I want a new Porsche

No, not that car. I think they look horrible, and they seem to be driven entirely by idiots. The company. The following should be illegal. I guess that it isn't. But note that I have no idea if the sequence of actions discussed actually happened.

From the comments section of this post at FT alphaville, mildly edited for readability:

Porsche bought cash-settled call options from a number of investment banks.

The banks bought shares to cover their positions - thus reducing the free float.

The banks then lent shares to various hedge funds who were shorting the stock, apparently (rumour) with the encouragement of Porsche.

Porsche then bought the shares that the hedge funds were selling, thus completing the circle (but not falling foul of their claim that they hadn't sold [lent?] directly to short-sellers).

Porsche then announced their massively increased position and the stock price rose. The short squeeze was exacerbated by the fact that Porsche now had more of the stock than anyone thought and the majority of the rest was held by index funds who couldn't / wouldn't sell.

Remember, we don't know this was what happened. But if it did, it feels a lot like market abuse to me. So how come Porsche have been cleared? Ah, wait, could it be something to do with being a German hedge fund (that also makes ugly cars), rather than an American or British one (that doesn't)?

Bigger is worse

There is a meme going around at the moment concerning size in banking. The basic idea is that too big to fail banks are a bad idea. Various people have various ideas of what 'too big' is, with numbers like 300B total assets (a number floated in a nice post at Dealbreaker) being discussed. Interfluidity also has a good discussion here.

My own take is that limits - whether $100B, $300B or some other number - are hard to impose and liable to manipulation, e.g. through off B/S financing. Rather I would make regulatory capital a function of equity. The more Tier 1 you have, the less you can leverage it. At $1B of Tier 1 or below, say, you are allowed a Tier 1 leverage ratio of 25. At $17B, it would be 12, so the formula would be something like

permitted leverage = 20 - 0.5 x [max($1B, Tier 1) - $1B]
total permitted assets = permitted leverage x Tier 1

This formula has a maximum at Tier 1 = $20B, where it permits total assets of $200B (and of course total assets would be defined to include off B/S assets as well as on B/S ones).

Support the government

While we cannot of course in any way support Jacqui Smith in the current expenses row, honestly if you were married to the Home Secretary, wouldn't you need a lot more than a few minutes watching Jodie Marsh, or whoever, to get you through the day?

Change that revolts us

Interfluidity has a nice hypothetical:

Consider a hypothetical asset manager, PIMROCK. PIMROCK reviews a pool of loans held by the bank J.P. Citi of America, and its analysts determine they are worth 30¢ of par value. The bank holds them at 80¢ on its book. PIMROCK agrees to put down $10B to purchase loans from the pool at 82¢ thrilling stock markets everywhere. It was all just a bad dream!

Under Geithner's plan, PIMROCK's $10B permits a $10B equity investment from the Treasury. Then the FDIC levers the whole thing up, providing $6 of debt for every one dollar of equity. So, $140B of bad loans are lifted from J.P. Citi of America, nearly $90B of which is sheer overpayment to the bank.

Of course, as cash flows evolve, PIMROCK's $10B is wiped out entirely, as is the Treasury's investment. The FDIC gets repaid in a bunch of securities worth about $50B, taking a $70B loss... These were real market prices, Geithner or his successor will argue. Our private partners lost everything. There was no subsidy here.

Meanwhile, taxpayers will be out around $80B.

Why would PIMROCK go along with this? Because they feel it is their patriotic duty to work with the government for the good of the financial system, even if that involves accepting some sacrifices. And because they hold $100B in J.P. Citi of America bonds, and they've received assurances that if we can get the nation out of the financial pickle it's in, there will be no haircuts on those bonds. "Shaking hands with the government" means that nothing ever has to be put in writing.

Welcome to America, 2009. Change we can believe in.

I agree, with one exception. PIMROCK doesn't need to buy the whole $10B. It just needs to buy enough that the bank can mark the rest at 82. So probably it only puts in $1B rather than 10. The taxpayer loses less on the subsidy, but more via having to recapitalise JP Citi of America in due course, while PIMROCK loses much less yet still has protection on its bond holdings.

Gearing up for trouble

Even by the intolerably low standards of this blog, this one is going to be obscure...

