Body
Look forward. The holy grail of any serious financial market player must now be: Become too big to fail. You can do it is as a megabank—this part is obvious. But you can also do it as a hedge fund or some other lightly regulated pool of capital—this, after all, is the lesson of long-term capital management that has never been addressed.
And quantitative trading, while in principle just one approach to investing or even only a set of tools, greatly increases the complexity and opaqueness of markets—further allowing you to become big (in any future sense) relative to the political and economic system, and moving us closer to a more complete version of the stock market shut down we saw on May 6.
For more on this, see my review of Michael Lewis's The Big Short and Scott Patterson's The Quants—now in the New Republic's online book section.
Also posted on Simon Johnson's blog, Baseline Scenario. The following were previously posted.
Senator Kaufman Was Right—Our Financial System Has Become Dangerous
May 13, 2010
Senator Ted Kaufman (D-DE) is best known these days for arguing that, as part of comprehensive financial reform efforts, our biggest banks need to be made smaller. His advocacy on this issue helped build support around the country and forced a Senate floor vote on the Brown-Kaufman amendment, which was defeated 33-61 on May 6.
Senator Kaufman has also strongly pushed the idea that in recent years there was a pervasive "arc of fraud" within the mortgage-securitization-derivatives complex. This thesis also seems to be gaining traction—according to the Wall Street Journal today, the criminal probe into this part of the financial sector continues to develop.
But the senator's biggest home run has been on a different issue: his warnings about the dangers of high-speed trading, involving "dark pools" of money, appear to have been completely vindicated—ironically enough, also on May 6.
Think about it this way. The US stock trading system, long established and widely thought to be robust, crashed on Thursday afternoon. Widely held stocks, traded with consistent liquidity, do not fall in value from $40 to 1 cent and then bounce back again—even in emerging markets, let alone in the United States. It is true that complex systems crash, but given the infrastructure and back-up systems involved here, this is much closer to east coast air traffic control shutting down for 15 minutes than it is to your local cable company having a problem.
And here's the most remarkable point—after 6 full working days (and top people do sweat this kind of issue on the weekend), we are still no closer to really understanding what happened. To be sure, there are plenty of theories—and no shortage of proposals for avoiding a recurrence. But, despite the evident resources thrown at this problem, we do not know what went wrong.
As Senator Kaufman points out, the Securities and Exchange Commission (SEC) does not even routinely collect the data it needs to understand the actions and impact of large traders.
The Merkley-Levin amendment would also likely be a step in the right direction, in terms of reducing the socially dangerous casino nature of our financial markets. But it is far from enough.
The rationale for organizing our financial system as we do is that this leads to a reasonable allocation of capital across the economy. We can argue the merits of this proposition at various levels—but no one would suggest that the extreme volatility and breakdown of trading last week was anything other than completely dysfunctional.
The SEC is, without question, beginning to get its act together under Mary Shapiro. But there is also no doubt that it needs to lift its game to a much higher level, if regulation is even to catch up with how markets have developed over the past decade—just look at this timeline of problem identification and policy response .
Senator Kaufman has flagged mortgage-related fraud, high-speed/dark-pool trading, and bank size as pressing issues to address. He was completely right on trading and, based on what we know so far, also right on fraud.
How long before he is completely proved right on the dangers posed by excessive bank size?
Our Eurozone Call in October 2008 and Banking Reform Today
May 12, 2010
Eighteen months ago, on October 24, 2008, Peter Boone, James Kwak, and I published an opinion piece in the Guardian (United Kingdom), "Start by Saving the Eurozone." We argued that the recession would put a great deal of pressure on the eurozone because of flaws in its design.
Our proposals for addressing these issues, and preventing a broader global crisis, included:
"2. Create a European Stability Fund with at least €2 trillion of credit lines guaranteed by all [e]urozone member nations and potentially other European countries with large financial systems such as Switzerland, Sweden, and the [United Kingdom]. This fund should provide alternative financing to member countries in case market rates on their government debt become too high. This will prevent a self-fulfilling cycle of rising interest rates. The fund should be large enough to have credibility; countries could access the fund automatically, but should then adopt a 5-year program for ensuring financial stability, subject to peer review within the [e]urozone."
