Wednesday, March 21, 2012

Today's links

Today's quote:   "In all the mass media reportage, the operations of the global financial system and the debt crisis are shrouded in mystifying and arcane language. But the essential class content is clear: the sovereign debt crisis and the consequent gutting of social spending is one of the central mechanisms of a worldwide social counterrevolution."  Nick Beams, "The Greek crisis is only the beginning", WSWS




1--Mortgage Settlement? Not So Fast!, American Banker

Excerpt: Bondholders are especially concerned about writedowns from Bank of America, which has privately securitized more than $285 billion worth of mortgages originated by Countrywide Financial Corp. (B of A acquired Countrywide in 2008)...

The settlement must be approved by a federal district court, and "there is the possibility that some private investors could resist the settlement," Bordia wrote in his report...

"Even after court approval, an indiscriminate application of modifications to non-agency loans is likely to be met with legal challenges," he added. "The possibility of legal challenges from investors cannot be ruled out if indiscriminate mass modifications were to take place."...

"How can the government impose a benefit on servicers at the expense of the investor?" asks Walter Schmidt...

Bondholders also claim that during a Feb. 14 conference call with 90 investors, HUD Secretary Shaun Donovan assured them that the number of private-label securities that could be modified under the settlement would be capped at 15%. The settlement did not include a cap, angering investors who claim the government favors banks over bondholders.”

2--Fitch: NY Fed data provide different perspectives on repo market, Reuters

Excerpt: A recent Fitch report about prime money market funds' use of

triparty repos showed a significant post-crisis increase in transactions backed by structured finance collateral, reaching levels last observed in late 2007. But Federal Reserve Bank of New York (FRBNY) data provides other perspectives. We thought it helpful to clarify the differences....

While the FRBNY data provides an excellent high-level overview, our study uses the SEC's recently developed Form N-MFP for in-depth insight on security-level details of repo collateral. These new forms enabled us to determine that at end-August 2011 about 50% of the structured finance collateral pool consisted of legacy subprime and Alt-A RMBS and CDOs, and to identify the top issuers of these securities (eg, Countrywide). The money fund data shows that much of the collateral is deeply discounted, with a median value of roughly 43 cents on the dollar. From a systemic risk perspective, these transactions involve relativelyless liquid, longer-tenor securities financed short term by highly risk-averse cash investors such as money funds....

Our sample of over USD90bn repo transactions captures 5% of the USD1.6trn triparty market, or 15% of the "riskier" collateral.

The FRBNY dataset reveals that structured finance repo haircuts increased after Fitch's end-August observation period. These haircuts could indicate greater conservatism among repo lenders or reflect a decline in the overall credit quality of this collateral...

Financial market trends and banking regulations could encourage use of repos to fund structured finance securities. Recent structured finance market activity points to increased investor appetite for legacy securities (eg, the FRBNY's completed sale of the Maiden Lane II portfolio of RMBS). This appetite comes partly from hedge funds, some of which finance investments through bilateral repos with prime brokers that may then refinance these securities in the triparty market. Money market funds, operating in a historically low-yield environment, are able to generate higher income on repos backed by structured finance collateral than on those backed by US government securities. Stricter banking regulations also create incentives for some riskier assets to befinanced through the "shadow" banking system, including both the triparty and the larger bilateral repo markets.

3--Bundesbank Official on ECB Cash Injection, 'We Have to Keep a Watchful Eye on the Money', Der Speigel

Excerpt: SPIEGEL ONLINE: The Bundesbank is partly responsible for that. The euro zone's central banks have flooded the markets with cheap money. Commercial banks have borrowed a total of more than €1 trillion ($1.3 trillion) for a period of three years. Where will all of this money go?

Nagel: For the most part, the money is being parked with the central banks of the euro zone. In November, some institutions had considerable refinancing difficulties, in other words with raising money in the markets. So we had to take this extraordinary step.

SPIEGEL ONLINE: Is it true that the banks in the crisis-affected countries of southern Europe invested the money they borrowed mainly in their countries' government bonds, thus helping to finance those governments' debts?

