An Epidemic of Price Fixing in the Financial Markets

Nothing is more antithetical to the principles of free enterprise than price fixing.  Rigged prices undermine the efficient functioning of markets and defeat their ability to maximize economic welfare.  Sadly, we've had an epidemic of price fixing in the financial markets, frequently involving the largest and most important banks.

The London Interbank Offered Rate has been the subject of governmental investigations in Europe and the U.S. for alleged years-long collusion. Billions of dollars of fines, penalties and other payments have been assessed on various big banks, and the investigation of other major banks continues.  Trillions of dollars of loans and contracts were priced based on Libor, and the potential impact of this price fixing is massive.

Foreign exchange rates have been investigated for rigged prices, and billions of dollars of fines, penalties, etc. have been paid in government and private civil lawsuits.  Again, some of the largest banks are implicated.

Now, word comes that the market for interest rate swaps has been under investigation for price fixing via the alleged collusive manipulation of the ISDAfix, a benchmark swap rate that is used in the pricing of a variety of financial products.  The interest rate swaps market, although obscure to the general public, involves hundreds of trillions of dollars of financial products (in notional value) sold to corporations and other commercial customers to offset interest rate risk.  Big banks are reportedly involved this collusion and the fines, penalties, etc. could total perhaps billions.

There are also reports of investigations of price manipulation by big banks in the metals markets.  These might involve restricting supply and other maneuvers to rig prices.  If wrongdoing is uncovered, more large fines, penalties, etc, can be expected.

Many of the banks involved in these matters are likely to be too big to fail.  In other words, while conspiring against the public in very large and important markets, these banks enjoyed the explicit and/or implicit backing of the taxpayers.  This backing helped them attain Brobdingnagian size, which in turn probably facilitated their ability to rig markets. 

The financial markets are the central venue of the capitalist system, being the place where holders of capital and borrowers of capital meet to determine the allocation of society's financial resources.  The largest banks are at the center of the financial markets, and their conduct ripples through the financial markets and the entire free enterprise system.  That such crucially important players are so regularly conspiring against the public and the public interest presents a galling spectacle that damages the credibility of the capitalist system.  Are markets truly socially beneficial or are they simply a means by which the rich and powerful fleece others? 

The world's largest banks have the legal and social responsibility to refrain from such reprehensible conduct.  However, their sad record of massive, multi-market price fixing seems to tell us that their chances of upholding these responsibilities aren't very high.  Their collusive activities often arise in markets that have a bi-level structure:  an inner inter-dealer market where the big banks and other financial firms trade among themselves, and an outer market where the dealers trade with the public at usually marked up prices.  The inside inter-dealer market is a perfect venue for price-fixing, as the dealers have to talk and trade with each other every business day.  As Adam Smith put it in The Wealth of Nations, "People of the same trade seldom meet together, even for merriment and diversion, but the conversation ends in a conspiracy against the public, or some contrivance to raise prices."

Thus, the challenge falls on regulators and law enforcement authorities to be vigilant and firm.  The sheer magnitude of the wrongdoing, as demonstrated by the billions that have been paid out to date, is astonishing.  Those who may seem paranoid about the financial markets have it right--way too often, the markets are rigged.

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. 

How To Stop the Too Big From Failing

Congress, and financial regulators in America and other nations, have struggled endlessly with the problem of financial institutions too big to fail.  Capital requirements have been increased, and regulation has been tightened (somewhat--much of the implementation of the Dodd Frank Act remains unfinished).  But the problem remains.

There is a simple way to seriously reduce the possibility of another taxpayer-funded bailout.  If a financial institution needs a government bailout, force the CEO, COO and CFO, and the members of the Board of Directors, to pay to the government the value of their entire compensation for the preceding five years.  This would include salary, bonuses, stock options, restricted stock, fees, country club memberships, company cars, and all other perks and compensation.  This payment would be required without regard to whether or not the executive officer or director was proven to have participated in any wrongdoing or neglect.  It wouldn't be a penalty for misconduct.  It would be an incentive to avoid sticking the government with the costs of mismanagement.

Any such proposal would, of course, provoke howls of outrage from financial institutions and their free-roaming packs of mouth-foaming running dog lobbyists.  Such a measure would be unfair if the officer or director hadn't been shown to have engaged in misconduct, it would be argued.  However, the SEC already has the legal authority to force a company's CEO and CFO to pay out all their compensation for the 12 months following the issuance of financial statements that are subsequently modified (in a form called a restatement)--see Section 304 of the Sarbanes-Oxley Act.  The SEC isn't required to show that the CEO and CFO did bad things.  They can be forced to make this payout simply because the original financial statements were wrong and needed to be restated.  The courts have upheld this authority.  There's nothing unfair about requiring senior executives to get important things right in the first instance.

Banks and other financial institutions might also object that they couldn't recruit the executive talent they need if this financial Sword of Damocles were to hang over their heads.  But, when we consider the geniuses at some financial institutions in the recent past who steered their firms right over cliffs and into government safety nets, this argument loses its persuasiveness.  Executive compensation arrangements at the too big to fail seem to incentivize risk-taking, even if it might entail unmanageable complexity.  There needs to be a disincentive--and a strong one.

The government has been criticized for not penalizing the high and mighty for the financial crisis of 2008.  Remember, however, that the statutes and regulations governing financial institutions are complex.  Proof of violations can be difficult.  A simple measure like a penalty of five year's compensation for a government bailout offers a way to nail the top dogs for signing a chit the taxpayers have to pay.

Costs of Quantitative Easing

The law of unintended consequences haunts economic policy.  The Federal Reserve's quantitative easing program, now in its third phase, is meant to provide economic stimulus.  However, it also drags on the economy.  Let us count the ways.

Reduced Interest Income.  Hundreds of billions of dollars of interest income have been lost because of the Fed's longstanding campaign to drive down borrowing costs.  Losses of this magnitude undoubtedly have dampened consumer demand.  Even though QE likely sprung loose some personal income by providing lower mortgage rates for homeowners to refinance, tight standards applied by banks making mortgage loans have limited the refi impact of lower rates.

Reduced Retirement Savings.  As bond yields shrivel up like corn in today's drought-ridden Midwest, many retirements look bleaker.  Even though the stock market has boomed, large numbers of shell-shocked savers abandoned stocks after the 2008-09 market crash and haven't participated in the gains.  Instead, they ducked into bonds.  Although the improbable bond rally of the past few years generated capital gains for many bond holders, the basic return sought by bond investors comes from interest paid.  That has been paltry.  As retirements look bleaker, many workers cut back on current consumption in order to save more.

Pension Pain.  Despite appearances from some recent press coverage, pension funds cannot take large risks, overall, with their portfolios.  However much publicity pensions' alternative investments may generate, a large part of pension assets must be invested in high quality bonds.  As returns on these puppies shrink, employers corporate and municipal confront the necessity for greater contributions.  Workers may be laid off, citizens may receive fewer public services, state and local taxes may be raised, shareholders may endure lower returns, and those workers still employed may have to make greater pension contributions.  All of which would further discourage current consumption.

