The end of the Asian Development Model

Now that the US is finally saving money, is the Asian Development Model of its last leg?

Michael Pettis thinks so:

Although the debate is much less transparent in China today than it was in the US in the early 1930s, I think the latter group – the domestic constituency and provincial leaders – is once again winning the debate, at least for now. It is probably no surprise to regular readers of my blog that I largely disagree with this camp, and the main reason I didn’t want to forecast very low 2009 GDP growth numbers with much confidence is because I doubt the former group will win the debate. As I see it, the massive expansion in credit and investment we are experiencing is simply more of the same set of policies that, especially over the past five years, have pushed China ever deeper into the Asian development model, and to the extent that they are successful they will keep pushing China, which I think of as exemplifying the Asian development model on steroids, in the same direction. Beijing, in other words, is increasing the dosage of steroids. (I think I am mixing metaphors all over the place.)

The reason I think this is a mistaken strategy is because I would argue that the Asian development strategy is dead, and over the next three to five years it will become increasingly evident that 2008 was the year it died. I may be wrong, of course because it is doubtful but not inconceivable that the great consumption party in the US can resume for a few more years. It would not be the first time that what seemed like an unstoppable correction in the trade imbalances was interrupted. To a certain extent we already saw a dress rehearsal for this event in the 1987 crash, around which time the US trade deficit, which had risen to around 3.5% of GDP the year before (a level which seemed unimaginably high at the time), began its inexorable reversion, to the point where the US achieved a small surplus in the early 1990s.

Chinese assumed that the US was an "importer of last resort". They were wrong....

In other words for small countries the need to export is not likely to be a constraint since they can always generate trade surpluses without creating significant global trade distortions. But when large countries, or a large grouping of countries, have policies aimed at generating trade surpluses they run into a very strict constraint – that some country or group of countries must be capable and willing to run large corresponding trade deficits. Without this willingness to run trade deficits, the Asian development model must inevitably run into brutal 19th-Century-style cycles of rapid production growth leading to overinvestment crises.

This is the main vulnerability of the Asian development model – its dependence on an importer of last resort. We don’t often think of this as a weakness because for so long the US was seen as the automatic importer of last resort, so much so that we didn’t even consider it a constraint. But we may have gotten lazy in our thinking. Many people who should know better simply write off US consuming habits as something endemic to American culture, and we just assume it as a universal constant, but in fact US consumption levels, like those of every other country, respond to changes in conditions, and these are about to change.

The US is the shit:

We should never underestimate the immense flexibility of the US and its ability to restructure itself at a pace far faster than most other countries can manage (anyone who grew up in the dismal 1970s will remember the dramatic – and seemingly improbable – US economic transformation of the 1980s), and if the Obama administration is serious about creating conditions for an increase in US savings, it probably wouldn’t be a good idea to bet heavily against success..

Say good by to the US trade deficit:

Those days are almost certainly over. Even without Obama’s desire to create conditions for an increase in US saving rates, US households have to increase their savings and rebuild their balance sheet, which means that we have several years ahead of us of deleveraging and increased savings. It also means we have several years ahead of US consumption growing more slowly than US GDP. I don’t think anyone is expecting much net growth in US GDP for the next three or four years, and so it is not at all implausible that we will see negative growth in US consumption and, as a consequence, a collapse in the US trade deficit, which may even turn into a trade surplus. The pace of this transition will largely depend on US fiscal policies aimed at slowing, but not eliminating, the contraction in demand.

If the US is no longer the importer of last resort, and if no one else can replace the US in that role in the medium term (I stress medium term because in the long term the demographic changes in Europe and Japan – and China for that matter – may well result in rising trade deficits in those countries), then any development model that necessarily results in production growth exceeding consumption growth – high savings development models, in other words – will run into the trade deficit constraint. They must run surpluses to grow, but if no one else runs sufficiently large deficits, they simply cannot run those surpluses.

The Chinese stimulus is prolonging the needed reforms to the Chinese trade surplus model, and also, the spark in new lending is liable to create a large number of non-performing loans (these are never good for economic recovery, just ask Shittybank)

This is why I am worried about recent fiscal and credit policies. It is not just that these policies are slowing down the rate at which China will adapt to the new world of lower US trade deficits. More importantly perhaps is that the only obvious replacement for US demand – domestic Chinese demand – will itself be sharply constrained by current policies, especially credit policies.

