Bundesbank President Weber has been the most candid to date about what the ECB could do in case Greece is downgraded again, especially by Moody’s.  Recall the problem:  Prior to the crisis, the ECB would take as collateral only paper rated A- or better.  During the crisis they have extended it to BBB-.  It is due to revert back at the end of the year.  Fitch and S&P rates Greece below A-, leaving only Moody’s above the normal threshold.

The ECB seems to loathe to postpone the return to normalcy again.  And yet as Austrian central banker Notwotny pointed out earlier this week, it seems unfair and untenable that a single rating agency determines whether a sovereign has access to the ECB’s lending facilities.                                

A solution, Weber suggests, could be that the ECB accepts the lower quality of collateral in exchange for a larger discount–or what the market calls a haircut.  There is precedent.  For example, some non-sovereign securities used as collateral are given a 20% haircut.

Weber acknowledges this is not the only solution, suggesting that this is a dynamic situation and the ECB has not made any hard and fast decisions.  At the same time, it indicates that although many ECB members, like Weber himself, are insisting on a narrow construction of the Maastricht and Lisbon Treaties, it is not above using monetary operations to assist fiscal objectives.

For example, some of the 12-month money the ECB provided at 1% appears to have been used in part to finance the purchases of European sovereign debt.  Indirectly, but no less significantly, the ECB helped support the weaker credits in Europe.  On July 1st the ECB’s 12-month massive 442 bln euro provision expires.  The ECB will seek to smooth this out by offering 6 month funds at the end of March and then a special tender at the end of June. Meanwhile, reports suggest that Greece has made an early preliminary report to the EU (due March 16th) that claims that it is ahead of schedule in implementing its austerity measures.  It is said to acknowledge that, as we pointed out, Greece’s 2009 GDP was revised lower and that this lowers the 2010 base.  Accounts also suggest that report notes that civil servant wage cuts will will crimp consumption.  This is one of the ironies.  Efforts to address the structural deficit risks adding to the cyclical deficit.

The markets have responded favorably to these developments and Greek bonds and the other weaker credits in the euro zone have rallied.  Ten year yields are off 2-4 bp and credit default swap prices have eased.  Note that current market conditions appear favorable for new issuance and there is already talk that Greece could come back to the market as early as next week to raise more funds.  Last week’s bond sale and the next ones, are part of the official effort to pre-fund a good part of the more than 20 bln euros in maturity and coupon payments due in the April and May period.

The euro has also moved higher on the news.  Resistance at yesterday’s high near $1.3635 needs to be overcome to spur a retest of the week’s high near $1.3705.  While many would like to see a near-term euro bounce to sell into, the shallowness of the upticks, given the more positive developments in Greece, over the past week disappoints.

Marc Chandler
Global Head of Currency Strategy
Brown Brothers Harriman & Co.

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The preceding is a post by Marc Chandler. For more of BBH’s currency views, please visit the BBH FX website here.

This material has been prepared by Brown Brothers Harriman & Co. (“BBH”) and is intended for information purposes only.  This communication should not be relied upon as financial, investment, tax or legal advice.  This communication should not be construed as a recommendation to invest or not to invest in any country or to undertake any specific position or transaction in any currency.  This information may not be suitable for all investors depending on their financial sophistication and investment objectives.  The services of an appropriate professional should be sought in connection with such matters.  The information contained herein has been obtained from sources believed to be reliable, but is not necessarily complete in its accuracy and cannot be guaranteed. Sources used are available upon request. Any opinions expressed are subject to change without notice. Please contact your BBH representative for additional information. BBH’s partners and employees may own currencies in the subject of this communication and/or may make purchases or sales while this communication is in circulation.

Related posts:

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• Greece sees credit rating cut by S&P
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Highlights

The US dollar is mixed against the major and emerging market currencies.  The euro is consolidating in yesterday’s range as bonds stabilize and despite a smaller than expected German trade surplus.  Comments from EU spokesperson Altafaj just before the NY open that measures taken by Greece are sufficient have so far failed to take the currency above yesterday’s high around $1.3635.  By contrast, the pound came under further pressure extending losses against both the dollar and the euro overnight, hit by another round of weak data (industrial and manufacturing production.)  While the currency was oversold and has managed to recovery some modest ground, gains are likely to be limited with resistance around $1.4980 and support on the cross at around 0.9080.  The New Zealand dollar is one of the top performing currencies today on position squaring ahead of this afternoon’s RBNZ meeting.  The central bank is expected to leave rates unchanged but the market will be looking for any signals about the timing of the first hike.  Recent data have been mixed and given that households remain cautious and employment has softened, the RBNZ may leave its statement unchanged, a negative for the kiwi.  Amongst emerging market currencies, the Asian countries, many of whom export to China, saw their currencies gain after Chinese imports jumped. 

Global equity markets are firmer but with several exceptions.  In Asia, Japan’s Nikkei and Topix closed down (a modest -0.04% and -0.2% dragged lower by declines in energy related and tech shares.  China’s Shanghai Composite also slipped, down 0.7% as consumer related shares fell amidst concern rising exports and inflation (due in the next few days) could lead to tightening and despite reassurances from the Commerce Dept that stimulative fiscal policies will remain in place.  Most other Asian markets as well as the European bourses have posted modest gains while early indications suggest US markets may open flat. The MSCI Emerging Markets index is up 0.5% today and is now up on the year.

Global sovereign bonds are narrowly mixed.  In Europe, the German 2- and 10-year yields are up just 1 to 2 bp after successful 2- and 10-year auctions totaling 7 bln euros.  The comparable Greek yield is down 3 bp while Portuguese yields are down 2 bp.  Portugal’s 11-year 990 mln euro bond auction, like the German auctions, also saw good demand.

Currency Markets

The British pound’s poor performance in the European session was exacerbated by worse than expected Jan industrial production data. Output contracted -0.4% m/m (vs. an expected gain of 0.3% and after a 0.5% gain in Dec) leaving the yearly rate well in negative territory, at -1.5% (vs -3.6% in Dec.)  Manufacturing production also contracted unexpectedly by -0.9% m/m (vs +0.9% prior) and for a yearly rate at a very sluggish +0.2% (from -2.0% in Dec).  Poor weather contributed to the disappointing performance, but it is not all due to weather.  Yesterday’s Jan trade figures (and considering the highly manufacturing orientated nature of the UK external sector) hinted at a likely disappointment on the industrial production front too. Moreover, it should be noted that the French Jan industrial production also released this morning came out on the strong side of expectations (at +1.6% m/m) yet the weather conditions were dreadful in France too in January.  The bottom line is the UK economy has started the year on a poor note and this has implications for both the monetary policy outlook (i.e. extra QE could be considered again) and for the fiscal prospects (the weaker growth profile means lower growth generated revenues and a deteriorating fiscal position), risking exacerbation of current UK credit concerns.

China reported stronger export and import figures for February than expected, with the net result of a smaller than expected trade surplus.  In fact, February’s trade surplus of $7.6 bln is the smallest in a year and a bit more than half of the January surplus.  This is consistent, however, with an under-appreciated development that we think is important.  In terms of global imbalances, the US trade deficit and the Chinese trade surplus have been roughly halved as a percentage of GDP over the last couple of years.  In the US case, it seems largely cyclical and the growth differentials that we expected to close the output gap in the US before Europe and Japan will likely see the US trade deficit grow again, though from a lower base.  In China’s case, the possibility of a structural shift is greater, though too early to tell.  China’s exports rose 45.7% in February from the depressed year-ago levels. Yet this is more than twice the pace in January and may also have been distorted by the earlier lunar New Year.  Imports jumped almost 45%, better than the 39.7% expectations, but well off the mind-boggling 85.5% pace reported in January.  There are several implications of today’s Chinese trade report.  First, with foreign demand improving and domestic demand still appearing robust, it can only add to the near-term inflation pressures.  CPI figures are due out as early as tomorrow and the expected 2.5% year-over-year pace would be the fastest pace in 16 months and spur the already growing expectation for a PBOC rate hike.  In this regard, note that China reported that commercial and residential real estate in 70 cities rose at an almost 11% clip, which plays on fears of over-heating.  Second, although the US Congress is seeking action to try to pressure China into allowing its currency to appreciate, the decline in China’s trade surplus makes it all the more difficult for the Obama Administration to cite China as a currency market manipulator in next month’s Treasury report.  There has been some speculation that China would be cited as the Obama Administration seeks to pre-empt Congressional action and seeks to get support for some of the outstanding free trade agreements.  Some observers note the weapon sales to Taiwan, the Dalai Lama visit to Washington and the trade frictions all as signs that the Administration is edging toward a more direct confrontation with China.  Meanwhile, the 12-month non-deliverable forwards are fairly stable today, ahead of more macro economic data; implying almost a 3% appreciation of the yuan over the next year.  We suspect that a rate hike is still several months, with additional administrative moves, like the increase in reserve requirements and tweaking money market rates, continuing to be seen first.

Japan’s economy may be benefiting from the revival in its neighboring Asian economies, but domestic demand remains very sluggish and deflationary forces continue.  Feb machinery orders were softer than expected at down 3.7% m/m (vs +20.1% in Dec.) That put the yearly rate at -1.1% (vs -0.6% exp). Machinery orders are a good proxy for business investment, so this disappointing January performance is not particularly promising for Q1GDP.

 
Upcoming Economic Releases

US Jan wholesale inventories, which represent about a quarter of business inventories, are due at 10AM EDT/15:00 (0.2% m/m exp vs. -0.8% prior.)  The RBNZ announces its policy decision at 3PM EDT/20:00 GMT (rate expected unchanged at 2.5%.)

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The preceding is a post by Marc Chandler, global head of Brown Brother Harriman’s top ranked Currency Strategy Team. For more of BBH’s currency views, please visit the BBH FX website here.

This material has been prepared by Brown Brothers Harriman & Co. (“BBH”) and is intended for information purposes only.  This communication should not be relied upon as financial, investment, tax or legal advice.  This communication should not be construed as a recommendation to invest or not to invest in any country or to undertake any specific position or transaction in any currency.  This information may not be suitable for all investors depending on their financial sophistication and investment objectives.  The services of an appropriate professional should be sought in connection with such matters.  The information contained herein has been obtained from sources believed to be reliable, but is not necessarily complete in its accuracy and cannot be guaranteed. Sources used are available upon request. Any opinions expressed are subject to change without notice. Please contact your BBH representative for additional information. BBH’s partners and employees may own currencies in the subject of this communication and/or may make purchases or sales while this communication is in circulation.

