Afraid of Another Financial Crisis? Watch the Banks

Financial crises like we had in 2008 before the Great Recession, and earlier in the 1930's before the Great Depression, are the triggers for big, long lasting economic downturns that require painfully long times from which to recover.  They differ from ordinary economic recessions (i.e., two quarters of negative economic growth), which generally don't last more than a couple of years and are usually followed by good levels of growth.  Financial crises are caused by liquidity shortages in the financial system.  When major banks and other financial institutions cannot obtain ready access to loans, especially short term loans, the financial system can teeter, and in worst case scenarios, collapse. 

Recent news articles report that European banks are under stress because of the decline in oil prices (http://www.cnbc.com/2016/02/08/european-banks-face-major-cash-crunch.html), and because of low interest rates and legal costs, as well as oil prices (http://money.cnn.com/2016/02/05/investing/bank-stocks-worse-than-oil/index.html?iid=EL).  Things got so shaky today that Deutsche Bank, Germany's largest, felt compelled to put out a statement reassuring shareholders about its financial condition.  http://www.reuters.com/article/us-deutsche-bank-stocks-idUSKCN0VI1WI.  If Europe's major banks begin to encounter liquidity shortfalls, we could have a problem.  If not addressed properly, it could be a big problem.

Europe's big banks are in general not as well capitalized as America's big banks, so it's not surprising that the Europeans might encounter turbulence sooner.  But if Europe's big banks teeter, America's big banks will, because of the interconnections between all major banks worldwide, at least feel pretty nauseated.  Of course, in such a scenario, the European Central Bank and U.S. Federal Reserve will mount up and ride to the rescue.  But not even the Brobdingnagian bailouts of 2008 prevented the Great Recession.

If the financial system stays sound, the slowdown in China and the other BRICS may cause a recession, but probably not a catastrophe.  But if the financial system dives into the septic tank, as it did in 2008, then we can expect a stinky mess.  So watch the banks.

OIl's Great Fall: This Time, The Bailouts Will Be Harder

In a desperate move, Russia's central bank recently raised a key interest rate by 6.5% to 17%, propping up the ruble at least momentarily.  This was after the ruble had already lost about 50% of its value in the past few months.  Even if the ruble stabilizes, Russia verges on economic collapse. 

Venezuela was already hitting the skids when the price of oil began its big swoon.  Now, it will possibly default on its sovereign debt.  Other oil producing nations are hurting, too.  Some could survive by drawing down their financial reserves.  Others may not have adequate reserves on which to draw.

The impact of the oil price drops on major financial institutions and financial markets players is much more opaque.  When a key commodity like oil, and the currencies issued by its producers, belly flop as we have seen in the past few months, big losses are inevitable.  Some of these losses could be greatly magnified by the leveraging effect of derivatives.  A crucial question for regulators is where these losses are landing.  Surely there are losses on Wall Street and in the City of London.  But proportionately much greater losses may have been sustained by Russian and other European banks.  Dec. 31, 2014 will mark the close of financial reporting periods for many banks and other institutions. At that point, they will be required to disclose their financial conditions.  It wouldn't be surprising if the losses are big.  Talk of bailouts might follow.

It's one thing for the taxpayers of a nation to bail out the banks of their own nation.  They may be frustrated and outraged, and demand the punishment of bank executives and others.  But they have a strong interest in preserving their own financial system.  It's another thing when a foreign country wants a bailout, just after it sent its Special Forces surreptitiously into a neighboring country to seize territory by force, lied to the world about what it was doing, and then made aggressive moves against many other nations--especially those that border it and have historically been dominated by it.  The West has imposed sanctions on Russian banks.  It can't now bail them out.  It's attempting to force Russia out of Ukraine, using financial leverage as a key weapon.  It can't provide Russia with a financial bailout.

Venezuela has for years been seriously hostile toward the U.S., while getting cozy with Cuba.  Its current predicament is the result of spending way more than it was taking in.  A bailout for Venezuela has no chance of receiving Congressional approval, nor would American generosity do anything to ameliorate the key problem, profligacy by the Venezuelan government in order to win over voters.  The IMF would impose financial discipline on the Venezuelan government as a condition of any international bailout, something the current Venezuelan government surely wouldn't accept.

Free market advocates have railed for years about the bailouts made in the aftermath of the 2008 financial crisis, proclaiming that handouts to the wealthy and powerful would only foster moral hazard and encourage undue risk taking at the expense of taxpayers.  They may have their way in the wake of oil's great fall.  Some of the key players likely to need a bailout won't be getting them.  Chips will fall where they may, and we'll see how the markets operate in the absence of government intervention.  The results will be good for some, bad for others, and undoubtedly painful for many. 

A destabilized Venezuela will probably experience internal political change.  But a destabilizing Russia is much less predictable.  As long as Putin is in power, who knows what will happen?  And what is the potential for Putin to leave power?  Not much and it's not likely to happen in a gracious way.  Demagogues at risk of losing power sometimes turn to foreign adventurism to stay in control.  The farther oil prices drop, the harder these questions will become, and the more disturbing the potential answers. 