Why? Among other things because if the explosion in new lending (loans are up 15% in the first quarter of this year) leads, as it almost certainly will, to a subsequent explosion in non-performing loans, in the next few years just as China is expanding its production and struggling with US reluctance to absorb its rising excess capacity, the resolution of the NPLs will itself constrain Chinese consumption. Resolving future NPLs, in other words, will reduce future domestic consumption growth in China, just as the current resolution in the US of bad loans and shattered household balance sheets must come with reduced US consumption growth.

This is because if China’s banks see an explosion in non-performing loans it will have to pay for that increase in the coming years in one or both of two ways. The central government can recapitalize the banks by giving them money, which they have raised by borrowing or increasing taxes, or the regulators can keep deposit rates very low as a way of subsidizing bank profitability so that they earn their way out of the NPL losses. They did both after the last banking crisis, and will probably do both again.There is a third thing they can do, appropriate the money from SOEs, but I suspect that there won’t be nearly enough to resolve the NPLs – the World Bank estimates that the last banking crisis cost China 55% of GDP.

China could experience its own domestic credit crisis if things do not work out correctly:

Both strategies will represent, ultimately, a large transfer of income from households to banks, and in either case it will also represent a continued drag on consumption growth in the medium term. If the government borrows to bail out the banks, it will divert resources from the real economy and so slow income growth. If it raises taxes, it will reduce disposable income and so reduce household consumption growth. If it keeps interest rates low it will again reduce disposable income (interest income is an important source of income) and so slow consumption growth (in China lower interest rates tend to increase the savings rate).

Since it is unlikely that the US will be in a position in the near future to return to the halcyon days of large trade deficits, and since no other economy can replace the US in the role, turgid consumption growth in China will translate directly into turgid GDP growth for many years. Rising non-performing loans are not a small threat to China’s long-term growth. If the Asian development model is dead, China will need domestic consumption growth more than ever, and this is cannot be the best time for China to try to revive the production-enhancing model in a way that may limit future domestic consumption growth.

Links

They are finally going to prosecute this asshole

Big Bonuses continue for bankers

Blame Libertarianism for the FEDs failures

Another bad decision from Obama/Treasury

The current bank paradigm needs a reform

Why the stimulus is not going to work

J.C. Flowers Commenting on the Crisis

Chris Flowers Q&A[1]

Publish at Scribd or explore others:

Citigroup continues to claim solvency

More bullshit out of Citigroup today. I wonder how many more preferred shares the government needs to convert to common equity before we can rename this piece of crap Shittygroup:

From the FT:

Citigroup has told US regulators it could fill the capital shortfall identified in the government’s “stress test” by selling large businesses, asking more investors to convert their preferred shares into common stock and reducing its balance sheet.

Executives are trying to persuade the government Citi does not need more capital beyond its recent plans to bolster its battered balance sheet and cut costs.

However, with days to go before the results of the tests are announced, Citi, which has been bailed out three times by the authorities, is looking for ways to avoid receiving more government help if the authorities insist on an increase in capital.

And finally, save the best for last, a hilarious quote snuck in at the very bottom (Shittygroup probably figure the quote would be at the bottom of this article and no one would stick around to read it):

Some Citi executives believe the government may still have to convert more of its preferred shares into common stock, raising its holding above the 36 per cent it is due to take following the latest bail-out in February.

Citi shares closed down 5.9 per cent. BofA shares closed down 8.6 per cent at $8.15.

BofA declined to comment. Citi said its capital base was “strong”.

Looking at Citigroup's current capital base is probably very similar to watching Steven Hawking doing pushups.

Ken Lewis's days are numbered

The egotistical asshole Ken Lewis may finally be losing his job. That is, if enough mutual funds and pension funds will vote him (and his incompetent board) out. I guess the nasty details of the Merrill deal coming to light this week have made the shareholders realize that maybe, just maybe, he was not fulfilling his fiduciary duty! From Bloomberg:

April 29 (Bloomberg) -- Bank of America Corp. Chief Executive Officer Kenneth Lewis is losing shareholder support heading into today’s annual meeting amid speculation that government stress tests will show the bank needs more capital.

Lined up against Lewis’s re-election as chairman of the biggest U.S. bank by assets are the California Public Employees’ Retirement System -- the nation’s largest public pension fund -- as well as proxy advisers Glass Lewis & Co., RiskMetrics Group Inc. and Egan-Jones Proxy Services, among other investors. Shareholders have also targeted 70-year-old lead directorTemple Sloan Jr.