It's unfortunate that policymakers—in Washington, Brussels, and pretty much everywhere else—ignored this suggestion until just now. But this tells you a great deal about what it takes to change any part of our economic system. It's only in the face of great crisis and the potential breakdown of financial markets that US and European authorities are willing to act.
The good news is that change happens. The bad news is that because leading governments are unwilling even to seriously discuss difficult economic scenarios ("too radical," "don't rock the boat," "powerful interests are opposed"), when they bring in new policies there is a great deal of improvisation and major mistakes are entirely possible. "Change only when we must" is a dangerous approach—see Hank Paulson in September 2008 (Lehman allowed to fail; AIG "saved" after a fashion; Troubled Asset Relief Program (TARP) proposed without any oversight, etc.).
And this is exactly why our seriously dysfunctional megabanks—in the United States and in Europe—are not being "fixed." When the crisis breaks, people like Tim Geithner and Larry Summers say it would be too dangerous to even fire some boards of directors, let alone change CEOs in top banks. The anticrisis improvisations in Europe focus —as they did under Mr. Geithner's direction here—on "just save the big banks as they are."
But after you save the banks, they again become so politically powerful that they fight hard to block serious reform. They already turned back the effort to really limit their scale—the Brown-Kaufman amendment, defeated last week. And now they are striving to prevent effective restrictions on their scope—the Merkley-Levin amendment (supported in principle by Paul Volcker, the White House, and the president, coming up this week): press release; amendment text ; Wall Street Journal story.
If you don't fix the system now, you'll have another major crisis—and then you likely won't fix the system again.
Eurozone: The Kitchen Sink Goes In—Now It's All About Solvency
with Peter Boone, May 10, 2010
The eurozone self-rescue plan announced Sunday night has three main elements:
- 750 billion euros in a fiscal support program, with one-third coming from the IMF (although this was apparently news to the IMF).
- The European Central Bank promises to buy bonds in dysfunctional markets.
- Swap lines with the Federal Reserve to provide dollars.
At first pass this package might seem to be in with what we recommended a week ago and again on Thursday.
But the European central banks have come in very early—with government bond prices still high—and there is no sign yet of credible fiscal adjustment for Spain and Portugal. The eurozone apparently did not even discuss the situation in Ireland, which seems increasingly troubling.
This is a whole new level of global moral hazard—the result of an alliance of convenience between troubled governments in the south of Europe and the North European banks (and implicitly, North American banks) who enabled their debt habit. The Europeans promise to unveil a mechanism this week that will "prevent abuse" by borrowing countries, but it is hard to see how this would really work in Europe today.
Overall, this is our assessment:
The underlying problem in the eurozone is that Portugal, Ireland, Italy, Greece, and Spain are locked into a currency, which means they are uncompetitive in trade terms while they are also running large budget deficits. To get out of this they need large wage and price cuts to restore competitiveness and they need to make fiscal cuts to get budget balances back at sustainable levels.
Markets decided these adjustments were going to be difficult, so spreads on those countries' debts widened (i.e., interest rates relative to German government bonds). As the rates go up, this causes local asset prices to fall, concerns over bank balance sheets increase, etc. This combination was causing an incipient run on banks. Any country with its own currency could reasonably devalue in such a situation, but this is not an option within the euro bloc.
All these problems were exacerbated by the appearance that the Germans were going to be unwilling to bail out troubled nations—and would eventually choose to bail out their own banks instead. It is this risk that is now resolved. The Germans have shown willingness to provide very large amounts of money (the 750 billion euro support is probably just enough for Spain and Portugal if they got packages in line with that received by Greece) and they would obviously provide more if needed (e.g., for Italy). (Here again is the ready reckoning chart for interlinkages between indebted Europeans.)
However, the solvency issue remains. The Spanish and Portuguese have said they will now cut their budgets further, but their forecasts were optimistic, and neither has seemed willing to admit they have severe budget problems, so we will need to watch how they implement in the near term. Greece remains simply far too indebted.
As Willem Buiter (formerly Bank of England, now at Citigroup) remarked last week, you have the greatest incentive to default when you are running a balanced primary budget (i.e., after substantial budget cuts) and still have a large government debt outstanding. His point is that the incentive structure of these programs means they will postpone a decision to default, which would otherwise be rational now.
There is no discussion of Ireland, which has one of the highest deficits of all the EU nations. This is a vulnerability to the European Stabilization Mechanism—more countries will flock to its embrace.