I want to talk about gears. Bicycle gears. For ordinary people, rather than, say, drug crazed Americans who have recently broken their collar bones. So, what does a reasonable rider want from his or her gears?

• A bottom gear that is low enough to get up most hills. In practice unless you are really fit that means a gear of 42* or lower.
  
• A top gear that is high enough that you can pedal going down moderate hills. 100 is plenty.
  
• A fine spacing of gears in between.
  
• And in particular a relatively gentle change from the little to the big ring at the front.

It doesn't sound like much, does it? Yet pretty much all standard gear set-ups from the large manufacturers fail on one or more of these criteria. 39/53 or 39/52 at the front gives far too big a change. You want at most a difference of ten cogs, I would suggest, or the change up is too jarring.

To get a bottom gear of 40 with a front ring of 42, you need a big cog on the back of more than 27. You can't buy one. So that means that 42/52 at the front doesn't work either.

By this point we have eliminated all of the standard front gears available. What does work is 38/48 on the front, and 13/25 or 13/27 at the back. This gives a top gear of a shade under 100, a bottom gear around 40, and a relatively gentle change between rings. But that requires custom front rings. Why does it have to be so hard?

* The gear in inches is given by dividing the number of teeth at the front by the number at the back and multiplying by the wheel size (usually 27) in inches. The biggest gear is therefore the largest ring at the front through the smallest at the back: the lowest is the small ring at the front through the big ring at the back.

Transatlantic Coup

Simon Johnson has an excellent article in the current issue of The Atlantic magazine. His basic premise, as an ex-IMF chief economist, is that crony capitalism is a fundamental part of many emerging market crises, and it is only when the cronies are forced to take some pain that the crisis can be resolved. Furthermore he argues that this kind of coup, whereby power has been seized by a small group who manipulate the economy for personal profit, took place in the US during the Clinton and Bush years. Thus the Quiet Coup of the article's title. Go and read the whole thing: it is quite persuasive.

Strained, but not entirely silly banking system metaphor no. 150

Political Futures

I don't always agree with Michael Meacher, but this letter in the Guardian is so good, and hits the tone which is lacking in both the government and the official opposition so well, that I am going to quote it nearly in full:

We urgently need ... an alternative to the prevailing Tory-New Labour orthodoxy. I would propose three central strands. It should seek to restore a social democracy which has been ripped apart by greed and an out-of-control inequality epitomised by the banks' bonus culture. We need a solidarity tax levied on the top 5% of incomes and on the so-called non-domiciled super-rich - who use Britain but don't pay into it - with the proceeds hypothecated to end child and pensioner poverty.

We need to redraw the boundaries between the state and the market. The market fundamentalism of the last 30 years is well and truly busted. But ending privatisation, deregulation and PFI is not enough. We need a new perspective for the state, not - as now - passive facilitator and rescuer of last resort, but actively interventionist where the public interest requires it, and strong promoter of the key social values of accountability, equity and real equality of opportunity. A robust market has an essential role, but so does the state, not only in health and education (where private markets do not belong), but in energy (a key to national security), housing (neglect of which is the biggest repository of social misery), transport (for a fully co-ordinated system), and banking (to prevent another collapse and provide reliable housing for low-income households).

We need a state which is less an intrusive snooper and more the guardian of our civil liberties. And we need a major redistribution of power: away from a top-down state to disenfranchised citizens; away from top-down industrial relations to a fair and constructive role for trade unions: and away from a top-down politics to a much more genuinely participative system of governing.

Strained, but not entirely silly banking system metaphor no. 149

What Timmy did next

The FT article is titled Geithner lays out new financial rules, but that is a little misleading. Rather our lad Timmy has laid out a framework under which new rules will be written, but we have no idea what the rules will be yet. What details there are do not allow one to form any precise conclusion. The principles seem reasonable, but the devil will be in the details (and in the inter-agency battles).

Wasteful Timmy

The Geithner plan, understandably, has generated many column inches since it was unveiled on Monday. There is little consensus among the commentariat, but the markets have taken it well. What should we take from Timmy's last (or at best next to last) stand?

First, it might actually work either by accident - because we are through the worst anyway and it doesn't hurt - or by design. It is certainly positive in the short term for the shareholders of American banks. And it betokens a reluctance to nationalise which, while negative for the taxpayer, is the kind of thing markets like.