Ballots will be cast at the bank headquarters in Charlotte, North Carolina on whether to re-elect directors and split the chairman and CEO jobs held by Lewis. Dislodging Lewis after eight years as chairman may depend on how mutual funds and brokerages vote, opponents including CtW Investment Group said.

“It’s largely up to the big mutual fund companies and they are usually very hesitant to cross with the management of financial services companies,” said William R. Atwood, executive director of the Illinois State Investment Board, which will vote its 1.5 million shares against Lewis’s re-election.

Lewis, 62, may face demands from regulators to raise capital after results of government stress tests are released May 4. The bank needs $60 billion to $70 billion of capital, according to Friedman, Billings, Ramsey Group Inc. analyst Paul Miller, who cited separate tests performed by his firm, which assumed a 12 percent jobless rate, compared with about 10 percent used by the government test.

I guess CALPERs finally realized enough is enough after watching there ~23 million shares of BOA drop 79% over the past year and 1/2. If Lewis goes, I wonder how long it will take these same shareholders to sue the US government (Paulson and Bernanke) for cocercion.

Citigroup trying to sidestep salary caps on illustrious Phibro

From the WSJ:

Citigroup Inc., soon to be one-third owned by the U.S. government, is asking the Treasury for permission to pay special bonuses to many key employees, according to people familiar with the matter.

The request comes as Citigroup is grappling with broad government pay restrictions that could break apart its legendary energy-trading unit. People at that unit, Phibro, are threatening to leave because of pay caps tied to the U.S. bailout of Citigroup. Phibro has been the source of hundreds of millions of dollars in profits for the bank, and has paid out hefty compensation to its employees, including a roughly $100 million windfall last year for the unit's leader, Andrew Hall. Citigroup is looking for ways to free Phibro from the federal restrictions, including a spinoff of the unit, according to people familiar with the matter.

Meanwhile, Citigroup is trying to get U.S. approval for special bonuses for many employees in the rest of the company. In a meeting earlier this month with Treasury Secretary Timothy Geithner, Citigroup Chief Executive Vikram Pandit made the case for the stock-based bonuses. Executives are describing the bonuses as "retention" awards designed to perk up demoralized employees who the company worries are vulnerable to poaching by rival firms, people familiar with the matter said.

A person familiar with Mr. Geithner's thinking said the Treasury hadn't made a decision on whether to allow the bonuses. It is unclear how much Citigroup would pay out in bonuses if the government approved the move. A Citigroup spokesman declined to comment on details of the proposed compensation plans.

From the sounds of it, I do not blame them:

Citigroup is looking for ways to free Phibro from federal pay constraints so it can hold on to the staff of the lucrative unit, the people said. The bank is discussing plans to either spin off Phibro into an independent hedge fund or open it to outside investors, the people said. The unit currently only invests Citigroup's capital.

Phibro has been a lean and largely hidden profit center within Citigroup's investment bank. For 2008, Citigroup reported $667 million in pretax revenues in commodities trading, saying Phibro was the primary contributor to that figure.

Apparently they are just going to spin the already autonomous unit out into a separate hedge fund, just like JPMorgan is doing with their proprietary trading desks:

A Bank's Balance Sheet in Layman's Terms

From Calculated Risk:

Now imagine the bank starts reporting higher than expected credit losses - or at least depositors believe the bank will start reporting huge loses. 

Here the bank has lost $5 billion, and the capital has been cut in half.

Fearing further losses, the commercial paper (CP) investors run for the hills and refuse to reinvest again when their short term paper matures.

The FDIC insured depositors run (or amble) towards the hills too. A classic bank run.

The long term debt holders are stuck. They can sell in the market, but at a lower price - and that doesn't impact the bank's balance sheet (OK, there are some accounting issues here that I will ignore).

To stop the bank run, the FDIC stepped up and increased the guarantee on FDIC insured assets to $250 thousand. But this did nothing for the commercial paper investors. 

Next the Fed steps in and replaces the commercial paper liability as it matures.

If this was just a panic, and the bank was actually fine, the commercial paper investors would return (or the bank could sell more long term debt), and the Fed would be replaced by private debt.

However this is not just a liquidity crisis, and the Fed is still providing liquidity to the banks.

