August 30, 2013

Two Months And Counting To The Real Debt Ceiling D-Day

There has been much confusion in the past several months relating to the US debt ceiling, and specifically the fact that total debt subject to the limit has been at just $25 million away from the full limit since late May.

As we explained first in January 2011, there is nothing sinister about this. Any time the Treasury hits its physical debt cap, it activates its available "emergency measures" which include such money releasing options as disinvesting the Civil Service Fund, Suspending reinvestment in the G-Fund, Selling securities from the Exchange Stabilization Fund, and others, which cumulatively free up around $300-$350 billion. In essence the "emergency measures" act like a revolving credit facility that is slowly but surely being drawn down. Add to that sporadic cash creation over the past few months from cash inflows from the GSEs and one can see why the US has been able to be in breach of the debt ceiling for as long as it has. And why it still has just under two months of capacity.

The chart below shows how much emergency capacity the US has currently when adding all the emergency benefits, and how much it will have over the next three months. Of note is the period between October 15 and November 1, when tifrst the "revolver" cash balance dips below $50 billion, and then hits $0 by November 1. Either way, there better be a debt deal by mid-October, or late October at the very latest, or the summer of 2011 debt ceiling fiasco will seem like a walk in the park in comparison to what's coming.

For all other debt-ceiling related questions, we present Goldman's take.

Q: What did Treasury announce earlier this week?

Treasury Secretary Jack Lew informed Congress on August 26 that the Treasury would exhaust its borrowing capacity by the "middle of October." Specifically, this is when the Treasury has determined that it will have used the last of the "extraordinary measures" it has been employing to temporarily lower debt held in internal trust funds in order to make room under the debt limit for marketable Treasury issuance. Once those accounting strategies are no longer available, the Treasury will be left to rely on incoming tax receipts and the cash balance on hand to finance any disbursements.

The Treasury projects its cash balance to be roughly $50bn in mid-October when it exhausts its borrowing authority. This is a greater level of detail than the Treasury has provided ahead of previous debt limit deadlines. Prior announcements never stated the precise cash level the Treasury expected to have around the deadline, and thus left some uncertainty about whether payments scheduled to be made in the days following the deadline were truly at risk. For example, the Treasury announced in 2011 that it expected to exhaust its borrowing authority by August 2 of that year. Deficits turned out to be slightly lower than anticipated in the weeks leading up to the deadline, leaving the Treasury with $54bn in cash on hand at the deadline, which could have allowed the Treasury to operate without additional borrowing for at least another week.

Q: How does that compare with our forecast?

We had previously projected that Congress would need to raise the debt limit before November 1, give or take a week or two. However, although the deadline we projected differs from the Treasury's "middle of October", it is the definition of the deadline that differs rather than our view of projected Treasury cash flows. Our latest projection implies that the Treasury's total financing capacity--i.e., the headroom under the debt limit plus the cash balance--will drop below $50bn in mid-October, similar to the Treasury's projection (Exhibit 1). Based on the pattern of daily receipts and outlays that we project (we base these on prior years' patterns scaled to current levels and adjusted for calendar differences), we expect that the roughly $50bn cash balance that the Treasury will have in mid-October will gradually shrink over the following two weeks. The Treasury would probably be able scheduled payments in late October with the cash we expect it to still have on hand, but it would be unable to make all of the payments scheduled for November 1.

Q: So what is the real deadline?

To avoid disruptions to the Treasury market, Congress will probably need to raise the deadline by mid-October, as the Treasury states. Since the Treasury plans its securities issuance with the expectation of a sizeable cash cushion--the cash balance has averaged around $60bn over the last couple of years--it should be expected that the debt limit, net of extraordinary measures, would be reached before the point that the Treasury is unable to pay its obligations as they come due. The upshot is that Treasury's regularly scheduled auctions could be scaled back or delayed if Congress doesn't raise the debt limit by Treasury's stated deadline, even though scheduled payments might not be immediately at risk.

The Treasury is scheduled to hold auctions of 3- and 10-year notes and 30-year bonds the week of October 6 that are scheduled to settle October 15. The Treasury's projection that it will exhaust its "extraordinary measures" by mid-October seems reasonable if one assumes that Treasury auctions continue on schedule in amounts similar to what is implied by the Treasury's most recent issuance projections. Assuming those projections are accurate, the Treasury might not be able to conduct those auctions as planned without a high degree of confidence that the limit would be raised by the time the securities settle on October 15.

This would be highly unusual but not unprecedented. A Government Accountability Office (GAO) report lists 17 Treasury auctions between 1995 and 2006 that for which the announcement date was delayed; in 11 of those cases the auction itself was delayed. Most of these involved short delays to bill auctions, but during the 1995 debt limit debate the Treasury postponed 3-year and 10-year auctions for roughly one week.

Q: How does the Treasury's announcement affect the upcoming fiscal debate?

The announced deadline probably shifts attention further toward the debt limit and away from the debate over extending government spending authority. Current spending authority expires at the end of the fiscal year on September 30. While that issue could still be dealt with separately from the debt limit, a mid-October deadline increases the likelihood that they will be rolled up into one debate given their proximity on the calendar (perhaps involving a short extension of spending authority to more closely line up the deadlines). The practical consequences of this are not that great, however. Republican leaders have not appeared enthusiastic about strategies to block the renewal of spending authority unless changes to the Affordable Care Act (also known as "Obamacare") are made, and had already appeared to be more focused on negotiating around the debt limit even before the Treasury's announcement.

The detail the Treasury has provided regarding its cash balance may also lead some lawmakers to believe they have more time to raise the limit than they really do. As noted earlier, the Treasury's mid-October deadline is analogous to the August 2 deadline from 2011. The Treasury still had a significant cash balance it could use to make scheduled payments, but due to normal scheduled Treasury issuance it had exhausted its capacity to borrow under the limit. In the 2011 episode, lawmakers had little doubt that they needed to raise the debt limit by the deadline. This was, among other things, due to the perceived risk that the Treasury could miss an important scheduled payment, which seemed quite possible without knowledge of how much cash the Treasury expected to have on hand. If lawmakers feel confident that payments scheduled for the days following the mid-October deadline are likely to be made on schedule, they may feel less pressure to enact an increase by that point and could conceivably wait until later in the month. (Complicating matters further, Congress is scheduled to be on recess October 14-19.) Given this risk, it seems likely to us that the Treasury will make clear to Congress in upcoming communications that while it may have some remaining cash on hand to pay obligations after the mid-October deadline, waiting until late October would nevertheless be disruptive and should be avoided.


August 29, 2013

Will War With Syria Cause The Price Of Oil To Explode Higher?

Are you ready to pay four, five or possibly even six dollars for a gallon of gasoline?  War has consequences, and a conflict with Syria has the potential to escalate wildly out of control very rapidly.  The Obama administration is pledging that the upcoming attack on Syria will be "brief and limited" and that the steady flow of oil out of the Middle East will not be interrupted.  But what happens if Syria strikes back?  What happens if Syrian missiles start raining down on Tel Aviv?  What happens if Hezbollah or Iran starts attacking U.S. or Israeli targets?  Unless Syria, Hezbollah and Iran all stand down and refuse to fight back, we could very easily be looking at a major regional war in the Middle East, and that could cause the price of oil to explode higher.  Syria is not a major oil producer, but approximately a third of all of the crude oil in the world is produced in the Middle East.  If the Suez Canal or the Persian Gulf (or both) get shut down for an extended period of time, the consequences would be dramatic.  The price of oil has already risen about 15% so far this summer, and war in the Middle East could potentially send it soaring into record territory.

We can always hope that cooler heads prevail and that a conflict is avoided, but at this point it does not look like that is going to happen.  In fact, according to Richard Engel of NBC News, a senior U.S. official has admitted that "we're past the point of return" and that a strike on Syria can be expected within days.

Obama is promising that the U.S. will "take limited, tailored approaches", and that we will not be "getting drawn into a long conflict, not a repetition of, you know, Iraq, which I know a lot of people are worried about", but how in the world can he guarantee that?
Syria, Iran and Hezbollah have all threatened to attack Israel if the U.S. attacks Syria.

If missiles start raining down on Israeli cities, the Israelis are not just going to sit there and take it like they did during the first Gulf War.  In fact, according to the Los Angeles Times, "Israeli leaders are making it clear that they have no intention of standing down this time if attacked".

