The Three Stooges Meet Wall Street

I couldn't make this stuff up.

One facet of U.S. efforts to inject life into capital markets is a provision in which, for payment of a fee to the Federal Deposit Insurance Corporation (FDIC), financial institutions can have their bonds backed and thus obtain a coveted AAA rating.

On March 9, the FDIC announced that it would be raising this fee for the largest banks effective April 1. And the banks didn't miss a beat in bellying up to the bar before happy hour ended.

Since that time, the banks, led by Bank of America, Goldman Sachs and General Electric, have issued $29.8 billion in bonds, the second highest weekly amount on record (see Bloomberg). Disappointing, but hardly surprising.

What might raise some eyebrows is the rationales offered by the banks. Goldman Sachs said the sale was

consistent with our long-term funding strategy

While Keycorp opined

[the] bond issue was part of our normal funding strategy and not predicated on any change or proposed change in FDIC structure

These folks make Curly, Larry and Moe look like models of sobriety and probity.

China and the Footsteps of Doom

DEATH, in Terry Pratchett's discworld series, always shows up just when a character faces his or her inevitable end. Yet the character is always surprised and is never prepared for what in retrospect is obvious.

The news today from the New York Times that China is concerned about its holdings of U.S. Treasuries has this flavor. China's own difficulties, its inevitable discomfort with the financial abyss facing the United States and the sheer size of its treasury holdings made this moment inevitable. Yet as Bloomberg notes

President Barack Obama is relying on China to sustain buying of Treasuries amid record amounts of debt sales to fund a $787 billion stimulus package.

Good luck. As the NYT piece notes

. . . much of the Treasury debt China purchased in recent years carries a low interest rate, and would plunge in value if interest rates were to rise sharply in the United States. Some financial experts have warned that measures taken to combat the financial crisis — running large budget deficits and expanding the money supply — may eventually create price inflation, which would lead to higher interest rates.

This puts the Chinese government in a difficult position. The smaller the United States stimulus, the less its borrowing, which could help prevent interest rates from rising. But less government spending in the United States could also mean a slower recovery for the American economy and reduced American demand for Chinese goods.

So where does the U.S. go if the Chinese start to get cold feet? Keep a close eye on treasury yields.

A Damning Indictment of the Finance Crowd

Say what you will about Jon Stewart, last night's interview with CNBC financial guru and future perp walk demonstrator Jim Cramer was as damning an indictment of the financial system and its media sycophants as I have seen during this crisis. Cramer was shown boasting of behavior which, to my non-legal mind, is criminal, and then explaining it away as if he were doing his listeners a favor.

As Stewart said, how many millions of people have been devastated by advice to take the long view with their retirement investments while their erstwhile advisors played fast and loose with their money in this fashion. Bernie Madoff is in jail for being basically stupid. Why run a ponzi scheme when you can do this stuff with impunity.

If we are going to float the banks, here in Canada or in the U.S., then we have a moral obligation as citizens to control their behavior. Obviously they cannot or will not do so themselves. And we had better start to treat the media with the skepticism if not the derision they so richly deserve. They are not telling us the truth.

Why We Don't Trust Markets -- My Morning Rant

On Tuesday, I had some harsh comments on Citigroup's claim to seemingly miraculous profitability, and the market's uncritical acceptance of the bank's story.

So imagine my chagrin this morning when Bloomberg ran a story that Citigroup executives had pocketed a quick $2.2 million U.S. on the rise resulting from the announcement. And the profits were on shares purchased last week -- i.e. prior to Tuesday's announcement by CEO Vikram Pandit. Surely this is insider trading.

The hapless American taxpayer has watched countless billions thrown at these institutions to avoid financial Armageddon. While this may be necessary, surely the same government that grants these gifts has a moral obligation to investigate, and where necessary prosecute this type of behavior. Bernie Madoff will be a guest of the state for the rest of his life, why not these guys (and they are guys) too.

In my Tuesday comment I said that Citigroup's actions bespoke desperation. I was wrong. If Citigroup executives were long on this trade, one wonders if they had short positions as well when the stock dropped 95% over the past five quarters. In fact, one wonders whether they, or their "masters of the universe" colleagues in general are capable of subordinating self interest to any greater good.