Insurers Backpedal.  Insurance companies' returns on their investments are falling.  This means policies that depend on long term returns, such as annuities and long term care policies, become more expensive or even impossible to buy.  Or else, they offer fewer benefits.  Policy holders suffer.  Those people who want to provide for themselves, through long term care policies, annuities, whole life and similar products, have a harder time.  More people end up having to rely on government programs like Social Security, Medicaid and so on.  That's not good in an age of serious federal deficits.

Yield Curve Flattens Bank Incentive to Lend.  Back in the days when they made loans, banks would borrow short term (usually through demand deposits, interbank loans via the fed funds market, and savings accounts) and lend longer term.  The difference between short term interest rates (historically lower) and longer term interest rates (historically higher) provided profits for the banks.  But the yield curve (the graph of interest rates from short to long) has been flattened by the Fed's monetary policies.  There isn't that much difference any more between short and long term rates.  Potential profitability for banks has been squeezed.  Banks have less incentive to lend, and fewer loans means less potential for economic growth.

The Fed has sworn on a stack of printed money to keep short term rates darn near invisible until at least mid-2015.  It may achieve some of its objectives.  But it will also create unintended consequences.  The impact of these opposite reactions to the Fed's actions may be greater than the central bank foresees.  There are few real life experiments in economics.  But if we look at the most obvious example of the impact of a central bank squashing interest rates for years at a time, we can see that Japan has remained moribund for two decades since its financial and real estate crashes in the early 1990s.  The Bank of Japan has ruthlessly stamped out any positive upswings of interest rates in that nation.  But that hasn't produced the spark needed to revive Japan's economy.

It now looks like the Fed will keep rates unnaturally low for the better part of a decade.  Given Japan's experience, one wonders what is in the Fed's playbook.  If it's a sensible fiscal program from Congress and the White House, the next question would be what is the Fed smoking?  But if the Fed is acting on the reasonable assumption that we will have fiscal dysfunction for the foreseeable future, only the arrival of Godot, it would seem, would offer reason for optimism.

The EU Sovereign Debt Crisis: A Farewell to Globalization?

Today, the Federal Reserve announced a new round of stress tests for the six largest American banks to find out how well they would withstand a market discombobulation emanating from the EU sovereign debt crisis. Translated from regulatory speak to plain English, this is a strong hint to the big banks that they straightaway ditch as much of their EU exposure as they possibly can, devil take the hindmost. Those banks that don't move with alacrity will be required to boost capital levels, an exercise detested by bonus loving bank executives (which would be about all of them).

It is ironic that the Fed would try to quietly build a firewall around the U.S. banking system. It has preached internationalism throughout the past four years as the financial markets belly flopped, and maintains generous dollar-denominated lines of credit to foreign central banks. The latter measure helps the dollar fulfill its role as the world's reserve currency, ensuring that there are enough dollars for the wheels of commerce. But encouraging major U.S. banks to offload Euro-denominated obligations de-globalizes. In effect, the Fed is saying, "Lafayette, nous allons partir."

Euro-denominated investments will face downward price pressure if U.S. banks begin casting them away. The Fed surely knows this would be bad for the EU's banking system, which is desperately reaching for any lifeline in turbulent seas. One can't help but wonder whether the Fed has concluded that the EU may not be able to pull itself out of its nosedive.

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.

The Fragility of the Financial System

Is the stock market crazy with its recent belly flops? In the past 5 weeks, it's dropped over 15%, with the Dow adding another 519 points today (over 4%). We're getting close to a bona fide bear market. While the trading may look like panic selling, maybe it's not. Over half the market is computerized trading. The firms that do this stuff leave it to the algorithms and machines. Many of the non-computerized sellers are institutional investors--mutual funds, pension funds, hedge funds, and so on. The money managers of these institutions presumably have the professional experience to stay focused even when under stress. Are they right to jump ship so quickly?

The heart of the world's economy is the financial system. Banks and other firms that comprise the financial system are unusually fragile. Even the biggest banks have Achilles heels where their commercial counterparts don't. A bank's principal asset is the confidence in which it is held by those that deal with it. Without that confidence, the bank would be overwhelmed by a flash mob of depositors, counterparties and creditors all trying to get their money out immediately. By contrast, the Apples, Googles, Microsofts, and even Fords of the world can't go under in a matter of a day or two or three, no matter how little confidence others have in them. They need months, and even years, to collapse.

Confidence in the big banks has been shaken. The European debt crisis is the biggest reason. Europe's big banks hold large amounts of EU sovereign debt. If the EU's debt crisis keeps metastasizing (and it likely will, by all indications), these banks will have greatly shortened half-lives. While the major U.S. banks hold only modest amounts of EU sovereign debt, they are bound by numerous interconnections to Europe's big banks (through the settlement and clearance process for checks, trade financings and the like, interbank lending, derivatives exposures and so on). If Europe's big banks become insolvent, America's big banks will be living in a world of ships (or something like that). Just a couple of days ago, Spain and Italy were the focus of domino-like rumors as the next shoes to drop in the EU crisis. Now, France is vigorously denying that it has problems. Many in the market are taking this as confirmation that France does have problems (on the theory that if you have to deny it, you're already toast). The EU debt crisis acts like a battering ram on confidence in the world's big banks.

Another confidence shaker was the S&P downgrade of U.S. Treasuries. The proximate connection of the downgrade to the big banks is they hold boatloads of U.S. Treasuries. Since the 2008 financial crisis, the big banks have played a sure-win game where they borrow from the Federal Reserve, for virtually nothing, and reinvest the money in U.S. Treasuries. The Treasury securities effectively give the big banks a wash with the federal government, except for a net positive interest payment. In effect, the Fed has been sending income to the big banks for free. There was also no credit risk, that is, until the downgrade. While Treasuries have momentarily risen in market value due to flight to quality buying, the rating downgrade highlights the risks of the concentration of bank assets in Treasury securities.

Taken together, the large holdings of EU sovereign debt by EU banks, and the large positions of U.S. banks in U.S. Treasuries, make the international banking system unusually sensitive to difficulties with sovereign debt. And lately there have been difficulties galore. Hence, the financial system looks shakier and stock values less certain.

To make the situation worse, the Fed's relentless campaign to drive down interest rates along the length and breadth of the yield curve has, perversely, weakened the banks. Banks, in a nutshell, make their money by borrowing on a short term basis, usually at the low rates available at the short end of the curve, and lending longer term at the higher rates usually available for longer maturities. This strategy works when long term interest rates are sufficiently higher than short term rates (i.e., the yield curve is sufficiently upward sloping). The flatter the yield curve gets (i.e., the lower long term rates go, relative to short term rates), the less profitable lending is for banks. The Fed's various policy measures, most recently QE2, have flattened the yield curve quite a bit. Recent flight to quality has flattened it even more. Perhaps one reason why the Fed hasn't yet announced QE3 is because it doesn't want to further stifle the profitability of bank lending by making the yield curve resemble the horizon.