Oil Prices: The Next Test For Central Bankers

Most of the benefits of falling oil prices are obvious.  Consumers, whose median incomes have been falling too, are fist bumping over lower gas prices.  Businesses are seeing some energy costs fall, burnishing the bottom line.  Members of Congress, who aren't doing jack about stimulating the economy anyway, can breath a sigh of relief over the economic stimulus from the gas pump.

Falling prices, however, have downsides.  Today, the stock market tumbled because energy stocks are under stress.  The more vulnerable oil producing nations might default on their sovereign debt (think Venezuela, and maybe others).  Many oil frackers are heavily leveraged, and they could start defaulting as their cash flow sputters.  Some financial market players are surely taking losses on falling currencies of many oil producing nations (the ruble being Exhibit A).  More opaquely, but perhaps of great concern, big banks, hedge funds and other financial market players might well be taking losses on derivatives contracts bets linked to the price of oil or the currencies of oil producing nations.  With oil price losses approaching the 50% level in the past few months, it looks like we have a bursting bubble on our hands--and the potential for another financial crisis.

Recall that it wasn't falling real estate prices alone that triggered the 2007-08 financial crisis.  It stemmed from a poisonous synergy of massive quantities of poorly underwritten mortgage loans, falling real estate prices, defaulting mortgage borrowers (many of whom didn't have the ability to repay the loans, measured by any reasonable standard), a compounding of the losses because falling prices precluded the availability of refinancing, the massive impact of these losses on the financial system through diverse and obscure derivatives contracts not well understood by market players and regulators, and, ultimately, a surprising concentration of losses onto a single entity (AIG-Financial) to which numerous key players in the financial system had unmanageable exposures.  Only an unprecedented bailout by the federal government prevented the collapse of the world financial system.

A sharp fall in oil prices doesn't necessarily mean the financial system is at risk.  There was a proportionately larger oil price fall in the middle of the 1980s which didn't result in a financial collapse (although this occurred before the evolution of complex derivatives markets that allow risk to metastasize with blinding speed).  Another big drop in oil prices in 2008-09 also didn't tip the big banks into bankruptcy (although they were already in major bailout mode by this time because of the mortgage crisis, so this instance may not prove much). 

But the proliferation of risks created by today's highly imaginative financial engineering can mean that any major drop in the price of a key asset like oil could surprise us in unpleasant ways.  One lesson from the 2008 financial crisis is that regulators didn't know where the hot tamale would land, until it hit the fan.  Regulators worldwide should be sending their examination SWAT teams into the major money center banks and other key financial institutions to scope out the direct, secondary and tertiary impacts of falling oil prices.  And that should be now--as in right now--not weeks or months from today when it may be too late to take protective action. 

Dexia and MF Global Holdings: Canaries in the Financial Markets?

Financial market volatility as we've had in recent months inevitably takes a toll if it continues long enough. A few weeks ago, a large Belgian-French bank, Dexia, was bailed out and partially nationalized after sustaining heavy losses from the European sovereign debt crisis. This weekend, news services report that MF Global Holdings, a financial services firm, is on the ropes because of sizeable losses in proprietary holdings of European sovereign debt. MF Global and its advisers have reportedly been seeking to sell part or all of the firm, but no transaction appears imminent. This evening (Sunday, Oct. 30, 2011), we now learn that the firm has hired bankruptcy lawyers. http://www.marketwatch.com/story/mf-global-hires-bankruptcy-lawyers-wsj-2011-10-30?link=MW_home_latest_news, and http://www.reuters.com/article/2011/10/30/us-mfglobal-idUSTRE79R4YY20111030?feedType=RSS&feedName=topNews&rpc=71.

Because Dexia is a bank, its bailout was not a particular surprise. The EU could hardly allow a major bank to collapse at this moment of crisis, lest its entire financial system nosedive.

MF Global, however, isn't a bank and doesn't have a hovering government Sugar Daddy waiting to hand over a blank check. It brokers derivatives transactions, and its operations include the clearance and settlement of derivatives trades. It also trades for its own account. The firm reportedly held about $6.3 billion in hinky European sovereign debt, and disclosed a quarterly loss of $191.6 million on Oct. 25, 2011. Moody's and Fitch have lowered MF Global's credit rating to junk, which could disrupt its normal access to credit. Some brokerage customers have apparently been exiting, stage right. Press reports indicate that, to maintain liquidity, MF Global has drawn down two bank lines of credit. Its banks include Citigroup, Bank of America and J.P. Morgan Chase. That these big boys would allow MF Global to tap out its lines of credit indicates a difficult situation. One surmises that MF Global may be facing a potentially major run by customers and, with its banks' assistance, is doing whatever it can to buy time to find an acquirer.

