Implicit Bailouts and Moral Hazard

From Bloomberg comes news that ten banks are set to repay TARP funds. This is scarcely surprising as the banks have been complaining for some time about the onerous conditions attached to the bailouts, particularly limits on compensation. Boo hoo!

As Yglesias notes, repaying these funds does not alter the greater fact that the implicit guarantee remains. As he describes it

. . . merely repaying the funds won’t change the fact that all large financial institutions are now benefiting from a few different federal programs and an immensely valuable implicit federal guarantee.

What Yglesias doesn't say, and what for me is the even larger problem, is the moral hazard arising from these implicit guarantees. There is little incentive for prudent management and much for malfeasance when government signals that losses will be socialized.

Are We There Yet?

Is this financial crisis over? When even Paul Krugman and Nouriel Roubini are arguing that we have avoided the catastrophe that was looming a few months ago, and so many others are speaking incessantly of "green shoots", it is tempting to think so. Markets are up by more than 30% and while unemployment continues to rise, it is always a lagging indicator we are told.

Yet as Sandy Lewis and William Cohen argued in yesterday's New York Times, this crisis, which began in the financial sector is far from over, principally because that sector remains in dire condition. Massive subsidies and accounting rule changes have papered over many of the problems and allowed the banks to return to a sort of faux profitability.

What has changed? The structural problems remain. Incentives continue to reward excessive risk-taking -- witness the gaming of rescue measures by the rescued. Banks retain the very toxic assets that did so much damage on their books because they do not wish to face the writedowns that even subsidized sale would allow -- aided by controversial accounting rule changes. The erstwhile "masters of the universe" that did so much to create this mess have not been held to account -- not hauled before congress or prosecuted. And when we continue to believe that debt fueled consumer spending -- also a contributing factor -- will re-ignite a stagnant economy.

Will more of the same really create something different?

The authors argue, and it is hard to disagree, the any remedy will begin with real transparency. So while

Treasury Secretary Timothy Geithner has made much of financialstability.gov, the Treasury’s new Web site dedicated to “transparency, oversight and accountability.” But look it over and try to find, for example, just one record of a bona fide credit-default swap, or the names of the hedge-fund and private-equity investors who have participated in the Term Asset-Backed Securities Loan Facility bonanza. It was only a lawsuit filed by a watchdog group that convinced the Treasury to divulge details of former Secretary Henry Paulson’s October meeting with the chief executives of the 10 largest Wall Street firms to force them to take money from the Troubled Asset Relief Program. A lawsuit filed last November by Bloomberg News to force the Federal Reserve to reveal the details on more than $2 trillion in loans that went to banks including Citigroup and Goldman Sachs is still pending in federal court.

And in Canada, the Extraordinary Financing Framework is even more opaque than this. As so many have noted before, sunlight is the best cleanser. Solutions crafted in the dark are usually no solutions at all.

Gearing Up for New Pecora Hearings?

Simon Johnson, former chief economist for the IMF, has a brief comment on the Washington Post's The Hearing this morning on the overwhelming U.S. Senate vote to hold hearings into the current economic crisis. He also refers to his appearance yesterday on Bill Moyer's Journal in which he and Michael Perino discussed the 1933 Pecora Hearings in which an upstart New York prosecutor, acting as counsel for Senate hearings, almost singlehandedly turned public anger massively against the titans of Wall Street, on whom they placed blame for the horror of the Great Depression. Here is a preview:



Simon Johnson also has an essay in this month's Atlantic. In it he makes the provocative argument that the crisis in the U.S. is much like earlier crises in developing economies brought about by the disproportionate power of financial elites on government. Johnson makes a compelling argument that the economic prescriptions are relatively unimportant. What is crucial for him is removing the hands of the financial elite -- Wall Street -- from the levers of power.

It seems increasingly clear that the American public at least is losing patience with explanations for this debacle that focus on either outside influences or inadequate regulation. As in 1933, they seem increasingly hungry for an opportunity to bring those they see as responsible to account. Whether or not this is a good thing, it is an opportunity for the Obama administration to stop bowing to the needs of these elites, something particularly painful to watch with Timothy Geitner, and to begin taking the bold, decisive steps that Roosevelt for one was able to in the shadow of the Pecora hearings.

More on Minsky

On Wednesday, I noted that I am revisiting some of Minsky's work, and that I will comment on his work from time to time.