Thus, the Fed's interest rate policies are probably adding to the fragility of the banking system. Folk wisdom on the Street holds that when the yield curve inverts (i.e., the short end rises above the long end), a recession is likely. Today, it's hard to apply this thesis, since the Fed artificially prescribes rates. But if we could extrapolate somehow to what a more normal, less government controlled market would look like, we'd have to be concerned that prospects for the economy are far from rosy.

Last, but certainly not least, the real estate/mortgage crisis still haunts the banking system. Recently, the robo-signing foreclosure debacle has operated like a pipe bomb in bank balance sheets, with escalating costs that the banks have been desperately trying to cap through court settlements. Once the banks are able to foreclose again, they'll have to book losses by writing down a lot of loans currently held in suspension because foreclosures remain in limbo. It will be years and many more losses before the real estate disaster is cleaned up.

So have investors been freaking out and selling in a panic? Or does it make sense that the sudden flaring of the EU sovereign debt crisis over the past few months, coupled with the debt ceiling dance of governmental dysfunction, and the nine lives of the real estate/mortgage crisis, would reveal the ethereal foundations of stock market valuations? This isn't necessarily a situation where the market must be crazy. Maybe the world really is screwed up, and market valuations are adjusting to reflect that reality.

It's the Economy, Stupid, and Republicans and Democrats Are Stupid

Politicians make their livings bashing other people, so it's only right and fair to bash them. There's a lot of grist for this mill.

Republican Congressional leaders were quick to criticize the Obama administration on Friday, June 3, 2011, after bad unemployment numbers were announced. Total job creation in May was 54,000, and the unemployment rate rose from 9.0% in April to 9.1% in May. The weak job creation number wasn't surprising, given other recent data signaling stagnation. The unemployment rate increase naturally flowed from the economy's need for a net increase of over 100,000 jobs every month simply to keep up with population growth (which increases the labor force). In addition, some previously discouraged workers may have jumped back into the labor force to actively look for work. That expands the labor force and raises the unemployment rate when there aren't enough jobs for them.

How did the Republicans shoot themselves in the foot? The private sector increased employment in May by a net of 83,000 jobs. That's not a great number, but it shows hiring exceeded firing. The reason for the lower total of 54,000 new jobs was that governments laid off a net 29,000 workers. This is due to state and municipal governments cutting back to meet austerity demands from primarily Republican governors and legislators. Do we think these government workers who lost their jobs because of Republican policies will blame the Obama administration? (Hint: take a look at recent events in Wisconsin politics.) Government employment levels have fallen for seven months in a row, and that's not because the Obama administration is laying off federal employees. If unemployment trends continue like this, expect the growing numbers of unemployed government workers, and many among their family and friends, to vote Democrat. Republicans hoping to see their party do well in 2012 should be careful what they wish for because the jobless have plenty of time to vote.

As for the Democrats, the Obama Administration announced on Saturday, June 4, that it would make a renewed push for principal reductions on defaulting mortgages, in an effort to keep more homeowners in their homes. This is meant to help not only struggling homeowners, but also to keep more houses off the foreclosure and resale markets, where distress sales continue to nudge home prices lower. But principal reduction has been a fools errand. It hasn't worked well in the past and isn't likely to work well now. The people who need principal reduction the most--the jobless--won't qualify because of their lack of income. Banks aren't required to reduce principal, and have little incentive to do so. There may be arguments why banks and mortgage investors lose less from principal reductions than from foreclosure. But the legal latitude banks have to make principal reductions on mortgages they have sold to investors is less clear than proceeding with foreclosure, and banks may be stuck with some or all of the loss to lenders when principal is reduced. In other words, banks may be in a riskier position with principal reduction than they would be with foreclosure (where they can generally pass the loss onto investors because banks mostly sell mortgages they originate). So why would they put themselves at increased risk in order to give a defaulting borrower a break? Never forget that on Wall Street, money talks and bullswaggle walks.

A second, and more important point for political purposes, is that the neighbors are watching. Yes, they want to see if the person next door has a better big screen TV than they, or if the person across the street is having an affair, or if the teenagers two houses away are getting out of control. But keeping up with the Jones would become most urgent if neighbors got a reduced mortgage because they didn't keep up with their monthly payments. Talk about envy. The defaulting Jones would get, perhaps, the equivalent of tens of thousands of dollars over time because they were deadbeats. Principal reductions could have a bandwagon effect--give one to the Jones, and others on their block will start defaulting so they, too, can get a principal reduction. After all, how can you tell your kid to borrow tens of thousands of dollars for college because you wouldn't stiff the bank like the folks next door? If entire neighborhoods start having mortgage default parties, bank earnings will fall and bankers contributions to the Republican Party will soar. Neighbors too proud or too protective of their credit ratings won't default. But they will likely vote Republican to assuage their anger.

So politicians are stupid. That's not news. The scary thing is they don't move up the learning curve. Governance failures are now in vogue. The Japanese government's dysfunction exacerbated its slow reaction to the nuclear crisis that followed the recent earthquake. The Euro bloc's weak governance structure makes bailouts without a true restoration of fiscal discipline the only way to cope with its sovereign debt crisis. This is not a solution, but a deferral of the train wreck to come. California's governance failure has pushed its budget crisis virtually beyond the realm of resolution. And, last but certainly not least, the mud-slinging, gotcha-politics in gridlocked Washington have imperiled the creditworthiness of the U.S. government and the strength of the U.S. dollar. The dumb thing about all this is that Japan, Europe, California and America are all very wealthy. They have the resources to solve their problems. But they can't make their political processes work in a constructive way. Forget all the predictions for the economy and the stock market you're now hearing. Politics has thrown a wild card into the game, and no one knows how things will turn out.

Derivatives Dealers Grumpy Over Deutsche Bank Ruling

Derivatives dealers worldwide are grumpy because of a ruling by the highest civil court in Germany finding that Deutsche Bank AG was responsible for disclosing the risks of a derivatives transaction to a company that bought an interest rate swap. The German court was concerned by the bank's conflict of interest from the risks in the transaction being stacked in its favor, at the customer's expense. The court especially didn't like the bank's failure to disclose that the customer's starting value in the transaction was an unrealized loss of -80,000 Euros, or over -$100,000. The court noted that although Deutsche Bank had warned the client that the risk of loss was theoretically infinite, it also predicted that the transaction would be profitable for the customer. The court thought the bank should have made loud and clear that the customer's losses could really be costly, and not just theoretically so. (See Wall Street Journal, Dec. 23, 2011, P. C3).

From a derivatives dealer's standpoint, disclosure obligations like those required by the German court seriously erode the dealer's informational advantage. In the financial markets, an informational advantage is more valuable than gold. That's why, as illustrated by the U.S. government's investigation into trading by hedge fund manager Galleon Group and others, there is so much apparent insider trading. Having the informational advantage really pays. If derivatives dealers now have to make disclosures as contemplated by the German ruling, bank profits might suffer. And nothing, as we all know, could be more horrifying than that.