Nagel: There are no reliable figures on that, but it's obvious that banks which have obtained money from the central banks will use it in part to buy sovereign bonds. But that wasn't unusual even before the crisis.

SPIEGEL ONLINE: If it hadn't been for the assistance from the central banks, would there have been bank failures in Europe during these past few months?

Nagel: What is clear is that in November some banks barely had any access to the market. That is a situation where, in the opinion of the central banks, it is justifiable to resort to such measures. But now we need to be careful: The system cannot be allowed to get used to such an overabundant supply of money. The banks need to accept the idea that at some point (the generous supply) will be over.

SPIEGEL ONLINE: The Bundesbank is partly responsible for that. The euro zone's central banks have flooded the markets with cheap money. Commercial banks have borrowed a total of more than €1 trillion ($1.3 trillion) for a period of three years. Where will all of this money go?

Nagel: For the most part, the money is being parked with the central banks of the euro zone. In November, some institutions had considerable refinancing difficulties, in other words with raising money in the markets. So we had to take this extraordinary step.

SPIEGEL ONLINE: Is it true that the banks in the crisis-affected countries of southern Europe invested the money they borrowed mainly in their countries' government bonds, thus helping to finance those governments' debts?

Nagel: There are no reliable figures on that, but it's obvious that banks which have obtained money from the central banks will use it in part to buy sovereign bonds. But that wasn't unusual even before the crisis.

SPIEGEL ONLINE: If it hadn't been for the assistance from the central banks, would there have been bank failures in Europe during these past few months?

Nagel: What is clear is that in November some banks barely had any access to the market. That is a situation where, in the opinion of the central banks, it is justifiable to resort to such measures. But now we need to be careful: The system cannot be allowed to get used to such an overabundant supply of money. The banks need to accept the idea that at some point (the generous supply) will be over....

SPIEGEL ONLINE: To what extent do investors in the financial markets share the blame? They lent money to countries like Greece and Portugal over a period of many years at low interest rates. Then they suddenly demanded exorbitant interest rates on sovereign bonds, even though the real situation had hardly changed. Did investors previously underestimate the risks?

Nagel: In retrospect, one has to say: Yes. Up until three years ago, investors lumped together all the government bonds of euro-zone countries. Back then, Greece, for example, barely had to pay 0.1 percentage points more than Germany in interest on a two-year bond, even though the differences in competitiveness were already evident. And it was already apparent that speculative bubbles were forming in some countries as a result of the large amounts of cheap money. For example, when I was in Ireland I was surprised at the prices that people were asking for houses. It was a similar situation in Spain. When you saw something like that, you had to wonder how long it could go on.

SPIEGEL ONLINE: But nobody issued any warnings.

Nagel: We thought the risks were manageable. We believed in the efficiency of financial markets. We had been influenced by the theory that every investor always behaves rationally. Today we know that is not entirely correct. The markets are prone to overreacting. All it takes is a trigger and they suddenly shoot far beyond what might be described as rational.

SPIEGEL ONLINE: What were the factors that both triggered and exacerbated the crisis?

Nagel: When it emerged at the beginning of 2010 that the Greek government had presented false debt figures, investors were shocked. That led to a complete reevaluation of the situation in the whole of Europe (by investors). Then in August 2011, a debt restructuring was added to the mix, with private sector involvement. From that point on, it was clear to every investor that European government bonds were no longer risk-free assets.

4--“The Eurozone in Crisis: Origins and Prospects”, econbrowser

Excerpt: For the eurozone to resolve its crisis requires the political will to undertake painful measures, with serious distributional effects. As long as certain groups seek to avoid those costs, resolution of the crisis will be elusive...

The eurozone crisis is the result of at least two key weaknesses in the original project of European monetary integration. First, the common currency and its monetary policy were applied to a set of economies that were very different one from the other. In the lingo of economists, the original group of 12 nations—Austria, Belgium, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, Netherlands, Portugal, and Spain—did not constitute an “optimal currency area.” (Greece joined in 2001 between the euro’s establishment and introduction.) The countries were subject to too diverse a set of economic shocks. They were not sufficiently integrated, and they lacked a fiscal union that could smooth out those shocks, compensating hard-hit economies with transfers from better-performing economies. Further, with the euro in place, the monetary policy of the new European Central Bank proved to be too loose for some countries and too tight for others.