This doesn't work long term because the Fed requires the banks to over collateralize any money borrowed from the Fed. As the long term debt starts to mature, those investors will follow the commercial paper investors to the hills - and the Fed will have to provide more and more liquidity. And eventually there will not be enough collateral to borrow from the Fed. Here is an example of the Collateral Margins Table for the discount window.

Part II also found on Calculated Risk:

The larger problem is the toxic assets (now known as legacy assets). These are mostly related to residential real estate, but there are many other toxic loans (Construction & Development, foreign loans, LBO PE loans, etc.)

The banks are facing huge additional losses for these legacy assets, and these losses will make some banks "balance sheet" insolvent (liabilities will be great than assets). However, the bank is not insolvent in the business sense, because the bank can still pay their debts as they come due - at least for now.

.....

Basically the goal is to replace the legacy assets with money from the MLEC, TARP (original plan) or the PPIP.

All of these programs suffer from the same problem. If they buyer's pay too little, the banks will be insolvent, and if the buyer's pay too much for the assets, this is a transfer of wealth from the buyers to the stakeholders of the banks.

The Geithner approach is to keep injecting capital into the banks to cover the losses. This is known as the "Zombie" bank approach.

In essence the balance sheet looks like this with liabilities greater than total assets. To make the zombie balance sheet "balance", I've added "??????" to the assets.

These "??????" assets are either future retained earnings or additional money from the government. Although the bank is balance sheet insolvent, the bank will never be business insolvent because the government will continue to provide money to cover losses.

If only a small percentage of financial assets are held by zombie banks, then this approach will probably work. These banks will be crippled, but the other banks can meet the financing needs of the economy.

This is why the stress tests are so important in helping identify zombie banks - and why financial institutions relying on government support should be required to make the entire test results public. If there are too many zombies, we need to insist on 

The World Is Running Out Of Money

I found an interesting and scary article today discussing what is going to happen when various sovereign entities around the world cannot roll over (refiance) their debts in the future due to the bleak economic conditions. The US is being hit with a double-whammy of having to issue a shitload of new treasuries (think Obamas 787 billion dollar surplus, Obama's 410 billion dollar omnibus, TARP, TALF, and every other one of the Feds facilities) when the largest buyers of treasuries are curbing their purchases. China is spending money internally on their own surplus, and also trying to diversify away from the USD risk (lets face it, Bernanke is going to have to print his way out of this one). With oil back down from its astronomical levels, the Middle East and Russia have less USD they need to recycle into US Treasuries. Of course the US could always raise the coupons it pays on these bills, but that would create holes in future budgets due to servicing the debt at the higher interest rates:

From The Telegraph:

Unless this capital is forthcoming, a clutch of countries will prove unable to roll over their debts at a bearable cost. Those that cannot print money to tide them through, either because they no longer have a national currency (Ireland, Club Med), or because they borrowed abroad (East Europe), run the biggest risk of default.

Traders already whisper that some governments are buying their own debt through proxies at bond auctions to keep up illusions – not to be confused with transparent buying by central banks under quantitative easing. This cannot continue for long.

ooked easy for Western governments during the credit bubble, when China, Russia, emerging Asia, and petro-powers were accumulating $1.3 trillion a year in reserves, recycling this wealth back into US Treasuries and agency debt, or European bonds.

The tap has been turned off. These countries have become net sellers. Central bank holdings have fallen by $248bn to $6.7 trillion over the last six months. The oil crash has forced both Russia and Venezuela to slash reserves by a third. China let slip last week that it would use more of its $40bn monthly surplus to shore up growth at home and invest in harder assets – perhaps mining companies.

Where is the money going to come from ?

So where is the $6 trillion going to come from this year, and beyond? For now we must fall back on the Fed, the Bank of England, and fellow central banks, relying on QE (printing money) to pay for our schools, roads, and administration. It is necessary, alas, to stave off debt deflation. But it is also a slippery slope, as Fed hawks keep reminding their chairman Ben Bernanke.

Threadneedle Street may soon have to double its dose to £150bn, increasing the Gilt load that must eventually be fed back onto the market. The longer this goes on, the bigger the headache later. The Fed is in much the same bind. One wonders if Mr Bernanke regrets saying so blithely that Washington can create unlimited dollars "at essentially no cost".

Great Video About LTMC

More Simon Johnson

link to video

Wall Street compensation heading back to pre-crisis levels

From the NYT:

Even as the industry’s compensation has been put in the spotlight for being so high at a time when many banks have received taxpayer help, six of the biggest banks set aside over $36 billion in the first quarter to pay their employees, according to a review of financial statements.