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The Bloomberg video is a bit sensationalist in my opinion. But it gets to the heart of the problem in Europe, namely Spain. Spain has an economy and debt which is an order of magnitude larger than Greece. That means that problems in Spain are more critical than in Greece. But it also means that an EU bailout would simply not be feasible.

Watch the video and I will make a few other remarks below.

The first thing to realize is that government deficits are balanced by imports and private savings. I’m talking here about the financial sector balances, of course.

The chart to the left from the FT shows you that the collective financial balances in each individual Eurozone country must sum to zero.  Where there is a government surplus it is matched by either the capital account or private balances. The same is true for deficits.  Take Spain, for example. There, the government’s budget was in surplus in 2006 and it had a very large capital account surplus (the financial sector equivalent of a current account/trade deficit). This was matched by a substantial private sector deficit. By 2009, due in large part to an unprecedented housing bust, the government’s finances were in tatters. Look at the chart. This is matched by net private sector savings and a capital account surplus.  The financial sectors must balance.

This brings me to the second thing to realize. Spain is to Germany as the United States is to China. In a fixed exchange rate environment, the U.S. is running an astonishing current account deficit while China runs an equally outsized surplus. Similarly, you can’t have Germany and Spain both running current account surpluses, unless the EU as a whole runs a current account surplus. So, if Germany (or the Netherlands) wants to be the export juggernaut and run a massive current account surplus, this has intra-EU ramifications. The most important is that Germany’s (or the Netherlands’) current account surplus (capital account deficit) is matched by current account deficits (capital account surpluses) in Spain (Portugal, Greece, Ireland and Italy). That’s how it works, folks. You sell more to me than I do to you and I get more cash than you do. There are always two sides to every transaction. It’s right there in the data.

The FT’s Martin Wolf is on to this and notes in his column yesterday:

In the short run, it is impossible to shift external balances quickly, particularly when domestic demand in the surplus countries is so weak.

Now Germany insists that every country should eliminate its excess fiscal deficit as quickly as possible. But that can only happen if current account balances improve or private balances deteriorate. If it is to be the latter, there needs to be a resurgence in private, presumably debt-financed, spending. If it is to be the former, there are two choices: first, current account balances must deteriorate elsewhere in the eurozone, entailing a move to smaller private surpluses in countries like Germany. Or, second, the overall balance of the eurozone must shift towards surplus – a “beggar my neighbour” policy.

In practice, the most likely outcome of such fiscal retrenchment would be a slump in countries with large external and fiscal deficits. Given the lack of competitiveness of such external deficit countries and the weakness of demand elsewhere in the eurozone, such slumps might become very long-lasting. The question is whether populations would put up with this. If not, political crises will emerge, with inherently uncertain consequences.

I would add to this by running a brief two-stage analysis of what happens under austerity (sorry, no charts yet).  In stage one, we have the FT chart for 2009. Spain has an enormous budget deficit, which is offset by private savings and a capital surplus (more imports than exports). Germany has a smaller deficit and a capital deficit (more exports than imports) matched by a huge private sector savings.

If Spain is forced to run austerity measures as seems likely, in stage two, this shifts their government deficit markedly down. Given Spain’s poor labour competitiveness, sticky wage prices and inability to depreciate the currency, all of the adjustment falls onto the private sector in the form of reduced net savings (which could include larger debt burdens). But, the thing to realize is that total GDP in Spain is lower in this scenario, which means total imports are lower, which means Germany’s total export volume is lower. This is a deflationary scenario.

I know for a fact that Germany and Austria (another net exporter) are already cutting back their deficits, Austria via higher taxes. We see Ireland, Spain, Greece and Portugal doing ‘austerity’ measures to rein in government deficits too. Meanwhile, having seen the financial sector balances chart, you know that austerity means higher debt burdens in those countries, but also lower exports in Germany, which is also cutting back its own Government spending. So, austerity not only kills the Spanish economy and makes it prone to a debt deflation scenario, it also hurts the German export economy while they themselves are cutting back on government deficits.

What you have here is a perfect recipe for a double dip and a serious economic nightmare.  Unless Germany can get its consumers to start spending more, the Eurozone is going to double dip.

Source

Germany’s eurozone crisis nightmare – Martin Wolf, FT

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Ann Lee and Dan Alpert joined Bloomberg’s Pimm Fox today to talk about the housing market recovery. Lee, a professor of finance at New York University, was sceptical that population growth predicts any substantial increase in housing transactions and prices simply due to the continued pressure on wages and disposable income. and Dan Alpert, managing director at Westwood Capital LLC, said we are not looking at market-clearing prices in the near-term because home ownership percentages need to drop. This process will take two to two and a half years in his view.

Short clip below.

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You!

Hat tip Prieur du Plessis.

Source

Dave Granlund, Comics.com

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According to Bundesbank President Axel Weber, Germany’s economic recovery is “essentially intact”, and is now set to benefit from stronger demand in countries outside the euro region.

“I firmly believe that the recovery process that began in summer 2009 is essentially intact, and that it will continue despite the slower growth dynamic in the winter semester. An additional factor in this context is that the German labor market continues to be in extremely robust shape.”

What exactly it means to say that an economy is intact we will explore below, but it is clear that some confirmation for the view that the German economy is benefiting from increased demand originating outside the Eurozone can be found in the latest press release on manufacturing industry turnover from the Federal Statistics Office, where they note that while January’s manufacturing sector turnover surpassed that of January 2009 – by a working day adjusted 2.6% – domestic sales actually fell (by 1.1%), and export turnover rose by 7.3%. Most interestingly, as between destinations, sales to euro area countries only increased by 2.4%, while those to other foreign countries were up 12.0%. This illustrates two points: that the German economy is now more dependent than ever on exports, and that sales to emerging markets are what is really driving export growth at this point. This latter development is hardly surprising given the strong fiscal corrections being applied in many of Germany’s former customer countries.

In fact, while German industry is surely now in "recovery mode", the process is something of a stop-start one (see chart below), since even though according to the latest data from the technology ministry output was up by an estimated 0.6% in January over December (and even up by 2.2% over the very low level hit in January last year) it is still down by 18.5% over the March 2008 peak.

More Export Dependent Than Ever

Still the story of the German economy remains very much one of a tale of two components, with net trade offering some relief to pretty negative domestic demand data. According to the Federal Statistical Office, German gross domestic product stagnated in the fourth quarter of 2009, remaining unchanged from the level of the previous quarter level(0.0% change). Thus the slight upward trend noted during the second (+0.4%) and third quarters of 2009 (+0.7%) did not continue.

GDP from October to December was down by 1.7% on a year earlier. The decrease, which was smaller than in the previous quarters of 2009 still meant that German GDP fell by 5% in 2009 as a whole when compared with 2008.

Economic growth in the fourth quarter of 2009 was, in fact, only really supported by foreign trade: exports rose 3.0% on the previous quarter, while imports decreased 1.8%.

The resulting balance of exports and imports contributed 2.0 percentage points to GDP growth. That positive contribution was, however, entirely offset by a fall of 2 percentage points in total domestic demand (including inventory movements). Both household consumption expenditure and gross fixed capital formation exerted a negative impact on growth.

Final private consumption expenditure fell by 1.0% shaving 0.6 percentage points from headline GDP growth.

Interestingly German wage rates rose (see chart below) in the second half of 2009 (although due to significant quantities of short time working, gross wages were more or less stationary), but even this surge seems to have had little in the way of positive impact on consumption.

Gross fixed capital formation fell back, and was down by 0.5% (spending on machinery and equipment fell by 1.5%).

In addition the German government started to rein in spending (after many quarters of significant support) following the election, and government final consumption expenditure fell by 0.6%.

So We Are Back To Inventories

In fact however, the biggest drop in domestic demand did not come from household spending, or from fixed capital investment, or from government consumption: it came from movement in inventories. Inventories were cut back sharply again during the quarter, and made a negative contribution to growth of 1.2 percentage points (out of the 2 percentage point negative contribution from domestic demand as a whole). This drop followed a considerable increase in inventories in the third quarter, whereby they contributed 1.5 percentage to growth.

Now, I think I am beginning to discern a pattern in these large swings in trade and inventories which characterise German GDP movements. Basically, it is important to keep in mind the East European component in German manufacturing (Hans Werner Sinn’s Bazaar – not bizarre – economy idea). Basically a significant part of German exports are assembled products put together from materials manufactured in the East (a process which Delia Marin suggestively calls Maquilladores in reverse), and thus there may well be a correlation between high imports in one quarter (based on anticipated demand) and rising inventories (and falling imports) in the subsequent one as demand expectations systematically fail to be achieved (the excessive business expectations factor). Let’s see.

Below you will find three charts summarising movements in the key components of German GDP during the last three quarters of 2009. In Q2, as you will see, trade is up (as exports rise much faster than imports), while inventories are down, as accumulated stocks are exported.

The in Q3 we see the opposite phenomenon, as inventories pile up, as imports surge without the expected growth in exports.

Then finally we have Q4, and the opposite happens again, imports fall, exports rise, net trade is a growth positive, and inventories are cut back. In each case the other components of growth are rather insignificant, and have in fact weakened as the recession has progressed – I hope this is not what Axel Weber means by saying that the German economy has survived the recession "intact" (namely that it is as export dependent now as ever it was).

Well, this is only a hypothesis. But if the hypothesis has any validity we should be able to make some predictions on the basis of it. I would make two.

Firstly, since East Europe’s economies are often dependent for their growth on exports to the West, and in particular to Germany, then we should be able to see some "shadow" of this German process cast out into the East.

In the second place, we should see the process continue to some extent in Q1 2010. That is, based on what we have seen so far, in Q1 imports should rise, as industrial output in the early parts of the supply chain surges, and net trade should as a consequence be less positive than in Q4 2009. On the other hand, all the imported components awaiting processing should make inventories rise. So that’s a prediction. Now we need to wait and see how good it is.

But on the upstream components, maybe we can learn something from the East. Let’s start with Hungary, which has Germany as its largest single customer, and the manufacturing Purchasing Manager’s Index (PMI).

Well, basically if we think about the fact that German inventories were run down in Q4 last year, and imports slumped, then it is interesting to note that Hungarian manufacturing, after improving steadily during the earlier part of the year (barring August), slumped back again in the three months from October to December.

If we also look at Czech industry, a similar sort of picture emerges – stagnation in Q4 2009, and a surge in activity in this quarter.