Friedman Right on the Money

I am not usually a fan of Thomas Friedman. He seems catch every policy wave at the peak of its trendiness and ride it as far as he can. But his NYT column today is right on the money.

Like Friedman, I have thought for some time that this crisis is much bigger than most realize, and that we are quickly falling behind in our efforts to address it. A faux rally on the market proves nothing. As Friedman notes

It’s always great to see the stock market come back from the dead. But I am deeply worried that our political system doesn’t grasp how much our financial crisis can still undermine everything we want to be as a country. Friends, this is not a test. Economically, this is the big one. This is August 1914. This is the morning after Pearl Harbor. This is 9/12. Yet, in too many ways, we seem to be playing politics as usual.

Canada, in particular, is a small open economy highly dependent on trade. And world trade is in disarray. It is also dependent on two economic engines, the auto sector and oil. The auto sector has collapsed, and unless oil prices recover quickly that sector is in trouble as well. And while our financial sector looks comparatively healthy, the Harper government is hedging its bets to the tune of $200 billion dollars, which certainly raises questions.

In short, we too are staring into the abyss while our political class often appears to be using this crisis for their own gain (see Sen. Elaine McCoy's blog on this). Friedman is right when he says

. . . I wake up every morning hoping to read this story: “President Obama announced today that he had invited the country’s 20 leading bankers, 20 leading industrialists, 20 top market economists and the Democratic and Republican leaders in the House and Senate to join him and his team at Camp David. ‘We will not come down from the mountain until we have forged a common, transparent strategy for getting us out of this banking crisis,’ the president said, as he boarded his helicopter.”

Canada too needs a common and transparent strategy and a much greater sense of urgency.

Bernanke on Valuation

In a speech that helped drive markets upward today, Federal Reserve Chairman Ben Bernanke talked, in part, about the problem of valuing assets, a problem that to my mind lies at the very heart of the crisis in the financial system. Long story short, he insisted that valuation is a problem because of the competing issues of procyclicality and transparency -- in plain English, between driving the banks deeper into insolvency and telling the truth. Key passage:

The ongoing move by those who set accounting standards toward requirements for improved disclosure and greater transparency is a positive development that deserves full support. However, determining appropriate valuation methods for illiquid or idiosyncratic assets can be very difficult, to put it mildly. Similarly, there is considerable uncertainty regarding the appropriate levels of loan loss reserves over the cycle. As a result, further review of accounting standards governing valuation and loss provisioning would be useful, and might result in modifications to the accounting rules that reduce their procyclical effects without compromising the goals of disclosure and transparency. Indeed, work is underway on these issues through the Financial Stability Forum, and the results of that work may prove useful for U.S. policymakers.

Surely there are better ways to support credit markets than to fudge the numbers on the real health of the banks. Bernanke seems to suggest this, but is short on details. Moreover, markets are not fooled, as reflected in dropping share prices. And regulators surely understand how a lack of transparency precludes effective supervision. If the emporer is naked, we would save ourselves a lot of trouble if we just told him.

Yglesias on the Banks

Some solid common sense from Matthew Yglesias on bank bailouts, in response to a WSJ piece. Key quote:

You don’t rescue banks by “tak[ing] distressed assets off the balance sheet of Citigroup or other troubled financial institutions.” The problem isn’t the assets, it’s the debts. You can deal with the problem by giving the banks vast sums of money in exchange for their toxic assets but in this case what’s solved the problem isn’t that the assets came off the balance sheet, it’s that the money you gave them got on the balance sheet.

And the key lesson for Canada? You are either paying more than market value for the assets or you aren't doing much to help the banks.

Fair Value or Fantasy

General Electric may be answering the question of what happens when we tell each other the truth about asset values, or absent this, when investors begin to suspect the truth.

Driven mainly by fears about its financial division, GE shares have declined by more than half since early January. The reason, according to a report on Bloomberg today is that the company reports only 2% of its assets at prices that approximate market values. And this, the report notes, strikes fear into investors as

“The notion of having 98 percent opaque and 2 percent valued with clarity is something that by its very nature would make investors nervous,” said Robert Arnott, founder of Research Affiliates LLC, which oversees $30 billion in Newport Beach, California and owned 481,201 GE shares as of Dec. 31. “Having some clarity on what the other 98 percent is worth is valuable.”