One of Minsky's key arguments in Stabilizing an Unstable Economy is that what he calls "Big Government" plays two roles in alleviating the recurrent crises that plague capitalism in its current guise. First, there is fiscal action both deliberate and automatic as stabilizers kick in. Second, is the role of central banks as lenders of last resort.

And one of the results of the second role is that an implicit floor is placed on prices of financial assets. This, for Minsky, is critical, as it means that as balance sheets deteriorate during a financial crisis, financial institutions are not forced to sell assets at distressed prices. Commentators have referred to this as the Greenspan or Geithner "put", but it is clear from Minsky that this has been a feature of central banking for at least a century.

What strikes me is that if this is the case, then perhaps (it pains me to say this) the changes to fair value accounting rules might make some sense. And they might make some sense because, given this implicit asset price floor, they closer reflect reality. As Minksy notes, in every financial crisis since the late 60s, central banks have intervened to prop up asset prices. If this too is an (almost) automatic stabilizer, then asset prices at a time of crisis should reflect this.

The Press and the Crisis

Lionel Barber of the Financial Times commented at length yesterday on the role of the financial press in allowing the present crisis to sneak up on us last year, arguing that

[i]n the final resort, there can be little debate that the financial media could have done a better job. In this spirit of self-criticism, I identify four weaknesses in the coverage.

First, financial journalists failed to grasp the significance of the failure to regulate over-the-counter derivatives that formed the bulk of counterparty risk in the explosion of credit following the dotcom bubble. Alan Greenspan was opposed to such regulation, but how many commentators took the former Fed chairman to task and warned of the risks? For the most part, journalists were too enamoured with the prevailing tide of deregulation.

Second, journalists, with a few notable exceptions, failed to understand the risks posed by the implicit state guarantees enjoyed by Fannie Mae and Freddie Mac, the mortgage finance giants. Here, we should tip our hats to the now much-maligned Mr Greenspan. He raised alarms early about the risks. Of course, it was hard for journalists to attack the ideal of broader home ownership in America, but that is no excuse.

Third, journalists failed to grasp the significance of the growth in off-balance sheet financing by the banks, its relationship with the pro-cyclical Basle II rules on capital ratios, and the overall concept of leverage. How many news organisations reported on the crucial Securities and Exchange Commission decision in 2004 to loosen its regulations on leverage? The explosive growth of structured investment vehicles at the height of the credit boom was also woefully under-reported.

Fourth, financial journalists were too slow to grasp that a crash in the banking system would have a profoundly damaging impact on the real economy. The same applies to regulators and economists. For too long, too many experts treated the financial sector and the wider economy as parallel universes. This was fundamentally wrong.

He also did not shy away from the idea that journalists were knowingly complicit -- that they often did understand what was happening, but remained silent for a variety of self-interested reasons.

I am convinced that this is all the more true in Canada, where there is really no competition in the business press; the Globe's ROB is really the only game in town, and its pages often seem more like an infomercial than bare-knuckles reporting.

There was a quip made recently that perhaps the Canadian Labor Congress should purchase the National Post (and thus the Financial Post) from the hapless Aspers. Here is the reason this just might be a solid idea. If nothing else, it would at least keep things more honest.

Building a Big Giant Enron

Option ARMageddon is claiming that a large portion of Wells Fargo's celebrated earnings report last week is due to accounting changes (ht Naked Capitalism). In other words, there has been no change in the underlying profitability of the firm.

And over at Goldman Sachs, who, praise be, have also returned to profitability. NYT blogger Floyd Norris suggests how they have done this

Goldman Sachs reported a profit of $1.8 billion in the first quarter, and plans to sell $5 billion in stock and get out of the government’s clutches, if it can.

How did it do that? One way was to hide a lot of losses in not-so-plain sight.

Goldman’s 2008 fiscal year ended Nov. 30. This year the company is switching to a calendar year. The leaves December as an orphan month, one that will be largely ignored. In Goldman’s earnings statement, and in most of the news reports, the quarter ended March 31 is compared to the quarter last year that ended in February.

The orphan month featured — surprise — lots of write-offs. The pretax loss was $1.3 billion, and the after-tax loss was $780 million.

Would the firm have had a profit if it stuck to its old calendar, and had to include December and exclude March?

This, of course, was Enron's scam -- to use accounting sleight of hand to turn losses into profits. And now the U.S. is doing it for their whole economy. And there is a good possibility that with changes to accounting rules in Canada, we are doing it to.

Recovery? Not Quite Yet.