When we come to Poland things are rather different, since the Polish economy have vibrant autonomous demand, so the Polish industrial sector has local market growth to give some impetus, but things did taper off a bit in Q4, and they have now rebounded.

So What Does "Intact" Really Mean In The German Case?

So, to come back to Axel Weber’s point, I fear intact does mean "business as usual".

Certainly, if we look at the most recent manufacturing PMI, the pace of expansion has improved slightly over the previous quarter, which may mean that those good old inventories are simply piling up again.

While the services element has, if anything, lost momentum over Q4.

Bad weather seems to have sent construction falling off a cliff – falling an estimated 14.3% in January:

And the February construction PMI looks even worse, with the indicator showing the worst decline in activity since the survey was introduced in September 1999.

Poor weather conditions continued to have a negative impact upon the construction sector in February. Anecdotal evidence pointed to widespread weather disruptions, alongside relatively weak underlying demand. As a result, the headline seasonally adjusted Construction Purchasing Managers’ Index – a single-figure snapshot of overall activity in the construction economy – fell sharply from 40.2 in January to 28.9 in February. This was the lowest reading in the survey’s ten-and-a-half year history.

Consumer and business confidence readings are faltering:

Retail sales have been in serial decline since the VAT increase in January 2007.

And the February retail PMI showed another sharp contraction, although again, weather conditions do seem to have played a part.

Retail sales in Germany declined sharply on a month-on-month basis in February. At 42.1, down from 42.7 in January, the seasonally adjusted Retail PMI was below the 50.0 no-change threshold, continuing the trend observed since June 2008.The latest reading pointed to the sharpest rate of contraction since January 2009, which survey respondents linked to a combination of bad weather and unfavourable economic conditions. A post-scrappage scheme downturn in demand for new cars was also cited by those in the automobiles sector.

So, to conclude where we started, we can well agree with Axel Weber that the German economy is indeed intact – intact and near stationary. If we look at the composite PMI below (which is the nearest thing we have to a GDP indicator), it does show slight improvement over Q4 2009, but only a very slight one. Given everything I have said above about swings in imports and inventories, I would say German GDP will be very near to stationary again this quarter, with a possible slight upside depending on the inventory swing, but whatever upside we do see will more than likely disappear as quickly as it came when we get to the Q2 2010 data.

Edward Hugh also blogs at Global Economy Matters.

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About a month ago I wrote a post called “The coming wave of second mortgage writedowns” the gist of which was that the big four banks (Citi, JP, BofA, and Wells) had a shed load of exposure to now worthless second mortgages. With many first mortgages now hopelessly underwater, it stands to reason that second mortgages on those same properties have zero value.

The big four are certainly well aware of this problem and are looking for ways to extend the wherewithal of underwater borrowers and pretend they don’t need to take losses on these loans. On paper, these companies are very well capitalized. However, in the real world, the likely losses they must eventually take on loans already on their books would probably render them insolvent. This is what I hinted yesterday in my post on the stress tests.

I said:

I would say the stress tests were a mock exercise to instil confidence in the capital markets. This was important first and foremost because it would induce private investors to pay for bank recapitalization instead of taxpayers. But it was also important for the economy as a whole as the sick banking sector was dragging the whole economy down. The key, however, is that the tests were a mock exercise. Despite the additional capital, banks are still hiding hundreds of billions of dollars in losses in level three, hold to maturity, and off balance sheet asset pools. If asset prices fall and/or the economy weakens, all of this subterfuge would be for nought.

-Geithner: jusqu’ici tout va bien

And when I use the phrase ‘mock exercise,’ by mock, I mean fake. Mike Konczal has done a remarkable job of putting these two concepts – the worthless second mortgages and the stress tests – together.

He writes in a recent post:

Let’s talk specifics: Last June I made a DIY Stress Test, using values reversed-engineered from the public documents, where you could play around with the values online or download an excel spreadsheet yourself (it’s still one of my favorite blogging items). The backbone of the overview of results, page 9 from the Federal Reserve’s document, looks like this:

I’m going to isolate the four largest banks Frank questioned about second-liens, along with their loses as they’ve legally sworn to being accurate during the stress test:

Again, this is data as reported to the government by the major banks during the stress test of 2009. So what’s going on here? The four major banks have about $477 billion in junior liens, either in the form of a second mortgage or a home equity line of credit. If you go to the Fed Funds data online, you’d see that there’s about a trillion dollars of 2nd/Juniors out there, so the four major players have about half the market.

The four major players each report that they expect to have a 13-14% loss on these items under an “adverse scenario”, with Citi reporting a 20% loss under an adverse scenario. That means of the $477bn, $68.4 bn is junk that’ll never be collected on. This, combined with all the other expected losses (see the link to the stress test for the rest) meant that the four biggest players needed around $53bn to be raised.

Notice how Frank’s letter, and pretty much anyone you’d speak to who isn’t working for the four largest banks, assume that second liens in the country aren’t worth 86% of their value (for a 14% loss). You see in Frank’s letter “no economic value.” Huh. Well, that’s a problem.

Let’s look at these values again, assuming that the expected total loss would be 40%, and then 60%.

So the original loss from second-liens, as reported by the stress tests, was $68.4 billion for the four largest banks. If you look at those numbers again, and assume a loss of 40% to 60%, numbers that are not absurd by any means, you suddenly are talking a loss of between $190 billion and $285 billion. Which means if the stress tests were done with terrible 2nd lien performance in mind, there would have been an extra $150 billion dollar hole in the balance sheet of the four largest banks. Major action would have been taken against the four largest banks if this was the case.

See what I mean by fake?  The point is this whole charade is transparent to anyone who actually runs the numbers. Yet, you have people like John Cassidy spreading disinformation in the New Yorker, writing puff pieces of zero negative value with drivel like this:

Other critics dismissed the tests as a sham, arguing that the economic assumptions underpinning them were too benign. As the tests unfolded, however, it became evident that the government’s loss projections were quite high, and that many banks would be forced to raise considerable sums of money—in some cases, more than ten billion dollars.

Baloney. Run the numbers like Mike did, John; and then you wouldn’t make such asinine comments. Of course the stress tests were a sham.  They were a confidence trick to raise more capital and buy time for the banks to earn yet more still. The point was to allow the banks to ease into their losses. And that’s exactly what’s been happening for the past year.

The problem with the stress tests, however, is they gave the banks a way to get from under the yoke of the government’s TARP program. The banks said, “look, we are now well-capitalized even in the worst case scenario of the stress test. We want out of TARP.”

This is bad for three reasons.

• The big banks all paid back $25 billion in TARP funds. Smaller banks like Northern Trust paid back $10 billion or less. That’s hundreds of billions of capital that they all could have as a buffer against losses. Some of them raised additional capital to replenish the coffers. Nevertheless, net-net, we had less banking capital in the system after the repayments than before.
• Banks free of TARP paid out a lot of cash in bonuses that could have gone to shoring up their capital base.  Every dollar paid in cash compensation to staff is a dollar less of capital.  Had these banks been under TARP, they would have been forced to pay lower bonuses – if only for this year.
• The lower capital – and the fact that banks know that having renewed capital problems would mean the end of the line for them – means that banks are less likely to lend freely.  They understand that now is the time to husband capital. Heads would roll if a big bank or super regional which had repaid TARP had another capital shortfall.

The real question is: why is the Obama Administration running victory laps, unrolling the ‘Mission Accomplished’ banner on the credit crisis, as Mike Konczal describes it? I suspect this is just a political stunt to provide cover in the mid-term elections to somehow demonstrate that the Democrats fixed the problem which the Republicans created. 

I think it could backfire if only because the underemployment rate is still 17%. Nobody wants to hear the “I saved the economy routine” when they’re unemployed and losing their home.

Related posts:

• Black: Stress tests and the Big Lie
• At least six banks need more capital under stress tests
• The coming wave of second mortgage writedowns
• Bank by bank breakdown of stress test results
• Saturday Night Live Grades the Stress Tests

I almost have to laugh at this. But, a proposal is afoot to require all employed persons in America submit biometric data as a control against illegal immigrants. This is part of an Immigration Bill now wending its way though the Senate.

The Wall Street Journal writes ID Card for Workers Is at Center of Immigration Plan:

Lawmakers working to craft a new comprehensive immigration bill have settled on a way to prevent employers from hiring illegal immigrants: a national biometric identification card all American workers would eventually be required to obtain.

Under the potentially controversial plan still taking shape in the Senate, all legal U.S. workers, including citizens and immigrants, would be issued an ID card with embedded information, such as fingerprints, to tie the card to the worker.

The ID card plan is one of several steps advocates of an immigration overhaul are taking to address concerns that have defeated similar bills in the past.

The uphill effort to pass a bill is being led by Sens. Chuck Schumer (D., N.Y.) and Lindsey Graham (R., S.C.), who plan to meet with President Barack Obama as soon as this week to update him on their work. An administration official said the White House had no position on the biometric card.

"It’s the nub of solving the immigration dilemma politically speaking," Mr. Schumer said in an interview. The card, he said, would directly answer concerns that after legislation is signed, another wave of illegal immigrants would arrive. "If you say they can’t get a job when they come here, you’ll stop it."

Wow. Who said you couldn’t get bipartisan efforts into Congress. Good thing the Ministry of Truth has authorized me to inform you that data from this national database will be used only to police immigration. As I said, I almost have to laugh at this.

It’s stuff like this that rightly imbues the citizenry with a certain knee-jerk distrust of government.

No related posts.

This 30 Rock parody almost has it down.

No related posts.

This is the fifth in a series of posts about ideas for financial reform generated by the “Make Markets Be Markets” conference I attended yesterday in New York City on 3 Mar 2010. You can download all of the written presentations here.

Let’s talk about regulatory capture and financial reform for a few minutes. Arnold Kling has an interesting take on last week’s conference. He wasn’t there, but did see the videos online.  In a recent post, he says:

What is ironic to me is that the Roosevelt Institute people can cite clear evidence of government failure while proposing more government. For example, Richard Cornell points out that bank soundness regulators have every incentive to be lax until it is too late, yet his proposed solution is to consolidate bank regulation. Cornell begins his talk by listing comic book characters who never seem to learn (Charlie Brown, Wylie Coyote). In my opinion, he could be talking about policy wonks who think that regulation can be reformed so that special interests can be curbed and regulators will act wisely.

In selective cases, and without consciously realizing it, these folks apply public choice theory. But they assume it away when making their proposals.