Not to be outdone in the understatement sweepstakes, GE spokesman Russell Wilkerson responded

We recognize there is a need and an opportunity to do more to improve disclosure and transparency.

Do tell.

If we are ever going to get to the bottom of this mess, we need to at least begin to tell ourselves the truth about balance sheets, particularly in the financial sector.

This is The Market on Drugs

Citigroup, the troubled U.S. banking giant, is today reporting a profit for the first two months of this year, the first since 2007, with significantly increased revenues. And this, believe it or not, is driving up markets.

Read the fine print!

The "profits" being reported are before provisions for "credit losses, writedowns and additions to loan-loss reserves". In other words, they are not profits at all. Further, those of you not battling significant memory issues might recall that this is the same Citigroup that the U.S. government bailed out to the tune of $45 billion, holds a 36% stake in and is offering to buy tens if not hundreds of billions of toxic assets from. Yet their share price is poised to slip below a dollar.

Yet Bloomberg's headline reads U.S. Stock Futures Rally as Citigroup's Profit Outlook Drives Banks Higher. This isn't reporting, it's cheerleading. It points to a willingness by the business press to trade integrity for the smallest scrap of good news. In other words it smells like desperation.

Send in the Clowns?

Remember when a trillion dollars was a lot of money? Well now you can also reminisce about when a Harvard MBA was a ticket to upper class respectability. In the Times today, Philip Delves Broughton, himself an alumni, provides an irreverent but nonetheless damning assessment of failures attributable to his fellow graduates. A particularly egregious example is the schools intense focus on the Royal Bank of Scotland, now a ward of the state, as a paragon of management virtue. Key quote:

When I was a student at Harvard Business School, between 2004 and 2006, I recall a distinguished professor of organisational behaviour, Joel Podolny, telling us proudly of his work with Fred Goodwin at RBS. At the time, RBS looked like a corporate supermodel and Podolny was keen to trumpet his role in its transformation.

As we now know, however, the reality was quite different

Every trendy business school idea was being implemented, it seemed, while what really mattered – the bank’s risk assessment, cash flow and capital structure – was going to hell. To be fair, neither Podolny nor the authors of the case studies were finance professors, but it’s still pretty shocking that a school that purports to teach general management should fail to see the gaping problems at a firm they studied in such depth.

I have thought for years that many graduate professional programs (I hold an MPA) are finishing schools more concerned with imbuing graduates with the poise, confidence and the accoutrements of image as much as a solid foundation of knowledge and skills. The result is all too often arrogance unsupported by ability. In the current financial disaster, the results speak for themselves.

Thomas Ricks on Counterinsurgency

Local NPR affiliate, WNED, today replayed a talk given by Thomas Ricks, on the successes and failures of the surge in Iraq that began two years ago. The most interesting of his remarks were on the effects of the new counterinsurgency strategies being used, and how and where these are now succeding,

He indicated that there are three crucial lessons from this. First, controlling and ultimately ending the insurgency will ultimately be accomplished by the Iraqis with help from the Americans and others. Second, this will not be accomplished by military means alone, but instead by a judicious use of military force, financial incentives and most important by a rebuilding of the social fabric of Iraq over an extended period of time. And finally, and perhaps most important, this will involve direct engagement and negotiation with insurgents.

And America's role in this will be, and can only be one of support.

As I noted in an earlier post, this is also true in Afghanistan, as the Prime Minister noted last week. This does not mean the insurgency cannot be ended, it only means that we cannot defeat it militarily.

Will We All Pay for GM Pensions?

One of the questions that continues to haunt the big three auto makers, particularly GM, is what would happen to unfunded pension liabilities if the automaker were to enter into bankruptcy proceedings.

Under a regulatory provision introduced by the Rae government, GM was allowed to underfund its pension plan, or "fund it as a going concern" (not!) in return for contributions to Ontario's Pension Benefits Guarantee Fund. It currently contributes a laughable $5 million per year to a fund that already has a deficit of $102 million. This fund would guarantee $1000 per month to retirees if GM were to fail, also a laughable amount. It would, however, cost the fund billions, not a laughable amount, which the Ontario government would have to backstop.