The second weakness is that investors interpreted the creation of the union as an implicit guarantee of member countries’ government debt. It seemed clear that if a serious financial crisis erupted in one eurozone member country, the risks of contagion to the rest of the zone and of a negative effect on the euro would force other countries to bail out the member in crisis. Investors believed this interpretation even though no such formal guarantees were made. These implicit guarantees were problematic because they pushed interest rates lower, which, in turn, gave governments, businesses, and households incentive to borrow more than they would have had they properly understood the risks. In other words, risk was underpriced due to the perception of an implicit guarantee. The result was that Europe, particularly Southern Europe, which experienced unnaturally low interest rates, borrowed far more than was sensible, and is now suffering from the resulting debt binge. And in certain countries, this problem of over-borrowing is compounded by a long-term problem of public spending on pensions and health care that has exceeded what the rate of economic growth made possible....

The implementation of the eurozone was problematic insofar as it was subject to asymmetric shocks. This was well understood, but proponents argued that a combination of currency union and a program of economic liberalization could mitigate this shortcoming. Increased labor mobility was one key prerequisite, and certainly this increased in the wake of Economic and Monetary Union (EMU). However, it wasn’t anywhere near sufficient; as a consequence, the other great deficiency -- the absence of a fiscal union -- came to the fore....

For instance, Ireland, in contrast, was a paragon of fiscal rectitude on paper. In the midst of a boom in financial and housing markets, the Irish government ran budget surpluses. With the financial crisis, the government implemented a complete bank deposit guarantee and subsequently bailed out major banks, resulting in massive increases in the government’s debt. Similarly, Spain was running a budget surplus —until the collapse of its housing market...

In other words, credible precommitment to no-intervention when a massive and systemic financial crisis strikes -- the libertarian prescription -- is not feasible. That means running small budget deficits is not a sufficient condition for avoiding a debt crisis; effective and smart financial regulation is also essential.

What’s our prognosis for the eurozone? From the article:

...While we hope for the early recognition of the need for North-South transfers, recapitalization of the banking system, and accelerated inflation, our observation of the political process makes us pessimistic. Thus far, electorates in the creditor countries do not seem to be convinced that transfers are necessary. As long as this characterization holds true, progress toward a true solution will be elusive.

Much more likely will be a process of lurching from one crisis to temporary palliative to the next crisis. In that scenario, recovery will be years off.

5--The Japan debt disaster and China’s (non)rebalancing, Michael Pettis, credit writedowns

Excerpt: China’s current account surplus has declined sharply from its peak of roughly 10% of GDP in the 2007-2008 period to probably just under 4% of GDP last year...China is not rebalancing and the decline in the surplus was driven wholly by external conditions. In fact until 2010, and probably also in 2011, the imbalances have gotten worse, not better...

The savings and investment numbers show that the last time investment exceeded savings was in 1993-94, and during that time China of course ran a current account deficit. This was just before Beijing sharply devalued the RMB, after which it immediately began running a surplus, which has persisted for 17 years. Since 2007 savings have climbed from 50% of GDP to nearly 53% in 2010. During this time investment has climbed from just over 40% of GDP to nearly 49%. the difference between the two has declined from just over 10% of GDP to just under 4%, and this of course is just another way to say that China’s current account surplus has dropped from just over 10% of GDP to just under 4%....

the first case a declining savings rate indicates that Chinese consumption is indeed rising and Chinese investment is declining (or at least rising more slowly than consumption). This is the “right” way for the trade surplus to decline because it represents a rebalancing of the Chinese economy away from its dependence on investment and the trade surplus and towards consumption. In the second case – the “wrong” way – consumption is actually declining further as a share of GDP, and the reduction in China’s dependence on the trade surplus is more than matched by an increase in its dependence on trade.

So is China rebalancing? Of course not. Rebalancing would require that the domestic consumption share of GDP rise. Is the consumption share of GDP rising? Clearly not. If consumption had increased its share of GDP since the onset of the crisis, the savings share of GDP would be declining.