I think he makes a good point here. He’s saying in effect that many regulators are captured by the industries they are supposed to regulate. Everyone knows this – and many of the Roosevelt Institute presentations point this out. Yet, those very same presenters seem to think the solution is to just get different regulators who aren’t captured or change the structure of who does the regulating.  Kling is suggesting that doesn’t work. If market failure is what caused the credit crisis to spiral out of control, you’re just replacing market failure with regulatory failure.

So, how do we deal with this problem? 

Self-regulation. The ivory tower libertarian solution would be to de-regulate i.e. reduce regulatory oversight and permit self-regulation to rule the roost. I liken this to having citizen police officers (with guns) to police criminals. If an individual is caught stealing a car, the self-regulating community can apprehend the criminal and let the court system adjudicate his sentence. Quite frankly, I think this solution is nuts. This is the Libertarian paradise in Somalia – and it’s called anarchy. Moreover, it assumes the economy tends to equilibrium i.e. when a large bankruptcy disrupts the economy, eventually things will right themselves. This is a false neo-classical assumption.

Trust but verify. A better approach would be to operate a two-stage system that I will call “trust but verify.” Judge Stanley Sporkin was right when he voiced his frustration in Q&A at the end of the conference that you can’t have a good regulatory system without regulators who actually regulate. So, I agree with him that stage one is filling regulatory seats with real regulators, rather than anti-regulators like Alan Greenspan, who believed that markets could self-regulate fraud. But that still leaves you with a potential that those same regulators could be captured or that at a later date different regulators could be captured.

As a result, you need a second fallback mechanism. It’s called bankruptcy.  The problem with having let Lehman Brothers fail was not that it failed, but that a mechanism was not in place to limit the damage of that failure. Of course, Lehman should have been bankrupted. That’s the price you pay in a capitalist society for failure – and it’s the reason we have bankruptcy laws. Now, for most firms, bankruptcy is not destabilizing to the entire national or global economy. However, large financial companies like Fannie Mae, Freddie Mac, Citigroup, AIG, and Bank of America are too big to fail (TBTF). We have to deal with this problem by breaking them up – or in the case of Fannie and Freddie, eliminating them. If you have another solution i.e. a failsafe TBTF resolution mechanism, please chime in.

So, I say install the right people as regulator and trust the regulator to her job. But verify that the job is being done by first allowing firms to fail and then replacing incompetent regulators.

Related posts:

• Mark to market is beside the point
• The failure to address the looming too-big-to-fail issue
• Jamie Dimon makes the best case for not breaking up banks
• Bill Black and The Federal Reserve’s War Against Effective Regulation
• The FSA signals a need for regulation-heavy

We have a bit of a divide developing between the EU and the U.S. on banking and bank reform. The most significant move in this tiff has come in retaliation for Wall Street’s role in helping countries like Greece hide their debt burdens. According to the Guardian newspaper, all American banks have been shut out of the sovereign bond market in Europe. While many might think the U.S. government does not have a role to play in this dispute, I know from my own experience as a diplomat that the U.S. government is very aggressive about advocating for U.S. firms abroad.

The Guardian says:

European countries are blocking Wall Street banks from lucrative deals to sell government debt worth hundreds of billions of euros in retaliation for their role in the credit crunch.

For the first time in five years, no big US investment bank appears among the top nine sovereign bond bookrunners in Europe, according to Dealogic data compiled for the Guardian. Only Morgan Stanley ranks at number 10.

Goldman Sachs doesn’t make the table. Goldman made it to number five last year and in 2006, and number eight in 2007, the data shows. JP Morgan was in the top ten last year and in 2007 and 2006 but doesn’t appear this year.

"Governments do not have the confidence that the excessive risk-taking culture of the big Wall Street banks has changed and they still cannot be trusted to put the stability of the financial system before profit," said Arlene McCarthy, vice chair of the European parliament’s economic and monetary affairs committee. "It is no surprise therefore that governments are reluctant to do business with banks that have failed to learn the lesson of the crisis. The banks need to acknowledge the mistakes that were made and behave in an ethical way to regain the trust and confidence of governments."

European sovereign bond league tables are now dominated by European banks such as Barclays Capital, Deutsche Bank, and Société Générale, the Dealogic table shows. Their business model is usually seen as more relationship-based, while US investment banks have traditionally been focused on immediate deal-making.

Being left out of government bond sales means missing out on one of the top fee-earning opportunities this year, given the relative drought in mergers and acquisitions and stock market flotations. Western European governments need to raise an estimated half a trillion dollars this year to refinance debts and pay for bank bailouts and rising unemployment.

I would expect the U.S. bank lobby to pressure the Obama Administration into developing demarche communiqués at the State and Commerce Departments condemning this as a protectionist move. This is the type of work that State and Commerce does regularly on behalf of companies like Chiquita Brands International. The bank lobby is much more powerful. So, one should expect this to rise to an Ambassador-level talking point.

But apart from American firms being shut out of European sovereign debt deals, there are a lot of other ideas in the hopper which indicate an increasing friction between Europe and the United States on bank reform. Obama proposed a $117 billion bank levy (the so-called “financial crisis responsibility fee”) which is to tax banks in order to pay back taxpayers for the bailout he and President Bush conducted. European leaders have been cool to this plan. Obama received support from Bank of England Governor Mervyn King on the issue of banning proprietary trading under the Volcker rule. But, on other meaningful banking sector reforms, there has been little agreement.

Moreover, an influential German politician has floated a contentious idea for a European Monetary Fund to replicate the functions of the International Monetary Fund. The fund proposal is an implicit recognition that the IMF would be a palatable option for a workout of the Greek sovereign debt crisis if not for American influence and control at the IMF. This idea has been panned by other leading German political figures. However, German Chancellor Merkel has some praise for it. The fact that plans for an EMF are proceeding despite its irrelevance to the current debt crisis in Europe tells you that it is a political move to gain independence from the IMF.

On the surface, relations between Europe and the U.S. appear to be mostly harmonious. However, recent developments demonstrate a significant divide on finance and banking between the U.S. and Europe. To date, President Obama’s popularity in Europe has not translated into any substantive trans-Atlantic initiatives, at least on the banking and finance front. And judging from this anti-Wall Street move, I don’t imagine it will anytime soon.

The interesting bit is how much of this is just politics.  In the Greek case, up to fifteen banks may have helped Greece hide debt. Yet, the focus here is on Wall Street firms – I suspect purely for demagoguery. Should we expect a tit-for-tat move of some sort?

Stay tuned.

Sources

Europe bars Wall Street banks from government bond sales – Guardian

Bananas and ‘1992′: the Battle to Preserve Protected Trade from the Caribbean – Trocaire

Related posts:

• The Europeanisation of the Credit Crisis
• Will we have to blow up a continent (again) before we stop Wall Street?
• Rumours, Rumours, and No Greek Bond Sales To China
• Chandler: Uncertainty and contagion at work with Greece
• Spain can’t sell its bonds

Highlights

The US dollar and yen are trading with a firmer tone against the major and emerging market currencies.  But the markets still appear to be consolidating and we expect the “rule of alternation” to remain in play meaning that the top side of the euro’s range was tested yesterday and the bottom side around $1.3500 is likely to be tested today in the absence of any key news.  The pound has been rocked by weak data (retail sales, housing data and a worse than expected trade deficit despite the pound’s slide in recent months) and another warning from Fitch that the country is not moving fast enough to address its structural imbalances.  (Fitch also warned Portugal and Spain to put their houses in order.)  That said, the pound is oversold around the $1.4940 support area and amidst talk of M&A related demand for pounds against the Scandinavian currencies.  The Swedish krona is now the worst performer on the day amidst cross related selling and after Moody’s warned the outlook for the Swedish banking system is improving but remains negative. 

Global equity markets are mixed.  The MSCI Asia-Pacific index was barely changed, gaining just 0.1% after reaching a six-week high yesterday.  Japan’s Nikkei was also relatively unchanged, down just 0.2%.  Materials related shares were amongst the hardest hit as gold slipped after China’s Yi Gang, the Director of SAFE, said gold was unlikely to become a primary investment for China’s reserves but noted that given the size of the country’s reserves, the US Treasury market is “an important one to [China]”.  The comments are not overly surprising despite recent rumors China could buy gold from the IMF.  China’s gold holdings make up a very small proportion of the country’s almost $3 tln of reserves.   European bourses have given up early gains with the key bourses down about -0.7% while early indications suggest US markets may open lower.

Global sovereign bonds are firmer.  In Europe, the German and French 10-year bond yields are down 4 bp.  The comparable Greek yield is down 5 bp despite differences of opinion over the German Finance Minister’s proposal yesterday to establish a European Monetary Fund with some officials unwilling to change the rules at this juncture.  That suggests formation of an EMF would come too late to help address current problems in the euro area.  Spanish and Portuguese yields are flat with Fitch warning of a downgrade in Portugal if consolidation is insufficient and that Spain is vulnerable given an inflexible labor market that could prolong a recovery and reduce tax revenue.  At the same time, Fitch said a European sovereign default would not cause a break-up of the euro zone and said the US had no short or medium term problems.  US 10-year Treasury yields are down 4 bp.

Currency Markets

Sterling has come under renewed pressure after a mini perfect storm consisting of weaker than expected data (retail sales, housing and trade), new opinion polls and further warnings from Fitch and Moody’s.  Fitch indicated the UK has a serious row to hoe and that the authorities are not moving fast enough in addressing the deficit.  Last week, Fitch warned the UK is the most vulnerable of the AAA rated countries to financial crisis and should trim its budget deficit more sharply in the next four years.  Today’s warning from Moody’s focused on the UK banks and lenders.  Moody’s said those lenders that have not improved their financial position could be downgraded as government support is withdrawn.  The rating agency had taken the UK government’s GBP1 tln ($1.5 tln) of assistance into account in rating banks but will cease this practice as the money is withdrawn.  The announcements came after the UK released a much weaker than expected housing report from RICs (with real estate agents saying house prices had risen vs. those saying they fell at 17%, vs. 30% exp and down from 31% in Jan) and Feb BRC retail sales monitor confirming a sluggish consumer sector (up 2.2% y/y but from an extremely low Jan 09 base, so far from impressive.)  That was coupled with a widening of the trade deficit despite the weakness of the pound.  The deficit was £7.98bn in Jan (vs -£7bn previously and vs -£7bn expected) while the non-EU trade gap widened to -£3.8bn (from -£2.6bn). This was the worse trade performance since Aug 08 and resulted from a 6.7% monthly drop in exports while imports were down 1.6%. The slump in exports is disappointing at a time of sterling weakness but one should not forget that the UK main trading partner (the euro zone) recovery is extremely sluggish and a weaker currency will do little in the near-term if external demand is very weak to start with. Coupled with the negative adverse effects that the poor Q110 weather will have on GDP growth, the highly disappointing trade figures underline a further drag on economic activity.  It looks increasingly likely that Q1 GDP (due on April 23rd) will be very weak – an unfortunate timing for Chancellor Brown ahead of the May 6th general elections. In this context, some would argue that the case to call the elections before April 23rd is growing by the day.  Note that the most recent Populus poll of 100 key seats shows both Labour and the Tories at 38%.  On the downside for PM Brown, a YouGov poll puts the Tories at 39% with Labour at 34% while the LibDems, which according to leader Clegg, won’t form a coalition with Labour if Brown runs the party, have 16%.  