Second, it is clearly an ineffective use of money. The government is providing nearly all the cash. If the same amount had been spent on recapitalising the banks, then there would be more leverage and hence more assets controlled for a dollar saved. Taxpayers should be outraged by this.

Third, it indicates that Geithner believes that an interestingly modern form of systemic risk is important: the risk that quasi-forced sales by one institution causes losses at others via mark to market. This plan achieves a de facto recapitalisation (albeit wastefully) via the ability for all banks to mark their assets to the purchase price in the plan. This means of course that the plan managers will be strongly encouraged to pay more than the market price for the assets: something they can afford to do given the government subsidy built into the structure.

In summary, then, the plan is far from optimal, but it will probably help a bit. The concern is that it won't be enough. If that happens, then Timmy will need a new job.

Update. Felix Salmon picks up an interesting quote from Sheila Bair. This makes it clear that the intent of the plan is to crush the non-default component of the credit spread:

They [the prices assets are bought into the plan] will still be, they will be market prices. We're just trying to tease out the liquidity premium. What's weighing on market prices right now is that people can't get financing to buy assets, they can't get financing to buy assets not many people want to buy, you don't want to buy. And then you have to hold on to them forever because there's nobody to sell them to. So, that's -- by providing that liquidity that's lacking now, we're hoping to get the prices up to what would really be a true market level.

They are doing this by removing all the risk - funding risk, liquidity risk, and credit spread volatility risk. It's an awfully expensive way to recapitalise the banks.

Go close enough and it will break your arm

I think China is all talk and no action on the dollar at the moment. But if they are not, there is a fortune to be lost or made when the Wile Coyote moment arrives.

Update from the Huffington Post here. My favourite quote is from Chalongphob Sussangkarn, a former Thai finance minister and now president of the Thailand Development Research Institute:

The U.S. deficit is so huge... This is why all countries, particularly [in] East Asia, are concerned because we hold a lot of these assets. What happens if the U.S. dollar falls 40 percent? Many central bankers will be losing huge amounts of money.

Editing Harvard

Greg Mankiw writes some complacent nonsense:

At Harvard, we have not instituted any radical reforms in the introductory economics curriculum in response to recent events. We have had some guest speakers, such as John Campbell and Andrei Shleifer, give excellent and well received lectures about the current crisis to assure students that, despite all the uncertainties, economists really are on the case and that the tools of economics are useful in trying to figure out what is going on. But nothing in the current situation makes the basic lessons of economics irrelevant. And the basic lessons are where education needs to begin.

Let's rewrite it, to make more reasonable:

At Harvard, we have realised the economics has been singularly unhelpful in predicting recent economic events, or in providing advice on how to deal with them. In response to this, we have instituted radical reform in economics teaching and research, reaching out to mathematicians, physicists, computer scientists, systems biologists and others who seem to have useful things to say about interacting systems like the economy. We believe that the tools of economics are rather unhelpful in trying to figure out what is going on, and we are urgently trying to improve them.

Update. Harvey Mansfield has a nice summary of what is required:

What has happened in the last few months should give them [i.e. economists] pause. It should make them consider the necessity of looking at economics from the outside, at how it looks and behaves as a whole. There's no way to do this from within economics--no way to formulate an equation that will correctly predict the failure of equations to predict. The idea of prediction itself has to come into question. Prediction is designed to reduce the role of chance in our lives, eliminating unpleasant surprise and replacing it with gratitude and satisfaction. But somehow it doesn't have this effect.

Sunday Competition

Is it a Barclays tax structurer or is it a carnivorous plant? A tricky one I know so take your time.

Barclays' creek proves deeper, longer and browner than first thought

The Guardian had another set of articles on Barclays' tax structuring group yesterday. The point is not whether the practices of this group are legal. Some may be; some are borderline; some may not be. The point is the continuing reputational damage being done to the Bank as these articles continue.

Any firm with a tax structuring activity must be asking themselves how this group's transactions would be taken by their clients, regulators, tax authorities, and other stake holders were they to be made public. If, as I suspect, the answer in most cases is `rather badly', then perhaps the practice of structuring transactions simply to avoid paying tax will be moderated. I think that this business is immoral and damaging to the reputation of honest bankers, and I know a lot of people do too. Do you really want to live in a world where banks have large groups of smart and well paid people just to ensure that there are fewer schools and hospitals?