If Israel is attacked, their military response will be absolutely massive.

And then we will have the major regional war in the Middle East that so many people have been warning about for so many years.  Hundreds of thousands of people will die and the global economy will be paralyzed.

So what will Obama do in such a situation?

Will he pack up and go home?

Of course not.  We would be committed to fighting a brutal, horrific war that there was absolutely no reason to start in the first place.

And we are already starting to feel the effect of rising tensions in the Middle East.  This week, the price of oil rose to a 10-month high...
U.S. oil prices soared to an 18-month high as traders worried that a potential military strike against Syria could disrupt the region's oil supplies.
October crude futures surged 2.9%, to $109.01 a barrel on the New York Mercantile Exchange, their highest close since February 2012. Brent futures ended up 3.2% at $114.28 a barrel, a six-month high.
Posted below is a chart that shows how the price of oil has moved over the past several decades.  Could we soon break the all-time record of $147 a barrel that was set back in 2008?...

And of course we all remember what happened when the price of oil got that high back in 2008.  The global economy was plunged into the worst downturn since the Great Depression of the 1930s.
A major conflict in the Middle East, especially if it goes on for an extended period of time, could send the price of oil to absolutely ridiculous levels.

Every single day, a massive amount of oil is moved through the Suez Canal.  The following is from a recent Wall Street Journal article...
To the southwest is the Suez Canal, one such chokepoint, which connects the Red Sea and the Gulf of the Suez with the Mediterranean Sea. The canal transports about 800,000 barrels of crude and 1.4 million barrels of petroleum products daily, according to the U.S. Energy Information Administration. 
Another regional oil shipping route potentially threatened by the Syria crisis is the Sumed, or Suez-Mediterranean, pipeline, also in Egypt, which moves oil from the Persian Gulf region to the Mediterranean. The Sumed handles 1.7 million barrels of crude oil per day, the EIA said.
And of course an enormous amount of oil moves through the Persian Gulf each day as well.  If the Suez Canal and/or the Persian Gulf were to be shut down, there would almost immediately be global supply problems.

So how high could the price of oil go?

Well, according to CNBC, some analysts believe that $150 a barrel could easily be hit if the U.S. attacks Syria...
Some analysts believe even U.S. crude, West Texas Intermediate (WTI crude) could get close to the $150 zone. "If oil prices spike on the Syria attack, and surge above $120, the next logical upside target is going to be the 2008 high of $147, which could easily be taken out," said John Kilduff of Again Capital. "It's the retaliation to the retaliation that we have to be worried about."
If the price of oil soars up to that level and keeps going, we could see the price of gasoline go up to four, five or maybe even six dollars a gallon in some areas of the country.

You better start saving up lots of gas money.

It looks like you are going to need it.


August 28, 2013

Has the Shale Bubble Already Burst?

Just like the famous Gold Rushes of the 19th century, US shale gas development is turning out to be a limited and regional market opportunity. Across the Atlantic, the high financial and human costs to fracking also mean that Europe should forget any fantasies about repeating the US shale boom.

Many US shale companies that have been beating the drums of shale “revolution” are now facing oil and gas well depletion. In February 2013 the US Energy Information Administration (EIA) warned that “diminishing returns to scale and the depletion of high productivity sweet spots are expected to eventually slow the rate of growth in tight oil production”. It was a cautious but intriguing statement.

Arthur Berman, a prominent shale skeptic who runs Labyrinth Consulting firm in Sugarland, Texas, is not surprised. “The shale gas phenomenon has been funded mostly by debt and equity offerings. At this point, further debt and share dilution are less feasible for many companies” – he wrote in The Oil Drum blog several months ago.

The average depletion rate of wells in the Bakken Formation (the largest tight oil play in the US) is reported to be 69 percent in the first year and 94 percent over the first five years (37 percent and 50 percent in the Barnett Formation). Due to the lack of reliable data on shale industry many experts (for example, Deborah Rogers from Energy Policy Forum) await possible future write-downs in shale assets. Naturally smaller investors will not hear about the write-downs in the news.

Rock-bottom gas prices on the American market make it extremely difficult to drill more wells and maintain current levels of production, unless technology radically changes.

“The cheap price bubble in the US will burst within two-to-four years,” believes David Hughes, a geoscientist and former team leader on unconventional gas for the Canadian Potential Gas Committee. “At a high enough price, the supply bubble will burst perhaps 10-to-15 years later, when drilling locations become sparse.”

It means that natural gas market is successfully absorbing shale output for now.

The sharp inflection points for shale gas wells result from a well-known drawback of horizontal drilling and hydraulic fracturing technologies. Production peaks for a year or two but then the initial flow peters out. Overall lifespan of shale wells in Texas is about 8 years. Drilling company must continuously invest in the new wells or refrack the old ones. In comparison conventional, vertically drilled wells demonstrate more stable output for 20-30 years.

Fracking business model in 2009-2012 was based on enormous cashflow from investors attracted by tall promises of natural gas bonanza. At the same time shale wells were considerably underperforming in dollar terms making the whole business a very risky venture. Lack of statistics was sugar coated by lucrative promises.

Will domestic gas prices be high enough to pay for the continuing exploration and development in the coming year? It is hardly probable. Natural gas futures for September and October 2013 slid to the lowest price in more than five months in New York after U.S. stockpiles increased more than forecast last week, Bloomberg reported.

There are also sensational industry reports that reveal how investment bankers promoted shale bubble in order to profit from a short-lived energy boom. Subprime mortgage crisis has shown that the Wall Street is very good at creating financial bubbles.

A lot of the small investors now being solicited by respected investment publications may lose their money, forecasts Professor Robert U. Ayres in Forbes. The shale gas boom was profitable in 2009 but now small players are late for dinner.

Europe Must Forget Fantasies About Repeating The US Shale Boom

Strong anti-fracking grassroots movement in Europe proves that people on the continent also understand the hidden dangers of shale gas development. Many countries in continental Europe have shelved unrealistic shale projects despite the fact that European energy prices are double those in the US. Germany set strong barriers against fracking. France’s president Hollande blocked shale initiatives. The Paris-based International Energy Agency has strong doubts about shale gas in Europe pointing to the lack of drilling equipment, higher population density and environmental concerns. The only apologist of fracking in the European Union is Great Britain. London is strongly influenced by US companies trying to sell drilling equipment on the island.

In May 2013 the EU Cimate Commissioner Connie Hedegaard stressed that geological and geographical factors of Europe shale did not make its large-scale exploitation as cost-effective as in North America. Finally, the Director of Strategy at the European Commission’s DG Environment Robin Meige has recently said that “in the most optimistic case, European shale gas can only compensate for declines in domestic conventional gas”. In other words, Europe must forget fantasies about repeating the US Shale Boom, writes online industry journal

Some Eastern European states are pushing forward the shale agenda for purely political reasons disregarding interests of their own population. For instance, the government of Poland has painted itself into a corner by making loud and unsubstantiated statements about shale gas “revolution”.

Despite around 40 wells being drilled in the country since 2010 by oil majors, no company has announced that it can extract gas for commercial purposes. However heavy pro-fracking lobbying resulted in dramatic corruption scandal. Seven officials were arrested last month in connection with licenses to explore and exploit shale gas deposits.

At the same time Polish farmers have initiated massive protests against shale gas development. It seems they understand the situation far better than many professional energy analysts in London.

“If they go ahead with drilling thousands of meters underground, our water will be affected and there will be no more life in our fields,” villager Stefan Jablonski told IPS during a protest in Warsaw last week. “Not to mention that we might end up with no gas and no water too.”


August 27, 2013

CNBC: Larry Summers Is Likely To Be Named Chairman Of The Fed In A Few Weeks

A source from Team Obama told CNBC that Larry Summers will likely be named chairman of the Federal Reserve in a few weeks though he is "still being vetted" so it might take a little longer.

It's largely come down to a two-horse race between Summers, a former Treasury secretary, and Fed Vice Chairman Janet Yellen for the next Fed chief.

It is widely expected that the current Fed Chairman Ben Bernanke will resign by the end of the year as his term ends in January. President Obama has already said that Bernanke has "already stayed a lot longer" in the role than he expected. Those remarks came in an interview with Charlie Rose on PBS in June.

Who might take the reins from Bernanke has been an undertone in the market and at the Fed's recent meeting in Jackson Hole, Wyoming.