The Federal Reserve continued its slow but steady march preparing the normalization of monetary policy.  Yesterday, it announced it would expand the counterparties it would use for the reverse repos (which are one of the tools the Fed has indicated it will use to neutralize the excess reserves before it raises rates) to include large money market mutual funds.  Usually the Fed’s activity is focused on the primary dealer community.  Like the earlier steps, there is no policy implication per se, but taken together, would seem to reflect a central bank committed to this process and continuing to "get its ducks lined up" so that it is prepared for the eventual rate hike.  The Fed also indicated that it would use a range of instruments in its reverse repo operations, including Treasuries of course, but also mortgage-backed securities and agency bonds.  Several large money market mutual funds seemed eager to participate, according to news wire accounts.   The Fed’s long-term asset purchase program winds down this month.  It is interesting to note that despite the supply and the absence of the Fed’s buying, the US 10-year yield is off 15 bp this year.  And even though the Fed’s buying of agency securities has slowed, the yields on Fannie Mae and Freddie Mac mortgage securities appears to be the tightest on record compared to Treasuries.

Upcoming Economic Releases

There are no key US or Canadian data releases today.  The Fed’s Evans speaks at 9:30AM EDT/14:30 GMT.

—————————

The preceding is a post by Marc Chandler, global head of Brown Brother Harriman’s top ranked Currency Strategy Team. For more of BBH’s currency views, please visit the BBH FX website here.

This material has been prepared by Brown Brothers Harriman & Co. (“BBH”) and is intended for information purposes only.  This communication should not be relied upon as financial, investment, tax or legal advice.  This communication should not be construed as a recommendation to invest or not to invest in any country or to undertake any specific position or transaction in any currency.  This information may not be suitable for all investors depending on their financial sophistication and investment objectives.  The services of an appropriate professional should be sought in connection with such matters.  The information contained herein has been obtained from sources believed to be reliable, but is not necessarily complete in its accuracy and cannot be guaranteed. Sources used are available upon request. Any opinions expressed are subject to change without notice. Please contact your BBH representative for additional information. BBH’s partners and employees may own currencies in the subject of this communication and/or may make purchases or sales while this communication is in circulation.

Related posts:

• A strong dollar, euro downside and a gold liquidation panic
• Euro Drivers
• Beijing is not Washington’s banker
• Why the euro gets weaker when national governments deficit spend
• The Pound Suffers while Asian Currencies Gain

Related posts:

• China is now on the same bubble path as Japan post-1987 crash
• Links: 2010-02-28 – CRE meltdown in DC, emigration from Ireland and more
• Links: 2010-03-07 – Comparing job losses, China’s workers and more
• Links: 2010-03-05 – Debtflation, the role of government, and lessons from Japan
• Links: 2010-02-17 – Bubbles, Greece, Irish banks and Japanese consumers

This is the fourth in a series of posts about ideas for financial reform generated by the “Make Markets Be Markets” conference I attended yesterday in New York City on 3 Mar 2010. You can download all of the written presentations here.

Dylan Ratigan was at last week’s meeting on financial reform – and he thinks the joke is clearly on us because bankers are laughing all the way to the… you know where. Below is his take on the meeting with comments from Josh Rosner and Rob Johnson.

Related posts:

• Ratigan: Geithner and Summers as O.J. Simpson
• Conference on financial reform: Make Markets Be Markets
• Make Markets Be Markets: The Report
• Obama caves to pressure on consumer financial protection
• Rosner: Financial Stability Act “single worst not-yet passed piece of legislation”

The car went to speeds over 90 MPH. This can’t be good. Watch Toyota shares fall.

No related posts.

No related posts.

As a departure from my recent rants on the economy, I offer you this:

Related posts:

• ‘Slumdog’ cleans up at the Oscars
• News from around the web: 2009-07-31
• Links: 2010-01-29
• Financial News: 2010-01-03
• Links: 2010-01-04

I know I shouldn’t beat this dead horse but I can’t help myself. Just this past Friday, when describing Andy Xie’s hopeful tone in sensing a change of the short-sighted and ruinous mindset that was driving policy makers in the U.S., I wrote:

I am glad he is hopeful that Obama sees the folly in more bailouts and malinvestment. Perhaps he is on to something.  However, I do not expect the mindset to change whatsoever. Bank profits are back at record levels and the worst of the panic is now over. You don’t get a change in mindset in that environment. More likely, you get a victory lap.

-The mindset will not change; a depressionary relapse may be coming

 

And almost on cue we have two pieces on Tim Geithner which are clearly victory laps by the Obama Administration.  In the Atlantic’s piece, we learn:

[The Clinton folks running things in Obama’s White House] see themselves as an elite corps, bound by the common experience of having battled the crises of the 1990s and mostly prevailed. They share the belief that a potent combination of speed, force, and nerve—a buccaneering willingness to cast aside doubt, seize the levers of government, and apply its full power—can halt financial panics. They also believe that governments typically do too little to respond, rather than too much, and pay a steep price for it. Applying this formula is what Geithner has been doing in the biggest crisis since the Great Depression. Other Obama officials share this outlook, notably Summers, who now directs the National Economic Council. But the faith runs purest in Geithner.

From Geithner’s perspective, this approach is the surest, cheapest, and least destructive way to save an economy in danger of collapse.

While written in the present tense, you almost can hear Geithner speaking of the credit crisis and economic destruction it wrought in the past tense.

Hello? Have you noticed the 17% underemployment and record foreclosures?  Oh yes, those. That’s the cost of doing the right things that are also “deeply unpopular, deeply hard to understand.” The cost:

is that it is galling to the public. It requires abstaining from moral judgments and pumping tax dollars into the same institutions that inflicted the pain, as part of an all-hands-on-deck effort to restore economic confidence. This has had the politically deleterious effect on the administration, and especially on Geithner, of appearing to routinely submit to Wall Street. It’s what lies behind the public’s anger, the feeling that some fundamental injustice is being allowed to perpetuate itself—a sentiment that violently upended the Obama agenda in January, when the Massachusetts Republican Scott Brown won the special Senate election to replace Ted Kennedy. Brown’s victory immediately derailed Obama’s signature initiative, health-care reform. But his win was widely interpreted as an expression of anger at the White House for its handling of the economy, and particularly of Wall Street.

The Atlantic points out that Geithner does not represent change you can believe in. And says:

The fact that most of the bailouts driving this anger occurred under George W. Bush has been easy to overlook, in part because Geithner is the most visible constant between the two administrations. At every stage, he has been central to the crisis—during the initial response, the design of the recovery plan, and the effort to devise new rules. “During the Bush administration,” Keith Hennessey, a former director of Bush’s National Economic Council, told me, “you basically had three people who were the core in making the policy recommendations to the president and implementing them. And they were Hank Paulson, Ben Bernanke, and Tim Geithner. Now it’s Larry, Ben, and Tim, and Tim has moved chairs. What this means is that two-thirds of the core policy group is unchanged from Bush to Obama. The Obama political and communications operations have always wanted to emphasize just how different and transformative the Obama solutions are, relative to the Bush people who—they claim—left them this enormous problem. The reality is, there is remarkable continuity, from a personnel standpoint and a policy standpoint, in what’s being done.”

This is a fairly even-handed piece that paints Geithner as a well-meaning man who is a product of the system we witnessed bringing the world to its knees.

On the other hand, a New Yorker article is an out and out puff piece titled “No Credit” that Timothy Geithner himself could have written.  Don’t be fooled; this is a clear plant to help bolster public opinion for a bailout and transfer of wealth, which was both unnecessary and politically damaging.

Let me give you a few quotes.  As you read them imagine the Treasury Secretary writing them, reminding himself “I need to plant an even-handed but flattering account of myself” as he does it. I have inserted my own commentary too!

Straw man argument

In the history of product launches, the rollout of the Obama Administration’s plan to stabilize the financial system was in the category of “Ishtar,” smokeless cigarettes, and New Coke. On February 10th of last year, the newly appointed Treasury Secretary, Timothy F. Geithner, appeared in the Treasury’s Cash Room to outline proposals that would relieve banks of toxic assets, force them to undergo stress tests, and provide relief for struggling homeowners. Immediately after Geithner’s speech, the Dow fell sharply, and it closed the day down 382 points. Critics from all quarters dismissed Geithner’s plan as vague and inadequate. “Has Barack Obama’s presidency already failed?” Martin Wolf, the Financial Times’ influential economics commentator, wrote. “In normal times, this would be a ludicrous question. But these are not normal times.”

Those Obama people looked pretty bad at first. I have to admit.

But look at the success

And yet—whisper it softly—there is good news about the financial system and the roundly loathed bank bailout, the seven-hundred-billion-dollar relief package that Congress approved in October, 2008. During the past ten months, U.S. banks have raised more than a hundred and forty billion dollars from investors and increased the reserves they hold to cover unforeseen losses. While many small banks are still in peril, their larger brethren, such as Bank of America, Wells Fargo, and Goldman Sachs, are more strongly capitalized than many of their international competitors, and they have repaid virtually all the money they received from taxpayers. Looking ahead, the Treasury Department estimates the ultimate cost of the financial-rescue package at just a hundred and seventeen billion dollars—and much of that related to propping up General Motors and Chrysler. Barring something unexpected, the bailout will end up costing taxpayers less than the savings-and-loan implosion of the early nineteen-nineties. The government could conceivably end up making money.

$140 billion. That’s a lot of money that didn’t have to come from taxpayers. Gosh, I did not know that. Wow, the Obama Administration really got the job done, didn’t they? But what about the Bushies?