From Naked Capitalism, a guest post by Edward Harrison of Credit Writedowns entitled "The Fake Recovery" -- to my mind as good a summary of our present predicament as I have seen.

I include it in its entirety.

I last posted on "Credt Writedowns" on Thursday before the Easter Holidays in two posts very much at odds with one another. The overall thrust of the first post was that the financial services industry in the United States was due to gain from some very advantageous circumstances in 2009. Meanwhile, the later re-post pointed out the continued fragility of the U.S. economy and banking system and focused on liquidity and solvency as unresolved issues. I would like to bring these two posts together here because I believe the concept behind the dichotomy is best described as the Fake Recovery.

Why 'Fake'? This is a fake recovery because the underlying systemic issues in the financial sector are being papered over through various mechanisms designed to surreptitiously recapitalize banks while monetary and fiscal stimulus induces a rebound before many banks' inherent insolvency becomes a problem. This means the banking system will remain weak even after recovery takes hold. The likely result of the weak system will be a relapse into a depression-like circumstances once the temporary salve of stimulus has worn off. Note that this does not preclude stocks from large rallies or a new bull market from forming because as unsustainable as the recovery may be, it will be a recovery nonetheless.

The real situation
In truth, the U.S. banking system as a whole is probably insolvent. By that I mean the likely future losses of loans and assets already on balance sheets at U.S. financial institutions, if incurred today, would reveal the system as a whole to lack the necessary regulatory capital to continue functioning under current guidelines. In fact, some prognosticators believe these losses far exceed the entire capital of the U.S. financial system. Witness a recent post by Nouriel Roubini:

The RGE Monitor new estimate in January 2009 of peak credit losses (available in a paper for our RGE clients) suggested that total losses on loans made by U.S. financial firms and the fall in the market value of the assets they are holding would be at their peak about $3.6 trillion ($1.6 trillion for loans and $2 trillion for securities). The U.S. banks and broker dealers are exposed to half of this figure, or $1.8 trillion; the rest is borne by other financial institutions in the US and abroad. The capital backing the banks’ assets was last fall only $1.4 trillion, leaving the U.S. banking system some $400 billion in the hole, or close to zero even after the government and private sector recapitalization of such banks and after banks’ provisioning for losses. Thus, another $1.4 trillion would be needed to bring back the capital of banks to the level they had before the crisis; and such massive additional recapitalization is needed to resolve the credit crunch and restore lending to the private sector.

Now, obviously, if we were to face up to this situation, there would be no chance of recovery as the capital required to recapitalize the banking system would mean a long and deep downturn well into 2010 and perhaps beyond. This is not politically acceptable as 2010 is an election year. Nor is the nationalization of large financial institutions acceptable to the Obama Administration. Moreover, bailing out banks to the tune of trillions of dollars while the economy is in depression is equally unacceptable to the American electorate. The Obama Administration is keenly aware of this fact.

These constraints, some artificial and others very real, leave the Administration with limited options.

Engineer recovery
With the preceding constraints in mind, we should remember that the first priority of elected officials in Washington is not necessarily to make the best long-term choices for the American people, but rather to get re-elected in order to have the opportunity to make those choices. It should be patently obvious that a downturn which began in December 2007 would be fatal to many politicians if allowed to continue well into 2010. This is why recovery of some sort must take place before that time - irrespective of whether it is sustainable.

How to engineer recovery is another question altogether. Here again there are a set of political constraints which make things more challenging. First, there are large swathes of the population that are uncomfortable with the huge debt load and deficit spending that a stimulus-induced recovery creates. Moreover, a government-sponsored nationalisation or recapitalisation plan would only increase this deficit spending and these debts.

As a result, the Obama Administration has crafted a plan to circumvent these obstacles.

1. Moderate fiscal stimulus. The Obama Administration decided not to seek massive stimulus earlier this year because they deemed it non-viable politically.This clears the first obstacle: deficit hawks. Most economists understand that the output gap that has opened up in the American economy is $2 trillion or more whereas the Obama stimulus package was only $800 billion. That leaves a massive hole in output in the U.S. Moreover, the immediate effective stimulus is less. Much of this 'stimulus' will be saved or will not come into play until months from now. Obviously, this is not going to meet the grade (See my comments on this from February).