MF Global hired three of the largest law firms in New York to assist in a possible bankruptcy: Skadden Arps Slate Meagher & Flom, Weil Gotshal & Manges, and Sullivan & Cromwell. Chances are it wouldn't hire firms of this size and stature unless something very big might happen very soon. These firms can, on a moment's notice, throw legions of lawyers onto a matter such as a bankruptcy of MF Global. The retention of such massive potential legal resources doesn't signal a bright near term future for MF Global.

What's unclear from news stories is the condition of MF Global's derivatives clearance and settlement operation. Such operations typically are protected by the capital of the settlement and clearance firm, which may also hold collateral from counterparties. A crucial question is whether losses from the proprietary trading could spill over into the brokerage operation and impair its ability to honor its brokerage and clearance and settlement obligations. If so, the value of an unknown quantity of derivatives transactions could be thrown into doubt. Were that to happen, a pathway for financial contagion could open up and spread outward into the larger financial system. If there is a potential for financial contagion to spread, expect the Federal Reserve to open the monetary floodgates.

The MF Global situation provides yet even one more reminder that we really need to implement a new regulatory regime for derivatives. The possibility that a derivatives broker, that provides clearance and settlement services, might put customers at risk from its proprietary transactions is simply unacceptable today. For many decades now, clearance and settlement in the stock markets have been legally insulated from proprietary trading, and separately capitalized. Mistakes and misjudgments at proprietary trading desks shouldn't be able to blindside clearance and settlement customers. The Dodd-Frank legislation provides a framework for making clearance and settlement in the derivatives market much more rigorous and secure. With all the volatility we've had, it's entirely possible that more financial firms beyond Dexia and MF Global are headed for the shoals. How many more canaries in the financial markets need to stop tweeting and fall over before we have reform?

Will Customer Fee Increases Hurt the Big Banks?

Recent bank fee increases are pushing consumer funds to credit unions and other financial firms. (See http://www.cnbc.com/id/44930883.) This is understandable from the consumers' standpoint. Why enrich banks when you're barely making ends meet? A less obvious question is whether these fee increases are bad for banks.

Banks play a potentially dangerous game. They make medium and long term loans and investments, using short term money (i.e., money that can be withdrawn quickly). Because short term deposits and other borrowings tend to cost banks less in interest expense than medium and long term loans generate in interest income, banks make profits on the difference. This game works fine as long as the short term depositors and other creditors of banks don't bolt. But, as we all know from recent financial upheavals, a run on the bank results muy pronto in its collapse--unless it's so big that the government steps in and gives the bank a blank check drawn on taxpayers.

Consumer deposits tend to be stable. This is true even for nominally short term accounts, such as checking accounts that theoretically can be closed on demand. It's a hassle for consumers to change banks, especially now that they often have direct deposits made to their accounts and direct bill paying from their accounts. The banks that have been raising fees are betting that a lot of customers will find it too bothersome to switch accounts, and will cough up $5 a month for a debit card or whatever.

But many customers may leave, particularly after a few months or maybe many months. While the banks will probably profit short term by raising fees, after a while growing numbers of customers may tire of paying for what's free elsewhere. If banks see a shrinkage in their retail deposit base, what will they do? They can either reduce their balance sheets (i.e., reduce the loans and investments they hold) or they can seek alternative funding. Banks, as a rule, don't shrink their balance sheets. If you're a bank CEO, you aren't likely to perceive a lot of benefit to making your organization smaller. The more assets the bank holds, the more profits it will hopefully make and the larger your bonus will hopefully get.

Since banks losing consumer business won't be inclined to shrink their balance sheets, they will seek alternative funding. The choices are likely to be much less stable than consumer deposits. Typical alternatives would include the fed funds market, the commercial paper market and the repo market. Funding from these markets is susceptible to great instability. Money a bank borrows in these markets can evaporate faster than a hedge fund can execute a computerized trade.

Europe's big banks are funded to a large degree in wholesale markets, more so than many of America's big banks, and are consequently less stable. That's one reason why the EU sovereign debt crisis became so acute so fast earlier this year--the money market vigilantes fled the big EU banks, and Europe's governments had to ride to the rescue. (If you have an account with a U.S. money market fund, though, your fund may have been one of these vigilantes and you'd probably consider this a good thing.)

If America's big banks experience a large enough shift in their liabilities, with less retail deposits and more wholesale funding, their risk profiles could change and not in a good way. Are bank executives are concerned? Come on. If a big bank goes way out on a limb and the limb starts to break, the Federal Reserve will climb into its Black Hawks and helicopter to the rescue. But taxpayers should be concerned. If America's big bank risk profiles tilt toward the European model, the potential for bailouts increases.

The risks of reliance on wholesale funding are well-illustrated by Lehman Brothers' collapse in 2008. When the word got around the Lehman was struggling, its funding dried up faster than rich people rushed out of New Orleans as Hurricane Katrina approached. That one time, the Fed and the Treasury Department didn't deliver a bailout by courier. They've been harshly criticized ever since. So you can bet your bippy that no large bank will ever again be allowed to fail. Period. That's why, long term, it might end up being a bad thing if consumer deposits leave big banks. Regulators should require more capital as banks' risk profiles become hinkier. Then again, a lot of things that should be done aren't.