Summers didn't attend the Jackson Hole meeting but his name was tossed around the sidelines.
Several Fed officials, who spoke on condition of anonymity, told Reuters that they did think Summers was Obama's clear favorite, though they had a few doubts.

"Has he devised a strategy to be effective within the institution?" one asked.

Some insiders also expressed concern about Summers' close ties to Wall Street.

The race for the next Fed chief comes amid another big point of discussion for policy makers — when to begin tapering the Fed's $85 billion per month bond-buying program. There has been much speculation that it will begin in September.


August 26, 2013

Fed’s Jackson Hole Participants to QE-Exit Whacked Emerging Economies: Drop Dead

The latest Fed confab at Jackson Hole is demonstrating that central bankers were so keen to avoid taking much blame for the global financial crisis that they also failed to learn critical lessons from it. That lapse in turn is directly related to the present emerging markets upheaval that has the potential to morph into something worse.

In case you managed to miss it, the prospect of the end of QE is leading investors to rearrange their portfolios in a fundamental way. One of the most widely-followed sayings among traders is “Don’t fight the Fed.” Having the central bank that runs the world’s reserve currency on the verge of ending its extraordinary bond market interventions and indicating that it expects later to enter a conventional tightening cycle is a fundamental change in stance. This shift is particularly important for risky investments, such as those in emerging economies, since the Fed’s super accommodative posture fueled a global carry trade. As Ambrose Evans-Pritchard wrote last week:
India’s rupee and Turkey’s lira both crashed to record lows on Thursday following the US Federal Reserve releasing minutes which signalled a wind-down of quantitative easing as soon as next month…. 
A string of countries have been burning foreign reserves to defend exchange rates, with holdings down 8pc in Ecuador, 6pc in Kazakhstan and Kuwait, and 5.5pc in Indonesia in July alone. Turkey’s reserves have dropped 15pc this year…
It was Fed tightening and a rising dollar that set off Latin America’s crisis in the early 1980s and East Asia’s crisis in the mid-1990s. Both episodes were contained, though not easily. 
Emerging markets have stronger shock absorbers today and largely borrow in their own currencies, making them less vulnerable to a dollar squeeze. However, they now make up half the world economy and are big enough to set off a crisis in the West.
Fears of Fed tightening have pushed borrowing costs worldwide to levels that could threaten global recovery. Yields on 10-year bonds jumped 47 basis points to 12.29pc in Brazil on Thursday, 33 points to 9.72pc in Turkey, and 12 points to 8.4pc in South Africa… 
Hans Redeker from Morgan Stanley said a “negative feedback loop” is taking hold as emerging markets are forced to impose austerity and sell reserves to shore up their currencies, the exact opposite of what happened over the past decade as they built up a vast war chest of US and European bonds. 
The effect of the reserve build-up by China and others was to compress global bond yields, leading to property bubbles and equity booms in the West. The reversal of this process could be painful. 
“China sold $20bn of US Treasuries in June and others are doing the same thing. We think this is driving up US yields, and German yields are rising even faster,” said Mr Redeker. “This has major implications for the world. The US may be strong to enough to withstand higher rates, but we are not sure about Europe. Our worry is that a sell-off in reserves may push rates to levels that are unjustified for the global economy as a whole, if it has not happened already.”
So given that developing economies have become canaries in the coal mine as far as the Fed’s taper is concerned, their central bankers are calling on the Fed to show a bit of mercy, say by going a bit easier on them and/or coordinating with other central banks. Not surprisingly, it appears that the most these petitioners will get are some comforting words. From the Financial Times today:
The world’s top policy makers must be more aggressive in handling the unfolding emerging markets crisis, the finance minister of Africa’s largest economy has warned, calling for greater action on global capital flows and currency volatility.
Pravin Gordhan, South Africa’s finance minister, told the Financial Times in an interview that there is an “inability to find coherent and cohesive responses across the globe to ensure that we reduce the volatility in currencies in particular, but also in sentiment… 
“There’s no doubt that the multilateral institutions that participate in, and often work for, and with, the G20 need to desperately try to come up with new answers and do some heterodox thinking to find a new framework which will enable us to embrace the current environment, create less volatility,” he said… 
Mr Gordhan added that while it was understood that “you cannot manage all of these phenomena in a fine-tuned way”, policy makers needed to “come up with better answers” to reduce volatility and create a more predictable environment.
But policy makers at Jackson Hole did not have many answers for Mr Gordhan. “As much as we may like to find it, there is no master stroke that will insulate countries from financial spillovers,” said Terrence Checki, the head of international affairs for the New York Fed. 
In a paper presented to the Jackson Hole conference, Hélène Rey of the London Business School concluded that central banks would struggle to adapt their policies to avoid spillovers to other countries, because it would conflict with their domestic goals.
In fairness, Christine LaGarde did say the IMF was ready to help, but the python-like embrace of an IMF rescue is not likely to be the sort of assistance the beleaguered central bankers were seeking.
The fact is that the current emerging markets upheaval demonstrates that the economics policy elite has been unwilling to look at the real roots of the crisis and come up with workable remedies. And Gordon’s remarks give a clue as to why this hasn’t occurred: that it would require “heterodox thinking” which really means “heretical thinking”. Not only would policymakers and the public need to identify the bad policies and decisions that produced the crisis (naming names!) but also abandon some deeply held beliefs.

Not surprisingly, Carmen Reinhart’s and Ken Rogoff’s idea that high government debt levels were bad for growth was touted widely because it justified what amounted to policy prejudices. Yet another finding they published around that time, that high levels of international capital flows are correlated with more frequents and more severe financial crises, got nowhere near the same level of attention.

Similarly, Claudio Borio and Piti Disyatat of the Bank of International Settlements published a paper in 2010, “Global imbalances and the financial crisis: Link or no link?” that argued, persuasively, that overly high international capital flows were a direct cause of the financial crisis, and those resulted from “excessive financial elasticity”, which one might also call too little regulation. Borio has the misfortune to be the Cassandra of financial crises; he joined William White in trying to warn Alan Greenspan and other central bankers in 2003 of a global housing bubble and was brushed off. His 2010 paper with Disyatat was written defensively and for professional economists and thus is not layperson-friendly. Andrew Dittmer’s translation helps explain why: the paper also savages Bernanke’s self-serving “global savings glut” explanation of the crisis. From Dittmer’s summary:
The global financial crisis led to widespread dislocations and misery. However, another set of victims, hitherto overlooked, were central banking authorities and professors of economics who had staked their names on the thesis that the current configuration of the global financial system (which they had helped to engineer) was generally wonderful. These unfortunate souls were forced to come up with an explanation for the crisis on short notice, and it had to be an explanation in which they themselves played no role. 
Ben Bernanke et al. rose brilliantly to the challenge. They remembered that many Asian countries had stocked up on foreign currency reserves in the hopes of never again being at the mercy of the IMF (26, note). Obviously, trying to resist the IMF was wrong and deserved criticism. Moreover, saying bad things about the Chinese would inevitably be welcomed in foreign policy circles eager to talk about the coming “bipolar confrontation” between America and China. 
This “savings glut” theory argued that savings by Asian (and Middle Eastern) countries had washed like a tidal wave onto US financial markets, effectively forcing US money managers to invest imprudently in the course of their attempts to cope. For instance, these “excess savings” were widely assumed to have reduced long-term interest rates, thereby making credit cheaper. 
There were some obvious problems with the global imbalances theory. Before the crisis exploded, many of the same economists had pointed to the same imbalances as a happy coincidence of needs, leading to better results for all (23). According to the sort of economic theory that was used in these explanations, if “global imbalances” were causing long-term interest rates to fall, that was simply a natural market outcome that should be contributing to equilibrium (23)… 
Despite the consensus of these eminent authorities, we have decided to take a second look at the theory. Unfortunately, we have found further problems. 
The idea of “national savings” or “current account surplus” refers to the total amount of exports sold minus the total amount of imports sold (more or less). The “excess savings” theory holds that this excess had to have been financed somehow, and so presumably by countries in surplus, like China. 
However, for the US in 2010, the total amount of financial flows into the US was at least 60 times the current account deficit (9), counting only securities transactions. If this number were correct, then inflows would be 61 times the current account deficit, and outflows would be 60 times the current account deficit. The current account deficit is a drop in the bucket. Why would anyone assume it had anything to do with the picture at all? 
Moreover, if the “savings glut” theory was correct, we would expect there to be certain historical correlations between the following variables: (a) current account deficits of the US, (b) US and world long-term interest rates, (c) value of the US dollar, (d) the global savings rate, (e) world GDP. There aren’t (4-6, see graphs). 
You would also expect credit crises to occur mainly in countries with current account deficits. They don’t (6). 
Suppose we look at a more reasonable variables: gross capital flows (13-14). What do we learn about the causes of the crisis? 
Financial flows exploded from 1998 to 2007, expanding by a factor of four RELATIVE to world GDP (13), and then fell by 75% in 2008 (15). The most important source of financial flows was Europe, dwarfing the contributions of Asia and the Middle East (15). The bulk of inflows originated in the private sector (15). 
If we look instead at foreign holdings of US securities (15-16), Europe is still dominant, but China and Japan are a little more prominent due to their large accumulations of foreign exchange reserves (15). Still, the Caribbean financial centers alone account for roughly the same proportion as either China or Japan (16). Other statistics provide a similar picture (17-19). 
So what caused the crisis? Clearly, the shadow banking system (mainly based around US and European financial institutions) succeeding in generating huge amounts of leverage and financing all by itself (24, 28). Banks can expand credit independently of their reserve requirements (30) – the central bank’s role is limited to setting short-term interest rates (30). European banks deliberately levered themselves up so they could take advantage of  opportunities to use ABS in strategies (11), many of which were ultimately aimed at looting these same banks for the benefit of bank employees. These activities pushed long-term interest rates down. Short-term rates remained low because the Fed didn’t raise them as long as inflation didn’t appear to be an issue (25, 27). 
The Asian countries played a small role as well. They didn’t want US/European-driven asset price inflation to spill over into distortions in their economies, and so they protected themselves by accumulating foreign exchange reserves (26 and 26 note). That was mean of them. If they had allowed more spillover, then the costs of the shadow banking system would have been partly borne by them, and that would have made the credit crisis less severe in the advanced countries (26). As things stand, instead, the advanced countries are suffering, while Asian countries have bounced back strongly (26). 
What should we do? Well, we have suggestions for theory and practice. Let’s start with the practical suggestions. 
Countries should do a better job of restraining their financial sectors (24). However, that will probably not be enough (24). Countries should also work together to share the burden of consequences of further crises (27). Unfortunately, countries are irrational and political and so are often unwilling to cooperate in ways we consider wise (27).
Now this important paper covers even more ground, but the parts above are most germane for this discussion.