And yet savings continue to rise. This is the opposite of rebalancing, and it should not come as a surprise....

Meanwhile investment continues to grow and, with it, debt continues to grow, and since the only way to manage all this debt is to continue repressing interest rates at the expense of household depositors, households have to increase their savings rates to make up the difference. So national savings continue to rise.

What then explains the decline in China’s current account surplus over the past three years? The numbers make it pretty obvious. The sharp contraction in China’s current account surplus after 2007-08 had was driven by the external sector, and in order to counteract the adverse growth impact Beijing responded with a surge in investment in 2009. You can argue whether or not this was an appropriate policy response (yes because otherwise growth would have collapsed, or no because it seriously worsened the imbalances), but certainly since then as consumption has failed to lead GDP growth, investment has continued rising too quickly.

Can China’s surplus rise further?

It is, in other words, rising investment, not rebalancing towards higher consumption, that explains the contraction in the current account surplus....

If investment rates drop more quickly than the savings rate, by definition this would result in an increase in China’s current account surplus....

Remember that until 1990 Japan had the same problem that China did: its rapid growth was largely a function of policies that transferred wealth from the household sector to subsidize growth.

These policies – an undervalued currency, repressed interest rates and low wage growth, which of course are the same as China’s – restrained consumption and encouraged debt-fueled investment. This investment, we now realize, was wasted on a massive scale and the eventual government absorption of all the bad debt caused government debt to rise....

China’s surplus can decline only if we see a very improbable decline in its savings rate or a very unwelcome increase in its investment rate – and my guess is that the internal pressures are for the savings rate to hold steady as the investment rate declines. And Japanese reluctance to solve its debt problems by privatization requires that it resolve them with an increase in the trade surplus.

Needless to say this isn’t going to work, and at least one of the above is going to be extremely disappointed. The “good” news is that if this conflict leads to much slower global growth, as it certainly will, the resulting reduction in commodity prices, including oil, will help absorb some of the changes in the trade imbalances as commodity exporting countries see their exports fall sharply. But I don’t see much other relief.

6--What really caused the financial crisis? It wasn't leverage!, naked capitalism

Excerpt: (cause of meltdown)--"at least as far as US securities firms were concerned, it took place much more via an increasing mismatch between the illiquidity of many of their assets versus their heavy reliance on short-term funding rather than nominal leverage."...

So why have perceptions remained so stubborn? A big one seems to be the human desire to have tidy explanations of complex phenomena. Leverage is much easier to understand as a culprit, and it is true that all the major financial firms were running with much too little in the way of risk buffers relative to the risks they were taking. One the culprit was that securities firms, and big banks that were running major securities and derivatives businesses, kept holding more and more of their exposures in illiquid, hard to value instruments, yet were financing them with repo, which is relatively short term funding. Historically, securities dealers held only assets that traded actively or had prices that were established readily and reliably with reference them (corporate bonds were the classic example).

Dealers are structurally long financial assets. Particular firms might be able to hedge single positions or even (in the case of Goldman) a large book, but the big players are too large to be anything other than net long the major markets they trade. As the Fed and other central banks engineered a long-term fall in interest rates from 1983 onward, banks and securities dealers benefitted from a gradual rising tide. That plus the Greenspan put (the Fed rushing in to limit the downside of a market decline) emboldened dealers to take more risk. But at least as far as US securities firms were concerned, it took place much more via an increasing mismatch between the illiquidity of many of their assets versus their heavy reliance on short-term funding rather than nominal leverage. The change in the composition of their exposures should have led the authorities to require them to carry more capital, but in the era of “markets know best” that sort of intervention would have been seen as overreaching and a proof that the regulator was a Luddite. The Greenspan-Rubin-Summers pillorying of Brooksley Born over her effort to regulate credit default swaps no doubt had a chilling effect on any other regulators who might have challenged the destructive orthodoxy they put in place. As McLean concludes her piece, quoting Andrew Lo: “If we haven’t captured the killer, then the real killer is still out there somewhere.”