The UBS $2 Billion Loss: This and the Banks Want Easy Capital Standards?

Here we go again. Another big bank, this time UBS AG, reports an elephantine loss attributed to unauthorized trading. In this instance, the big boo boo was allegedly made by a derivatives trader identified in the press as Kweku Adoboli. It seems just like yesterday that Societe Generale 'fessed up to a $6.7 billion loss from its own rogue trader, Jerome Kerviel. Then, there was Nick Leeson at Barings bank, Yasuo Hamanaka at Sumitomo Trust, and John Rusnak at Allied Irish, among others, who have attained notoriety for generating leviathan trading losses. The big banks just don't seem to move up the learning curve when it comes to risk management.

It's no surprise that both the UBS mess and the preceding scandals involved lightly regulated markets. Bad behavior is always more likely when there are few hall monitors. But the banks themselves have the primary obligation to watch over their people and preserve their assets. They keep failing.

One has to wonder if the inevitability of government support makes it easier for bank executives to short sheet the risk management budget. Top management knows that no matter how massive losses get, the government will not allow a major bank to fail. Experience teaches that top management will generally not suffer much from one of these financial tectonic events. Some embarrassment, yes, and perhaps a modest haircut off one's bonus. But loss of employment and legal sanctions seem to be out of the question. So, why invest large sums in risk management systems when that would only reduce the amount of net income used to determine executive bonuses?

In addition, truly effective risk management would likely mean lower levels of risk taken. That would probably reduce income. It would also reduce losses. But management compensation tends not to be diminished as much by losses as it is leveraged by gains. So top executives are incentivized to take risks, and collecting outsized gains if the risks pay off. And if the risks fry the bank's butt? That would be a shame for shareholders.

Risk management is not just a problem for trading. One sees weak risk management in recent mortgage-related problems. Alleged poor underwriting standards for mortgage-backed securities may cost some big banks tens of billions each. The robo-signing foreclosure scandal will cost yet billions more.

And then there's Europe's sovereign debt crisis. Europe's major banks were the doofusses that financed the profligacy of Greece, Ireland, Portugal, et al. How the . . . heck . . . did they manage to put the world's financial system and economy at the edge of the abyss? Didn't they have controls that suggested diversification--not exactly a novel concept--might be in order?

For the past half-decade or more now, the world's largest banks have repeatedly imperiled prosperity worldwide. At the same time, they are coddled with bailouts, subsidies, and explicit and implicit government guarantees. Yesterday's announcement by Germany and France of support for Greece, and today's announcement by the Fed and other major central banks offering emergency dollar loans to Europe's commercial banks, are just the latest in a long line of handouts. Europe's banks have been facing growing customer runs, and more government munificence was deemed appropriate. Banks are like kids that never lose a soccer game, no matter how far behind they fall. No wonder they don't act maturely.

The regulators' proposal to end this cycle of wealth transfer from taxpayers to bank executives has been to raise capital standards. The so-called Basel III standards, which are in the process of being implemented, may require major banks to more than double the amounts of capital they hold, compared to the ineffectual Basel II standards. Banks are pushing back as vigorously as they can. Increasing capital means downward pressure on executive compensation, and that can't possibly be, can it? Some regulators may be wavering. The $2 billion loss reported by UBS is a timely reminder that there actually is a purpose to increasing capital standards--and in fact it's a good purpose even though it may likely decrease bank executive compensation.

We must not be lulled into thinking that the $2 billion loss by UBS will motivate banks to clean up their risk management messes. Prior scandals didn't, and this one won't. There surely are more rogue traders who haven't been caught yet. When their losses get big enough, they will be. Bank shareholders will pay the price, and taxpayers may have to pony up another bailout. Even though the Volcker rule will, if ever implemented, make it harder for U.S. banks to self-destruct from unauthorized proprietary trading, international interbank linkages will preclude insulation of the U.S. financial system from the failures of foreign banks.

Truth is we'll never get rid of too big to fail. It's a tax on the citizenry that cannot be repealed, Tea Party or no Tea Party. The next best thing would be to proceed with increasing capital standards. Only when banks are forced to pay, at least in part, for the costs they impose on society, will they begin to stop acting like welfare queens.

From Family Farm to Government Benefits to What Next?

It might be constructive if we could just, for a moment, step back from all the screaming and yelling, and look at our current fiscal situation from a historical standpoint. We got to our current social structure, with substantial governmental benefits and a substantial government budget, because of structural change in the economy. At the end of the 19th century, America's population was about 70% rural, living on the quintessential family farm. Multiple generations lived and worked together. Because the farm produced much of their basic needs, people were more self-sufficient than they are today, particularly if they diversified the crops they planted and kept a few hogs to sell for cash if needed.

