Saturday, November 29, 2008

Who ultimately benefits from local fiscal stimuli?

Many governments are coming to realize that the most effective way to get their respective economies moving again is through a fiscal stimulus. With monetary policies and various central bank actions still proving insufficient in jumpstarting capital markets and inducing consumer spending, the only clear government action left is through fiscal action.

Fiscal stimuli can take many forms: tax refunds, transfer payments to consumers (stimulus checks), or direct subsidies to retailers.

There’s just one thing I am wondering about now. There is no denying that world is now more inter-linked and inter-dependent now than ever before. Global trade is deeper now than the last time a major economic stimulus was taken on the scale necessary today.

Given this, just how much of a local stimulus is likely to trickle away to a nation’s top trading partners. In other words, if the US undertakes a huge fiscal stimulus, so as to induce local consumers to consume, who are going to be its direct beneficiaries?

Sure, the local US stores will benefit. The local logistics chains will also likely pick up business. But the ultimate beneficiaries will likely be the manufacturers and high value-added producers that produce the goods that the consumers will buy. These would come from the biggest net exporting nations to the US. In short, a big US fiscal stimulus will likely also pick up the economies of these fortunate nations.

Is this the reason the Harper government in Canada is waiting for the Obama government’s plan before deciding to undertake on its own stimulus? If it is, and the Harper solution is similar to the preferred solution of governments the world over, then we are only going to propagate the unsustainable balance of the US being the consumer of last resort while the rest of the world over-produces. We need to have a new focus of economic development. It is long over-due.

Monday, November 24, 2008

The 3 laws of risk, and their implications for an inter-connected financial system

The last half-dozen years has seen a steep rise in the use of Credit Default Swaps in the banking system. That’s a principal reason the financial crisis has reached the epic proportions it has. One, this created moral hazard among banks who, feeling they have managed risk away, began to take on more risk, and two, the greater risk was dispersed more broadly across the financial system.

When one bank wants to manage its risk of a financial contract being defaulted on by a major counterparty bank, it buys a credit default swap the way a normal person buys accident insurance. Another bank that sells the swap, acts as the default risk counterparty. As I described in an earlier post, that counterparty bank’s assumed risk is much like that of an insurance company covering a specific event risk.

In the case of credit default swaps, the event risk is a major bank becoming insolvent, and defaulting on its obligations. If the risk event being insured against does not happen, the CDS seller pockets the premium as profit. If the bank sells enough derivatives CDSs, this transaction can become very profitable.

What happens if the insurance buyer and seller are in the same line of business? What happens when the party being covered by a CDS insurance is also in the same line of business? In the last half-dozen years, commercial banks have been significant buyers and the sellers of credit default swaps. The buyers were buying protection from default by still other banks.

Because banks have taken out billions of credit default swaps with one another, banks have succeeded in becoming intermediaries of risk. If a major financial counter-party fails, what happens to the entire financial system? This financial crisis has amplified for us what I would consider as three basic laws of risk. There could be more, but let me focus of the three, and they all apply to what the CDS experience has come to demonstrate:

The 3 Laws of Risk

1. For every potential return created, we create an opposite potential risk. If banks wish to earn investment income, they need to engage in a financial transaction. The more transactions they entered, the greater the potential income and risk.

2. Risk, once created, cannot be destroyed or absolutely decreased (unless potential return is also decreased or given up). It can only be transferred, shared, or dispersed. As mentioned, banks managed their greatly increased credit risk by engaging in mortgage bond securitization and entering into CDSs.

3. In a system where risk has been shared and dispersed among interconnected institutions, any random adverse change in risk in any locality will adversely change the risk in other localities of the system. This is true of all kinds of risk, whether credit default risk, market risk, volatility risk, interest risk, currency risk, sovereign risk, or capitulation risk. They are all inter-connected. This is where the financial system is in now.

These three laws then lead us into extrapolating five major implications of risk on a financial system.

5 implications of risk on a financial system

1. Any firm trying to earn additional return by taking on the risk of another party, either by entering into a swap, selling an option, guarantee, or insurance to the other party, incurs a potential risk of loss that runs up to a maximum of the loss of the counterparty. AIG and Citibank, more than any others, have learned this the hard way.

