business.

This has been said by others before - fear and greed are more powerful forces than long-term considerations. This is true for most capitalists and investors. So what government always needs to do is to always help people overcome fear and manage greed. In times of crisis, it needs to do whatever it takes to conquer crises of confidence, while at the same time making clear that it will not bail out every mistake made by private initiatives.

Very tricky distinction, especially now that all financial markets are inter-linked, and any adverse event in one area can easily spread to others. When is a bail out not a bailout? How do we know that an intervention is to overcome fear and not to reward greed? It helps if the intervention is made before a crisis spreads, and cuts those most liable for the mess. But again easier said than done. It's also a fine line since, with every incremental increase in government intervention in the economy, we could be undermining the market in unforeseen ways.

Investor speculation can increase the demand for commodities artificially. But since investors are essentially following the end user’s momentum, at some point, they have to follow his lead. In an inflationary environment, the leaders in falling demand will be the poorer consumers and the smaller businesses.

There will be a new world equilibrium after this crisis, and it will be less centric on US consumption. Developing countries will have to develop their own local consumers if they want to continue growing their economies. But this won’t likely happen until after raw supplies increase and commodity inflation has been tamed. Otherwise, a new growth surge in global demand will just increase prices again.

Economic growth in the developed world will now have to come from real value creation. There is only so much growth that can come from shifting resources around. The latter is not sustainable as a stand alone source of growth. Real growth can only be experienced by mature markets if they integrate with growing markets, but that growth will be uneven across various locations and industries.

Because capital flows are now global, and financial institutions worldwide are deeply inter-linked, individual monetary policies by themselves will likely have little effectiveness. Capitalists and investors can, and will, move their capital around to take advantage of arbitrage opportunities created worldwide by digressing policies.

Because of globalized capital flows, many of our current economic indices, matrices, and indicators are no longer useful and appropriate. They need to be tweaked, to reflect the fact money flows into an economy, by itself, is no longer an accurate indication of growth. Value creation is.

Unless capital mobility is, in the future, accompanied by labour mobility, globalization will not result in the development of comparative advantage in any location. Capital speculators will only end up criss-crossing money around, chasing after a shadow. Ordinary people everywhere will not reach enough affluence unless they can follow capital the way capital can follow them.

The real businessmen, those who create real value, will be discouraged in starting businesses where increased capital mobility can change his cost of funding at a snap, but where he cannot attract the people he needs from anywhere at the same snap, and where his local consumers never reach enough affluence to become sustainable consumers.

7 toxic economic quests

All the current economic mess in the world are due to human failings. Nobody will dispute that. I’d like to take this observation further and state that all the current economic mess in the world are due to our quest for economic rationalization.

Economic problems caused by people following basic economic principles? Well, yes. But as they always say, anything taken to its extreme is always a vice. Herein are seven “ideal” economic quests that have led to the current mess we are in. I’m sure you’re well familiar with each.

1. Quest for everything at the cheapest cost. Not only has this led to the occasional substandard or dangerous product, this has also led to global wages standardizing down instead of up. Do the math.

2. Quest for maximum utility. When it comes to scarce resources, every additional utility we squeeze for the present, we are taking away an equal utility from the future. Do the math.

3. Quest for the riskless reward. The recent derivative innovations has only led people take even bigger risks, while at the same time diversifying the risk onto everybody else.

4. Quest for overspecialization/division of labor. This has led to people putting ever greater focus on ever more specific tasks and objectives, each time leading to greater over-all loss of sight of how real value is created.

5. Quest for the person who will take the first step during uncertain situations. This has led to longer and deeper recessions than necessary, and also to lack of innovation during times when it is needed the most.

6. Quest for someone else to pay your liabilities. This has led to the proliferation of all sorts of insurance and health management firms that either end up in bankruptcy, or taking money from people while avoiding paying claims at all costs. This leads to the last….

7. Quest for the greater fool. This has led to momentum investing in the stock market and in all other financial markets. Everybody hopes that there will always be that someone else who will bail him out after he makes that one last bold move at the “peak” of the market.

Viva l’ economique!