The Bushies were horrible

When President Obama came to office, the Bush Administration had already committed two hundred and thirty billion dollars of taxpayers’ money to big banks—a policy that Geithner, as president of the New York Federal Reserve Bank, helped to enact. During the transition, he warned the incoming President that more “repugnant” actions would be necessary to shore up the financial system and restore economic growth. (In the first three months of 2009, G.D.P. declined at an annual rate of 6.4 per cent.) “We knew it would be politically costly, but not nearly as costly as if we hadn’t got it right,” Geithner said to me of the financial stabilization plan. “And we didn’t think we had other options available that were credible.

Wow, yet more I didn’t know. I thought the second AIG, Bank of America and Citigroup bailouts were done by Obama. I though the PPIP was an Obama program too. This is a lot different than the Atlantic account where Ben, Tim and Hank turn into Ben, Tim and Larry. I’m glad I’ve got it straight now – Bush bad, Obama good.

We were tough but fair

Other critics dismissed the tests as a sham, arguing that the economic assumptions underpinning them were too benign. As the tests unfolded, however, it became evident that the government’s loss projections were quite high, and that many banks would be forced to raise considerable sums of money—in some cases, more than ten billion dollars. “When people did the math, they said, ‘This is for real,’ ” Mark Zandi, the chief economist and co-founder of Moody’s Analytics, recalled. “That went for the banks, too. They complained that they didn’t need to raise all of this capital.”

In fact, some commentators agreed that the Treasury and the Fed were being too tough on banks.

Yep. The banks didn’t like the tough cop on the beat bit one bit. We sure showed them! That’s why we allowed them to exit TARP, no strings attached – and pay record bonuses too.

Back on Earth

Can I run my Jack Nicholson clip again, please?

Secretary, I have just one more question. If you gave an order that the economy wasn’t to be touched and your orders are always followed, then why would the economy be in danger?

I want the truth!

Geithner: You can’t handle the truth!

I have a greater responsibility than you can possibly fathom. You weep for the unemployed, you curse the U.S. Government. You have that luxury. You have the luxury of not knowing what I know – that the bailout, while tragic, probably saved lives. And, my existence, while grotesque and incomprehensible to you, saves lives.

I have neither the time nor the inclination to explain myself to a man who rises and sleeps under the blanket of the very freedom that I provide and then questions the manner in which I provide it.

Did you order the Code Red?

You’re goddamn right I did.

Sources

No Credit – The New Yorker

Timothy Geithner: Inside Man – The Atlantic

Related posts:

• Did Brown’s win spark Obama’s war on Wall Street?
• Volcker: ‘I wasn’t persuasive enough’ for Obama to heed my economic advice
• The less optimistic view of Treasury’s handling of the crisis
• Greenspan: “If they’re too big to fail, they’re too big”
• U.S. forfeiting billions in future taxes to let Citi repay TARP

Related posts:

• Canadian housing bubble
• Links: 2010-03-10 – Mortgage writedowns, bank levies, gold bubble and more
• Links: 2010-02-19 – Canadian housing bubble, Brazilian bonds and more
• Links: 2010-02-18 – fallacies of composition, housing bubbles, taxes and more
• Links: 2010-02-17 – Bubbles, Greece, Irish banks and Japanese consumers

You remember those stress tests the government conducted at the largest too-big-to-fail financial institutions. They have long since been forgotten. But, they are a relevant topic of conversation because some of the policy makers’ thinking in administering them of has come to light in the Atlantic’s recent exposé of Treasury Secretary Geithner. I suggest you read it because it highlights Geithner’s view that the elites’ need to take “deeply unpopular, deeply hard to understand” measures was the only way forward.

How I see the stress tests

Before we get to the Treasury Secretary’s comments, let me remind you of how Credit Writedowns characterized the stress tests last year. Here are a few quotes.

• Meredith Whitney: Regardless of stress tests, banks will still need more capital, 21 Apr 2009 

  The Bloomberg video below makes it seem that Whitney believes the stress tests are a sham. She says the tests are a theoretical exercise whereby banks ask: “what will our earnings power be in two years after we sell off these ‘toxic’ assets?” She goes on to suggest that the answer to this question will be a self-serving, upbeat response not wholly reflective of the real dangers lurking.

  In reality, much more capital is still going to be required.  Some of this will happen via asset sales, as she suggests.  However, one should anticipate a real need for yet more capital still.

• Reinhart: Not everybody can be above-average in stress tests, 22 Apr 2009

  Irrespective of whether one thinks the stress tests used to test the U.S. banking system is a sham (10% unemployment is not a worst-case scenario), the fact of the matter is these tests MUST show some differentiation in order to be credible.  Vincent Reinhart, a former Fed official now at the AEI, makes this case in the video below with Bloomberg News.

  Most of us have fixed on whether the stress tests will be credible or not.  In order to be credible, there will have to be stress test winners and losers. Now, mind you, the government has to be very careful about the stress exercise hurting some institutions, so it will tread carefully. This is very much a political exercise. So, having heard Reinhart voice his view, my question is whether the winners and losers will be picked based on real financial differentiation or based on other more political factors.

• Stress tests reveal Citi and BofA need more capital, but you knew that already, 28 Apr 2009

  It sounds a lot like a test where the student banks who just failed go to the teacher regulator with mommy and daddy bank lobbyists in tow to see if they can get their grades changed higher. See, the stress are just a scheme to make us think the Federal government is actually doing something about the under-capitalized banking system in the U.S.. In reality, the Obama Administration is just buying more time in order to let us grow our way out of this problem.

  According to MIT Professor and former IMF Chief Economist Simon Johnson, this is very nearly what Larry Summers said in a Feb 24th speech at the Inter-American Development Bank…

  Now, Summers and Geithner are not stupid. They do have a backup plan here. As I said in a recent post, not everyone is going to pass, and indeed, some banks have failed. What does that mean? It means these banks will be given some time to come up with the capital necessary to be adequately capitalized. If they cannot do so, the government will have to explore other options. This Plan B could include debt-for-equity swaps, nationalization, and FDIC seizure.

• What the stress tests reveal about Obama’s thinking on banks, 23 May 2009

  The stress tests are seen as the make or break for banks i.e. banks that don’t raise enough capital to meet the TCE requirements will be seized by the FDIC and treated to a BankUnited outcome. So the stress tests tell investors what the likely outcome is to be in regards to nationalization. Translation: if you raise enough capital or are well-capitalized enough already to pass the stress test, we’ll leave you alone. You might even be able to pay back your TARP funds. But, if you can’t make the grade in a few months, you will be seized, cleansed, management thrown out, equity reduced to zero, and we will sell you on to private equity concerns or another bank or chop you up into little pieces. This is the IndyMac/BankUnited solution.  Notice that bondholders did not lose any money here…

  My conclusion from all of this building from March on was that bank shares would pop and I said so in April.  Now, the rally has been way over the top and shares have come under pressure as these companies have gone to market for capital.  However, if writedowns from CRE, Prime and Credit Card loans turn out to be less horrible in Q2 and Q3 as I anticipate, shares can rally again and again.  Note, Meredith Whitney takes the opposite view i.e. that major losses are coming for banks – so I am aware of the other side of this argument.

  I am left concluding that accounting alters behaviour and has an appreciable impact on share prices, especially when it dictates government intervention.  This is why mark-to-market, tangible common equity, and the stress tests are all significant for the financial services industry.

If I had to summarize these thoughts I would say the stress tests were a mock exercise to instil confidence in the capital markets. This was important first and foremost because it would induce private investors to pay for bank recapitalization instead of taxpayers. But it was also important for the economy as a whole as the sick banking sector was dragging the whole economy down. The key, however, is that the tests were a mock exercise. Despite the additional capital, banks are still hiding hundreds of billions of dollars in losses in level three, hold to maturity, and off balance sheet asset pools. If asset prices fall and/or the economy weakens, all of this subterfuge would be for nought.

How Timothy Geithner sees the stress tests

I think you’ll find my characterization very much in line with Tim Geithner’s.

Geithner thought the best plan would align three cannons. The first was monetary policy: the Federal Reserve would lower borrowing costs to nearly nothing. The second was fiscal policy, through which massive government outlays—a stimulus—would help fill the gap in private spending. The third was the recapitalization of the financial sector, which meant getting money into banks to help them absorb losses and continue lending…

All of this was textbook crisis response. The daring break from form—really, the plan’s defining feature—lay in where the bulk of the money would come from. History said the answer was government. But there was, theoretically, another option. “The distinction in strategy that we adopted when we came in,” Geithner says, “was to try and maximize the chance that capital needs could be met privately, not publicly”—that investors, rather than taxpayers, could supply the money banks needed. If the plan worked, it could save taxpayers a great deal… The danger, if the plan failed, was that the crisis—and the cost—would escalate, and that the government’s credibility would be shot. It’s a barometer of how uneasy some administration officials were about the plan that they referred to it in the press as the Geithner Plan. If it failed, there’d be no doubting who would get the blame.

The first challenge was to persuade panicked investors, amid what amounted to a run on every bank, to buy shares in any of them. The infamous “stress tests” were designed to accomplish this…

Geithner says he settled on stress tests as the centerpiece of the economic response in December, while sitting on a beach in Mexico. The plan was to force banks to submit to an appraisal of how they’d fare if conditions worsened, and then make a judgment about how much additional capital they’d need. They’d have a chance to raise that money privately. But if they couldn’t, the government would supply it—with all the strings that implied. The gambit was that injecting this new measure of uncertainty would ultimately be helpful. Good results would halt the panic and might lure back investors; bad ones would at least clarify the severity of the crisis. “The basic strategy,” Geithner says, “was to dispel the cloud of uncertainty.” Initially, that didn’t happen. Many people assumed the tests were a pretext for allowing the government to seize weak banks. Others complained that the tests were too mild, and suspected that the whole thing was an excuse to let banks try to grow their way out of trouble—to reprise what Japan did.

To just about everybody’s surprise, though, the plan has appeared to work.

So far! And yes – this was a ruse to let the banks grow their way out of the crisis like Japan, albeit after they had already received huge capital injections from the private sector. That’s why big banks are earning gobs of money with interest rates at zero percent. If it weren’t for all the hidden losses, we’d be home free. But, notice the word “appeared” in the last sentence of the quote. The only difference between what Geithner says and what I have been saying has to do with the hidden losses and their likely impact. Therefore, the article’s most important sentence was this one:

The danger, if the plan failed, was that the crisis—and the cost—would escalate, and that the government’s credibility would be shot.