In shorter form, the implication is that too much in the way of international capital movements is destabilizing. Thus restricting capital movements, as in tougher financial regulations or even targeted capital controls, would be desirable. Yet the economics elite (no doubt due at least in part to indoctrination by bankers) believes that allowing international investors to chase returns is a good thing. They seem unable to recognize that hot money by its very nature isn’t reliable as a source of real economy funding and worse, its sudden influx and exodus will distort the pricing of capital for real economy projects.

In the wake of the crisis, central banks and national regulators have done virtually nothing to address this problem. And it appears to have gotten worse. We’ve written often of the dangers of tight coupling, that overly interconnected systems are vulnerable to catastrophic failure. If one node on the grid goes out, the damage propagates through the system faster than officials can intervene. The combination of extensive counterparty exposures and an undercapitalized shadow banking system created just this sort of danger in the runup to the crisis.

While some measures are underway to reduce counterparty exposures, such as moving more activities to exchanges and centralized clearing, they don’t appear to be far-reachign enough to change the architecture of the financial system. We’ve seen some evidence that the interconnectedness has increased, such as investors moving in massive herd-like “risk on, risk off” trades, and concerns that ETFs, which have become a favored trading vehicle for many investors, are a potential source of systemic risk. Yet tellingly, the Jackson Hole participants seem unwilling to recognize that the only way to reduce the risk of international hot money is to change the structure of the grid. For instance, a Reuters write-up of a Jackson Hole paper by one of France’s former central bankers, Pierre Landau, worked through several ideas for alleviating the negative feedback loops of the unwind of what he called “more accommodative monetary conditions than warranted.” Unfortunately, he concluded that it would be well-nigh impossible to get the political support for the needed national coordination. He concluded:
As a result, the outlook for global capital markets is not encouraging, Landau said, warning of a “segmentation” between nations with surplus capital and others that will suffer from a dearth of investment due to a lack of access to capital.
“The most likely scenario is that of progressive fragmentation of the international financial system,” he added
This sort of thinking is why we are likely to have another bout of bad outcomes. More compartmentalization of international capital markets is necessary and desirable, precisely because regulation and legal systems are nation-based. Having capital able to escape proper oversight has repeatedly led to miserable results for everyone but the speculators who were able to cash in their chips before the casino collapsed (or more recently, was bailed out). So we can either have an organized and well-thought out approach to containing cross-border money flows, or we can have it take place as a result of panicked, uncoordinated action and possible or actual institutional failures. It’s looking more certain that because the authorities are unwilling to do the hard intellectual and political work to move to a more robust system, we’ll have a chaotic end game instead.


August 23, 2013

What is Shadow Banking?

By Stijn Claessens, Assistant Director in the Research Department of the International Monetary Fund, Professor of International Finance Policy at the University of Amsterdam and Lev Ratnovski, an economist in the Research Department of the IMF. Cross posted from VoxEU

There is much confusion about what shadow banking is and why it may create (systemic) risks:
  • Some equate it with securitisation.
  • Others with non-traditional bank activities, or non-bank lending.
Regardless, most think of shadow banking as activities that can create systemic risk. This column proposes to describe shadow banking as ‘all financial activities, except traditional banking, which require a private or public backstop to operate’.

Backstops can come in the form of franchise value of a bank or insurance company, or a government guarantee. The need for a backstop is a crucial feature of shadow banking, which distinguishes it from the “usual” intermediated capital market activities, such as custodians, hedge funds, leasing companies, etc.

It Has Been Very Hard to Define “Shadow Banking”

The Financial Stability Board (2012) describes shadow banking as “credit intermediation involving entities and activities (fully or partially) outside the regular banking system”. This is a useful benchmark, but has two weaknesses:
  • First, it may cover entities that are not commonly thought of as shadow banking, such as leasing and finance companies, credit-oriented hedge funds, corporate tax vehicles, etc. (Figure 1).
  • Second, it describes shadow banking activities as operating primarily outside banks.
But in practice, many shadow banking activities, for instance, liquidity puts to securitisation structured investment vehicles, collateral operations of dealer banks, repos, and so on, operate within banks, especially systemic ones (Pozsar and Singh 2011, Cetorelli and Peristiani 2012). Both reasons make the description less insightful and less useful from an operational point of view.

Figure 1. Spectrum of financial activities

Note: see Claessens et al. (2012) for more discussion of the mechanics of shadow banking processes.

An alternative – ‘functional’ – approach treats shadow banking as a collection of specific intermediation services. Each of them responds to its own demand factors (e.g., demand for safe assets in securitisation, the need to efficiently use scarce collateral to support a large volume of secured transactions, etc.). The functional view offers useful insights. It stresses that shadow banking is driven not only by regulatory arbitrage, but also by genuine demand, to which intermediaries respond. This implies that in order to effectively regulate shadow banking, one should consider the demand for its services and – crucially – understand how its services are being provided (Claessens et al. 2012).

The challenge with the functional approach is that it does not tell us what the essential characteristics of shadow banking are. While one can come up with a list of shadow banking activities today, it is unclear where to look for shadow banking activities and risks that may arise in the future. And the functional approach is challenged to distinguish activities that appear, on the face of it, similar, yet differ in their final (systemic) risk (e.g., a commitment to provide for credit to a single firm vs. liquidity support to structured investment vehicles). Related, most studies focus on the US and say little about shadow banking elsewhere. In Europe, lending by insurance companies is sometimes called shadow banking. ‘Wealth management products’ offered by banks in China and lending by bank-affiliated finance companies in India are also called shadow banking. How much do these activities have in common with US shadow banking?

A New Way to Define “Shadow Banking”: All Activities that Need a Backstop

To improve on the current approaches, we propose to describe shadow banking as ‘all financial activities, except traditional banking, which require a private or public backstop to operate’. This description captures many of the activities that are commonly referred to as shadow banking today, as shown in Figure 1. And, in our view, it is likely to capture those activities that may become shadow banking in the future.