Of course, the real answer is tax modernisation. Barclays and the rest can only play their games because tax codes are so complex and international tax treaties can be arbitraged. While we might deplore the practice of tax arbitrage, at least some of the blame must go to the government for not closing the loopholes.

Those who do not remember the past are condemned to relive it

The best comment on bonuses and social inequality so far:

(HT Jonathan Hopkin.)

Details, details

Martin Wolf is a little harsh on Lord Turner in the FT. He says:

First, it does not explain why we can hope to contain the behaviour of companies too important to fail.

True, but increased capital requirements will certainly help, along with better supervision of liquidity risk. The devil is in the details, I know, but Turner has not clearly not addressed this.

Second, it does not demonstrate that regulators can contain regulatory arbitrage by profit-seeking financiers.

Third, it does not deal with risks posed by institutions that may be too big to rescue by some host countries.

Stronger supervision of on-shore entities without too much respect for home country supervision of the parent will help. And Turner is surprisingly harsh on the EU passport regime. Clearly there is a limit to the extent of the UK's extra-territoriality, but within that Turner is certainly looking in the right direction.

Fourth, it does not explore the room for charging heavily for guarantees.

Fair point. I should like to see a UK version of the FDIC scheme where all banks pay a premium for the deposit insurance the government sells to them. This premium should I believe be strictly based on the notional of deposits, and not on any risk measure of the deposit taker (which will always let the big boys off lightly).

I still like the idea of taking this deposit insurance premium in the form of a call option on the bank's stock (which the regulator would hedge, hence locking in its value), but obviously this is fairly left field.

But first, accountants embarrass themselves

This is so incredible, so bizarre that I have to blog.

The FASB has lost its mind. It is proposing that:

U.S. companies would be allowed to report net-income figures that ignore severe, long-term price declines in securities they own. Not just debt securities, mind you, but even common stocks

(Quotation from an excellent Bloomberg article by Jonathan Weil. This is a large, forceful slap in the face to the users of financial statements. As Weil says:

if these rules had been in place last year, a company that still owned shares of American International Group Inc. or Fannie Mae, for instance, could exclude those stocks’ price declines from net income entirely. It would make no difference that the companies were seized by the government last year, or that both are penny stocks.

Idiocy on this scale is deeply depressing. One can only hope that this proposal goes nowhere.

Hiatus, leading to...

I am looking at hosting Deus Ex on my company website, and so posting will be light over the next little while as I investigate alternatives. Probably I'll go for Word Press. Any comments from those with experience of such things would be very welcome.

The Turner review

The FSA's regulatory response to the global banking crisis is out: see here.

My first reaction is that it is fairly sensible. Some highlights:

• Section 1.1 is a really nice summary of the development of the crunch.
  
• There is an interesting, and perhaps surprising, insistence on the inadequacy of current transnational arrangement to cope with global banking groups. A quote from Mervin King sets the tone: The essence of the problem ... is that global banking institutions are global in life, but national in death. There is then surprisingly strong language on the inadequacy of current arrangements: Until and unless there is a willingness to change this approach and to move to a much more unified approach to global financial supervision and even fiscal support, mechanisms such as colleges of supervisors can make an important but still limited contribution... they cannot deliver fully integrated global supervision.... On European arrangements, the tone is similarly harsh: The crisis has shown the philosophy [of European supervisory arrangements] to be inadequate and unsustainable for the future... It is essential that the European Union now considers the appropriate way forward. This willingness to contemplate radically new arrangements is definitely positive.
  
• There are seven key suggestions on changes to the FSA regulatory regime. Several are unsurprising and have been suggested by FSA or the BCBS already. Thus bank capital requirements will go up, with trading book capital requirements in particular increasing. There will be a bigger focus on core Tier 1, and a gross leverage ratio backstop.
  
• Turner goes further than I had thought that he would in embracing anti-cyclical capital, and anti-cyclical reserving. This is a big change for a major regulator and is definitely to be applauded.
  
• As expected, the status of liquidity risk increases, with consideration being given for the first time to an overall core liquidity ratio which would limit firm's appetite for liquidity risk.
  