The whole thing has been a gamble – a roll of the dice. This demonstrates the clear need for keeping up appearances, doesn’t it?

Much more below.

Source

Timothy Geithner: Inside Man – Joshua Greene, The Atlantic

Also see the more Administration-friendly spin in No Credit by John Cassidy of the New Yorker.

Jusqu’ici tu va bien!

Related posts:

• Bank by bank breakdown of stress test results
• Stress tests reveal Citi and BofA need more capital, but you knew that already
• At least six banks need more capital under stress tests
• Black: Stress tests and the Big Lie
• The fake stress tests and the coming wave of second mortgage writedowns

I have taken a less optimistic view of the credit crisis’ workout phase as evidenced by recent posts like Wood: “The endgame will be a systemic government debt crisis in the western world” and The mindset will not change; a depressionary relapse may be coming. So I want to give you a bit more colour into what I am seeing and why my tone has shifted.

I have been quite sceptical about the economic policy response to the credit crisis offered up in the U.S. and elsewhere. The general theme seems to have been:

Wow, this subprime crisis has really exposed some glaring weaknesses in our financial system. We could end up in a depression. Luckily, because of the great work of people like Milton Friedman, Anna Jacobson Schwartz and Ben Bernanke, we actually know how to defeat a depression. Let’s not sit on our hands the way policy makers in the 1930s did. Let’s flood the global economy with moneyto prevent a repeat of that. And we’ll use deficit spending for good measure too.

Now that the crisis has abated, it seems to be business as usual. Mind you, there are some changes coming. Nevertheless, the feeling in policy circles is that the system is sound – a mere minor tweaking necessary. We experienced [past tense] a liquidity crisis. We are not experiencing [present tense] a solvency crisis in the financial system. The recent announcement that the Federal Reserve is going to receive regulatory authority over too-big-to-fail banks tells you that this is the prevailing view.

The medicine seems to have worked… temporarily 

I don’t share that view – never have.  However, I do have a lot of faith that stimulus can arrest an economic freefall – if only temporarily. In October 2009, I outlined why stimulus works – and can lead to a multi-year recovery despite systemic problems.

The problem I have with the recent history of growth in the United States, the United Kingdom, Spain and Ireland in particular is that the growth was underpinned by high debt accumulation and low savings.  As debt is a mechanism through which we pull demand forward, the debt and consumption has meant we have been growing today at the expense of future growth.

Low quality growth can go on for a long time

This dynamic can continue for a very, very long time. In the United States, by virtue of America’s possession of the world’s reserve currency, an increase in aggregate debt levels has been successfully financed for well over twenty-five years. Mind you, there have been a number of landmines along the way. But, time and again, these pitfalls have been avoided through asymmetric monetary policy and counter-cyclical fiscal expansion.

So, poor quality growth can continue for very long indeed. And it is this fact which allows the narrative of easy money and overconsumption to gain sway.

The boy who cried wolf

A soothsayer who counsels against this type of economic policy, but who warns of impending collapse will surely be seen as the boy who cries wolf. Think back to 2001 or 2002. Did we not witness then the same spectacle whereby the bears and doomsdayers were let out of their holes to warn of impending doom from reckless economic policy? By 2004, unless these individuals changed their tune, they were long forgotten or even laughed at – only to resurface in 2007 and 2008 with their new tales of woe…

The fact is: low quality growth does not lead to immediate economic calamity. It can continue through many business cycles. Even today, it is wholly conceivable that we could experience a multi-year economic expansion on the back of renewed monetary and fiscal expansion.

Marc Faber: “Don’t underestimate the power of printing money”

You will recall that I wrote a post at the depths of the market implosion highlighting a phrase by Marc Faber, “Don’t underestimate the power of printing money.”  This quote has stuck with me as asset markets have soared in the intervening time.  What Faber was alluding to was the fact that printing money works.  It does goose the economy as intended and it can induce a cyclical recovery.

Nevertheless, the recovery is likely to be of poor quality due to significant malinvestment. Debt levels will rise and capital investment will be directed toward riskier enterprises. Look at what’s happening in China.  Are you telling me stimulus is not working? It most certainly is.

-Is economic boom around the corner?, Oct 2008

That’s exactly why the U.S. economy grew at a 5.9% annualized pace last quarter. And that’s why GDP growth will be high yet again this quarter.

But let’s forget about the short-term for a moment. Let’s think about the long-term. And I want to focus on three issues: The complexity of the financial system, the lack of financial reform and the growth in debt.

Complexity

The global financial system is a byzantine maze of different companies, domiciled in different countries, competing in different arenas, all regulated by an amorphous set of regulation across a panoply of different national, state and local regulators. It is the definition of a complex system. Some complex systems adapt, reform and continue. Others do not. They fail.

Interestingly, Wikipedia has defined the stock market – a subset of the financial system – as one of the former adaptive systems as opposed to the latter:

Complex adaptive systems (CAS) are special cases of complex systems. They are complex in that they are diverse and made up of multiple interconnected elements and adaptive in that they have the capacity to change and learn from experience. Examples of complex adaptive systems include the stock market, social insect and ant colonies, the biosphere and the ecosystem, the brain and the immune system, the cell and the developing embryo, manufacturing businesses and any human social group-based endeavor in a cultural and social system such as political parties or communities. This includes some large-scale online systems, such as collaborative tagging or social bookmarking systems.

-Complex adaptive systems, Wikipedia

And I suspect this is how much of our political elite view the global financial system, the main reason reforms have been limited.

Maladaptive complexity

I would like to argue that we are living in a complex maladaptive financial system with an extreme status quo bias and an extreme lack of reform. This is exactly why I see problems ahead. I wrote a few posts on a recent conference on financial reform that I attended (see here, here and here). And while I fully support these efforts, I do not see any traction for substantial financial reform whatsoever. In the U.S. the focus has mainly been to increase liquidity to support asset prices.

Look at some of my comments from February 2009 to the policy proposals of the new Obama Administration in the United States.

late [in 2008], I predicted that the Obama Administration would not change course significantly on the economic policy front. This was largely due to the make up of his proposed cabinet and their previously stated positions on economic policy. Frankly, they are subject to cognitive regulatory capture and beholden to the same special interests in the financial sector that the Bush Administration were.

Geithner is unwilling to nationalize any banks, preferring to roll the dice on a scheme whereby the Fed and the Treasury buy up toxic assets in order to provide liquidity to the market for those assets. The theory here is that these assets have fallen in value by much more than is necessary…

But, is that really true?…

President Obama has a limited window of opportunity here. He will need to decide the correct path and delegate appropriately. Sidelining Paul Volcker for Larry Summers does not leave one with a good tingly feeling. Bailing out banks when populist sentiment is rising shows a tin ear to the shift in national sentiment. On the whole, I am very worried that Obama does not see the poor optics of all of this. Politically, this is not a good plan.

-The Obama-Geithner Plan will fail, February 2009

So you have the Change President instituting a massive transfer of wealth from the taxpayer to bankers and rolling the dice on a plan that basically depends on providing enough bailouts and liquidity to get the financial system re-started. Bank profits are sky high as a result as are bonuses. Meanwhile, unemployment and foreclosures are rising, credit growth is not happening, and securitization markets for mortgages are still frozen. Does that make any sense? I didn’t get it. So I tried to look at it from the other side’s view in Channeling my inner Larry Summers. But that only led to the same conclusion: Obama is trying to increase asset prices in order to return to the status quo ante.

Stimulus is the only thing going in the U.S.

But, then you turn to the data and you see that the only thing between the U.S. and another recession is federal government support.

In creating the chart above, Tim Duy says:

I took the difference of nominal personal income and current transfer payments and deflated the resulting series by the personal consumption expenditures price index. I then estimated the (log) linear trend over various time horizons. We are currently well below the trend extrapolated the from Jan-91 to Dec-07 period.

What this means is that U.S. economy is afloat only because of government largesse and huge deficits. Duy goes on to reveal that:

Importantly, the gap between trend and actual real personal income less transfer payments has reached its widest since 1975:

And we used to think the late 70s were bad! (The same qualitative result holds using the Jan-75 to Jan-10 sample).

The end game

In October 2009 when I wrote The recession is over but the depression has just begun, one of my most read posts, my implicit assumption was that we lived in a complex maladaptive system and that policy makers would assume the worst was over too soon and fail to follow through on more substantive enduring measures of reform and economic healing. This is exactly what is occurring.

• Example par-excellence is this from November 2009: Barack Obama: “if we keep on adding to the debt… that could actually lead to a double-dip”
• But, Obama is just playing politics as I wrote in Triangulating on deficit reduction, 2010 version.

All evidence suggests that, politics or not, stimulus is out and deficit reduction is in. I have long since decided on Moving away from stimulus happy talk to focus on malinvestment because that is the crux of the problem. This is what the Christopher Wood piece was all about.  It’s not about whether stimulus works. It’s not about whether there is some pre-defined sovereign debt level where things go kaboom. It’s not about whether a sovereign issuing debt in its own currency can default. It’s about whether the entire world can prop up malinvestments indefinitely through bailouts and easy money without a collapse in the current financial system.

Can everybody do the bailout hustle simultaneously? The answer of course is no. You have to meet the problem head on – and the problem is the debt and leverage. The bailout hustle leads to a transferring of what were private debts into public debts, while leaving the financial system’s leverage and undercapitalization in place. And that eventually leads to a systemic crisis.

How does this end then?  I focus less on the sovereigns than on the maladaptive financial system. The financial system is fundamentally unsound because it depends critically on large connected financial institutions who have scaled up in a way that magnifies any localized financial problem into a systemic problem. Think of it like this:

We have had a long hot and dry spell. The forests are in a critical state where anything could tip us into a major forest fire. We could have 100 different forests across which there are minimal opportunities for the localized fires to jump. But, alas, we have one big interconnected forest with many fingers of instability. So, when the fire hits, it does major damage. Luckily, our firemen are able to douse the fire, which alleviates the pressure on the forest. But, this is only a patch. The fingers of instability remain – which is the real problem, of course. Then, another hot and dry spell hits. This time, however, the firemen’s solutions are ineffective.

Replacing a few words, it reads like this. 

We have had a long spell of increased leverage and risk. The financial system is in a critical state where anything could tip us into a major financial sector meltdown. We could have 100 different financial systems across which there are minimal opportunities for the localized credit crisis to jump. But, alas, we have one big interconnected financial system with many fingers of instability. So, when the credit crisis hits, it does major damage. Luckily, our policy makers are able to stop the credit crisis, which alleviates the pressure on the financial system. But, this is only a patch. The fingers of instability remain – which is the real problem, of course. Then, another spell of increased leverage and risk hits. This time, however, the policy makers’ solutions are ineffective.