Even with the historic concessions on pensions made yesterday by the CAW (without the consent or retirees), this continues to be a sword hanging over the head of GM and in fact all Ontarians.

Is this perhaps the chief motive behind the provincial government's willingness to provide massive assistance to the auto makers?

Krugman on Obama's Recovery Plans

The Cassandras are becoming the majority party.

In his New York Times column this morning, Paul Krugman unloads on the Obama administration about both its stimulus effort and its effort to rescue the financial system. On the stimulus front

[e]mployment has already fallen more in this recession than in the 1981-82 slump, considered the worst since the Great Depression. As a result, Mr. Obama’s promise that his plan will create or save 3.5 million jobs by the end of 2010 looks underwhelming, to say the least. It’s a credible promise — his economists used solidly mainstream estimates of the impacts of tax and spending policies. But 3.5 million jobs almost two years from now isn’t enough in the face of an economy that has already lost 4.4 million jobs, and is losing 600,000 more each month.

Thus the stimulus plan is too little, too late. Meanwhile, he argues that the effort to rescue the banking system is equally inadequate

As I read it, this dismissal [of nationalization] — together with the continuing failure to aonnounce any broad plans for bank restructuring — means that the White House has decided to muddle through on the financial front, relying on economic recovery to rescue the banks rather than the other way around. And with the stimulus plan too small to deliver an economic recovery ... well, you get the picture.

Krugman, this years economics Nobel laureate, has been something of a voice in the wilderness for more than a year, beginning with his talk of a liquidity trap early last year.

My fear, like his, is that the scope of this crisis is growing in a way that escapes us. We are responding, but seemingly to last week's problem, or as Krugman put it today

O.K., that’s a warning, not a prediction. But economic policy is falling behind the curve, and there’s a real, growing danger that it will never catch up.

Recession, Depression, What's in a Name?

Bloomberg has a depressing (pardon the pun) piece on their site this morning that draws on remarks from half a dozen or more prominent economists that together suggest that if we are not in a depression now (and we are not) then we certainly are facing the real possibility of one. Key quote:

Combined with collapsing house prices, the free-fall in the stock market will destroy $23 trillion worth of U.S. wealth, reckons Lawrence Lindsey, a former senior White House official who now heads his own consulting company in Arlington, Virginia.

To put this in perspective, world GDP in 2008 was about $60 trillion U.S.. So U.S. losses in wealth alone amount to almost 40% of world GDP. And we're not done yet. Debt deflation is a real possibility, unemployment is growing as fast as it ever has and we still have no real clue where all of the toxic assets are buried. If we are not staring into the abyss, we are surely sneaking a peak at it.

So are we in a depression? Stay tuned.

Journalism 101

Listening to Michael Enright's show on CBC this morning, I was very surprised to hear that Prime Minister Harper had said on Farreed Zakaria's show last week that the Taliban could not be defeated. As I noted in a post last week, Harper said nothing of the sort. What he did say was that western military might alone would not defeat the Taliban, or any other insurgency, but that insurgencies such as this can be managed and controlled by competent and effective local governments aided by foreign powers. He further suggested that Canada might well have a role in making a contribution to this kind of transformation, though it would be very careful in assessing that role.

Again, I am amazed and depressed by the capacity of the MSM, and the CBC is certainly that, to get it wrong by putting their own spin on a story. If Enright is "the hardest working man in radio" as many of his fans describe him, then surely he, or one of assistants would have taken time to listen to the Zakaria interview. This is not an issue of left or right. Those in favor of military intervention have been just as guilty of inaccuracy and spin. It is simply an issue of separating fact from opinion and being honest about which is which.

Can the U.S. Lead Us Out of This Crisis?

Martin Feldstein, former leader of the Reagan economics team and one of the leading economists in the U.S. has a deeply pessimistic piece on the Project Syndicate site today. So at a time when many are suggesting that this recession is no worse than the 1981-82 debacle, Feldstein argues that while the numbers may not yet be as bad, the nature of the recession is entirely different and much more frightening in that

[p]revious recessions were often characterized by excess inventory accumulation and overinvestment in business equipment. The economy could bounce back as those excesses were absorbed over time, making room for new investment. Those recoveries were also helped by interest rate reductions by the central bank.