• Turner has come down firmly on the side of regulatory consistency regardless of legal form. He says: regulation should focus on economic substance not legal form. Off-balance sheet vehicles which create substantive economic risk... must be treated as if on-balance sheet for regulatory purposes. Prudential oversight of financial institutions should ideally be coordinated in integrated regulators (covering banks, investment banks and insurance companies)... And regulators must have the power to obtain information and identify new forms of financial activity which are developing bank-like characteristics, and if necessary to extend prudential regulation to them, or to restrict their impact on the regulated community. For the avoidance of doubt, this means hedge funds too.

Accountants and other criminals

My apologies for an incendiary title. I don't really mean it of course. I think I have a slight case of hyperbole from Francine McKenna. Still, in this article at The Huffington Post, she points out that

The Big 4 public accounting firms haven't yet been asked the hard questions by governments, legislators, or regulators.

Which is true. She also points out that they share some of the characteristics of organised crime. Which, so far as the analogy goes, is also true. But the big issue is liability.

Governments all over the world are protecting and shielding the public accounting firms from failure under any circumstances, even in the face of repeated failure on their part... The firms and their partners ... are unequivocally self-interested.

As one would expect them to be. But the time for pandering to their self-interest is over. If they want to give opinions on accounts, then they should be liable for them. If they don't feel ready to take responsibility, then they should not sign off the accounts. Removing caps on auditor liability is a really easy way to dramatically improve the quality of audited financial statements.

Barclays. Tax. Chortle.

Oh dear me. The biggest tax arb house on the street is being investigated by the Inland Revenue. The Guardian has the details. But clearly anyone structuring transactions whose main aim is to reduce tax (an international avoidance factory perhaps?) has reputational risk. That risk appears to be biting. If a senior politican says that you look like the spider at the centre of a highly artificial web of non-transparent transactions through tax havens, then you have a problem.

TALF to Taxpayer

The TALF says: please take a seat.

(The FED press release is here. Useful commentary from Philip Gelston of Cravath, Swaine & Moore via Marketpipeline is here.)

When is biggest best (or why to avoid British PCs)

A few years ago, in a fit of patriotism, or the desire to support local industry, or something equally foolish, I bought a British-built PC. A Mesh. Goodness, what a mistake. It wasn't delivered when it was promised. When it arrived, it felt shoddy. And ever since, it has had issues. The CPU cooling fan fell off, and had to be replaced. The CMOS battery ran down. (Did you know that 'CMOS corrupt' is an unhelpful error message you get when in fact it is likely that a watch battery inside your computer has given up the ghost?) And now the USB hub seems to have crashed. So, gentle reader, learn from my mistake: buy from someone big enough that they are likely to have got their design right. You don't want the PC equivalent of a TVR.

AIG - Where did the money go?

(HT The Big Picture.)

What is interesting about this is the GIAs. I _think_ that these are GICs, i.e. guarantees of minimum investment returns, sometimes on variable balances. Obviously as rates have fallen, GICs have become more valuable to the holder and riskier to the writer. Insurers have conspicuously underpriced the implied puts in GICs for years, and now it seems that for AIG these have come home to roost.

Good bad/bad bank

Willem Buiter has a discussion of how good bank/bad bank separations might work in detail: the mechanics come from Robert Hall and Susan Woodward. I will simplify the argument a little, and discuss the issues.

Consider a bank with:

Assets		Liabilities
Good loans	1000	Deposits	1200
Bad loans	500	Bonds Issued	600
Other assets	380	Shareholder's funds	80

(Let's ignore the off B/S stuff for this post and assume that all of the other assets are good.)

The proposal puts the deposits and good assets in the good bank, and calls the difference between assets and liabilities 'capital'. Thus we have for the good bank:

Assets		Liabilities
Good loans	1000	Deposits	1200
Other assets	380	Shareholder's funds	180

Notice that the good bank is well capitalised under this proposal.

The bad bank owns all of the equity in the good bank. For it we have:

Assets		Liabilities
Bad loans	500	Bonds Issued	600
Equity in good bank	180	Shareholder's funds	80

It is fairly likely that the equity holders in the bad bank will be wiped out over time, which is right and proper. If the good bank makes money and declares a dividend, the bad bank will receive that income as it stands. Meanwhile the debt holders of the bad bank now have a claim on a rather worse quality institution, at least at first sight. This is a proposal with rather little moral hazard.