Why Do Shadow Banking Activities Always Need a Backstop?

Shadow banking, just like traditional banking, involves risk transformation – specifically, credit, liquidity, and maturity risks. This is well accepted by the existing literature, and fits all shadow banking activities listed in Figure 1. The purpose of risk transformation is to strip assets of ‘undesirable’ risks that certain investors do not wish to bear.

Traditional banking transforms risks on a single balance sheet. It uses the law of large numbers, monitoring, and capital cushions to ‘convert’ risky loans into safe assets to back deposits. Shadow banking transforms risks using a different mechanism. It aims to distribute the undesirable risks across the financial system (‘sell them off’ in a diversified way). For example, in securitisation shadow banking strips assets of credit and liquidity risks through tranching and providing liquidity puts (Pozsar et al. 2010, Pozsar 2011, Gennaioli et al. 2012). Or it facilitates the use of collateral to reduce counterparty exposures in repo markets and for over the counter derivatives (Gorton 2012, Acharya and Öncü 2013).1

While shadow banking uses many capital markets type tools, it differs also from traditional capital markets activities – such as trading stocks and bonds – in that it needs a backstop. This is because, while most undesirable risks can be distributed away by shadow banking processes, some residual risks, often rare and systemic ones (‘tail risks’), can remain. Examples of such residual risks include systemic liquidity risk in securitisation, risks associated with large borrowers’ bankruptcy in repos and securities lending, and the systematic component of credit risk in non-bank lending (e.g., for leveraged buyouts). Shadow banking needs to show it can absorb these risks to minimise the potential exposure of the ultimate claimholders who do not wish to bear them.

Yet shadow banking cannot generate the needed ultimate risk absorption capacity internally. The reason is that shadow-banking activities have margins that are too low. To be able to easily distribute risks across the financial system, for example, shadow banking focuses on ‘hard information’ risks that are easy to measure, price and communicate, e.g., through credit scores. This also means these services are generally contestable, with too low margins to generate sufficient internal capital to buffer residual risks. Therefore, shadow banking needs access to a backstop, i.e., a risk absorption capacity external to the shadow banking activity.

The backstop for shadow banking needs to be sufficiently deep:
  • First, shadow banking usually operates on large scale, to offset significant start-up costs, e.g., of the development of infrastructure;
  • Second, residual, ‘tail’ risks in shadow banking are often systemic, so can realise en masse.
There are two ways to obtain such a backstop. One is private – by using the franchise value of existing financial institutions. This explains why many shadow banking activities operate within large banks or transfers risks to them (as with liquidity puts in securitisation). Another is public – by using explicit or implicit government guarantees. Examples include, besides the general too-big-to-fail implicit guarantee provided to those large banks active in shadow banking, the Federal Reserve securities lending facility that backstops the collateral intermediation processes, the implicit too-big-to-fail guarantees for tri-party repo clearing banks and other dealer banks (Singh 2012), the bankruptcy stay exemptions for repos which in effect guarantee the exposure of lenders (Perotti 2012), or implicit guarantees on bank-affiliated products (as widely described in the press regarding so called ‘wealth management products’ in China (see The Economist 2013, Bloomberg 2013a, 2013b)) or on liabilities of non-bank finance companies (as noted for India, see Acharya et al. 2013).

The Need for a Backstop as a “Litmus Test” for Shadow Banking

Assessing whether an activity requires access to a backstop to operate could be used as the key test of whether it represents shadow banking. For example, the ‘usual’ capital market activities (in the right column of Figure 1) do not need external risk absorption capacity (because some, like custodian or market-making services, involve no risk transformation, while others, like hedge funds, have high margins), and so are not shadow banking. Only activities that need a backstop – because they combine risk transformation, low margins and high scale with residual ‘tail’ risks – are systematically-important shadow banking.

Policy Implications

Acknowledging the need for a backstop as a critical feature of shadow banking offers useful policy implications:
  • First, it gives direction on where to look for new shadow banking risks.
Among financial activities that need franchise value or government guarantees to operate. Non-traditional activities of banks or insurance companies are ‘prime suspects’. It is hard to point to the shadow banking-like activities which may give rise to future (systemic) risks conclusively, but one example could be the liquidity services provided by sponsor banks to exchange traded funds, or large-scale commercial bank backstops for leveraged buyouts.
  • Second, it explains why shadow banking poses significant macro-prudential and other regulatory challenges.
Shadow banking uses backstops to operate. Backstops reduce market discipline and thus can enable shadow banking to accumulate (systemic) risks on a large scale. In the absence of market discipline, the one force which can prevent shadow banking from accumulating risks is regulation.
  • Third, it suggests that shadow banking is almost always within regulatory reach, directly or indirectly.
Regulators can control shadow banking by affecting the ability of regulated entities to use their franchise value to support shadow banking activities (as was done in the aftermath of the crisis by limiting the ability of banks to offer liquidity support to structured investment vehicles). Or by managing the (implicit) government guarantees (as is attempted in the US Dodd-Frank Act by limiting the ability to extend the safety net to non-bank activities and entities; or by general attempts underway to reduce the too-big-to-fail problem).
  • Finally, it suggests that the migration of risks from the regulated sector to shadow banking – often suggested as a possible unintended consequence of tighter bank regulation – is a lesser problem than some fear.
Shadow banking activities cannot migrate on a large scale to areas of the financial system that do not have access to franchise values or government guarantees. This by itself does not make spotting the activity occurring within the reach of the regulator necessarily easier, but at least it narrows the task.


August 22, 2013

Economists Are Beginning To Crank Up Their China Forecasts After Last Night's Manufacturing Report

Overnight, the flash reading of China's August Purchasing Manager Index (PMI) indicated that the country's manufacturing sector unexpectedly stopped contracting and began expanding over the past month.

Specifically, the headline PMI index rose to 50.1 from July's 47.7 reading, beating consensus expectations for a slighter rise to 48.2 (any number below 50 on the index indicates contraction, whereas any number above 50 indicates expansion).

Following the release, BofA Merrill Lynch economist Ting Lu, who is bullish on the Chinese economy, asserted that "many Street economists will likely to revise up their overly pessimistic 3Q GDP growth forecasts soon."

Deutsche Bank economist Jun Ma did just that today.

"We revise up our H2 GDP growth forecast largely as a result of the improvement in recent indicators including today's August flash HSBC PMI report," writes Jun in a note to clients.

"Specifically, we raise our Q3 GDP growth forecast to 7.7% yoy from the previous 7.5%, and raise our Q4 forecast to 7.8% from 7.7%. As a result of these changes, our H2 GDP growth is upgraded by 0.1ppt to 7.7% vs. market consensus of 7.5%."

Jun expanded on the call, linking the PMI report to the bigger picture:

The recent pickup in growth momentum, which will likely continue in our view, benefited from the following changes in the last one and half months: 1) inventory restocking, which began in late July, driven by the recovery in prices of raw materials such as steel, coal, and copper; 2) the recovery in corporate confidence due to a slew of policy announcements is beginning to boost their incentive to investment. These policies include the tax exemptions for micro firms, the setting up of the Railway Development Fund to speed up railway construction, an increase in railway investment target for this year and the likely increases for coming few years, as well as a ambitious plan to invest in environmental and energy savings projects; 3) many real estate developers are beginning to increase land purchase and launch new projects due to strong pre-sales and a more accommodative policy environment. These real estate activities will likely help push up local government revenue and in term help support infrastructure spending in the remainder of this year and next year.
Today's HSBC flash PMI report is an additional confirmation of this recovery trend. It rose sharply to 50.1 in August from 47.7 in July, and is much higher than the consensus expectation of 48.2. As the official PMI in August tends to increase by an average of 0.4pts from July due to seasonality, we believe that the official PMI for August (to be released on September 1) will likely confirm this uptrend shown by the flash report. Given that August PMI is better than July, and assuming September PMI remains at the average of July-August, it means that IP growth in Q3 will likely reach 9.7% yoy, up from 9.1% in Q2. This acceleration in IP growth should easily add 0.2ppt to yoy GDP growth in Q3, from Q2's 7.5%.
Société Générale economist Wei Yao agrees that China is on track for above-consensus growth in the third quarter following the flash PMI report.