There is a more subtle issue with the seniority of debt. The EU packages to these countries are all senior to existing creditors. These creditors know therefore that countries that need packages will get senior funds from the IMF and European Union, and, therefore recovery values for bonds will be less.
This is perfectly fair since packages come when no one else will lend, but it explains why packages do not reduce secondary market yields as low as people would expect. The yield on Greek bonds needs to stay high given the risk that the bonds could have 70 percent write downs if the likely default does happen. The same is true, to a lesser extent, for Portugal, Ireland, and Spain. All of these might eventually need to access the 750 billion euros and might eventually default. Bond market yields need to stay high.
The decision by the European Central Bank (ECB) to intervene in the markets is very important. That will help keep markets liquid—but the ECB will probably not buy a lot of debt.
Will the ECB buy a great deal of Greek debt? We doubt it since this constitutes a clear, large credit risk. But it will be interesting to watch. If the ECB is not large in the market they will not impact spreads beyond reducing the liquidity risk premium. Today most of these nations have substantial default risk over 5 to 10 years, so spreads need to stay high—although they will come in from current levels.
The European Central Bank intervention and this package raise enormous moral hazard issues. The ECB's management was forced into this kicking and screaming. It was only when they realized that the whole eurozone financial system was at risk of collapse that they threw the kitchen sink at the problem. This can now go two ways: either they tighten fiscal policy across the eurozone, and introduce much more rigorous and enforced rules on deficits and profligate credit through banks, or they let a system persist that is another "doomsday machine" that will live again to grow, and could one day topple them.
To ultimately get out of this mess, the eurozone needs to grow fast enough to allow nations to grow out of debt. The global backdrop here is very positive in the short term. The jobs numbers in the United States last week and strong numbers out of core northern Europe suggest the world can grow. No doubt the ECB and the Fed will use the eurozone scare to justify longer loose policies.
It could be that in two years' time Europe's deficits are much lower, the ECB has hardly bought any bonds, and they have successfully managed a Greek debt restructuring while Spain is out of trouble and Portugal and Ireland are scraping by in limbo but now with isolated problems. With the United States likely to still be running near 10 percent GDP budget deficits—who will seem more risky then? This immediate confidence in the US dollar that has come out of this European crisis could very quickly evaporate.
Alternatively, the underlying fiscal problems in Europe could fester—and the "rules" designed to limit moral hazard may turn out to be a complete paper tiger. In that case, the Europeans again have to make a fateful decision: Do they try to inflate out of the debt burdens of their weakest member countries; or do they instead try to manage selective default, keeping in mind that most Greek debt at that stage will be held by other eurozone governments.
Falling Back on Waterloo
May 7, 2010
The bank lobbyists have the champagne out—the Brown-Kaufman amendment, which would have capped the size and leverage of our largest banks—was defeated in the Senate on May 6, 33-61. Feeling ascendant, the big banks swarm forward to take on their next foe—the Kanjorski amendment (that would greatly strengthen the power of regulators to break up megabanks), which they plan to gut in the backrooms.
This is overconfidence because the consensus against them is beginning to shift significantly. Partly this is the result of great efforts by Senator Ted Kaufman, Senator Sherrod Brown, and their colleagues over recent months and weeks. Partly this is due to all the people who came on board and pushed hard.
But, as in many such cases, it is also a question of luck—and timing.
The European sovereign debt crisis is deepening. And the picture that is worth many thousands of words is the New York Times' graph of interlocking debt within the eurozone.
As far as anyone can ascertain, this is almost all debt held by banks (often then "repoing," or borrowing against it as collateral, at the European Central Bank.)
In other words, the European megabanks—lauded by Senators Dodd, Corker, Warner, and others as a model for us to follow—are up to their eyeballs in bad debt. Their governance has completely failed. Their regulatory systems have been gutted—on their way to being turned into ash.
None of this would matter, of course, if the eurozone policy elite had its act together and could terminate its current position with minimal losses. But it cannot—the deer are in the headlights.
Ask everyone this question: Which are the huge global banks that Senator Dodd, Jamie Dimon, and Larry Summers think we should be emulating? Surely not the Chinese—their governance failures are profound and complete; this is state banking run amok. Surely not the British—after all Mervyn King and Adair Turner, the top authorities on those banks, are globally the most articulate officials on how good finance has gone so deeply wrong. Surely not the Canadians—those myths have been long exploded (and without dissent in our conversations with the Bank of Canada).