2. Quasi-fiscal role for the Fed. Having partially assuaged deficit hawks, Obama still needed to close the output gap. Enter the Federal Reserve. You will have noticed that the Federal Reserve has added legacy assets as eligible for the TALF program. In effect, this allows banks to slip tens or even hundreds of billions of dollars in so-called toxic assets off their balance sheets. Mind you, these are assets already on the books impairing banks' ability to loan money. Under normal circumstances, one would expect the Federal Government to take these assets out of the system (bad bank, good bank, nationalization) after being given legislative approval to do so. However, as I have previously stated this approval is not going to be forthcoming. This is why the Federal Reserve is taking these assets on. In so doing, the Federal Reserve is taking on a quasi-fiscal role that re-capitalizes the banking system in order to stimulate the economy by increasing credit availability.


3. Quasi-fiscal role for the FDIC. The new PPIP is a similar end-run around Congress. After all, the role of the FDIC is that it "maintains the stability and public confidence in the nation’s financial system by insuring deposits, examining and supervising financial institutions, and managing receiverships." Meanwhile, the PPIP has the FDIC guaranteeing dodgy assets in a massive transfer of wealth from taxpayers to banks and select investors. (See my previous comments on this issue).


4. End of mark-to-market as we knew it. You should have noticed that most of the assets written down in the past two years have been marked-to-market. Securities traded in the open market are marked to market. Loans held to maturity are not. This is one reason that large international institutions which participate in the securitisation markets have taken the lion's share of writedowns, despite the low percentage that marked-to-market assets represent on bank balance sheets. But, this should end because of new guidelines in marked-to-market accounting. However, the new guidelines do have two major implications. First,there are still many distressed loans on the books of U.S. banks that if marked to market would reveal devastating losses. Second, there will also now be many distressed securities on bank balance sheets that if marked-to-market would reveal yet more losses. In essence, the new guidelines are helpful only to the degree that it prevents assets being marked down due to temporary impairment. If much of the impairment is real, as I believe it is, we are storing up problems for later.


5. Interest rate reductions. One reason often given for a large increase in writedowns at financial institutions had been the coming reset of Alt-A adjustable-rate mortgages in 2009. With the subprime writedowns mostly accounted for, a souring of the much larger pool of Alt-A and Prime residential mortgage loans is the real Armageddon scenario. Well, part of this problem has been temporarily relieved because the Federal Reserve has reduced short-term interest rates to near zero and has begun trying to manipulate long-term interest rates lower by buying long-dated treasury securities.


6. Bank margin increases. Key to the whole program is banks' ability to earn massive amounts of money and re-capitalize themselves through retained earnings as opposed to shedding assets or receiving additional paid-in capital (see post from last April on these three methods of recapitalizing). The market for bank assets is distressed and few banks can get enough capital from private sources or investors. Therefore, Obama's plan hinges on the ability to allow these banks to earn shed loads of money as quickly as possible. If the banks cannot do this, we are going to have a big problem very quickly (Of course, I think the can).

The stimulus to come from these measures is still in the pipeline and, by the end of this year, will probably add a big kick to the economy. You should note that only the fiscal stimulus required legislative approval. All of the other 'stimulus' has been done without Congressional approval and largely without Congressional oversight. These activities have been specifically designed to be opaque. The government's claims of wanting to increase transparency ring hollow (see my post on Bloomberg's suit against the Fed as an example of what is really happening).

I should also mention that the Federal Reserve has been a large factor here. It is acting in concert with the executive branch in a non-arms length fashion which I believe will have consequences regarding Fed independence down the line.


Other positive economic factors

There are a number of so-called green shoots (a phrase coined by Norman Lamont) of note.

• Jobless claims have plateaued and comparisons to last year are actually declining (see post).


• The U.S. trade deficit is declining significantly as U.S. import demand has fallen off a cliff.


• Inventory liquidation will put U.S. manufacturers in a better position by Q4 and help make quarterly and yearly comparisons favourable.

I linked to the first two bullets of these other factors. And I wanted to spend a little time on factor number three because I think it is important. Niels Jensen of Absolute Capital Partners has a very solid write-up on this in his most recent newsletter: (do sign up for his free newsletter because it is quite informative. Click here to see the newsletters and sign up.)

Turning my attention to the global economy, after a rather muted beginning, manufacturers around the world have now begun to react aggressively to the economic downturn and inventories are falling aggressively. Chart 5 below depicts US manufacturing inventories as published recently by the Census Bureau. Inventory changes can have a meaningful impact on GDP. There is one example from the 1981-82 recession where the inventory correction subtracted 5% (annualised) from GDP in just one quarter. The current inventory correction is very negative for GDP in Q1 and possibly also in Q2, but it is very difficult to quantify the effect it is going to have. We will have to wait and see.