This time, however, the fall in share prices and in home values has destroyed more than $12 trillion of household wealth in the United States, an amount equal to more than 75% of GDP. Previous reactions to declines in household wealth indicate that such a fall will cut consumer spending by about $500 billion every year until wealth is restored. While a higher household saving rate will help to rebuild wealth, it would take more than a decade of relatively high saving rates to restore what was lost.

This is a recession that will not resolve in the short term, or even in the foreseeable future, by itself. And as Paul Krugman has been arguing for some time, and as is now obvious, monetary policy has reached its limits, or as Krugman puts it, "it’s the zero lower bound, stupid"

As Feldstein notes, much of the massive stimulus package being implemented in the U.S. is in the form of tax cuts, which are likely to go into savings as households try to rebuild their balance sheets. And many of the public works projects will take years to implement. This, he suggests will require a further, equally sweeping stimulus package, but one much more targeted at immediate increases in demand.

The problem is that sooner or later, stimulative spending in the U.S. (and the rest of the world) will begin to push up interest rates, which could in turn choke off any recovery. Thus Feldstein closes on a note of uncertainty:

So it is not clear what will occur to reverse the decline in GDP and end the economic downturn. Will a sharp dollar depreciation cause exports to rise and imports to fall? Will a rapid rise in the inflation rate reduce the real value of government, household, and commercial debt, leading to lower saving and more spending? Or will something else come along to turn the economy around. Only time will tell.

How Stable are Canadian Banks?

With Canadian banks being praised throughout the world for their stability and soundness in the face of a worldwide financial crisis, it might seem churlish to raise pointed questions about their health. Yet there are a few questions that I think at least need to be considered.

The question of the health of the banking sector first arose for me with the Harper government's Extraordinary Financing Framework introduced in the January budget. This initiative has earmarked $200-billion largely for the purchase of bank assets. This is an astronomical sum even if, as the government claims, the assets purchased will be performing assets and that there will be no cost (it is thus not a fiscal matter) and perhaps even a profit.

The question this raises for me is why, if the banks are so healthy, do they need this amount of backing, particularly at a time when they do not seem particularly anxious to lend? Could it be that their balance sheets include assets whose value is at risk or uncertain? And is the government set to purchase (or have they already purchased) assets that might be a good deal less stellar than we have been led to believe?

In his column today in the Globe and Mail, Jim Stanford, economist for the CAW, strongly suggested that balance sheets are less than they seem, stating:

Believe me, if Canada's banks were truly stable, Ottawa wouldn't have pumped $200-billion into the system.

In another column in today's Globe, Fabrice Taylor reminded readers that whatever press the banks are getting, markets aren't buying it, as reflected in share prices. So what is on those balance sheets? And surely more important, how are they being valued?

It turns out that last October the accounting rules for banks were substantially altered by the Canada Accounting Standards Board. These changes allowed banks to reclassify many investments to which fair value or mark-to-market accounting rules had applied. And these changes were backdated to July 1, 2008, to allow their effects to be reflected in the fourth quarter earnings which now look so favorable.

What does this mean? It means that assets for which there is little or no market (many of which have been termed "toxic assets") can now be re-evaluated or removed from balance sheets, making the banks appear healthier than they really are. As Hugh Anderson of the Financial Post noted last fall,

It's quite possible that such reclassifications will enable banks to report substantial net income boosts from reversing previous writedowns. Simultaneously, assets off the balance sheets will grow.

So I have two questions. First, to what extent are these changes reflected in the banks surprisingly rosy outlook? And second, what is our government buying with its $200-billion?

Harper and the Taliban Insurgency

In an interview with CNN's Farreed Zakaria on Sunday, Prime Minister Stephen Harper spoke with surprising candor about the future of Canada's mission in Afghanistan. Although many sources, including the Globe and Mail, reported that he had claimed that the NATO effort could never defeat the Taliban insurgency, what he in fact said was quite a bit more nuanced.