"All major activity data are now moving in the same direction, indicating a much- strengthened growth momentum in Q3," says Wei. "a rebound in GDP growth in Q3 is almost certain and data so far point to something around 7.7% yoy."
However, Wei warns that it may not last: "We see this sudden turn-around as similar to that during Q4 2012, when the multi-quarter deceleration trend reversed shortly after the policy stance shifted to “cautious” easing. But, that growth pick-up did not last for more than one quarter. Given the on-going deleveraging of the shadow banking system and potential headwind from the external situation as a result of potential QE tapering, we caution that this uptick may not last either."


August 21, 2013

Bill Black: The Banksters Master Irony – Push Summers & Geithner for Fed Due to Their Regulatory Zeal

The big banks are desperate to prevent Janet Yellen from being appointed as Bernanke’s successor to run the Fed. Their sexist attacks have backfired. On August 1, 2013, Deutsche Bank launched the single most absurd assertion to block Yellen’s appointment. Deutsche Bank wants Larry Summers, or better yet Timothy Geithner, to (not) regulate them because not being regulated effectively is its highest priority.
“To the extent that the job has become much more international and with more regulation and supervision within the new financial world order, that makes people such as Summers and former Treasury Secretary Tim Geithner compelling candidates,” says Deutsche Bank economist Joseph Lavorgna.
Yellen vs. Summers? Depends on Risks of New Financial Crisis

Deutsche Bank’s story is that because President Obama has (purportedly) finally figured out that the “international” aspects of “regulation and supervision” are important to the “financial world order” he should appoint Summers or Geithner to Chair the Fed. It was at this juncture that I checked to see whether I had missed the inauguration of a new tradition of outrageous “August Fool’s” jokes. I expected the next paragraph of the article to propose Bill Clinton’s as Chair of the Marriage Fidelity Task Force and Todd Akin to head the “legitimate rape” counseling center. Summers and Geithner are among the greatest enemies of effective regulation, supervision, and prosecutions of banksters in the world.

Deutsche Bank is a systemically dangerous institution (SDI). The SDIs’ only fear is effective regulation and prosecution and they know that effective prosecution will be vanishingly rare in the absence of effective regulation. The SDIs’ highest priority is to maximize the three “de’s”: deregulation, desupervision, and de facto decriminalization. The SDIs have organized the effort to block Yellen from becoming Fed Chairman. They favor Summers and Geithner to run the Fed because they are the leading proponents of the three “de’s.”

The Financial Crisis Inquiry Commission (FCIC 2011: 199) documented that even within the anti-regulatory travesty that was the overall Fed system. the New York Fed under Timothy Geithner stood out for its recurrent regulatory failures at the SDIs it was supposed to regulate. Geithner infamously testified to Congress that he was never a financial regulator. I first learned of this while being interviewed on Bill Moyers on April 3, 2009.
WILLIAM K. BLACK: These are all people who have failed. Paulson failed, Geithner failed. They were all promoted because they failed, not because…  
BILL MOYERS: What do you mean?  
WILLIAM K. BLACK: Well, Geithner has, was one of our nation’s top regulators, during the entire subprime scandal, that I just described. He took absolutely no effective action. He gave no warning. He did nothing in response to the FBI warning that there was an epidemic of fraud. All this pig in the poke stuff happened under him. So, in his phrase about legacy assets. Well he’s a failed legacy regulator.  
BILL MOYERS: But he denies that he was a regulator. Let me show you some of his testimony before Congress. Take a look at this.
TIMOTHY GEITHNER: I’ve never been a regulator, for better or worse. And I think you’re right to say that we have to be very skeptical that regulation can solve all of these problems. We have parts of our system that are overwhelmed by regulation.  
Overwhelmed by regulation! It wasn’t the absence of regulation that was the problem, it was despite the presence of regulation you’ve got huge risks that build up.
WILLIAM K. BLACK: Well, he may be right that he never regulated, but his job was to regulate. That was his mission statement.  
WILLIAM K. BLACK: As president of the Federal Reserve Bank of New York, which is responsible for regulating most of the largest bank holding companies in America. And he’s completely wrong that we had too much regulation in some of these areas. I mean, he gives no details, obviously. But that’s just plain wrong.
Geithner spoke the truth when he said he had never been a regulator – but you’re not supposed to admit it!

Geithner was such a failure as a regulator that he thought that the fact that he had ignored his regulatory responsibilities when he was head of the N.Y. Fed as the crisis was growing massively excused him from responsibility for the crisis. When I saw Geithner’s testimony I recalled the words of a prominent director of an S&L that we (the regulators) sued alleging that he had breached his fiduciary duties. He told the press he could not understand why we were suing him because he had not attended a single meeting of the board of directors.

Geithner and Summers shared a belief in “winning” the international regulatory “race to the bottom.” Like Geithner, Summers claimed that the problem in finance was excessive regulation.
Mr. Summers, as a senior Treasury official in the late 1990s, played a leading role in the suppression of an effort by the head of the Commodity Futures Trading Commission to establish oversight of these customized derivatives [CDS], whose misuse already had contributed to financial catastrophes, including the bankruptcy of Orange County, Calif., and the collapse of a ballyhooed hedge fund, Long-Term Capital Management.
At the time, Mr. Summers emphasized that he wanted to maintain the status quo to preserve the stability of domestic markets, and to avoid pushing the business overseas.
Summers is one of the most culpable officials in the world for the global crisis. His disastrous attempt to “win” the regulatory race to the bottom “to avoid pushing the business overseas” created the regulatory black hole for financial derivatives that helped create the criminogenic environment that drove the crisis. Summers was blasé about shipping American jobs overseas in every industry except big finance. When it came to the SDIs it was suddenly essential that the SDIs remain located on Wall Street – where the U.S. Treasury rather than the UK Treasury would have to bail them out when they failed.

Summers was a strong proponent of repealing the Glass-Steagall Act that had helped prevent banking crises for over 50 years. Summers was a strong opponent of some of SEC Chairman Levitt’s efforts to create effective regulation and helped to block those vital reforms that helped lead to the epidemic of accounting control fraud during the Enron-era.

Summers and Geithner were frenzied supporters of the Basel II insanity that tried to eviscerate U.S. banking capital requirements on the largely fraudulent mortgage assets that drove the crisis. If the FDIC’s tenacious rearguard battle against that insanity had not prevailed our crisis would have been vastly worse. European banks, which operated under the fully eviscerated capital requirements of Basel II, had roughly twice the leverage of the already vastly excessive leverage of U.S. banks. This is why the European banking crisis was often markedly worse than our terrible crisis.

Summers was also a strong proponent of the disastrous “reinventing government” movement under Clinton and Al Gore that maximized the three “de’s.” I have explained in prior columns how this movement maximized the three “de’s” and sowed the seeds of the Enron-era crisis and the ongoing crisis.

The purported “savings” that Gore attributed to “reinventing government” came overwhelmingly from cutting the number of federal employees. The financial regulatory agencies suffered some of the deepest cuts under Gore. The Bush administration compounded that disastrous mistake. Together, the Clinton and Bush administrations cut the FDIC staff by more than three-quarters and OTS’ staff by more than half. This “saves” money in a manner similar to not changing the oil in your car. You cut your short-term expenses modestly but you vastly increase your longer-term expenses when you blow out the engine. Summers (and Gore and Clinton) were lucky in their timing for they epitomized the phrase that became infamous during the current crisis: “I’ll be gone, you’ll be gone” (IBGYBG) (FCIC 2011: 8). Summers was gone before the Enron-era crisis exploded or the current crisis was generally recognized as a crisis. Summers was, however, Treasury Secretary when he was warned in 2000 by the coalition of honest appraisers about the emerging epidemic of appraisal fraud led by lenders who blacklisted honest appraisers in order to extort appraisers to inflate their appraisals. No honest lender would ever inflate an appraisal. The appraisers’ petition was the perfect warning flag of “accounting control fraud,” but Summers and other senior Clinton administration officials ignored the warning.
From 2007 to 2007, a coalition of appraisal organizations circulated and ultimately delivered to Washington officials a public petition; signed by 11,000 appraisers and including the name and address of each, it charged that lenders were pressuring appraisers to place artificially high prices on properties. According to the petition, lenders were “blacklisting honest appraisers” and instead assigning business only to appraisers who would hit the desired price targets (FCIC 2011: 18).
George Akerlof and Paul Romer were consciously speaking to their fellow economists like Larry Summers when they explained the critical link between the three “de’s,” epidemics of accounting control fraud, and financial crises. (Akerlof is Yellen’s spouse.)
Neither the public nor economists foresaw that the regulations of the 1980s were bound to produce looting. Nor, unaware of the concept, could they have known how serious it would be. Thus the regulators in the field who understood what was happening from the beginning found lukewarm support, at best, for their cause. Now we know better. If we learn from experience, history need not repeat itself (p. 60).
Summers, however, ignored the warnings and refused to learn from experience. He maintained his blind spots about regulation and elite fraud. It was Harvard’s disgraceful refusal to act under Summers’ leadership against one of the university’s top economists that caused the faculty to revolt against his leadership to become overwhelming.