The U.S. SEC's 2010 case against Goldman Sachs for its role in a mortgage-related derivatives transaction called Abacus 2007-AC1 crimped the style of banks acting as underwriters. The German court's ruling may have a bigger day-to-day impact, since it concerns a bank acting as a dealer in the interest rate swaps market. Trillions of dollars of transactions per month take place in this market. Banks are dealers--i.e., they act as principal on one side or the other of the swap--because customers don't want the credit risk of any counterparty other than a very large (and de facto government guaranteed bank). Too-large-to-fail banks of commercially powerful nations like Germany and the U.S. have an advantage in this market, since their governments' implicit guarantees are worth much more than, say, the Greek or Dubai government's guarantee. If the laws of commercially powerful nations like Germany and the U.S. begin to tilt the derivatives playing field toward anything approaching level, the banks may seek more accommodating nations in which to ply their derivatives trade. But, as financial markets globalize, there will be fewer and fewer places for big banks to go. And increasingly savvy corporate clients may abjure from doing transactions routed through a Caribbean island or Equatorial African nation.

Progress on the regulatory reforms in the Dodd-Frank financial legislation enacted last year has, on the best of days, been confined to the slow lane. Big banks have lobbied combatively to limit and water down the changes. The SEC has long known of the informational disparity in the derivatives market, having brought an enforcement case in 1994 that illustrated the problem. See http://blogger.uncleleosden.com/2010/02/will-wall-street-get-pass-on.html. Perhaps the German court's decision will help to encourage U.S. regulators to push through the headwinds of the big bank lobbying juggernaut. Some of the big banks' corporate customers have been convinced to lobby against change. But the German case, and the SEC's 2010 and 1994 cases, reveal that corporate customers sometimes don't even know what they don't know. It's one thing to let people knowingly take risks. It's another thing to leave them unknowing and saddled with risk.

Taxpayer Liability for Banks: the Missing Link in Balancing the Federal Budget

As if the federal budget balancing debate weren't complicated enough, a key issue is absent from the discussion. Virtually no attention is being paid to the potential budget-busting problem of taxpayer liability for the banking system. Although this is a contingent liability, it can wreak astounding havoc when the banking system hits the fan. Ireland illustrates the problem.

Like so many other nations, Ireland rode to seeming prosperity on a rising real estate market. Its banks were instrumental in financing this bubble. When Lehman Brothers collapsed in September 2008, Irish banks rapidly slipped off the precipice. Their stock prices fell and a liquidity crisis loomed. The Irish government moved posthaste to stem the panic, guaranteeing some $570 billion of bank liabilities (which should be compared to Ireland's GDP of approximately $170 billion). Eventually, the Irish government nationalized one major bank, Anglo Irish. While the Irish government's direct debt is about 65% of GDP (not much different from the U.S. government's direct debt), its guarantee of bank liabilities vastly increased its potential obligations. The resulting morass was so bad that Ireland needed an EU bailout earlier this year.

The U.S. government (and American taxpayers) are on the hook for the liabilities of the largest American banks. Not officially, but we all know they'll get a bailout if they need one. In addition, taxpayers are liable for the housing banks--Fannie Mae, Freddie Mac, the FHA and Ginnie Mae. The amounts of all these contingent liabilities are unclear but likely very large. Illiquid real estate assets held by banks (so-called Level 3 assets) may be overvalued by hundreds of billions. Vast numbers of defaulted mortgages remain in limbo as the foreclosure mess crawls toward a resolution that will probably entail more losses for banks. The continued decline of the real estate market means more mortgages going underwater, and probably more defaults.

In addition, the largest banks have trillions of dollars of derivatives exposure. Much of the derivatives exposure is hard to see right now. Current accounting standards allow banks sometimes to net derivatives assets against derivatives liabilities. Netting means we don't see them on balance sheets. Once international accounting standards replace U.S. generally accepted accounting principles (probably within a couple of years), a lot of current netting of derivatives holdings would likely have to be unwound. Balance sheets of the largest banks could balloon by more than $7 trillion, in the aggregate. America's GDP is around $14 trillion, while annual federal spending is around $3.5 trillion. Readers may painfully recall that during the 2007-08 financial crisis, derivatives assets had a scary way of losing value while derivatives liabilities remained unwavering. Taxpayers would be on the hook for the losses. Reining in the amounts of bank derivatives exposure may be necessary to reducing the potential bite on taxpayers.

So, we can see that balancing the budget doesn't just mean getting expenditures down and government revenues up. It also means limiting contingent liabilities. Ireland's government didn't flagrantly overspend. Profligate lending by too big to fail Irish banks made it fail. Fortunately, Ireland's not too big to be bailed out by the EU. But there's no brother big enough to bail out America. Truly balancing the U.S. government's budget requires limiting taxpayer exposure to the banking system.

Progress on that front is painfully slow. The Volcker Rule is constraining some of the riskier activity. But reform of the derivatives market is hard to spot, even on sunny days at high noon. Banks remain Brobdingnagian in size, and executive compensation may soon run wild again. Implementation of the Dodd-Frank provisions for improved financial regulation is hindered by lack of funding. Fannie, Freddie and the FHA guarantee almost all new mortgages. Proposals for limiting the burdens they place on taxpayers will be obstinately contested by the real estate industry. Although neither Republicans or Democrats want to face the tough issues in balancing the budget--entitlement programs like Medicare, Medicaid and Social Security--we will eventually have to reform those programs. But all the pain and controversy we will endure squabbling over entitlements will be for naught if there is another financial crisis. And another crisis hardly seems any less likely than the one we still haven't recovered from.

The Federal Reserve's Failure to Supervise

Sometimes, the way to solve a problem is to question your assumptions. That's a lesson the Federal Reserve should take from the Financial Crisis Inquiry Commission's Final Report. There's an interesting tidbit on p. 54, which quotes a former senior Fed staff member as writing, "Supervisors understood that forceful and proactive supervision, especially early intervention before management weaknesses were reflected in poor financial performance, might be viewed as i) overly-intrusive, burdensome, and heavy-handed, ii) an undesirable constraint on credit availability, or iii) inconsistent with the Fed's public posture." In other words, when a bank was making profits, especially lots of profits, regulatory staff were supposed to hold back.

This is exactly wrong. Undergraduate level economics teaches that any high degree of profitability should be ironed out by competitive forces in the market. Thus, the existence of high profitability may be a sign that something less than entirely desirable may be happening. The bank might be taking a lot of risk (remember that risk comes with reward), such as by underwriting mortgage loans to people whose documented ability to repay is skimpy or nonexistent. Or the bank may be doing something illegal. Fraud, manipulation and other illegal conduct can be immensely profitable. That's why there are so many financial shenanigans. High profitability is a yellow flag, indicating that increased regulatory scrutiny is warranted.

Requiring staff members to hold back until a bank's financial performance has nosedived, as the Fed apparently did, is tantamount to fiddling until disasters burst forth and wreak a full measure of havoc and collateral damage. No glory is attained when the cavalry charges over the hill after the wagon train has been massacred.

The FCIC final report also notes, on p. xvii, that in 1980, the financial sector earned 15% of total corporate profits in America. This figure grew to 27% by 2006. This sustained rise in profitability is another yellow flag. It could indicate a sustained increase in risk levels (uh, duh). Or it could be a sign of illegal behavior. Either way, a sustained rise in profitability should have been seen as a reason for greater regulatory alertness.