2. Any firm that tries to hedge this risk by entering into a swap with another party only succeeds in transferring the original risk to another party. That’s what Lehman’s bondholders were successful in doing.

3. Worse, if each party in the chain that offers to be a counterparty in this risk management process tries to earn a minimal return on the transaction, it creates additional counterparty risk that was not there before. Hence the more firms involved in a chain of counterparty swaps and derivatives transactions, each trying to make a return for itself, the greater the resulting risk created in the system. Again, AIG and Citibank learned this the hard way. Hence, any and all returns earned from entering into these types of transactions should not paid out to employees or shareholders of the firms, but kept as capital buffer in the event of such systemic meltdown.

4. The more interconnected a system, and the more of these types of transactions it has, the greater the likelihood of a systemic meltdown. Due to risks of moral hazard, which includes potential need of a bailout by innocent taxpayers, inter-connected firms crucial to the continued functioning of the system should not be allowed to enter into derivative transactions. American taxpayers learning this the hard way now.

5. There is no such thing as a benign or risk-free environment. You can never create an environment where risk has been controlled or made benign. It only means risk has been put at rest. But the more risk is put at rest, the greater its potential blowup energy. You may only succeed in causing it to implode more fiercely, and in unexpected ways. This makes the case for having a centralized clearing house that more important. With a clearing house, we can better track where in the system risk is building up, and we can correspondingly require greater collateral protection before something unexpected blows up.

Economic growth 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. Risk comes with all value-creating activities.

Thursday, November 20, 2008

General Motors and alternative ways of getting bailout

GMAC, General Motors’ automotive financing arm, is applying to be a bank holding company. That’s what every investment bank, insurance, and financial services company is trying to do now. Becoming a commercial bank allows them access to the Fed discount window and, possibly, to the TARP.

Is this an indirect way for GM to get government bailout money then? That has been speculated today by Felix Salmon and John Carney.

But will it work for GM? John Carney doesn’t think so. I suspect that the Treasury might very well tell GMAC to take a hike…..All along the Treasury department, from Paulson to Kashkari, has told us that the TARP is an investment not a prop to failed companies. If they mean it, this would be a great chance to prove it by closing the TARP window to GMAC.

Well, we all know by now that begging for help is not the most effective way of getting bailout support. Causing systemic risk is. That means, transmitting the ramifications of its failure to a host of inter-connected institutions.

Perhaps, telling all its employees, suppliers, and affiliates to default on all their loan obligations, both corporate and personal, should GM fail, will actually do the trick. That worked out well for AIG, and the preferred banks of the TARP. Some of them didn’t even ask for the money, but they got it.

Money doesn’t go to the person who begs for it, it goes to the one who can cause a lot of trouble if he doesn’t get it. The Somali pirates know this.

Wednesday, November 19, 2008

Is the TARP a 'bait and switch' plan?

Did Hank Paulson lie when, in defence of opting out of buying troubled assets, he said “It was clear to me by the time the (TARP) bill was signed on October 3rd that we needed to act quickly and forcefully, and that purchasing troubled assets—our initial focus—would take time to implement and would not be sufficient given the severity of the problem. In consultation with the Federal Reserve, I determined that the most timely, effective step to improve credit market conditions was to strengthen bank balance sheets quickly through direct purchases of equity in banks.”

Or did he actually plan on using the TARP from the very start simply to purchase bank assets and not to purchase troubled assets at all?

This seems to be the theme of speculation in Naked Capitalism’s post. During the TARP negotiations in Congress, Treasury was resisting the idea of inserting language that would allow for capital injections into banks but that some members of Congress thought it was necessary, and put statements into the Congressional record via floor debates to allow for that interpretation.

Yves Smith says Either Paulson let his intentions be misrepresented via his silence, or he is now falsely claiming to have changed direction earlier than he did….. The bill was drafted to be extraordinarily vague and sweeping, and yet did not clearly give Paulson the authority he now says he realized back then that he needed while it was still being renegotiated.

The way I understand this, it seems Paulson took the stance of resisting equity capitalization as a solution to the bank solvency crisis, such that Congress inserted that as a vague provision in the legislation, with no specific guidelines, limits, or constraints on how Treasury should do it, or conditionalities it should insist from those who end up getting the money.