The expansion of the industrial sector, particularly after the Civil War, when the robber barons consolidated entire industries under a single corporate roof or in collusive, oligopolistic arrangements, gave rise to a large worker class. These wage earners moved off the land, and into economic dependency. Their livelihoods depended entirely on the actions and abilities of remote corporate chieftains, and on the vagaries of business and financial markets cycles that were beyond the comprehension of most Americans. Astonishing exploitation of labor was commonplace in the 19th century and early 20th century, with employees paid poorly (and sometimes in company scrip rather than cash), required to work in dangerous environments, provided little or no benefits if injured on the job, and fired for any reason whatsoever. These practices reflected the harsh competitiveness of pure capitalism, and the big government we have today evolved gradually over the course of the 20th century to soften the cruelties of the unregulated marketplace. In so doing, big government made capitalism palatable for ordinary citizens.

Without a government stepping in and protecting the working class (and here we mean not only blue collar employees, but today's more numerous white collar workers, who are mostly blue collar workers with cleaner work environments), capitalism would likely not have survived in a democratic nation like America. The working class would have voted it out of existence. Indeed, Franklin Delano Roosevelt, so often lambasted as a traitor to his class, was in actuality the savior of the wealthy. His New Deal allowed the holders of capital to maintain their grip on economic power while ameliorating the distress of the less well-off. The big government, big benefits structure allowed capitalists to continue to operate with relative freedom to hire, fire, and transfer as they saw fit, thus facilitating flexibility and innovation in the U.S. economy. Although pure rapacity is largely prohibited, America's capitalists still can indulge their buccaneering urges to a greater extent than their counterparts in most other developed nations.

Then the train went of the tracks. The problem was debt. A lot of people got it into their heads that they'd be better off if they borrowed their way to a nice standard of living, instead of working for it. Max out credit cards, get a home equity loan, and presto, we're all living large. Bankers, who never more clearly demonstrated that they really are mostly from the middle of the b-school class, made this all very easy with exceptionally stupid lending standards and the dimwitted belief that real estate would never, on a nationwide basis, fall in value. Having drunk of this Kool-aid, the banks extended mountains of credit to one and all who had a pulse and a signature. Requiring borrowers to have the ability to repay was discarded as a quaint notion reminiscent of horses and buggies. Everyone forgot that no asset rises indefinitely in value and that debt eventually has to be repaid.

When illusions and reality collide, reality always wins. We're now stuck with shiploads of debt--mortgage debt, home equity debt, consumer credit, governmental debt, and commercial debt--that can't be repaid. There is enormous political and legal struggle over who should bear the burden of this bad debt. Borrowers unable to repay can't. Taxpayers are rebelling over the idea that they should bear more than they've already borne. Corporations and other business interests are trying to pull every political string, employ every legal tactic, and pressure every regulator in sight to shift their losses onto consumers and anyone who files a tax return. Things are ugly and getting uglier because the losses and other burdens must eventually be borne by someone.

One striking dysfunction is that losses no longer fall where market forces would have placed them--on creditors. Instead, losses are dumped on taxpayers via government bailouts and other government policies. You could say that combatants have been able to steer bullets and shrapnel away from themselves toward innocent bystanders. Why stop shooting if you won't take the hits? Why stop taking risks when the losses will be dumped on those who are less powerful while you collect the profits? With market forces in retreat, the specter of oligarchic plutocracy looms.

It was one thing for 20th century Presidents to ask American taxpayers to pay substantial costs in order to stabilize and improve the functioning of the capitalist system. This accommodated the dramatic structural changes industrial-scale capitalism was bringing to America and paved the way to greater prosperity for all. It's another to burden taxpayers with the costs of capitalist excess, while bailing out the financial system so Wall Streeters can resume collecting Brobdingnagian bonuses.

One episode of this sordid drama is being broadcast from Greece. Ordinary citizens are abandoning their government and taking to the streets because they have nothing left to lose. They face lower living standards if they knuckle under to the European Union's demands for fiscal austerity. With little or no stake in the EU any more, why wouldn't ordinary Greeks give their northerly neighbors a digital salute? One wacko truth is that if Greece walks away from its current debt and issues is own currency again, it will probably be able to resume borrowing soon in the international markets. Self-help bankruptcy, as it were. And if the debt contagion spreads to other countries, they may also conclude they're better off saluting as well.

The question now, as governments worldwide struggle with the problems of too much private and public debt, is what social structure will ameliorate today's problems while giving everyone a continuing stake in the system? This isn't a question of what produces the greatest economic efficiency, or the greatest short term economic growth (as measured by GDP, an increasingly meaningless figure). It's a question of what produces social equanimity. The answer matters to any nation that aspires to be a democracy. Plutocrats can't always have their way in a democracy.

The precise features of a workable system for the future aren't easily agreed upon, because everyone wants to eat their cake and have it too. Tea Partiers want tax and debt cuts, but no cuts in Social Security or Medicare. Many on the right resist cuts in defense spending, even while they propose major tax cuts. Dreamers on the left argue for more federal deficit spending, while ignoring the spectacle in Greece. There is such a thing as too much government debt, even for America, the nation that issues the world's reserve currency.