7--Why You Should Hate the “Jumpstart Obama’s Bucket Shops” Act, naked capitalism

Obama seems determined to roll back the few remaining elements of the New Deal. As we’ve recounted, he’s keen to cut Medicare and Social Security; he said as much in a dinner with leading conservative luminaries shortly after his inauguration. And his JOBS Act, which guts securities law protections on smaller stock offerings, is touted as a way to increase employment by helping to fund smaller businesses. In reality, the only jobs it is likely to create will be due to the resulting explosion in stock scamsters and bucket shop operators.

Amar Bhide, who has written the classic, The Origin and Evolution of New Businesses, has decisively debunked the idea underlying the Obama Bucket Shop act, which is that public stock offering are an important source of funding for new businesses. The problem is, as Bhide explained, is that academics focus on the easy to study but relatively inconsequential venture capital funded companies which look to IPOs as an exit. Bhide found that only 1% of new and young businesses were funded by venture capital. Similarly, his multi-year study of Inc 500 companies found that a comparatively small portion had VC backing, and even then, many got VCs in at a late stage, not because they needed the money but having the “right” VCs would lead to a much bigger premium when they went public....

Simon Johnson and Bill Black have attacked the other obvious flaw of this bill: it’s terrible for the US capital markets. In the 1990s, the US equity market was the deepest and most liquid not just because the US was a big economy, but also because investors had confidence that tough rules on disclosure and prohibitions against insider trading and abuses like front-runnning protected them.

Johnson stresses that the bill will increase rather than lower the cost of capital for young firms:

The premise is that the economy and startups are being held back by regulation, a favorite theme of House Republicans for the past 3 ½ years – ignoring completely the banking crisis that caused the recession. Which regulations are supposedly to blame?

The bill’s proponents point out that Initial Public Offerings (IPOs) of stock are way down. That is true – but that is also exactly what you should expect when the economy teeters on the brink of an economic depression and then struggles to recover because households’ still have a great deal of debt. And the longer term trends over the past decade are global – and much more about the declining profitability of small business, rather than the specifics of regulation in the US (see this testimony by Jay Ritter).

Professor Ritter, a leading expert on IPOs, put it this way:

I do not think that the bills being considered will result in a flood of companies going public. I do not think that these bills will result in noticeably higher economic growth and job creation.

In fact, he also argued that the measures under consideration “might be to reduce capital formation.”

Professor John Coates hit the nail on the head:

While the various proposals being considered have been characterized as promoting jobs and economic growth by reducing regulatory burdens and costs, it is better to understand them as changing, in similar ways, the balance that existing securities laws and regulations have struck between the transaction costs of raising capital, on the one hand, and the combined costs of fraud risk and asymmetric and unverifiable information, on the other hand. (See p.3 of this December 2011 testimony.)

In other words, you will be ripped off more. Knowing this, any smart investor will want to be better compensated for investing in a particular firm – this raises, not lowers, the cost of capital. The effect on job creation is likely to be negative, not positive.

Sensible securities laws protect everyone – including entrepreneurs who can raise capital more cheaply. The only people who lose out are those who prefer to run scams of various kinds.

Bill Black, in a letter opposing the bill, is more curt:

The “Jumpstart Our Business Startups” Act, the comically forced effort to create a catchy acronym, is the most cynical bill to emerge from a cynical Congress and Administration. It is an exemplar of why Congressional approval ratings are well below those of used car dealers. The JOBS Act is something only a financial scavenger could love. It will create a fraud-friendly and fraud-enhancing environment. It will add to the unprecedented level of financial fraud by our most elite CEOS that has devastated the U.S. and European economies and cost over 20 million people their jobs. Financial fraud is a prime jobs killer.

Deregulation was the root of the financial crisis just past, but no on in the administration seems to have gotten the memo. This bill is astonishingly wrong-headed., which means it is par for the course for Team Obama

8--Fed Watch: Fed Still Lowering Potential Output Growth Estimates?, economists view

Excerpt: In the question and answer period (via the WSJ), Dudley commits to nothing but a data dependent policy:

Dudley was asked by an audience member what he expects will be the future path of interest rates. “We will continue to assess what’s appropriate” for monetary policy, he answered, saying “if the economy were to change in a meaningful way, obviously we’d change” the current plans for interest rates and other stimulus efforts.