Sustained elevated profitability might also indicate cartelization, with large, powerful banks extracting outsized profits by dominating markets. This is also undesirable, as greater oligopoly power would reduce the benefits of competition. Regulators should be vigilant against a shift toward concentration in market power.

The Fed appears to have viewed bank profitability as desirable. Better financial performers would presumably be more stable and less likely to collapse, which would reduce the Fed's worries. But we now know that the sustained increase in bank profitability resulted from high risk and sometimes illegal conduct that exacerbated the instability of the financial sector, ultimately leading to the crisis of 2007-08.

It may be counter-intuitive for regulators to scrutinize their regulatees more closely when the latter are reporting rosier financial performance. But greater profitability is a yellow flag, and perhaps a red flag, for serious problems. Regulators are not supposed to be cheerleaders for management, nor are they supposed to relax when the regulated industry is prosperous. They must apply unrelenting skepticism, 24/7. The history of financial crises preceding the creation of the Federal Reserve well-document that markets are not invariably self-correcting or self-regulating. That's why the Fed was created. One of the root causes of financial bubbles is too much credulity. The civil servants charged with preventing these disasters should never add to the credulity.

A Key to Facebook's Valuation

Recent press reports indicate that Facebook may go public in a year or so. Its recently reported private placement deal with Goldman Sachs supposedly put a $50 billion valuation on Facebook. Many think this is an optimistic number. Conventional measures of value are hard to apply to Facebook because it doesn't publicly disclose its finances. Uncertainties about its business model add to the problem. One wild card is the continued evolution of online privacy policies.

In many respects, online privacy is an oxymoron. Every day brings news of yet more security breakdowns and thefts of personal information. There doesn't seem to be a website that can't be hacked into, one way or another.

But online crime isn't the most important factor affecting online privacy. The commercialization of the Internet is far more significant. Businesses that want to sell your personal information will do much more to reduce online privacy than pimply kids eating junk food in front of computer screens.

Banks are starting to place targeted ads in your online statements. If your bank account shows, say, several recent debit card charges for fast food breakfasts, you may be offered a discount on your next Egg McMuffin. Some bank customers may like the idea of getting a discount while they review their account activity. Others will be creeped out by the idea that the most confidential financial information they have is being mined for the further profitability of purveyors of salt, sugar and fat. Many customers would be outraged at the possibility that insurance companies might pay to know about their slovenly eating habits and charge them higher life, health or disability insurance premiums. Actual insurance company access to your bank account hasn't been reported in the news, but don't think insurers--and the websites that are collecting your personal information--aren't pondering the possibility.

Banks have a lot of ways to make money, yet they are trying to profit from selling your personal information. Think of the pressures on Facebook, which has far fewer potential revenue streams than a bank. The most valuable thing Facebook has is the personal information it gathers about its members. If it can't find a way to monetize that data, its future could be difficult.

The FTC is proposing guidelines about online privacy. Members of Congress are getting interested in the issue and may offer legislation. One way or another, the law in this area will evolve and soon. When it does, Facebook's stock market value could rise or fall, depending on what rules are imposed. Indeed, since the monetization of personal information is likely to be Facebook's biggest potential revenue stream, online privacy laws could be crucial to determining the company's valuation.

How Tight Money is Hindering Recovery

It is axiomatic among students of financial history that tight money policies by central banks aggravated the economic downturn of the 1930s and pushed the world from a deep recession into the Great Depression. Policy makers, especially the Federal Reserve, have sworn on many stacks of many books to avoid the mistakes of the 1930s by maintaining an easy credit policy. Yet credit is tight, in some respects very tight. While the tightness isn't pushing us into a depression, it makes recovery very difficult. At its meeting today, the Fed Open Market Committee promised to keep short term rates at zero as far into the future as one can imagine, and to continue its program of quantitative easing by buying longer term U.S. Treasuries. Its accommodations, however, will do little to ease credit conditions.

Where is the tight money? Everywhere. Mortgage loans are subject to strict underwriting requirements, which may be getting stricter as the real estate market continues to soften. Credit cards are issued only to customers with sterling credit ratings. Business lending may be easing slightly, but the smaller businesses that can't directly access capital markets (like the S&P 500) find that bank credit is somewhere between almost inaccessible and absolutely unattainable.

The tightness of money is a reaction to the credit binge of the 2000s, when anyone with a pulse and a signature could get a loan. After the financial tsunami of 2008, banks, regulators and mortgage underwriters like Fannie Mae and Freddie Mac found prudence in their hearts. With the fervor of the newly converted, they now hew to the straight and narrow, dribbling pinches of credit only to right-thinking, clean living, pure-hearted borrowers who've never said a cuss word in their lives.

The tightness of credit is good for taxpayers, who are directly or indirectly on the hook for just about every liability of every bank in America (and perhaps some banks in Europe if the Euro crisis isn't resolved soon). And it's good for rebuilding America's balance sheet. The nation's banks, consumers and governments all are deleveraging, and another credit bingeapalooza is the last thing we need. Relaxing credit standards to accelerate economic recovery could easily foster a faux prosperity that would collapse when reality inevitably trumps fantasy.

The Fed's easy money isn't being loaned out much. To a large degree, it sits in banks' accounts at their local Federal Reserve bank, where it likely serves as a buffer against real estate losses the banks are afraid they'll have to book. The Fed surely knows this. So what is it doing, triggering battered savers syndrome from sea to shining sea? One suspects that it's deliberately trying to create inflation, in order to scare catatonic consumers into spending. The Fed's nightmare is deflation, which can inhibit consumer spending and thereby worsen a downturn. Instill the fear of inflation and consumers presumably will buy in order to avoid higher prices later.

The theory may be tidy. But what if consumers are afraid of losing their jobs? A new high-end washer/dryer combo won't make you feel very good if you're laid off the week after it's delivered. Even with the threat of inflation, consumers may choose to save (and invest in the best inflationary hedge they can find). The Fed has to contemplate the limits of monetary policy, and consider whether it's doing more harm than good. Its quantitative easing program has driven long term interest rates up, raising mortgage rates, cutting off refinancings and reducing the pool of qualified buyers of homes. That, in turn, may push real estate prices lower and cause credit standards to tighten even more. In other words, quantitative easing may be making credit tighter--and retarding recovery.

At the same time, if quantitative easing does trigger inflation, we could end up with much dreaded 1970s style stagflation. Then, leisure suits might come back, multiplying the horror of the situation.

In matters economic, the law of unintended consequences is remorseless and inflexible. Its judgments are rendered swiftly, with nary a thought given to mercy. The Fed normally likes to keep all its options open. But this time it seems hellbent on spending $600 billion smackeroos on Treasury securities, come something or shinola. The Fed is steering the toboggan toward slippery slopes. Hang on tight.