However, as we must remind ourselves, the stock market is not trading on what is going to happen in Q1 and Q2 of this year. Projecting at least 6-9 months ahead, the stock market is probably already looking ahead to Q4 and possibly even Q1 of next year. And the inventory adjustment currently underway is very bullish for GDP growth later this year and into next. The reason is simple. Manufacturers always overreact. Come Q3 or Q4, they will suddenly sit up and realise that inventories have fallen too much and that they need to produce more. There is no reason to believe that this recession will be any different.

Obviously, this means that U.S. Q1 and perhaps even Q2 GDP will be very low due to the subtraction of inventories now being purged. However, when we get to Q3 and Q4, this effect will be gone and quarterly and yearly comparisons will look favourable. So the inventory purge may mean a huge upside surprise to GDP in the second half of the year and early 2010 - potentially enough to see positive GDP numbers.

A brief reminder of what lurks beneath
Despite the positives from the previous section, there are significant headwinds which may even preclude a positive GDP number. They include:

• Rising joblessness


• Increased savings as households rebuild balance sheets


• Spending cuts by local and state governments


• Decreased capital spending by companies


• A calamitous GM bankruptcy

Moreover, credit availability --and hence GDP will be constrained by numerous factors including the following:

• Declining home values


• Increasing foreclosures


• Commercial property writedowns


• Credit card-related writeoffs


• Junk bond defaults

All of this means that a cyclical rebound is not a foregone conclusion at all.

Tying the threads together
You should be under no illusion that the coming rebound is permanent. Much of it is not. What we are seeing is the makings of a cyclical recovery that might begin as early as Q4 2009 or Q1 2010. How long or robust that recovery is remains to be seen. Moreover, it is still questionable whether we will get any meaningful recovery at all in spite of the 'green shoots' because the banking system in the United States is severely undercapitalised and more asset writedowns are coming due. This is a fake recovery underneath which many problems remain.

Nevertheless, banks are going to earn a lot of money and that is bullish for their shares - at least in the medium-term. Yes, the stock market is overbought right now. However, if banks put together some decent earnings reports over the next few quarters, their shares will rise.

Furthermore, if the banks can earn enough, this cyclical recovery will have legs as banks will then have enough capital to resume lending and that is supportive of the broader market as well. It is still too early to tell how this will play out over the longer-term. For now, I am much more positive on financials, and somewhat positive on the broader market as well.

Henry Mintzberg on Managing Our Way into Crisis

As I write this, CBC's Sunday Edition is airing an interview with Henry Mintzberg. Mintzberg, Canada's leading management academic, is arguing that our current crisis is one of management and not economics, and that in particular it is a product of the failure of business schools to adequately equip the current management cadre with the tools for effective leadership.

(In its usual elitist fashion, the host, Michael Enright, has posted no links to or references for Mintzberg's work. Nor is there a podcast. What can we expect for a paltry multibillion dollar budget.)

Much of the thrust of Mintzberg's argument can be found in a recent Globe & Mail opionion piece entitled America's Monumental Failure of Management. He summarizes his argument as follows:

We call this a financial crisis or an economic one, but, at the core, it is a crisis of management. To understand this, consider the mortgage debacle.

How could these mortgages have come to exist in the first place and, worse, how could they have spread to so many of the bluest of blue-chip financial institutions? The answers seem readily apparent. Those who promoted these mortgages were intent on driving up sales as quickly as possible for the benefit of their own bonuses, the ultimate consequences be damned. In fact, they sold off these mortgages as quickly possible.

But how could any serious financial institution have bought this junk - or, more to the point, tolerated a culture of people too lazy or disinterested to realize it was junk? That, too, is simple: These companies were not being managed. They were being "led" - heroically, no doubt - for short-term spectacular performance. The executives didn't know, and the employees didn't care.

What we have here is a monumental failure of management. American management is still revered across much of the globe for what it used to be. Now, a great deal of it is just plain rotten - detached and hubristic. Instead of rolling up their sleeves and getting engaged, too many CEOs sit in their offices and deem: They pronounce targets for others to meet, or else get fired.