Specifically on QE3, via Reuters:

"Nothing has been decided," he said of QE3, in which the Fed would make large-scale asset purchases in an attempt to lower rates and give the economy another controversial shot of adrenaline.

"It all depends on how the economy evolves," Dudley added. "It's about costs and benefits, and if we get to a point where we think the benefits of another program of QE outweigh the costs, then we'll certainly do so."

More interesting, in my view, were his comments on potential growth:

To put the recent pace of growth into perspective, we believe that the economy's long-run sustainable growth rate (what economists call the potential growth rate) is around a 2 1/4 percent annual rate. We need sustained growth above that rate to absorb the substantial amount of unused productive capacity. Thus, our recent growth rates are barely keeping up with our potential.

The 2.25% rate caught my eye, as it was slightly below the 2.3-2.6% range for longer term growth in the most recent Fed projections. And that itself was a downgrade from the 2.4-2.7% November projection.

At this point, it becomes a little tricky:

Although the sharp decline in the unemployment from 9 percent last September to 8.3 percent in February suggests we are doing better than that, it is important to recognize that about half of that decline was due to a declining labor force participation rate. In fact, had the labor force participation rate not declined from around 66 percent in mid-2008 to under 64 percent in February, the unemployment rate would still be over 10 percent.

So half the decline in the unemployment rate since last September was due to falling labor force participation, while the other half was the result of growth slightly above potential. GDP growth in the second half of last year averaged 2.4%, slightly above Dudley's estimate of potential GDP, and enough to bring down unemployment somewhat....

Also, it appears that productivity growth has slumped recently. Although that means that a given amount of growth translates into bigger employment gains, it certainly is not an unmitigated good development.

This isn't sounding so good - growth is weak, but the hurdle is lower. Does this mean that Dudley is less dovish than widely suspected? I don't think so. Another excerpt from Dudley's speech today:

More importantly, real economic activity has yet to be strong enough on a sustained basis to make a big dent in the overall amount of slack in the U.S. economy. While it is true that growth was stronger in the fourth quarter, most of that growth was due to inventory accumulation. Growth of final sales was actually quite weak. Historically, a quarter in which inventory investment makes a significant growth contribution is typically followed by a quarter in which that growth contribution is modest or even negative. That appears to be what is shaping up for the first quarter of this year....

Bottom Line: Dudley presents a rather sober view of the US economy - signs of life are hopeful, but he isn't counting on their sustainability in any way, shape, or form. His estimate of potential output growth is falling, but the existing gap remains wide. The gap coupled with his obvious lack of enthusiasm for the quality of the recovery should point him in the direction of QE3 sooner than later. But there is nothing to suggest that such a move is imminent barring a deterioration of the data - he seems to make this clear in the Q&A. He seems ready to stick with the wait and see approach to policy, possibly because the declining potential growth rate makes him somewhat concerned the output gap could close faster than he would expect. But it sure doesn't sound like it would take too much disappointment in the days ahead to push him to support going back to the monetary well for another round of easing.

9--Why State Attorneys General Shouldn't Settle on Robo-Signing, Ellen Brown, Truthout

Excerpt: As noted in an article titled “Risky Debt Use on Repo Market Hits 2008 Levels” in today’s Financial Times:

In the repo market, banks pledge their securities as collateral for short-term loans from money managers and other investors. The market played a key role in the build-up to the 2008 financial crisis. Banks used toxic assets, such as repackaged subprime loans, to secure trillions of dollars worth of cheap funding.

When the US housing bubble burst, the banks’ trading partners refused to accept such securities as collateral and the repo market rapidly contracted.

However, a study by Fitch Ratings says the proportion of bundled debt being used as security in repo transactions has returned to pre-crisis levels.

Using the repackaged loans can increase risk in the repo market, the rating agency says. This is because the securities may be prone to sudden pullbacks such as the one experienced in 2008.

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