The Foreclosure Crisis: Time to Put the Mortgage Industry in Federal Court

Another major bank, Wells Fargo, announced today that it's placing its foreclosures under review. Morgan Stanley estimated that as many as 9 million foreclosures might be open to legal challenge. (See http://www.bloomberg.com/news/2010-10-12/disputes-may-affect-9-million-foreclosures-morgan-stanley-says.html.) Mortgages whose ownership is unclear create an additional, potentially massive problem. They may have to be written off bank balance sheets. Or, if they were supposedly sold but really not, the "purchasing" investors may be entitled to reimbursement for failure of the underwriting bank to deliver the mortgages. The number of mortgages where title is unclear hasn't been reported. But it could be very large.

Legal processes are erupting nationwide. Lawsuits by the truckload are being filed. Attorneys general in 40 or more states are investigating. Federal agencies and departments are huddling and inquiring. Subpoenas are flying. The legal profession is smiling. Its recession has just ended and prosperity is around the corner.

The foreclosure crisis has become a raging bull. There are, or will be, many, many thousands of lawsuits brought over one aspect or another of the morass. The courts will be clogged for years. Title to millions of homes could be clouded for a long time. Real estate sales could slump as buyers back off and title insurance becomes far more expensive than before.

There's no easy or quick way out of the mess. Indeed, we got into this mess because banks owning or servicing mortgages wanted a quick and easy way through the complexities of recording liens against real estate and foreclosing on those liens. Those banks apparently didn't want to bother with the due process of law. They will now get a shipload of due process, from the courts of just about every state in the nation, and many federal courts as well.

Not even Charles Dickens could write so byzantine a novel, nor Mary Shelley so horrifying a story. The prospect of 50 or more judicial systems reaching every variety of result in this ocean of litigation (and taking years to do so), with no established mechanism for consistency or predictability, is stupefying. Homeowners could experience widely varying outcomes, depending on where they live. Investors in mortgage-backed investments may have little or no idea what their now increasingly illiquid investments are worth. Banks would face unenviable choices for accounting for the situation. Mortgage investors and bank shareholders may well indulge in class action litigation.

A gargantuan problem such as this needs an organized and unified nationwide process for resolution. The current multi-jurisdictional mosh pit promises only legal pandemonium. The financial markets will stomach such bedlam for only so long, and that won't be very long.

But how to institute a national claims resolution process? Federal regulators can correctly say, as they did with the Lehman situation, that they have no statutory authority to take on the problem. State officials have no authority beyond the borders of their respective states.

A claims process in federal court may offer a solution. The process would involve reviewing records relating to mortgage ownership, resolving disputes and deciding who owns what. Attorneys with appropriate backgrounds could be recruited to serve as special masters to handle the enormous amount of work this would entail. The federal claims process could also look into foreclosures, past, present and prospective, and resolve uncertainties and competing claims. (The latter process could be handled through related proceedings in federal district courts in each state, where local lawyers having knowledge of their particular state's laws could serve as special masters to resolve mortgage recordation and foreclosure issues, but as part of a national process to keep the overall resolution of the problem coordinated.) By using attorneys as special masters, the resources of the courts would be magnified exponentially. As things now stand, the foreclosure process has clogged up numerous state courts, with no obvious way to clear up the traffic jams.

Other claims, such as class actions by investors or shareholders, could also be incorporated into the master claims process and resolved as part and parcel of the nationwide cleanup of the mortgage market and foreclosure process. Judges and federal magistrates might be the best adjudicators for these other claims, as they are the most likely to resemble the kind of litigation judges and magistrates routinely handle.

A unified national process could offer at least some degree of consistency in procedures and principles. It might also provide for coordination of various claims, and some notion of a timetable. And the appeals process would be greatly simplified. Information about the mortgage problems would be centralized and presented in a more organized way, offering greater transparency to the financial markets. The big banks, which may face the greatest liabilities here, would have a single process in which to resolve the myriad claims they now likely face, simplifying their management, accounting and regulatory problems.

The federal courts have experience administering cases with vast numbers of claims. Products liability litigation over asbestos related illness and injury provides an example, in which the claims of thousands of individuals have been resolved, in some cases with substantial payments. A nationwide mortgage and foreclosure cleanup process might well be the most complex proceeding ever undertaken by the federal courts. But if there were ever a time to take on such a challenge, this is it.

There isn't an obvious way to institute such a proceeding. Perhaps a number of interested parties, including major banks, the key mortgage guarantors such as Fannie Mae and Freddie Mac, their regulator (OFHEO, or Office of Federal Housing Enterprise Oversight), the FHA, as many state attorneys general as can be mustered, federal financial regulators (citing their need to promote the safety and soundness of banks, and monitor and control systemic risk), and whoever else has legal standing to join the party could band together and petition a federal district court in Washington or New York (where the federal district courts have substantial experience handling massive litigation, and where there are hordes of lawyers who could be lined up to serve as special masters). As a legal foundation for such a process, the petitioners might invoke the equity jurisdiction of the federal courts (a body of law that, more or less, says the courts can, within certain limits, create solutions to problems that the existing legal system can't handle or doesn't handle well). Even though it's unlikely any of these parties alone could convince a court to institute such a proceeding, the combined interests of a consortium of interested parties might present a strong enough foundation that a judge would find jurisdiction.

Equity jurisprudence may be insufficient. If so, an act of Congress would be required. That's a scary thought. The temptation for the politicians to politicize such a process is obvious. But the alternative is a legal quagmire stretching from sea to shining sea. A unified national claims process, even if polluted by the underhanded, craven and disgraceful manipulations of pompous, self-interested politicians, may offer a less imperfect solution. (The biggest problem could turn out to be that Congress won't act quickly enough, a distinct possibility given today's shifting political winds; and that would aggravate a seriously aggravated situation.)

The bonfire of the mortgages is burning hot and fiercely, spreading its flames like a prairie fire on a windy day. A unified nationwide claims resolution process may be the only feasible alternative to the inferno.

The Financial Markets Are Regressing

It's been widely noted recently that individual investors are leaving the stock markets and shifting their savings into bank accounts or bonds. The bond market has improbably rallied in recent months, despite ultralow interest rates. That brings to mind investment patterns from the late 19th Century and early 20th Century. In the Gilded Age, stocks were volatile and viewed as little more than a form of gambling. Ordinary citizens made do with bank accounts. Bonds were a preferred investment for the wealthy. When British and other European investors financed much of the construction of America's railroads, they bought bonds, not stock. (Chinese, Japanese and other foreign investors holding dollars today are similarly conservative, with a preference for bonds.) Individuals with large amounts of savings were advised by financial professionals to choose bonds over stock, and they did. Not until the 1950s did stock investing attain widespread popularity among individual investors.

Most of today's stock trading comes from market pros--hedge funds (including high speed trading firms and other hedge funds), mutual funds and other institutional investors. Such was also the case in the late 19th Century.

Stock markets today are fragmented, with much opaque trading taking place in black pools patronized by big traders. Back in the late 19th Century, there were dozens of stock markets in America--every sizable city had one. Trading information was limited, and known mostly to market insiders. Individual investors in those days didn't have a good idea of what price they might get if they bought or sold. That's also the case today during increasingly common periods of high volatility.

The resurrection of risk accounts for the change in investor behavior. The financial markets of the Gilded Age brimmed with risk, and investors acted accordingly. Today's volatile markets reflect the renewal of risk, and modern investors have rediscovered ancient wisdom.