 Summers and Geithner remained the SDI’s closest allies even after the current financial crisis began and it was clear that their controlling officers’ frauds drove the crisis and made them wealthy. Summers and Geithner fought tenaciously to prevent the elimination of the SDIs. They remain too big to manage, too big to be efficient, too big to regulate, too big to prosecute, and too big to fail. The SDIs received the largest bailouts and special grants of credit from the Fed in world history. Indeed, the U.S. bailouts and special deals are so large that they exceed all previous bailouts in our history – combined. Summers and Geithner ensured that crony capitalism would continue to reign after the crisis. They fought against the re-adoption of Glass-Steagall and the repeal of the Commodities Futures Modernization Act in its entirety. Summers and Geithner were bitter opponents of Sheila Bair’s (none too radical) efforts to restore a modicum of financial regulation when she was Chair of the FDIC. In particular, Geithner blocked Bair’s effort to force Citi’s CEO accountable for his myriad failures.

The most scathing peer criticisms of the FRBNY’s abject failure as a supervisor under Geithner’s (non) leadership were that the NY Fed consistently failed to take vigorous actions to rein in Citi’s frauds, violations of the rules, and unsafe and unsound practices (FCIC 2011: 199).

Many people make the error of believing that the banksters are dull, humorless stiffs in gray suits. Many banksters have a finely developed sense of irony and utter contempt for financial reporters’ intelligence and independence. They find it hilarious that they can tell the WSJ that the President should make Summers or Geithner the next head of the Fed because the agency needs zealous supervisors who are tougher than junk yard dogs – and the reporter will dutifully put the farce into the paper as if it were a fact.

What the banksters reveal is that their highest priority is to block Yellen so they can get a financial high priest like Summers who will continue to venerate the “Greenspanke” creed that has caused such harm to this Nation since Greenspan was appointed in 1987. That creed proclaims that banksters cannot exist because financial markets automatically exclude fraud and that the great evil that must be eradicated from the world is regulation.


August 20, 2013

Bitcoin Is Recognized As "Legal Tender" In Germany

Virtual currency bitcoin has been recognized by the German Finance Ministry as a "unit of account", meaning it is now legal tender and can be used for tax and trading purposes in the country.
Bitcoins is not classified as e-money or a foreign currency, the Finance Ministry said in a statement, but is rather a financial instrument under German banking rules. It is more akin to "private money" that can be used in "multilateral clearing circles", the Ministry said.

"We should have competition in the production of money. I have long been a proponent of Friedrich August von Hayek scheme to denationalize money. Bitcoins are a first step in this direction,"said Frank Schaeffler, a member of the German parliament's Finance Committee, who has pushed for legal classification of bitcoins.

(Read more: Bitcoin gets the FBI, Homeland treatment)

Bitcoin is a virtual currency that allows users to exchange online credits for goods and services. While there is no central bank that issues them, bitcoins can be created online by using a computer to complete difficult tasks, a process known as mining. Currently one bitcoin is worth just over $119.

Schaeffler said the new ruling showed German authorities were preparing regulations on how to tax bitcoin transactions. According to German newspaper Die Welt, the government has stated that the legal classification of bitcoin means that commercial profits that stem from using the currency may be taxable.

Kathleen Brooks, a research director at, told CNBC that classification by the German government gave bitcoin legitimacy to be used as a settlement currency in one of the world's largest economies. She said this was a big step forward for the bitcoin movement.

(Read more: Bitcoin banned: Country outlaws virtual currency)

"I think it is interesting that Germany has gone ahead and given legal status to the bitcoin, as it could become an alternative to the euro if the single currency ever ceased to exist," Brooks said. "If the euro does go belly up the German authorities could potentially still collect tax if everyone started using the bitcoin - that's a good example of German forward-thinking!"

Success for bitcoin rests on regulatory fair-treatment and the existence of a level playing field with other currencies, said, Schaeffler. He added that it would be bad if national authorities smeared bitcoin as a criminal tool for money laundering, just because it makes anonymous transaction possible.

(Read more: Bitcoin ATM Gets Ready for Roll Out)

"Sooner or later, depending on the success of private currencies, authorities will feel the urge to ban or regulate private currency. A free country should resist and not intervene in citizen's private choice of money. In my opinion the production of money is none of the government's business," Schaeffler said.

Bitcoin regulation has been a hot topic in the last couple months. The New York Department of Financial Services issued subpoenas last week to several companies associated with bitcoin, as part of an inquiry into the business practices of the industry, and both the Federal Bureau of Investigation (FBI) and the Department of Homeland Security (DHS) are investigating the currency.

In addition, Thailand moved to ban the digital currency in July,according to Bitcoin Co., a Bangkok-based website that trades the digital currency. Bitcoin Co. said it was prevented from registering with Thai governmental agencies, which would have allowed people to legitimately use bitcoin.


August 19, 2013

Jackson Hole, Fed minutes dominate week

When central bankers and economists gather near Jackson Hole, Wyo., for their summer retreat this week, they know that most of the action will be 2,000 miles to the east, where President Barack Obama is considering his choice to replace Federal Reserve Chairman Ben Bernanke.

The retreat, at Jackson Lake Lodge in Grand Teton National Park, will feature speculation — some informed, some maybe not — on Obama’s deliberations over the next top central banker. And there will be an active debate among participants over whether, how and when the Fed should pull back from its $85 billion-per-month asset-purchase plan.
Bernanke has decided to skip the Jackson Hole retreat this year, so there will be no celebration of his legacy as there was for former Fed Chair Alan Greenspan in 2005.
Vice Chair Janet Yellen, one of the two leading candidates to replace Bernanke, will attend, moderating a panel discussion on Saturday. She’s not expected to make substantive comments.
Larry Summers, the former Treasury secretary and Obama confidant, will not attend.
The media, market economists and academics who attend the Jackson Hole event will press U.S. central bankers for the policy makers’ views on tapering.
Most top Fed officials who have spoken since the Fed’s last meeting have not ruled out a September tapering. St. Louis Fed President James Bullard is the only one making a strong case for waiting for either the October or December meetings.
According to The Wall Street Journal’s latest poll, 53% of economists surveyed expect the taper to begin in the third quarter and 36% expect it to begin in the fourth quarter.
There could be some more information about the central bankers views even before the retreat starts in the minutes of the July 30-31 policy meeting to be released on Wednesday at 2 p.m. Eastern.
The document could show how many policy makers were prepared to slow asset purchases, economists said.
“The July minutes may give some insight into just how strong the conviction level at the Fed is for tapering in September,” said Ethan Harris, chief U.S. economist at Bank of America Merrill Lynch.
“If the Fed is close to a September taper, then we would expect some discussion of operational details in the minutes, such as how much to taper and in which assets—mortgage-backed securities or Treasuries,” he said.
The Fed’s July policy statement seemed dovish, with the central bank highlighting higher mortgage rates and the risks of persistent low inflation.
“The minutes could explain why policy makers saw weaker growth, and how concerned they were over the impact of higher mortgage rates on the housing recovery,” said Jennifer Lee, senior economist at BMO Capital Markets.
The minutes of the prior Fed meeting in mid-June showed that half of the senior Fed officials wanted to end asset purchases by the end of 2013 but were talked out of it.
Bernanke has laid out a timetable where the Fed will start tapering sometime later this year and end it in mid-2014 if the economy picks up as the central bank expects.
But data over the last two months has been mixed, leading to competing views on when the Fed should move. Some say September is a good starting point, but others want the Fed to wait until there is evidence that better growth is in place and not just a forecast.
It is a light week for economic data, with most of the focus on two housing reports.
Existing home sales are expected to rebound 0.8% in July after falling 1.2% in June. The National Association of Realtors will release the existing-home-sales report at 10 a.m. on Wednesday.
Economists expect new home sales fell 2.4% in July to 485,000 units after surging 8.3% to a five-year high in the prior month. The Commerce Department will release the data at 10 a.m. on Friday.