The issue comes when we consider the bad bank's position. It is not capitally adequate, not least because material holdings in credit institutions (i.e. its shareholding in the good bank) is a deduction from equity. One might argue that it does not need a banking license as it is now in run off, but still, it is so leveraged that its management will have to sell some of the equity in the good bank. Does a forced seller of bank equity (albeit good bank equity) really help financial stability?

Also notice that the bad bank would consolidate the good bank from an accounting perspective. Again, to get deconsolidation it would have to sell at least 50% of the good bank's equity.

The proposal in short makes sense from a moral hazard perspective, and transfers the taxpayer's deposit guarantee to a well capitalised institution. But it does force the bad bank to sell its position in the good bank almost at once, and that is a rather worrying side effect.

Two things which seem to go together at the moment

Accounting for the dead

I have a terrible confession. I have never liked Elvis. But aside from dead musicians, Bloomberg is doing a great job on chronicling the absurdities of accrual. David Reilly says:

Of the $8.46 trillion in assets held by the 12 largest banks in the KBW Bank Index, only 29 percent is marked to market prices, according to my analysis of company data. General Electric Co., meanwhile, said last week that just 2 percent of assets were marked to market at its General Electric Capital Corp. subsidiary, which is similar in size to the sixth-biggest U.S. bank.

What are all those other assets that aren’t marked to market prices? Mostly loans -- to homeowners, businesses and consumers.

...investors already believe banks are underestimating just how bad losses will be on their unmarked loans. GE investors, for example, fled the stock due to concerns over its corporate loans and lending to Eastern Europe.

If investors could get a better sense of the losses actually facing GE, they might have more confidence in its financial strength. In other words, we need more mark-to-market accounting, not less.

Perspex* Steagall?

Paul Volcker suggests that:

the US could perhaps do with a new version of Glass-Steagall, this time splitting hedge funds, private equity funds and proprietary trading off from Wall Street banks.

How would you enforce it, though? You can't force them to take no risk, not least because banks cannot precisely maturity and FX match their funding, and so banks are net long liquidity which they need to invest. So you would have to have a de minimis risk limit. But how would it be expressed to prevent gaming? Remember that one of the reasons we got into this mess in the first place was that AAA subprime tranches looked very low risk in VAR models. Still, the idea merits discussion.

*No disrespect intended to Senator Carter Glass.

Freddie now has negative net worth

The big Mac is now not only little, but actually less than nothing. Bloomberg explains.

A recent trade explained

Why did I sell short dated Wells Fargo bonds at a small loss recently? Because as Bloomberg reveals today, Banks’ Bondholders May Be Next to Share Bailout Pain. Do I think that senior debt holders will take a haircut soon? Probably not. But probably not wasn't good enough, especially when Geithner can turn on a pin. If investors stay well away from bank debt of any kind until the dust has cleared, I wouldn't blame them. Of course, if they do that, then banks' funding problems will only get worse...

Credit protection sanity

I have made a bit of a sideline in highlighting some of the less helpful comments on the CDS market. It pains me to include a man I generally respect, Paul Krugman, in the list of people who have got the wrong end of the stick.

He first quotes marketwatch:

The spreads on credit-default swaps for U.S. government debt jumped to 97 basis points Tuesday, nearly seven times higher than a year ago and 60% higher than the end of last year, to a level roughly in line with those of France, according to data supplied by Markit.

Then he opines:

Has the risk of a US government default risen? Probably. Nonetheless, the people buying these contracts are crazy. A world in which the US government defaults would be a world in chaos; how likely is it that these contracts would be honored?

The answer is that it does not matter (much). Most CDS trading is about views on the spread, not views on default. People buy CDS on the US government because they think the spread will widen and they can close out at a profit, not because they think that default is likely. Therefore the CDS market often tells you rather little about default: what it tells you about is market participants expectations of spread movements. CDS spreads go out when there are more buyers of protection than sellers. That is the only reason spreads move. Any connection between CDS spread movements and expectations of default is a modeling assumption, and one that is particularly dubious at the moment.

This man writes well

He says:

The state that promises maximised choice and minimal risk is in serious danger of encouraging people to forget two fundamentals of economic reality - scarcity as an inexorable truth about a materially limited world, and concrete productivity and added value as the condition for increasing purchasing power or liberty, and thus sustaining any kind of market...