One reality is that economic growth may be modest or stagnant for quite a while. This is unavoidable because the burdens of excess debt are falling on our heads, and inhibit consumer spending. These burdens include higher unemployment, less government spending and lower government benefits, higher taxes (or revenue enhancements, or whatever euphemism becomes fashionable), and, consequently, less extravagant standards of living. It's clear, after three years of Fed money printing and federal fiscal stimulus, that there are no more magic bullets, no more bazookas.

What hope, then, is there for the future? The current political climate offers little reason to expect constructive action from the government any time soon. And Wall Street, by all indications, is determined to resume its bad old ways. The one avenue open to most Americans is to properly structure, and restructure if necessary, our own lives. Spend carefully, save plenty, avoid debt, and live well--but remember that living well doesn't mean displaying every tasteless urge to consume endless amounts of crap.

As a democracy, America is vulnerable to the irrationalities of crowds, and has taken big detours from the sensible and rational at times. At the same time, America has displayed a remarkable resilience and determination to survive and succeed, which carried it through a horrendous civil war, and a monumental world war with fascism. We will probably spend the next two or three decades fashioning the compromises needed for a new social structure. Trends toward greater inequality of income and wealth will come under scrutiny. Some economic inequality is inherent in capitalism and serves salutary purposes. But much of today's inequality doesn't come from market or commercial prowess. It comes from political influence and manipulation of regulatory processes. Such advantages are unfair in a democracy and will have to be reversed.

Until the process of reform is finished, keep a healthy balance in your emergency fund, and keep pumping part of each pay check into a retirement account. If you just take care of yourself, a lot of other problems won't seem so big.

Bondholder Bonanza in Europe

If you believe in reincarnation, think seriously about coming back as a holder of Euro-denominated bonds. (Or, skip the reincarnation part and just buy some.) Today, the bailout of Ireland makes clear that every nation in the European Union guarantees the obligations of every other EU nation, and also the obligations of every bank in every EU nation. Holders of European debt are in Heaven, dancing cheek to cheek with EU taxpayers.

The Germans (and French, kind of) made some noise about bondholders sharing in the losses from future national financial crises. But when push comes to shove, which could be in a week or two with Portugal, it's essentially a certainty that the dour Chancellor Merkel and frenetic President Sarkozy will hold their noses and sign another blank check. That's because the real beneficiaries of these bailouts aren't Ireland, Greece or whoever. They're German, French and other EU banks, which hold shiploads of Irish, Greek, etc. debt. A default by these nations would put the banks down the street from Chancellor Merkel's or President Sarkozy's office at risk, and those banks and their various constituencies are the real reason the wealthy EU nations are spreading Christmas cheer to the poorer EU nations.

It doesn't have to be this way. The sovereign debt crisis began with a dust up in Dubai about a year ago. While Dubai's problems quickly moved off the front page with the revelations of Greece economizing on the truth about its budget deficit, a workout continued quietly. Not long ago, the Dubai debt problem was resolved with some bond holders taking losses. Farther back in time, international financial crises in Latin America during the 1970s and 1980s involved banks taking losses on their loans. There is nothing magical about being a creditor that necessarily insulates one from loss.

The distressed nations can't devalue their currencies to boost their economies through exports (a standard maneuver in such circumstances). They all use the Euro, and its value is maintained by the European Central Bank. Only the long, poorly paved road of austerity and higher taxes is open to them. Without bailouts, defaults would loom and the debtor nations might have to leave the Euro bloc. Since Germany and France want the Euro to work, they are left with little choice except to make nice-nice with bondholders.

But just as American taxpayers are tired of bailing out bankers in New York, German taxpayers may eventually tire of bailing out the money men in Frankfurt. The poorer EU nations aren't leaving the Euro bloc--with Germany backstopping them, they have every incentive to stay. The Germans may, in the end, be the ones who leave. The more the Germans bail out profligacy in other nations and reckless lending by their own banks, the more their own financial condition will deteriorate. If Germany guaranteed all EU sovereign and bank debt, it would be in lousy shape. Since it more or less implicitly has done just that, it is. German taxpayers have already carried the substantial burden of incorporating East Germany in the West. They very possibly won't want the burden of incorporating the entire EU into Germany.

Taboos of the Real Estate Crisis

Today's housing news was that contracts to purchase existing homes fell 7.6% in January from the December 2009 level. Last week, we learned that new home sales fell 11.2% to the lowest level ever recorded since 1963, when the Census Bureau began tracking new home sales. Clearly, in spite of an expanded buyer's tax credit, the housing market remains a sick puppy.

Relief measures have treated symptoms. Defaulting homeowners get opportunities to restructure their mortgages, but lasting success is infrequent. Homeowners who haven't defaulted have trouble getting relief, especially if they are underwater. Underwater homeowners are increasingly tempted to walk away from their mortgages, especially if the loans are nonrecourse.