And he follows this by laying the blame for management failure squarely at the feet of managment schools, particularly the elite schools:

Management is a practice, learned in context. No manager, let alone leader, has ever been created in a classroom. Programs that claim to do so promote hubris instead. And that has been carried from the business schools into corporate America on a massive scale.

Harvard Business School, according to its MBA website, is "focused on one purpose - developing leaders." At Harvard, you become such a leader by reading hundreds of brief case studies, each the day before you or your colleagues are called on to pronounce on what that company should do. Yesterday, you knew nothing about Acme Inc.; today, you're pretending to decide its future. What kind of leader does that create?

Harvard prides itself on how many of its graduates make it to the executive suites. Learning how to present arguments in a classroom certainly helps. But how do these people perform once they get to those suites? Harvard does not ask. So we took a look.

Joseph Lampel and I found a list of Harvard Business School superstars, published in a 1990 book by a long-term insider. We tracked the performance of the 19 corporate chief executives on that list, many of them famous, across more than a decade. Ten were outright failures (the company went bankrupt, the CEO was fired, a major merger backfired etc.); another four had questionable records at best. Five out of the 19 seemed to do fine. These figures, limited as they were, sounded pretty damning. (When we published our results, there was nary a peep. No one really cared.)

In other words, as Mintzberg demonstrates in this video, the leadership function of management is not, and cannot be something that is effectively taught out of context in business schools. And to the extent that we draw elites from these schools they will not only be fallibe but both hubristic and excessively error prone.

Taking a Step Back

I haven't commented much on the debate swirling around the vast increase in the profitability of the financial sector, and the contribution to this sector to the greater public good. Though I am still searching for comparable Canadian figures, in the U.S., at the onset of the current crisis, financial sector profits had risen from 20% to 40% of all profits in just a few years. It seems likely that Canadian figures are not all that different.

Why, then, do we allocate so much to this sector? The baseline function of any financial sector is to aggregate resources and efficiently allocate these. But more and more, the corporate sector raises its own resources. Or perhaps it is to develop innovative investment vehicles, but we all know how that has turned out.

I think Yglesias hits the nail on the head

Could it really be the case that so many people were naive enough to trust their monies to institutions that were only claiming to have brilliant investment models? Well, it seems to me that it could. And that this would explain why it might make sense for a firm financial firm to pay Larry Summers $5 million a year for a one-day-a-week job. When your company’s underlying product isn’t necessarily sound, it’s important to invest a lot in marketing. Summers is like a celebrity endorsement. This is also a reason, I think, why having gone to a fancy college seems to have been very helpful for getting a job in finance. The firms’ business models very much depend on putt (ing a certain image of themselves forward.

In other words, as I commented earlier, trust in elite MBAs, buttressed by relentless image building and a unified message (invest for the long haul, don't lock in your losses) have led investors to naively trust financial advisors and to stay with them through a devastating downturn. Our lack of financial superstars in Canada is more than offset by our deference to authority -- even incompetent authority.

Those Pesky Accounting Standards -- Now Europe

The Economist reports today that the IASB, the body that regulates accounting standards in Europe is under political pressure to loosen fair-value accounting standards, particularly those known as "mark to market". We have, of course, already seen this in Canada and the U.S.. As the Economist describes it

On April 2nd, after a bruising encounter with Congress, America’s Financial Accounting Standards Board (FASB) rushed through rule changes. These gave banks more freedom to use models to value illiquid assets and more flexibility in recognising losses on long-term assets in their income statements. Bob Herz, the FASB’s chairman, decried those who “impugn our motives”. Yet bank shares rose and the changes enhance what one lobbying group politely calls “

European ministers instantly demanded that the International Accounting Standards Board (IASB) do likewise. The IASB says it does not want to be “piecemeal”, but the pressure to fold when it completes its overhaul of rules later this year is strong. On April 1st Charlie McCreevy, a European commissioner, warned the IASB that it did “not live in a political vacuum” but “in the real world” and that Europe could yet develop different rules.

So the rules change, and as this weeks experience shows, banks achieve instant profitability and are suddenly able to fully participate in credit markets. Isn't accounting fun! A stroke of the pen moves them from insolvency to darling of the market! (Warning: don't try this at home.)

Banks worldwide have suggested fair-value proponents are on the wrong planet. However, the Economist throws its considerable weight behind the argument that

[i]t was banks that were on the wrong planet, with accounts that vastly overvalued assets. Today they argue that market prices overstate losses, because they largely reflect the temporary illiquidity of markets, not the likely extent of bad debts. The truth will not be known for years. But banks’ shares trade below their book value, suggesting that investors are sceptical. And dead markets partly reflect the paralysis of banks which will not sell assets for fear of booking losses, yet are reluctant to buy all those supposed bargains.