And surely you are not proposing that the continental European banks are a model of anything other than ineptness, blind herding, and the transition from being "too big to fail" to "so big that even when you save them, you get an economic catastrophe."
To the victors last night in the Senate: congratulations—your opponents have fallen back. Your generals are known to be invincible, your forces are the best, and your resources are without limit.
And so we wait for you again, on a gentle slope and behind a ridge—appropriately enough with our backs to Brussels. Welcome to Waterloo.
The Agenda for Emergency Economic Strategy Discussions
with Peter Boone, May 7, 2010
Europe needs a new recovery plan, bigger and broader than anything put together so far. This weekend is the perfect time to put such a plan together. But be wary of committing official resources too early in this market downdraft—smart policymakers will calmly let the markets fall further in order to benefit from the rebound potential.
In the last few days, bond markets have decided that the deflationary adjustments—cutting wages and prices in large parts of the eurozone—are not politically feasible. The deflationary spiral that will come with fiscal cuts causes political turmoil and reduces revenues—that in turn makes it ever harder to service debt; see Greece this week. Eurozone countries running large budget deficits with substantial outstanding public debt are finding they are cut off from credit markets as a result. This is a solvency issue, not a liquidity issue.
But do not rush into this gap. If the European Central Bank (ECB) were to start buying Spanish debt today, for example, they would find an abundance of sellers because the bonds are fundamentally overvalued.
There is a good rule for foreign exchange intervention: you intervene to buy a currency at a time when you think you can really shift events—i.e., when the exchange rate has fallen more than really makes sense and shorting the currency has become overly fashionable. In that way you cause traders with short positions to lose a considerable amount of money, and you draw in real buyers who want to own the assets because they are inexpensive and can now see an end to the declines.
We are not yet at that point in the bond markets for weaker eurozone countries or in the foreign exchange market for euro.
Start with bonds: Greece clearly must end up restructuring its debt. The IMF program makes that obvious—how can Greece make a total of 19 percent of GDP in cuts, only to end with 149 percent of GDP in debt, and a perpetual bill to pay German, French, and other foreign holders roughly 10 percent of income each year just to cover interest?
This is a political disaster for all concerned and should be cleaned up now rather than left to ferment. The markets, with their high interest rates on Greek debt, show they believe this is the outcome. The market prices reflect about a 29 percent chance that Greece will default within one year, and 35 percent over two years (assuming a 40 percent recovery rate on Greek bonds after default and restructuring).
Portugal should restructure preemptively—they have a large budget deficit and current account deficit, and will have similar problems cutting the budget deficit. When the government takes fiscal austerity measures, unemployment will rise further, the economy will slow, so revenues will fall, and that will mean they make too little progress bringing in their deficit.
Spain is in a very difficult position. It is unlikely they can avoid restructuring for the same reasons as Portugal and Greece, but they are starting from a position with less public debt outstanding (if the numbers are correct). However, Spanish banks own a great deal of Portuguese debt, so if Portugal restructures it poses a major additional burden on Spain.
Italy and Ireland are clearly in trouble also, depending on exactly how expectations for eurozone growth are revised downward. Given that all these nations probably need to restructure their debt, or have large bailout packages that may not succeed in any case, we cannot expect bond markets to rally at this time. "Investment grade" investors, finally waking to the problems in the market, now fear holding these bonds.
The traditional holders of these bonds, such as AXA the French insurance group, or German Commerzbank, are telling investors exactly how much risk they have in Portugal, Ireland, Italy, Greece, and Spain. The true message is: "We promise we will not buy more of these countries' debt." Without the traditional investors available, who is going to finance Spain, Ireland, Italy, and Portugal's ongoing large budget deficits?
And this is the next problem. This week the EU commission released its forecasts for budget deficits in 2010 and 2011. Those were a depressing set of numbers. They expect Europe will grow by less than 1 percent this year and only 1.5 percent in 2011. Meanwhile, budget deficits would hardly change. Ireland leads the pack (in a bad sense) with an 11.7 percent of GDP budget deficit in 2010 and 12.1 percent in 2011. Greece, Portugal, and Spain are all in the same range—large budget deficits and little improvement on the horizon. These are unrealistic plans given the lack of buyers for their bonds. Careful study of the details will only exacerbate concerns about fiscal solvency.