In contrast to an economic model in which the exchange of goods is the basic process being analysed or managed, we have encouraged a model in which the process of exchange itself has become the raw material, the motor of profit-making. But the problem comes when massively inflated credit is "called in": when the disproportion between actual, measurable material security and what is being claimed and traded on the market is so great that confidence in the institutions involved collapses.

The writer, if you are interested, is Archbishop Rowan Williams. He reminds me of an insightful book from the 70s, The Limits to Growth. Perhaps we should be asking a little more forcefully what growth is for: if strong increases in GDP always come with volatility, or gross income inequality, or both, is maximising GDP always the right course?

Should the financial stability regulator be the central bank?

It is an interesting question. First, note that Ben's recent call for US regulatory overhaul is welcome, if overdue. Both the politics and the practicalities of any change are formidable, however necessary it is.

Even the question of role of the central bank is redolent with issues. If they are not the stability regulator, then how is the interaction between financial stability and monetary policy managed? But if the central bank does take this role, how do they balance the needs of the broad economy (which typically suggest looser policy) with financial stability? This is especially difficult as many central banks (yes, I'm thinking of you guys in Frankfurt) have a rather conservative attitude. Moreover Northern Rock shows that if stability is divorced from supervision then problems can fall in the gap between the two agencies. An uber-supervisor of insurers, hedge funds, banks and broker/dealers with both markets and financial stability responsibilities and the ability to strongly influence monetary policy is one alternative. But if a body like this gets it wrong, there is no check or balance.

I honestly don't know what the right answer is. But I certainly believe that the current US answer - FED, SEC, OCC, FDIC, OTS, OFHEO, CFTC, State Insurance commissioners, and UTC (Uncle Tom Cobley) isn't ideal. And when you factor in the global dimension, as the FT emphasises, things get even tougher.

Update. There is an interesting update from the FT here. The salient idea: There are arguments for adopting the ‘twin peaks’ model of Australia and the Netherlands, with one regulator handling consumer issues such as product sales and the other prudential supervision. Would that come with damn fine coffee?

The state of the credit markets

Two depressing data points, to add to the general gloom.

1. After talking with some friends in New York, I called Merrill for a quote on short dated Wells Fargo in size today. Their bid/offer was 3 big figures wide.

2. I hit the bid.

Losing Lloyds

Goodness, how the mighty have been laid low. Two large British clearing banks have been destroyed by one bad purchase: RBS by ABN; Lloyds by HBOS. I am heartened that the government has extracted a reasonably high price from Lloyds for its rescue: RBOS got away a little more lightly. A lot of the attention recently (and reasonably) has been focussed on the revisions to AIG's bailout (is it now V4?) and Merrill's dancing before the BoA purchase closed. But, rather quietly, the UK government seems to be acting somewhat sensibly. Now if only it would actually do something with the control that it has acquired, we might be able to move forward rather more quickly.

Towards Core Stability

No, not a post on my recent engagement with Pilates. Instead I am going to be a little Englander for a moment. This isn't out of prejudice: it is more a consideration of self sufficiency.

What's the problem with being an exporter? It is that if your clients stop buying, your economy runs into a wall. Look at Japan.

The problem with being an importer is that it is easy to import inflation.

A measure of self sufficiency therefore has some interest. The problem for the UK is that, with a few exceptions (cars, killing machines) we killed out manufacturing industry, making progress towards self sufficiency very difficult. It also makes our natural shortage of material much worse from a country risk perspective.

Therefore part of any long term financial stability plan should be the revival of manufacturing, especially engineering-based manufacturing, at the expense of financial services. It isn't impossible: Thatcher only killed manufacturing in the 1980s, and there are still some good engineers left (although many of them are retiring). This story is a tiny ray of light in that regard. But much, much more is needed.

Strained, but not entirely silly banking system metaphor no. 148

I will stop doing this soon I promise. But this is too good to resist.

Failure is its own reward?

There is at least one piece of good news in troubles that the Obama administration are having with filling some jobs. As the WSJ reports, Annette Nazareth, who was expected to be tapped as deputy Treasury secretary, has withdrawn. Annette was responsible for the consolidated supervised entity program at the SEC that was so successful at supervising the big 5 broker/dealers that one failed, two were sold in conditions of distress (extreme distress in the Bear's case) and two became banks. Why anyone thought that she should be Timmy's deputy is beyond me.