Interest rates are at record lows world wide. Our financial system cannot stand another shock – whether it be sovereign debt, double dip, commercial real estate or some other as yet undiscovered instability. My fear all along has been that policy makers were myopic and the system is maladaptive. Increasingly, my fears seem justified.

Update: A piece in the Atlantic reveals the thinking in the U.S. behind what I believe will sink the ship (hat tip Marshall Auerback). The article on Tim Geithner is a must-read. It says:

To outsiders, the Clinton Treasury doesn’t command the awe it once did. Memories of the bull market have been replaced by anger at the financial deregulation Clinton presided over, which precipitated the current crisis. Greenspan’s reputation has been ruined; Rubin’s has suffered as well, for the added sin of pushing his next employer, Citigroup, to make risky bets that nearly sank the firm. But inside the group, things look much different. Its members see themselves as an elite corps, bound by the common experience of having battled the crises of the 1990s and mostly prevailed. They share the belief that a potent combination of speed, force, and nerve—a buccaneering willingness to cast aside doubt, seize the levers of government, and apply its full power—can halt financial panics. They also believe that governments typically do too little to respond, rather than too much, and pay a steep price for it. Applying this formula is what Geithner has been doing in the biggest crisis since the Great Depression. Other Obama officials share this outlook, notably Summers, who now directs the National Economic Council. But the faith runs purest in Geithner.

That’s exactly the problem; these guys think they have it all figured out. You can’t be a change agent when everyone you surrounded yourself with was a part of system you’re trying to change.

Related posts:

• Stephen Roach sees a W-shaped recovery for China
• Japan does not demonstrate the failure of stimulus
• The year in review at Credit Writedowns – Stimulus
• What happened to the fiscal stimulus multiplier?
• The year in review at Credit Writedowns: Crisis Solutions

With the anxiety caused by the Greece situation alleviated for the time being by last week’s successful auction, words of support from Germany and especially France over the weekend, and follow through gains in the Greek debt market, attention may turn elsewhere ahead of Greece’s mid-March status report.

Portugal is the likely candidate and although the IMF’s Strauss-Kahn says that the Greek crisis will not spread to other euro zone countries, at least Portuguese officials are not as convinced.

Today Portugal announced more plans for fiscal consolidation.  While Greece is committed to reducing its budget deficit from 12.7% last year to 8.7% this year, Portugal intends to cut its deficit to 8.3% from 9.3% last year.  It projects a 6.6% deficit next year, 4.7% in 2012 and 2.8% in 2013.

Portugal intends to generate a decline in real wages of civil service by capping pay increase below inflation to generate saving as a part of a larger effort to decrease the size of the civil service through attrition.  The government also will postpone infrastructure investment, and step up its privatization efforts.

Portuguese debt is rated Aa2 by Moody’s, with a negative outlook.   Earlier today, Moody’s warned of the risks facing Portuguese banks .  It noted that "the debt and deposit ratings of Portuguese banks are at risk not only from a potential downgrade of the sovereign rating, but also from an assessment of the government’s decreasing ability and potentially, willingness to support the country’s banking system."

S&P rates Portugal at A+, with a negative outlook.  This is two notches below Moody’s and Fitch.  Our own proprietary model would put Portugal at single A.

Portuguese 10-year yields are near 86 bp on top of Germany.  This is almost half the premium that existed a month ago.  The spread peaked on Feb 8 near 160 bp.   After Greece (now around 6.22%) Portugal offers the highest 10 year yield in the euro zone (4.04%).   Inflation differentials largely can account for the difference in nominal yields between Greece and Portugal.  Greece’s year-over-year CPI was 2.4% in January and is expected to tick up to 2.5% when it is reported Tuesday.  In contrast, Portugal’s year-over-year CPI was 0.1% in January and on Wed, when it reports Feb data, it is expected to tick up to 0.2%.

Looking at 5-year credit-default swaps, Portugal (1.17%) is in third place in the euro zone behind Greece 2.86% and Ireland 1.2%.

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Related posts:

• Greece Update: More Efforts before Assistance
• ECB and Greece Update
• Portugal and Greece downgrades have silver lining in the reach for yield
• Why the euro gets weaker when national governments deficit spend
• Update: Greece may have had swaps with fifteen banks

European politicians have revealed that a European Monetary Fund is already in the planning phase. The reports suggest that this fund may be the mechanism through which the Eurozone will defend the sovereign debt of members and impose austerity conditions where necessary. The Europeans have – for political reasons – stressed that this fund will not compete with the IMF. However,  it is clear that the fund’s purpose is to prevent a recurrence of the Greek situation without the need for IMF intervention. The first decisions in creating the fund are already set to made next week.

When the Greek sovereign debt crisis reached a critical state last month, it became apparent that the Eurozone lacked a credible mechanism through which both to defend a sovereign debtor like Greece and to impose harsh austerity measures to ensure compliance with the stability and growth pact. This is now seen as a fundamental flaw in the design of the Eurozone. Crucially, politicians in core Europe were under enormous pressure to force Greece to make binding commitments to budget deficit reduction in exchange for some type of bailout.

The Maastricht Treaty, which is the basis for the Eurozone, has a bailout clause in Article 119 that comes into effect when difficulties arise. It allows assistance:

where such difficulties are liable in particular to jeopardize the functioning of the common market or the progressive implementation of the common commercial policy. 

Moreover, the Lisbon Treaty, which amends the Maastricht Treaty, has similar language in Article 122 where it reads that the EU may intervene with aid where a member state is:

seriously threatened with severe difficulties caused by natural disasters or exception occurrences beyond its control, the Council [of governments] on a proposal from the Commission may grant, under certain conditions, Union financial assistance to the member state-concerned.

This is all fine and good. However, deciding what kind of assistance to offer has been an intractable political problem. The only statement from the EU on the debt crisis in Greece to date offered no financial commitments for Greece and was merely a show of “psychological and political support.” Some have argued all along that this is all that was needed. However, if things spiral out of control for Greece or other affected Eurozone members like Spain or Portugal, the EU will need a better solution.

And they have found one in the proposed European Monetary Fund – which most definitely is an alternative to the IMF.

When Ireland was the talk of the town, I predicted that they would eventually need to go to the IMF to resolve their difficulties. But, Ireland resolved its problems through harsh austerity measures. As Greece was unwilling to take these same measures, a sovereign debt crisis ensued. However, the EU have been unwilling to use the IMF in Greece’s case for three principal reasons:

• This gives the Americans 9and the Chinese) a say in EU fiscal and monetary policy;
• The IMF head Dominique Strauss-Kahn is a political rival of the French President Sarkozy who Sarkozy wants to prevent from claiming an economic achievement;
• The Europeans see the use of IMF in the Eurozone as a humiliation because many see the IMF as a vehicle to help developing countries who cannot fend for themselves

So, it seems the IMF is out and the European Monetary Fund is in.

Financial Times Deutschland provides a little colour in my translation below. Notice the provision to specifically preclude Euro member states from receiving financial assistance from the IMF, something Greece has threatened to do.

The [German] federal government is working on a Monetary Fund for the euro area. "For the internal structural design of the euro zone, we need an institution that has the experience of the IMF and analogous implementation authority," Finance Minister Wolfgang Schäuble (CDU) said to the “Welt am Sonntag” newspaper. He will make suggestions about this soon.

According to information obtained by FTD, plans in the Finance Ministry are well advanced. Schäuble still wants to co-ordinate plans with the French government in order to push them through more easily at a European level. According to information from within EU circles, the first preliminary decisions could even come next week.

The plans in Berlin suggest that liquidity support for euro member states would be available in future debt crises. This would be subject to strict conditions. The Euro Group would decide unanimously whether one is helped, and under what conditions – to the exclusion of the affected member. Euro countries would also promise to receive no money from the International Monetary Fund (IMF). This is to avoid a situation in which the U.S. or China has influence on internal Eurozone affairs.

In order to maintain pressure on borrowers and investors, aid from the Fund shall under no circumstances be taken for granted. Rather, the possibility of state insolvency must continue to exist. As a last resort withdrawal from the monetary union should also be possible.

Preventively, violation of the Stability and Growth Pact must be punished much more severely than previously, according to the Finance Ministry plans. Thus, in the future, the EU could withhold funds from the Cohesion Fund if a deficit country is not saving enough. Voting rights of a euro area country could be suspended for at least a year if the country is in breach of European monetary rules.

The plans for a European Monetary Fund is an admission that the Stability and Growth Pact has failed in the debt crisis. So far, the currency regime of the euro-zone provides no help for a distressed member. In Greece, crisis pushed the rules to the limit: Investors bet on a Greek bankruptcy. The speculation subsided only after leading euro-zone countries such as Germany, granted a sort of implicit guarantee for Greece.

These reports that a European Monetary Fund is coming are very credible. And I believe this will be the mechanism through which future sovereign debt crises within the Eurozone will be handled.

Watch for commentary from non-Eurozone member states like Sweden, Demark and the UK for an idea of whether this mechanism will be successful. I would also be interested in whether the UK gets cover because they are outside the Eurozone. I anticipate this will be a sticking point since the Structural Funds and Cohesion Funds that will be used as the stick for austerity are EU-wide, whereas the principle problem here is a mismatch between fiscal and monetary sovereignty within the Eurozone. The UK could then be seen as a free rider, able to benefit from EU-wide bailouts without having to enter monetary union.

Sources

Pläne für EU-Währungsfonds werden konkreter – Der Standard Austria

Schäubles Eurofonds-Pläne liegen schon in der Schublade – Financial Times Deutschland

Related posts:

• Irish and Swedish join chorus of countries seeking austerity for the Greeks
• Greece sees credit rating cut by S&P
• Greece: Statement by the Heads of State or Government of the European Union
• Wall Street barred from European bond sales in retaliation for credit crisis
• The Eurozone and the spectre of banking collapse

Related posts:

• Links: 2010-02-12 – European recovery falters and mortgage problems
• Links: 2010-03-04 – The cost of aging, leaving Britain for taxes and more
• Links: 2010-03-01 – Obama is not FDR, George Soros, gross misconduct and more
• Chinese migrants losing jobs three times faster than reported
• News round-up: 21 Nov 2008 – Countries, Citigroup, and Corporates