Those Amazing, Magic Bank Profits -- II

From Floyd Norris of the NYT. Barclays Bank has discovered another route to instant profitability -- make a loan to yourself! Oh those clever banks.

As Norris describes it:

Barclays, the large British institution, announced a $3.1 billion loan today. And it also promised to keep the loan on its own balance sheet for a year, rather than sell off parts of it to other banks. Even after the year is up, it promises to keep most of the loan.

And who will get the cash from that loan? Barclays itself. It will also be able to report a large profit, of $2.2 billion, which is something every bank needs these days. And Robert E. Diamond, Barclays’ president, stands to take home $6.9 million of the money.

Barclays is selling its iShares business, which puts together exchange-traded funds, to a private equity firm for $4.4 billion, and financing the deal itself. So the cash stays right where it is, but a profit is posted. Mr. Diamond owns a stake in the business, so he gets to share in the bounty. (The bank says he was not involved in the negotiations.)

As with their American cousins, shares leaped on this news. One begins to feel less and less sorry for bank shareholders.

Those Amazing, Magic Bank Profits

Slate is reporting today what the markets told us yesterday: U.S. banks are somehow returning to profitability. But not so fast.

Scroll back less than two weeks to Congressional pressure on the Financial Accounting Standards Board to retreat on fair-value accounting, particularly mark-to-market requirements. On March 30, Bloomberg reported that

Four days after U.S. lawmakers berated Financial Accounting Standards Board Chairman Robert Herz and threatened to take rulemaking out of his hands, FASB proposed an overhaul of fair-value accounting that may improve profits at banks such as Citigroup Inc. by more than 20 percent.

So now, Wells Fargo is reporting a 27% rise in profits. As Howard Cosell used to say: amazing!

Of course, as I noted on March 4, Canadian banks achieved a similar miraculous return to profitability following changes in fair value accounting standards, issued last fall but backdated to the summer, so that fourth quarter profits would shine.

What I cannot understand is how and why sophisticated investors believe this. Putting lipstick on the pig of toxic assets does not alter their pig-like character.

So What is Plan B, Dalton?

Premier McGuinty's office has just announced the obvious, that the Pension Benefits Guarantee Fund cannot make good on pension liabilities for GM and Chrysler.

I commented on this in March, asking whether tax payers would be on the hook for GM pensions. The question remains.

McGuinty acknowledges that there will be a role for government though he is not forthcoming on which government or what the role might be. Given the premier's track record, this could be the opening move in a game of chicken with the feds.

However this plays out, the provincial government is likely to be caught between public outcry over what are often perceived as exceedingly generous pensions and driving the final economic nail into the coffins of communities such as St. Catharines, Windsor, Oshawa and St. Thomas among others.

Stay tuned.

It Ain't Over til the Weight-challenged Lady Sings

In a remarkably candid talk yesterday, Ed Clark, CEO of TD Bank said (somewhat disingenuously) that while the banking sector in Canada is quite healthy, the economy (truthfully) is in terrible shape, noting that

Just because our banks didn't collapse, Canadians are running around saying, wow, aren't we terrific. But the reality is this economy is going to get whacked just as hard as economies around the world.

In other words we are far from being out of this yet. And if one reads between the lines, Clark's talk indicates that the banks face troubled times too, first because they can no longer flog off sketchy debt as securitized bonds like they once did and second because troubles in the U.S. will slow the flow of funds into Canada that banks and their customers rely on. In other words, our banks will have to act like banks. Even given a massive injection of $125 billion and much softer rules on fair value accounting, we will see how profitable and stable they are then.

Ineptitude or Malfeasence? -- William K. Black on the Banks

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As has already been widely commented on, economist William K. Black was interviewed by Bill Moyers on his Bill Moyers' Journal show on Sunday. What Black had to say was damning. A prominent regulator during the Savings and Loan fiasco of the 1980s, he insists that subprime lending, securitization and the insuring of bad debt through insufficiently capitalized credit default swaps were not instances of ineptitude but of malfeasance.

If this is true, and this seems obvious,then, as Black argues, efforts to recapitalize and re-regulate banks are not only misguided, but are a form of willful folly. Those who gamed the system once, by trading off almost unimaginable short term gain for longer term disaster will at least try, and quite likely succeed, in doing so again. The breathtakingly self-serving behavior of financial institutions taking advantage of bailouts and accounting rule changes amply demonstrates this.