Mervyn being sensible

The full transcripts of Mervyn King's evidence to the Treasury select committee are not up just yet, but this morsel struck me as very much on target:

It is moral hazard that has led us to where we are. I don't want to blame anyone. All the players have acted rationally given the positions they were in.

Strained, but not entirely silly banking system metaphor no. 147

The slaves revolt

There is a growing meme at the moment on the failure of academic economics. Anatole Kaletsky has a piece in the Times which reminds of the responsibility economists bear using Keynes' famous quote:

Practical men, who believe themselves to be quite exempt from any intellectual influence, are usually the slaves of some defunct economist. Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back.

He points the finger at the rational expectations and efficient market hypotheses, arguing that the impact of these two ideas has been `dire', then says:

The prevailing academic orthodoxy has to be recognised as a blind alley. Economics will have to revert to a genuine competition between diverse intellectual approaches - such as behavioural psychology, sociology, control engineering and the mathematics of chaos theory.

So economics is on the brink of a paradigm shift. We are where astronomy was when Copernicus realised that the Earth revolves around the Sun. The academic economics of the past 20 years is comparable to pre-Copernican astronomy, with its mysterious heavenly cogs, epicycles and wheels within wheels or maybe even astrology, with its faith in star signs.

For my money, this is overly optimistic. Revolution is direly needed, but there will be massive resistance to change. (One is reminded of the similar useless and career-serving complexity in string theory.)

Meanwhile Willem Buiter uses a long and persuasive FT blog to flesh out the details of the failings of macroeconomics. Buiter questions the complete markets assumption, pointing out that the characteristic issue of the crunch -- illiquidity -- cannot even be addressed once that assumption is made.

He is also particularly good on how economists have simplified their theory so that they can work with it, abandoning any hope of realism for mathematical tractability. The simplest form of uncertainty (Gaussian random walks) was assumed; equations were linearised; equilibrium was assumed. (Buiter does not dwell on the last of these, but it is very important: one of the big issues in dynamic general equilibrium models is the `e' word, given that the frequency of shocks is large compared with the relaxation time of the model.)

Buiter is scathing about the use of these models to set policy:

The practice of removing all non-linearities and most of the interesting aspects of uncertainty from the models that were then let loose on actual numerical policy analysis, was a major step backwards.

The final nail is added by The Financial Crisis and the Systemic Failure of Academic Economics, a paper by David Colander et al. (Link via debtdeflation.com.) This goes over the same themes, stressing the need for someone, somewhere, to do some work on macro models which are useful for making policy. Perhaps academic economists are not actually the right people to do this - it may be that the Copernican revolution in economics comes from the theory of complex dynamical systems (the bastard son of chaos theory) or systems biology. Perhaps we will see a new experimentalism, with models being built which actually capture aspects of the economy, rather than aspects of economic theory. But certainly there is a huge problem waiting to be solved, and there should be kudos for anyone who can make a significant contribution to solving it.

Update. The New York Times has a piece on the lack of movement in academic economics so far. It isn't surprising. Change will require a reasonable number of young economists to say I am Spartacus, and that hasn't happened yet.

And the gold goes to...

AIG of course. RBS might have thought that it was in with a shot, but it is Tim Henman to AIG's Andy Roddick. The biggest loss in UK history just doesn't cut it on the world stage when someone like AIG can come in with a number like $61.7B. No contest: the Americans do world class losses best.

Wouldn't it be simpler if you only had one counterparty on derivatives?

Relax, it will happen soon. And that counterparty will be JP Morgan.

Bigger is worse

A correspondent of mine asks, apropos this story:

AIG, whose reach is so vast that the government warns letting it fail would cripple the very world financial system

Why are companies allowed to get this big? The answer is of course that they shouldn't be, if you care about financial stability and moral hazard, at least. What we need is capital requirements which are a strong increasing function of size, so that larger companies are forced to have a lower ROE than smaller ones, and hence so that they have an incentive to split. The current rules of course are the opposite: the ability to use internal models within Basel, and the advanced capital models that big insurers use, have the effect of making capital requirements lower for bigger companies. You don't need a crystal ball to figure out that that is a bad idea.