August 16, 2013

Why JPMorgan's 'London Whale' was set free

The most fascinating thing about the government's charge that JPMorgan Chase employees committed fraud in connection with the bank's $6 billion trading loss, and the one that will have the largest reverberations for Wall Street, is not who is being charged, but who isn't.

Ina Drew, the long-time head of the chief investment office and the person who pushed the bank to take on more risk and was well aware of the trades, does not stand accused of any wrongdoing. (Why not charge her with failure to supervise?) Nor is JPMorgan's CEO Jamie Dimon, who told investors the issue of the London Whale was "a tempest in a teapot" even after he was alerted to the size of trade, if not an accurate picture of the losses. Dimon also signed off on JPMorgan's faulty books, which eventually had to be restated, something Sarbanes Oxley was supposed to hold executives accountable for. Nor are any of the bank's multiple risk officers who signed off on the change in the risk model that allowed the London Whale's ill-fated trade to get bigger, even as the bank's books appeared to show that JPMorgan was reducing its trading risks.

MORE: New bait for the old office of JPMorgan's London Whale

Also getting off mostly scot-free is JPMorgan (JPM). The SEC says its investigation is continuing. And regulators have already ordered the bank to improve its risk controls. But it appears JPMorgan is looking at a minor slap on the wrist.

And remember the London Whale himself, Bruno Iksil, the actual architect of the ill-fated trades? Yeah, he's off the hook as well.

The Justice Department and the SEC's cases against Javier Martin-Artajo and Julien Grout, the two who are being charged, give an amazing window into what it's like to be a trader these days on Wall Street, especially the ones who are responsible for multi-billion dollar portfolios of the market's riskiest stuff. Martin-Artajo was Iksil's direct boss. Grout worked under Iksil and was responsible for valuing Iksil's portfolio, computing the gains or losses.

The conversations detailed in the government's complaints are not what you would expect from three guys in the heat of the market, facing the most difficult trade of their careers. In early 2012, when the losses appeared to be mounting, there was no discussion by any of the three about what bonds or derivatives they might sell or buy to minimize their losses -- also known as trading. In fact, Martin-Artajo seems to be driven by a desire to keep the synthetic portfolio, which had grown by this time to have a notional value of $157 billion, as is for as long as possible. That is not a trade.

Instead, according to the court filings, the three traders spend a lot of time (all of their time?) talking about valuations and marks. What are the trades they have worth, and how can they make the losses they've got look as small as possible. It starts off as minor tweaking. By the end, Grout is maintaining a spreadsheet showing the traders' actual losses are as much as $800 million more than what they are reporting up the chain. In one telling moment, on the last day of the first quarter, Martin-Artajo tells Grout that he wants to show a daily loss of just $200 million, even though it's likely the portfolio had sunk that day alone much more than that. When Grout does this, Martin-Artajo goes back and asks whether they can get the loss number down to $150 million. The daily loss they end up reporting: $138 million.

Late in the game a JPMorgan risk officer does catch up with Martin-Artajo and asks him to explain the way the portfolio is marked, to which Artajo responds basically, "Hey, I ain't no accountant." And that you know is a pretty funny excuse because all these guys seem to be doing is accounting, but not actually a legal one.

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At some point along the way, Iksil jumps ship. According to the government's case, Iksil breaks with Martin-Artajo and starts reporting larger losses than Martin-Artajo wants to acknowledge to others at the bank. And he tells the other two traders that it's time to come clean. That, along with the fact that Iksil is cooperating with the government, appears to be why Iksil is not being charged.

Ironically, Grout was the first of the three to warn that Iksil's derivative trades could produce huge losses. In early January, Grout drew up a plan for the bank to get out of the trades, but it would end up creating a $500 million loss. Iksil and Martin-Artajo told him no thanks.

At the heart of it, the government's case is about traders hiding their losses. And back in late 2011, that's exactly what Iksil did. He had a portfolio of bets, meant at least in name to protect the bank's loan book, that would pay off if a bunch of companies defaulted. But the U.S. economy was improving and that wasn't happening. So Iksil's trades were becoming costly for the bank.

So Iksil came up with a way to keep the trade on, but magically make it profitable. He did that by taking on a massive amount of offsetting bets on a slightly different index to make his slowly losing trading into one that was cashflow positive, but also likely pay off if suddenly companies stopped paying their loans and the economy blew up. For all the bashing Iksil has taken in the past year and a half for the $6 billion blunder, the trade itself was in a way brilliant, but it also opened the bank up to a lot more risk.

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And it shouldn't have been allowed. But Iksil's superiors -- including Drew, and in part Dimon -- signed off on new risk models that not only made the vastly larger portfolio not acceptable, but appear like it was actually a smaller bet, at least risk-wise. The Senate's investigation into the trading loss criticized JPMorgan for not telling investors that it changed its risk model, not actually for changing its model. JPMorgan and other banks change their models all the time. It's allowed.

The difference here is that Iksil and Drew and the others at JPMorgan not facing charges hid the losses in the bank's portfolio in a regulatory compliant kind of way. Martin-Artajo and Grout, on the other hand, did it in a lying kind of way. The end result of both techniques were the same: Investors and regulators were misled as to the size of JPMorgan's potential losses.

There will be some griping as to why Iksil and others weren't charged as well. But that's not the fault of the Justice Department or the SEC. Or really Iksil's either. He knew when his colleagues had crossed over from bending the rules of the market to breaking the laws of the land, and he wasn't willing to follow. That's not quite righteous, but it isn't wrong either.

What's really at fault is our still overly complicated, loophole-ridden financial regulations that allow banks to hide the huge risks they take all the time that are subsidized by the government and that taxpayers would have to pay for if they go colossally bad. In the end, the message to Wall Street of Jamie and the Whale could be, unfortunately, that you can still do that and stay out of jail, as long as you are clever about it.

August 15, 2013

Investigation Of Banks’ Role In Price Rigging Escalates With New Subpoenas

Regulators have ordered an aluminum company to preserve three years of documents that may be relevant to an investigation into price rigging in the markets for metals, Reuters reported Monday. The Commodity Futures Trading Commission (CFTC) subpoena is the latest signal of heightened regulatory scrutiny of financial firms’ role in the physical commodities markets, three weeks after a New York Times report revealed firms like Goldman Sachs exert control over metal prices that boosts bank profits at the expense of consumers.

Last week’s CFTC subpoena targeted one unnamed warehousing firm, and specifically focused on documents related to the London Metal Exchange (LME), which is the primary global platform for trading based on metals. The LME sets rules for how the metal industry operates, including limits on how much of a given metal may be moved out of a given warehouse on a given day – the rule which warehouse owners like Goldman Sachs are allegedly abusing for profit. The LME also takes a one percent commission off of the rent that warehouses charge to store metals. With the total global value of metals traded through the exchange measured in the trillions of dollars, changing the system that’s allowed financial firms to inflate prices would cost the LME vast sums.

Those LME rules and fee arrangements have existed for a long time, though, and experts say the market abuses now under investigation stem from the financial sector’s move into the warehousing business. The alleged Goldman scheme hinges on the investment bank’s 2010 purchase of Metro International Trade Services, one of the largest single metal storage companies. Until the deregulation wave of the 1980s and ‘90s, banks were forbidden from such crosspollination of ownership. But years of lobbying eroded the barriers that had restricted financial firms from entering the physical commodities business rather than simply making trades tied to commodity prices. The Federal Reserve has the power to reinstate such barriers, and is reportedly reviewing its past approval of financial industry purchases of warehouses, pipelines, and other physical commodities infrastructure.

The metals markets are just the latest flashpoint for financial industry profiteering through market manipulation that costs consumers and harms trade. Since the spring, investigations and fines have popped up over everything from electricity rates to oil prices to currency exchange rates. The manipulation of a key intra-bank lending rate known as LIBOR, revealed last year, may have cost U.S. taxpayers tens of billions of dollars. Analysts like Barry Ritholtz argue that financial traders manipulate nearly every market they touch, subverting the competitive process that benefits consumers and replacing it with an insider’s game that enriches the finance sector while harming all others.