Government does not need to 'nationalize' banks to correct their behavior. It has regulatory powers that can be made accountable and effective. And where banks or other financial institutions, whether through circumstance or error, are found to be insolvent by effective accounting standards, they can be put into receivership and reorganized. Our degrees of freedom here are not zero.

At a Crossroad?

It has seemed clear for at least the past couple of months that the global economy is at a point where it may be poised to recover or to slip much further into the abyss. Much has been made, for an against, of a replay of the great depression, and yet much of the debate has seemed like a tiresome repetition of talking points from both sides.

It is clear that the contraction of credit, rapid job loss and staggering market losses mirror the opening months of the depression. Yet it is equally clear that we have policy tools that were not then imaginable, let alone available in 1929-30. And there are what have been termed "green shoots", tantalizing hints of a recovery many believe might now be materializing.

Barry Eichengreen and Kevin O'Rourke yesterday published a brief paper noting that while from an American (or Canadian) perspective, this might look like a typical cyclical recession, from a global perspective, it is anything but. Industrial output, global trade and world stock markets are tracking downward much more quickly than in the opening months of the depression. At the same time, monetary and fiscal responses have been much quicker and much more robust than in the earlier episode.

The question that remains to be answered, for me and for these authors among many others, is whether the latter will offset or counteract the former. The fatuous optimism of Jim Flaherty notwithstanding, this remains to be seen.

Inflation???

So let me see.

Now that we have set aside an eye-popping amount of money for the banks, given tax cuts which always benefit the more well-off, ensured that there is plenty of money for businesses to lease equipment, and given billions to the auto sector, inflation is a problem.

How convenient.

You need to search high and low to find more than a handful of (ideologically driven) economists who are not concerned about deflation. Yes, given the level of stimulus applied around the globe since the start of this crisis, and the unprecedented levels of public debt, particularly in the U.S., inflation is not only possible but likely up the road. And we will surely need some of the ample monetary policy room we currently enjoy to control it.

But now?

Japan's experience in the 1990s, and everyone's during the 1930s is that a premature switch in focus to inflation is likely to choke off recovery and prolong what will already be an acutely painful recession. It is difficult to understand this concern now as anything but a reflexive ideological response to unprecedented and admittedly frightening efforts to respond to this crisis

NO!!!!!!!!!!!!

This is unbelievable.

In the wake of changes by the FSAB yesterday, relaxing mark to market accounting requirements, and following efforts by the U.S. Fed to entice investors to purchase toxic (though now less so) assets, the Financial Times reports today that many U.S. banks are poised to use public subsidies to purchase these suddenly less toxic assets from their rivals. This did not go unnoticed by legislators:

The plans proved controversial, with critics charging that the government’s public-private partnership - which provide generous loans to investors - are intended to help banks sell, rather than acquire, troubled securities and loans.

Spencer Bachus, the top Republican on the House financial services committee, vowed after being told of the plans by the FT to introduce legislation to stop financial institutions ”gaming the system to reap taxpayer-subsidised windfalls”.

Mr Bachus added it would mark ”a new level of absurdity” if financial institutions were ”colluding to swap assets at inflated prices using taxpayers’ dollars.”

This, of course, beggars the imagination. The AIG bonuses had terrible optics, but ultimately were of little consequence. This is simply a shameless raid on the public treasury by the same folks who brought you the financial meltdown.

Yes We Can Afford It

Conservative Senator Elaine McCoy's wonderful blog, Hulabaloos, which I cannot plug often enough, has a link to a piece by Oxfam Great Britain's Duncan Green comparing the amounts spent by governments world wide to bail out the financial sector and the costs of alleviating some of the worst global ills.

Many, if not most, have surely felt discomfort at the increasingly fantastical amounts thrown at a financial sector largely responsible for its, and our troubles. What Mr. Green puts in perspective is the almost trivial amounts, in comparison, that would be required to eradicate the worst of poverty and meet a host of other worthy development goals worldwide.

What the past several months have surely done is ended arguments about what we can or cannot afford. We may or may not have the political will or moral vision to do what is decent rather than expedient, but surely never again will be be able to hide behind financial rationalizations. Already we stand shamed as a society for putting the needs of the already wealthy so incredibly far ahead of those most in need.

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.