Treating symptoms often doesn't cure illnesses. Dealing with underlying causes is usually more effective. But the underlying causes of the real estate crisis are taboo. They cannot be discussed openly, not by government officials, nor Wall Street bankers, nor real estate industry professionals, nor consumer advocates. Candor would reveal the intractability of the crisis. At the risk of offending everyone having anything to do with real estate, we offer a little candor.

The 30-year fixed rate mortgage doesn't make commercial sense. It is a difficult loan for banks to manage, since their costs (i.e., the interest expense of deposits and other borrowings) fluctuate while the rate on the mortgage remains fixed for a very long time. Before the 1930s, the 30-year mortgage didn't exist. For all practical purposes, it wouldn't exist today except that, since the Great Depression, the government has promoted it as a way to make home ownership affordable. We can't get away from it, because real estate values would probably take a great fall without its easy terms. Even today's shorter term adjustable rate loans have amortization schedules that contemplate a long term loan of 30 or sometimes more years, so they're really just an elaboration on the 30-year fixed rate.

Banks don't like to hold 30-year mortgages. These loans can be made only by mismatching a bank's shorter term liabilities (like deposits) against a long term fixed rate asset. This mismatch is a formula for lending disaster when short term rates exceed long term rates, and they have periodically, going back to the 1970s. That's why the secondary mortgage market grew so large, first through federal agencies like Fannie Mae, Freddie Mac and Ginnie Mae, and later through private sector innovations like the mortgage-backed security, the CDO, the CDO squared, and so on. Banks became accustomed to offloading their mortgage risks. But the securitization market blew up along with the real estate crisis and remains moribund. Banks haven't been able to adapt to a world without securitization. Mortgage loans are almost entirely unavailable except when they can be guaranteed by Fannie Mae, Freddie Mac, or another federal agency, and resold. Securitization is now a federal program, not a commercial market.

The government and many others continue to believe that if home ownership is good, more home ownership is better. While this argument might make some abstract sense in a middle school civics class, reality is that home ownership in America usually requires credit. Even if some level of home ownership acquired with credit is good, that doesn't make more credit-fueled home ownership better. Only so many people are good bets for mortgage loans, and after that borrowers become riskier. We found that out the hard way in the 2000s, when defaults by the risky borrowers drove down home prices. In a society where home ownership is largely based on credit, there is an optimal level of home ownership, and after that it's a bad idea. However, not one policymaker in a trillion will openly endorse this point.

Another taboo is the proposition that banks should book the full extent of their home loan lending losses. America's banking system continues to hold hundreds of billions of dollars of losses attributable to home financing. Booking these losses would require more embarrassment on the part of banks (along with more capital raising efforts), more official consternation over the stability of the financial system and kabuki outrage over banker bonuses, and more houses in foreclosure sales pressuring prices downward. But not booking them is clogging up the banking system. Banks are afraid to lend because they want to hold onto their cash as a reserve against these unbooked losses. The paucity of bank credit is a crucial reason why the economic recovery is so tenuous. Economic stagnation is likely with the banking system in neutral.

So the wheels spin, caught in the muck of mortgages that don't make commercial sense, a secondary mortgage market that doesn't function except as a government program, the assumption that we need to make more, and then even more, bad mortgage loans in order to advance the goal of home ownership, and the unwillingness of banks and their regulators to fully face up to the losses of the mortgage mess. There's hardly any room for market forces to operate--and that's why they hardly do. Housing isn't a market. It's a government program. It's kept on life support by government subsidies, and can't be weaned off of them because the price collapse that would follow would bankrupt America's middle class.

Perhaps over the next ten years, the housing market will gradually revive. But it will surely continue to be built on the precarious edifice of taboos. Too much of America's capital will be misdirected into housing. Government borrowings will absorb vast amounts of what's left. Manufacturing and other activities fundamental to economic strength will be left with scraps. Growth will be stunted. Americans will squabble over who pays for health care, Social Security and other obligations that seem overwhelming when a slow growing economy doesn't produce wealth commensurate with society's generosity. But taboos cannot be discussed, so we end this essay. Good luck.

The Risks of Business As Usual in Banking

Banking today is structurally different from, say, three years ago. There are no more large brokerage firms under SEC regulation. All the major financial institutions are banks regulated by the federal banking authorities. There are notably fewer big financial institutions. Many faces in executive suites have changed.

But operationally, it would seem that plus ca change, plus c'est la meme chose. The banks still make big profits and pay big employee bonuses. They also take big risks. Today's Wall Street Journal reported on p. A1 that "value at risk," a measure of the potential for trading losses, is for the largest banks greater than it was in 2008, 2007 and even the boom year of 2006. In other words, after all the Federal Reserve accommodations, federal bailouts, bonus controversies, Congressional hearings and bank failures, business as usual continues and the banks are, if anything, putting taxpayers at greater risk than ever before.