The big banks have enough power to command bailouts and a gusher of subsidies until they recover profitability. Individual investors take losses on the chin. The first order of business with your hard earned savings is to avoid losing them, particularly as you get older and it becomes more difficult to replace losses. You know you can't count on the government. The administration is tapped out. There won't be more stimulus spending after the funding currently in the pipeline runs out. The Fed can't renew its quantitative easing measures without admitting that the economy is sliding back toward the porcelain bowl, potentially panicking the markets. The government is boxed in. You're on your own.

The flight of investors from risk undermines one of the Fed's goals. By keeping interest rates ultralow, the Fed has implicitly been encouraging investors to put their money into riskier but hopefully higher yielding assets. Such a shift in investing would provide capital to the private sector at a time when banks continue to pull back from lending. But the Fed is fighting human nature--in uncertain times, people seek to avoid loss, not hope for gains.

The financial system is reversing a trend of the last 60 years and moving back to intermediation. Many people are depositing their savings with guardians--i.e., banks--who then have the responsibility of lending it out at a profit in order to pay interest (at meager rates currently) on depositors' savings. Banks, too, steer away from risk and invest customer deposits to a large degree in U.S. Treasury securities or federally guaranteed mortgage-backed securities. About a trillion dollars of banks' excess reserves have simply been deposited with the Fed. In other words, banks are investing in the U.S. government. This is one respect in which the current financial situation differs from the Gilded Age. One hundred years ago, in an era of balanced federal budgets, banks invested scarcely a nickel in U.S. Treasury debt. When they eventually resumed lending, it went to the private sector and the economy recovered.

The key to unraveling the current mess is to promote economic growth. Growth won't come from banks transferring more and more resources to the government. Banks need to go back to their traditional role as lenders to private enterprise and provide more credit to the real economy. That's what they did in the 19th Century, helping the United States industrialize and prosper in spite of all the volatility of the Gilded Age. That's what they need to do again, and federal regulators should push them harder in that direction. With investors regressing and further government deficit spending off the table, there are no other options.

Banks Get Murkier

Just as an incipient credit crunch lurks in Europe's weeds, the financial condition of major banks is getting murkier. Spain's credit crisis is mostly a matter of banks being overleveraged (its government isn't in bad fiscal shape, compared to many Western nations). Some Spanish banks may not be marking their real estate assets to market. Spain's government is merging banks rather than liquidating them, which might obscure rather than illuminate the financial weaknesses of the banking sector (kind of like the way grocery stores mix good string beans in with the crappy ones to make lazy shoppers buy some, well, crap).

In the U.S., Citigroup and Bank of America have admitted to misclassifying in financial reports repo transactions (which are loans) as asset sales. This echoes the infamous Repo 105 strategem used by Lehman Brothers to reduce reported leverage levels. Both Citi and B of A claim the amounts were immaterial and that the misclassifications were errors. Nevertheless, billions of dollars of transactions were involved, and a curious investor might wonder, in light of the magnitude involved, how sound the banks' internal controls were.

U.S. banks continue to benefit from accounting rule changes made by regulators last year under political pressure from Congress, which loosened requirements to mark assets to market. It's possible that the major U.S. banks hold hundreds of billions of dollars worth of hinky assets that are carried at valuations above market prices. With residential real estate wobbly and commercial real estate falling, the banks can't continue indefinitely to wear rose-tinted glasses when compiling their financial statements.

One reason why the stock market goes on volatility frenzies is that investors are ambushed by surprises. The sovereign debt crisis began with Greece 'fessing up last fall to having a lot more debt than it had previously acknowledged. Things went downhill from there as it became clearer that various EU members had debt problems. Spanish and other European banks are having trouble selling or rolling over commercial paper in the U.S. Credit default swaps protecting against defaults on bank debt have been rising in price. While many failures contributed to the current problems, a failure of proper accounting was among the most important.

"Garbage in, garbage out" is a time-honored axiom from computer science. It also applies to the financial markets. Bad or inadequate information results in poor pricing. When the truth comes out, abrupt shifts in valuation can be expected. When bank accounting goes hinky, the soundness of the financial system can be endangered. Taxpayers must then gird themselves for more bailouts. Bank regulators don't always encourage transparency, in the fear that the truth will spark runs on troubled institutions. But in today's computerized, Internet-connected world, there are no secrets. At least, not for long, and when the word belatedly gets out, the run is all the more panicked. Full, fair and timely accounting and disclosure by banks, nations and other debtors is essential to a healthy financial system. Such should be a primary goal of financial regulatory reform in the U.S., Europe and elsewhere. Expediency, however, militates in the other direction. Sunshine is the best disinfectant, but human frailty the greatest source of continued infection.

Big Banks Make the Case for Continuous Disclosure

We learned late last week that 18 of the largest banks (including, among others, Goldman Sachs, Morgan Stanley, J.P. Morgan Chase, Bank of America and Citigroup) displayed a pattern of temporarily lowering their debt levels at the end of each quarter, just in time for their quarterly reports, and then ratcheting their borrowings back up at the beginning of the next quarter. (See Wall Street Journal, April 9, 2010, p. C1). Their reported debt levels averaged 42% below the intraquarter peaks. Thus, their quarterly reports understated the risks they carried.

As we know from the Lehman bankruptcy examiner's report, Lehman used a transaction called "Repo 105" to understate its leverage. While it is unclear that other major banks engaged in Repo 105 trades, they evidently have other ways to achieve a similar result.

Let us ask: who's in the dark? Not management of the big banks. They should be and hopefully are monitoring leverage levels on a continuing basis throughout market hours (which are basically 24 hours a day, five days a week, because trading is global). Certainly, they'd have the data at their fingertips.

Federal banking regulators can easily find out any time how leveraged the big banks are. They have examiners stationed at each of the major money center banks, who can get information on the spot. So there can be a continuous flow of information to the feds--and we hope there is.

That leaves (you've probably guessed it): you, the public investor. You're the chump. It's understandable why management wouldn't want you to know how risky their operations are. You might lower the price you're willing to pay for the bank's stock. That's not conducive to a brontosaurus size executive bonus. By reporting lower quarter-end leverage than they hold most of the time, the big banks can maintain a higher stock price. It's likely the big banks' lawyers have cleverly included language in their public filings saying that bank leverage levels fluctuate. But there's a distinct possibility they didn't disclose that they typically ease leverage levels down at the end of each quarter and pump them back up at the beginning of the next.

All this reinforces the case to require banks, and other public companies, to make continuous disclosure. We've advocated the idea before. See http://blogger.uncleleosden.com/2009/10/allow-insider-trading-why-not-reduce.html. Our earlier essay argued that with continuous disclosure, there would be less inside information and therefore probably less insider trading. Now, we can see that continuous disclosure would result in fairer pricing of stocks. It may well be that bank stocks are over-valued because investors didn't realize how risky they are.