What should economic policymakers—in Europe, the United States, and elsewhere—do about all this, for example, as they convene in emergency meetings this weekend?
First, the core problem is that the eurozone as currently designed is a failure. It has proven wrong to blend so many disparate nations into one currency, and then manage the currency according to relatively hawkish German preferences.
This is an unfortunate loss of face for the eurozone policy elite, but they need to get over this and move on.
The eurozone in its current form needs to be wound down, most likely being reduced to a core of countries that are sufficiently similar—and without the presumption that others will soon be admitted. The weaker countries badly need currencies that reflect their national fundamentals. Germany does not need a weak currency, but Greece, Portugal, Ireland, and Spain today do.
A depreciation of the euro against the dollar and other major currencies would help. But these nations trade more with each other than with noneuro countries, so they need to change competitiveness relative to each other.
Even if by a miracle the worst outcomes are now averted, what will prevent problems like this from happening again if the eurozone stays in place? The euro authorities have demonstrated repeatedly they are incapable of regulating banks well at the eurozone or EU level—it is unimaginable that the 16 eurozone countries could get together around a table and declare that any one regulator has been seriously derelict.
The planned budget reforms at the EU level will push toward more discipline, but you need an incentive structure to get that and the consensus-based decision making does not work for that. If this weekend only produces a reaffirmation of platitudes in this regard, next week will be very bad. This is fiddling while cities burn.
On top of all this, shocks to economic performance that are different across nations will persist. Sharing one currency across these very different and insufficiently convergent countries simply does not make sense.
Second, there needs to be an orderly plan for debt restructuring across the eurozone. This needs to be done quickly (this weekend works, but realistically it will take several weeks), while the exit to a new currency could take longer. Since most eurozone nations' bonds are issued under domestic law, such restructurings should be able to proceed quickly (in emerging markets, most of the bonds are often under US or UK law, which generally makes restructuring much harder).
But do not think that Greece can restructure its debts without having broader repercussions. All the weaker eurozone countries must proceed together on this front or there will be chaos.
Third, the G-20 needs to assist in the euro restructuring project. This body can authorize the International Monetary Fund to help each affected nation declare a standstill on debt, and then draw up a plan to restructure debt. The IMF should play a key implementation role in helping to decide which nations should restructure their debts and then support this process—not because it is particularly good or suited to this task, but simply because no one else is available.
During the next few years each troubled euro nation will need liquidity support from the ECB, and they will need fiscal financing from the IMF and core nations in the European Union. Probably the G-20 should commit more resources, at least as a back stop. These programs can be drawn up quickly, and, they should include a transition to a new currency where appropriate.
There is no real leadership in the European Union, combined with complete unwillingness to admit the fundamental error of the eurozone itself. The Germans are happy to let other nations suffer for their past mistakes, so they will do nothing until there is a more complete crisis.
The ECB, as witnessed by Mr. Trichet's news conference on Thursday, has decided that they will play the hawk, and so offer nothing of support to the nations in the periphery. Meanwhile, bond markets have closed for the periphery. This can only mean bond yields keep rising, there are runs on the banks in many nations, and then eventual economic collapse. This, unfortunately, is the path of least resistance for all parties.
So someone needs to take leadership. Who can do this? Not the IMF by itself—it is too weak and conflicted with Dominique Strauss-Kahn clinging to his position as managing director (against increasing pressure from the United States). Indeed, Strauss-Kahn should leave the IMF so he can launch his run for the French presidency—it would be appropriately ironic if he were to win; as an architect of the eurozone, he is the perfect person to dismantle it. A much more independent person with international stature should replace him.
President Obama needs to step in personally to help this process work smoothly. The president can rightly claim that this is an international issue, not just a eurozone issue, since it impacts global trade and financial stability. All the world's large banks are closely linked through debt, derivatives contracts, and other finance.
It would be irresponsible to presume that American banks will smoothly sail through the impending financial collapse in the eurozone. If this is left to the Europeans, as we learned this week in markets, there is a clear danger that Europe's problems will topple the world into a new recession and a serious round of financial instability this year.
Someone needs soon to bring clarity and restore confidence. If not President Obama, who?