That's bad, since business as usual is how we got into the recent credit crunch and Great Recession. Why haven't things changed? A couple of likely explanations suggest themselves. First, bank regulatory reform hasn't happened, and seems to be slipping toward the back burner. Health insurance reform is an extremely important priority, and, after eight years of meandering, the war in Afghanistan needs definitive direction. But let's remember that the current Great Recession was brought on by risky banking practices and more than anything the electorate chose Barack Obama as President to straighten out the economic mess. His administration cannot afford to lose focus of the need for financial regulatory reform. In the absence of reform, what else can we expect other than bad old business as usual?

The second likely explanation for the return and elevation of the banking system's risks is that the Fed, once again, is pumping out cheap credit. This time, it's really cheap credit, virtually free. Recall how banks make money. They borrow it (from depositors, commercial lenders, and nowadays most prominently the Federal Reserve) and lend it out or invest it. When the cost of borrowing is low, comparatively high risks seem sensible. (This is why so many people paid ridiculously high prices for houses when they could get 100% financing with interest only or option ARM loans--the credit was incredibly cheap so what did the price of the house matter?) High cost of funds imposes risk management discipline. Cheap money encourages profligacy.

How many times in the last decade or so have we seen this from the Fed? We've had the tech stock bubble, the housing bubble, the credit bubble, the 2008 petroleum bubble and now today's stock market, gold and who knows what else bubble. The Fed has made clear that it's going to keep credit cheap for an extended period of time. So why wouldn't the big banks ratchet up risk? Their costs are under control, courtesy of the Fed. And they know the taxpayers guarantee all their liabilities 100 cents on the dollar. What's not to like about risk? It's a great way to boost employee bonuses, when all goes well.

But the new data about banks taking more risk than ever raises the specter of another big asset bubble. If we are working our way toward another bubble, we'd better hope that this one defies the laws of economics and never pops. Since the Fed is already maintaining a zero interest rate for banks that borrow from it, it can't pull the nation out of another economic bust by lowering interest rates. There's no such thing as negative interest, because bank depositors will simply withdraw their funds and put the stuff in mattresses (which would mean the collapse of the financial system). The current combination of no bank regulatory reform, the cheapest credit possible from the Fed for an extended time, and a resumption and expansion of business as usual among the big banks could be deadly. With nothing changing, what can we expect except apres cette fois, le deluge?

Now, the United States of Enron?

The Washington Post reported on Saturday, April 4, 2009, that, for some bank bailout measures, the federal government is using a funding mechanism that harks back to the Enron scandal, in order to circumvent legal limits on executive compensation and the requirement for a government equity stake in the bailed out institution. Specifically, the government is setting up intermediate entities, called special purpose entities, that would stand between the government and the banks and other private interests participating in the bailouts. The government would fund the SPEs with capital and loans, while private investors would provide an additional amount of capital. Because government money would directly flow to the SPEs, instead of the banks or other firms being bailed out, the limits on executive compensation and the requirement for taxpayer equity would supposedly not apply to the latter, even though they are the real beneficiaries of the bailouts.

If the term special purpose entity rings a bell, it’s probably from something you read about Enron, which ensured that SPEs will live in infamy as devices for concealing risky investments and providing extra, undisclosed compensation to executives. SPEs acquired added notoriety when it turned out they had been used to hold all manner of dicey mortgage-backed securities and derivatives offloaded by banks that wanted to disavow those assets. The irony of the federal government using scandalized investment vehicles for bailouts is so obvious it hardly needs to be mentioned.

Perhaps less apparent, but more troubling, is the governmental weakness it reveals. The administration is seeking capital from the private sector because it does not feel it can go back to Congress for more bailout funds. Wall Streeters can smell weakness the way sharks can smell blood, and have exploited the administration’s weakness to get dispensation to keep doing business as usual for compensation as usual. This sets a dangerous precedent. Increased regulation of financial institutions is in the offing. Will the administration allow banks to continue business as usual through off-balance sheet techniques that circumvent its own increased regulatory oversight?

Congress strengthens Wall Street’s negotiating leverage by engaging in UHF quality histrionics on C-Span instead of a thoughtful review of the problems and issues. Its basement level standing with the public will seep lower than sump pumps can go if it needlessly weakens the president at a time of crisis.

Even if we assume the administration’s SPE structures are legally permitted, they are too clever by half. Once taxpayers realize that the administration has gone out of its way to allow Wall Streeters to eat their cake and have it, too, they will begin to lose faith in their newly elected president.

President Obama has an abundance of political capital at the moment. The electorate trusts him regardless of what fat guys on conservative talk radio say. His toxic asset purchase program might fail. Strong banks could take advantage of it to offload their problem children, and then raise more capital from the private sector. Weak banks might instead take advantage of the FASB’s new, relaxed approach to asset valuation and paint a glowing picture of themselves while actually remaining zombies. The financial crisis could continue largely unabated. Something much more direct, like temporary nationalization of banks, may well be necessary. The president should be prepared to step forward and take the lead on measures like nationalization, and weakening his standing now with potentially controversial SPE structures will only make the ultimate resolution harder.