Harper did in fact argue that Canada and its allies cannot simply "win by staying" and cannot on their own defeat the insurgency. He insisted, however, that we can bring about improvements, and he suggested that the most important improvement that might be made is the emergence of an honest and competent government that can "manage the insurgency" and govern capably. Success against the insurgency, he argued, must be indigenous, and the proper role for Canada and others must be to help bring about sufficient Afghan governance and military capacity to achieve such success. It is this, he insisted, that is the essential element of our engagement and ultimately our exit strategy.

The issue for Harper, therefore, is not "whether to stay or go" but "whether we are being successful" in building this local capacity. To my mind this is scarcely defeatist. It is simple common sense coupled with an accurate reading of history. Western democracies have seldom prevailed alone in foreign counterinsurgency efforts. And indeed such efforts have often destabilized the very societies mounting them. France in Algeria and the United States in Viet Nam are obvious examples.

John Nagl, a co-author with David Patraeus and others of the U.S. Army's widely regarded counterinsurgency field manual suggests that

[i]t is perhaps only a slight exageration to suggest that, on their own, foreign forces cannot defeat an insurgency; the best they can hope for is to create the conditions that will enable local forces to win it for them.

If this is the approach that an expanded U.S. role force in Afghanistan is going to take, and this would appear almost certain, then there is real hope that the type of success that Harper envisions will be realized. And if this is the case, then an argument can be made for our continued presence. However, I think Harper is right that if we are not making progress in this direction, then it might be better to recognize this and curtail our efforts.

Stanley Fish on Faith and Finance

As the financial crisis gains an ever tighter hold on our pocketbooks and thoughts, one of the questions that arises is where faith, for those who claim it, might intersect with finance.

There are some obvious if regrettable answers that are routinely offered, two of which are worth mentioning here.

On Oprah Winfrey today, the billionaire hostess was offering one such answer: advice on simplifying our lives as a virtuous response to tough economic times. This is all very good, but of course it might sound a bit paternalistic to those in the trenches of real economic hardship. Downsizing is a discipline that usually comes easier to those who have first managed to upsize.

A second answer is the desire on the part of many to see an approaching economic cataclysm as a chance to return to a world of Little House on the Prairie or The Waltons, 70s television depictions of families and communities pulling together in the face of scarcity and need. However, the result of these challenges is just as often family breakdown, violence, substance abuse and myriad other expressions of despair. And the strongest believers in the virtues of privation are again usually those least hurt by it.

The larger problem is that both of these assume an ability to forge our own answers or solutions to financial adversity. In a brief essay on his New York Times blog, Stanley Fish engages this from a more original and I believe much more productive angle. He contrasts what he calls "a Protestant linking of thrift and virtue", the view that informs the two answers described above, with a more tragic, but ultimately redemptive view of our inability to avoid or transcend our ultimate bankruptcy, financial or otherwise, the recognition of which brings us to God and so to Grace.

One view, he argues, sees us redeemed financially by our own efforts. It is as if in exercising our strength and virtue we are doing God's work ourselves. And our faith is mostly in ourselves, whether individually or collectively. The other sees us as humbled by our inability to redeem ourselves, financially or otherwise and thus unable to rely on ourselves. It is here, says Fish, that many turn to God. And this, he says, is the beginning of wisdom.

I would suggest that, whatever our conscious motivations or rationalizations, the first path is always one of idolatry -- worshiping our ability, virtue and financial resources. The second offers the only real possiblity for faith and thus for real redemption. Admitting our powerlessness, we look beyond ourselves.

This, of course, is the great insight of the recovery movement that first emerged with Alcoholics Anonymous in the midst of the despair of the great depression of the 1930s. But when all of the rhetoric and rationalization of religion is stripped away, this is also the message of the Gospel. We are bankrupt, though some experience the pain of this more than others. And we are more often than not blind to this. Yet any belief in and reliance on our own ability and virtue proves to be worse than useless -- it hides from us the true nature of our situation. It alienates us from each other. And in doing so it alienates us from God.

Thus in this crisis, faith in our individual strengths or the collective capacities of our institutions is a blind alley. Bringing this back to questions of economics, Fish closes out his argument as follows:

This economy, in which funds depleted are endlessly replenished, is underwritten by a power so great and beneficent that it turns failures into treasures. Some economists identify that power as the market and ask us to have faith in it. God might be a better candidate.