Continuous disclosure isn't difficult. It's already made to management as a matter of course, and to federal banking regulators on demand. We're not talking about highly tentative or immaterial information; we're talking about the info management relies on to run the banks and keep them solvent. There is no technological impediment to continuous disclosure, and the cost is small, since the data is already collected, crunched and disseminated (to some). Certain accounting decisions tend to be made on a quarterly or annual basis. Asset writedowns, adding to or drawing down reserves, writing off bad debts, depreciation and depletion are examples. But that's because the current reporting regime requires quarterly and annual reports. There's no intrinsic reason why these decisions can't be made more frequently. Even if they can't be made every day, assets depreciate and deplete, reserves can be set aside or used, and bad debts become uncollectible all the time, not just at the ends of quarters or years.

The quarterly and annual reporting requirements evolved in the 1930s and 1940s, when accountants collected data and prepared financial statements using pencils, paper and mechanical desk calculators. With the enormous capabilities of modern computers, there is no reason except inertia to stick with a quarterly and annual reporting regime. Indeed, there already are continuous reporting requirements for a limited number of items on SEC Form 8-K. The agency recognizes the need for continuous reporting; the only question is how much information should be continuously reported.

Of course, public companies will oppose the idea. Financial reporting is all too often treated as a game, in which management tries to present the company in the best possible light without violating any controlling legal precedents. And sometimes management presents the company in a better light than that and goes to jail. With only a tiny handful of exceptions, public companies don't seem to think that giving the public investor the full picture is a priority. That's too bad, because many public investors--i.e., individual investors--are MIA from the current stock market rally. Numerous commentators have observed that the past year's bull market progressed on rather thin volume, with individual investors licking their 2007-08 wounds from the sidelines. Even though the market has gone up for something like seven of the last eight weeks, the individual investor still hunkers down.

Of course, revealing the higher actual leverage of banks would tend to push their stock prices down. Indeed, continuous disclosure could in the near term be a short seller's banquet. But let us remember that a small group of mostly anonymous short sellers were among the first to realize that the real estate and mortgage markets amounted to a greatly over-valued bucket of mashed potatoes. Management and federal banking regulators, who had much better access to the relevant data, stood right at the front bumper but failed to see the tractor-trailer bearing down on them.

Continuous disclosure would enhance market fairness and efficiency. When stock prices reach a truly fair level, investor trust can begin. If investors continue to feel the stock market is a casino where they're always betting against the house, they'll embrace federally insured bank accounts and money market funds that invest only in U.S. Treasuries. This is exactly what happened in Japan after its 1989-90 stock market cataclysm, and the favorite savings vehicle for the Japanese today is an account with their postal system. (As odd as it sounds, the Japanese postal system runs the largest bank in the world measured by deposits; but then again, the U.S. postal system offered savings accounts until 1967.) Numerous individual investors in Japan never found their way back to equities. Very possibly, for many Americans that will also be the road not taken.

The Donkey-Backwards Housing Finance Debate

One of the biggest questions in housing finance is how to revive the securitization market. During the housing boom of the early 2000s, banks earned massive amounts of fee and commission income by packaging mortgages into mortgage-backed securities. These securities were often sliced and diced into CDOs, CDOs squared and what not, in order to further entice investors (and speculators). What happened next is all too well known. The banks, eager to bulk up low-risk fee revenue while offloading lending risk, thought that if writing a lot of mortgage loans was good, then writing a shipload more would be even better. Lending standards dropped, to the point where banks didn't always document borrowers' incomes, as if to avoid learning that they shouldn't extend the loan. There were plenty of times when they shouldn't have, but did anyway.

That insouciance toward prudence dug a very deep grave for investor interest in securitized loans. Today, just about the only mortgage-backed securities that can be sold carry explicit U.S. government guarantees. Housing finance has become a federal program, and today's housing stock enjoys what is effectively a federal price support policy.

Needless to say, taxpayers can't support housing values indefinitely. In the view of bankers and many regulators, securitization must be improved and revived. The two potential improvements most often discussed are (a) requiring the banks that package mortgages to keep some of the lending risk, or (b) improving underwriting standards without requiring underwriting banks to keep some "skin in the game." The first concept is intended to keep the banks honest. But banks holding increased amounts of lending risk also must increase their capital levels. That is likely to lower profits, anathema to their executives suites and also not to the liking of some bank regulators, who seem to equate lower bank profits with greater aggravations for themselves. The second notion--improved underwriting standards--is clearly necessary, but insufficient by itself. Investors aren't prepared to put down their money with just promises of improvement.

The problem is the discussion focuses on what the banks (and regulators) want, not what investors would like. This is donkey-backwards. A revival of a private securitization market depends on the willingness of investors to plunk their cash onto the barrelhead. There used to be a notion in American business that the customer is always right. A little fillip of customer service--i.e., investor protection--needs to be added to the mix.

First, there's the issue of trust. Trust is the true foundation of the financial system. Investors no longer trust the banks at the heart of the securitization process. That's why the only mortgage-backed securities acceptable to investors today bear a federal guarantee. Banks hoping to securitize on their own seem to be viewed as little more than potential scofflaws. Serious regulatory reform--of both banking and the derivatives market--is essential. Consumer protection must be greatly strengthened, lending standards bearing a reasonable resemblance to prudence have to be enforced, and the derivatives market must become much more transparent. But the scope of reform evolving in current legislative proposals may be inadequate to reassure holders of capital.

Second, the securitization market as it existed in the early 2000s ceased to be risk-sensitive. Investors had no effective way to discern that they were buying bags of digestive waste, and banks securitizing loans ceased to care that they were selling the same. The absence of risk sensitivity created grotesque market distortions that resulted in millions of bad loans being made, which may have enriched underwriting banks but also led to the defaults and foreclosures that have been driving down real estate prices.

Risk insensitivity is the problem that the skin-in-the-game requirement is intended to fix. The continued desertification of the securitization market is a signal that not enough is being done. Further product development is required. Perhaps banks should agree to limit investor losses to a predetermined number of cents on the dollar invested. After that, the underwriting bank would bear all losses. The less the investment resembles a pig in a poke, the more likely people will buy. Such a provision would improve the quality of mortgages in the pool, which would benefit investors--and homeowners. Fewer low quality loans would be made. Even if home ownership levels fall, bad loans do not, in the medium (let alone, long) term, increase home ownership. They do, however, drive down real estate values when borrowers default and end up in foreclosure.

Another improvement would be for banks to open up their databases concerning the underlying mortgages to credit rating agencies, and indeed, investors, for analysis. People are more likely to buy if they can kick the tires and lift up the hood. Any competitive issues would be unimportant if all offerings are subject to inspection. Of course, this may make pricing more accurate, or, stated otherwise, fairer to investors. And that's the idea. People will pay a fair price for what they understand, but not a penny for the opaque, black box CDOs of yore. Bank profits would be lower. But the current miserly dialogue about minimizing the extent of improvements to the securitization process may be holding down underwriting banks' costs, at the expense of expunging investor interest.

The bank-centric orientation of reforming the securitization market isn't even leading investors to water, let alone inducing them to drink. However, if banks and regulators would give a nod to the holders of capital who've been taking it on the chin for the last few years, maybe they'd see the phoenix rise from the ashes.