It turns out that much of the money went to healthy banks, because as Pauslon put it, we need to put money into healthy banks before they became unhealthy, and to encourage the less healthy banks to also participate. In his words, if some banks participated and others did not, those who did would be in effect declaring they were weak and scaring away depositors and investors. The stigma argument does carry some weight.

So as soon as TARP was enacted, Paulson unveiled plans to provide $125 billion to nine banks on terms that were more favorable than they would have received in the marketplace. The government, however, offered no written requirements about how or when the banks must use the money. Treasury's new program provided that a bank can exit by repurchasing Treasury shares with newly raised private capital.

Does this indicate that TARP was negotiated to allow preferred banks get the bailout money at the best terms possible, given the circumstances?

Monday, November 17, 2008

In the survival of the fittest, will small be the new big?

Will the next few years belong to the micro-size businesses?

A few months back, we said here that today belongs to the big companies. The reasons were obvious under an inflationary environment: geographic advantage; bigger cash pipeline; buyer bargaining advantage; product diversity; greater rational to seek government help.

Now that the environment is one of recession and deceleration, this means bad tidings for companies with large overhead.

We already see a lot of large companies starting to fail in banking, financial services, and automobile industries, perhaps soon, in the retail and in the tech industries. General Motors may soon file for bankruptcy. Dell and Apple are starting to lose traction. Of course, everybody knows all the names that have gone under in the financial industry, Lehman, AIG, Bear Stearns, and many others worldwide. More may soon follow. Government appetite for bailout is rightly waning as business after business seeks for protection from the inevitable.

Being big is no protection when no product is rolling out the door. In this kind of environment, small and informal may be more appropriate. Large and extensive only translates into heavy and expensive.

If the global recession proves to be deep and long, how many more large businesses will we see fail? I also have to re-think the usefulness of consolidation among financial institutions from here on...

Friday, November 14, 2008

A new Bretton Woods type of meeting?

Tomorrow’s G20 meeting is garnering expectations of convening a new Bretton Woods type of meeting. Given the economic mess the world is currently mired in, it is not surprising that many people believe that a new international framework and new international rules need to be put in place, if globalization is expected to continue into the foreseeable future.

Capitalism has an ugly side, and with globalization, this ugly side has been given free rein. Capital chases after the highest return, and globalization has given it the means to arbitrage national regulations. In the process, it sometimes ended up trampling on local economies or specific sectors of the world economy.

Below are some simple ideas leading to possible avenues of discussion, if such a meeting were to be convened. Some are meant simply to address the current mess, some to improve the current global framework, but all these were tackled in some way in previous posts here.

1. Prevent the further threat of global deflation that could come from China, or from any one single country.
2. Current economic indices, matrices, and indicators are no longer useful and appropriate, and need to be tweaked.
3. US dollar should be complemented by alternative world currencies.
4. Minimize emerging economies' susceptibility to mass starvation from a prolonged slowdown by assisting them in extending agriculture-based stimuli.
5. Manage growth of regional blocs from potentially undermining global competition.
6. Synchronize global deposit guarantees so as not to create deposit arbitrage or bankrupt less prosperous nations
7. US housing problem should be addressed better.
8. Standardize shortselling regulation globally.
9. Bank capital requirements regulation should be re-thought to become countercyclical and not procyclical.
10. Banking oversight should be strengthened in areas, such as banking fees.
11. Capital mobility, if continued, should be accompanied by labour mobility, or globalization will not result in the development of comparative advantage in any location.
12. Fiscal obligation of nations should be clarified.
13. Functions of a now needed global central bank should be discussed, and a possible proposal for it or a close alternative reached.
14. Market should be restructured to realign the rating agencies’ interest with those of investors.
15. Bubble hot money flows should be curtailed and regulated, and more incentives given to long-term investment.
16. Re-think the implementation of mark-to-market accounting to make it less procylical.
17. Find ways to manage spread of risk through the global financial system.
18. New focus of economic development should be on local demand creation.
19. Currency manipulation to gain unfair trade advantage should be ceased.
20. Sustainability should always be central to government policy.

Update: Financial Times came up with a similar article. HT Naked Capitalism