If that pace continues all year, the money set aside for compensation suggests that workers at many banks will see their pay — much of it in bonuses — recover from the lows of last year.

At least this article managed to point out that huge bonuses are part of the problem:

Compensation is among the most cited causes of the financial crisis because bonuses were often tied to short-term gains, even if those gains disappeared later on. Still, as profits return, banks do not appear to be changing the absolute level of worker pay — or the share of revenue dedicated to compensation.

Historically, investment banks have paid workers about 50 cents for every dollar of revenue. The average is lower at commercial banks like JPMorgan Chase and Bank of America, because they employ more people in retail branches where pay is lower.

But every dollar paid to workers is a dollar that cannot be used to expand the business or increase lending. Some of that revenue, too, could be used by bailed-out banks to pay back taxpayers.

Wall Street, of course, has a long history of high wages. Not all that long ago, most investment banks were private partnerships, and the workers were also typically the owners. Even when those firms began listing their shares on public stock exchanges, a standard was set in which half of their revenue was paid out to workers.

Congratulations to Dick Fuld: ranked the WORST CEO ever by Portfolio Magazine

From Portfolio:

Wow, you know you suck when you are ahead of Caynes, Lay, Mozilo, and Joseph ...

What would Thomas Jefferson do?

Interesting post in Vanity Fair:

It appears Obama should look back in history to solve some of his current problems:

In the early days of our republic, the economic foundation of the country was in disarray. The debt of the federal government was vast, as was that of the states, each of which had its own currency, not to mention debt and tariff laws. Some states were credit-worthy, some were not, and most paid the soldiers who had helped win the Revolutionary War merely in I.O.U.’s. 

In order to steady the economy, Treasury Secretary Hamilton consolidated these I.O.U.’s, and other state debt, under the federal government. The move was called “assumption,” and Hamilton planned to pay for it by introducing a debt scheme funded by new taxes and the use of western land as collateral. Even before Hamilton’s plan was enacted, skillful investors and speculators began purchasing these depressed instruments from soldiers and other debt holders, creating the widespread appearance of an arbitrage. The states’ debt and I.O.U.’s were trading at very large discounts to par, some as low as 15 cents on the dollar.

This profiteering of the insiders caused a public uproar. Did the shrewd speculators deserve the money more than the soldiers who had risked life and limb for it? Did they attain it fairly? In the Senate, Thomas Jefferson—supported by John Adams—decried that many New York fortunes had been made at the expense of unsophisticated citizens. Even if no laws had been broken, Jefferson argued, the money was ill-gotten and the profits should be redistributed to the original bond and I.O.U. holders. That was the only fair response, wasn’t it?

It wasn’t, Hamilton argued. The country’s financial well-being relied upon the sanctity of contracts. The speculators should be rewarded because they had shown faith in the success of the new government. But, perhaps more important, in order to develop viable markets, a deal had to be a deal. Hamilton knew the speculators may not have had a patriotic motivation for buying the soldiers’ debt, but this matter paled in comparison to preserving the underpinning—and the future—of the young country’s financial system. Were the monies to be redistributed, he feared, the economy would be dealt a massive—potentially irreparable—blow. 

And the conclusion:

Though he lost the assumption battle, Jefferson eventually got what he wanted: a government that would be far away from the influence of money. (Figuratively, of course, but also literally: the nation’s capital began a decade-long southern migration—first to Philadelphia, then to the banks of the Potomac.) Unable to halt the (heavily taxed) A.I.G. bonuses, now is the time for Congress and President Obama to figure out what they want in return from Wall Street. As we did centuries ago, we must move beyond the public’s ex post facto cry to redistribute soiled income and concentrate instead on creating lending capacity. Washington must figure out how to replace the asset-backed, structured investment vehicles and other parts of the non-traditional, or “virtual,” banking system that have all but disappeared. Until an overall deal or structure is clear, the critical risk capital that drives our economy will stay on the sidelines interminably to the detriment of us all, and the dismay of our founding fathers.

Collapse of the high-yeilds

From zerohedge:

What is more troubling is that new issuance volume is not supply constrained: 81% of HY new issue proceeds is to refi existing debt, mostly near-maturing and cheaper loans. Normally refis stand at around 50% from a Use Of Proceeds perspective. As there is $80 billion in 2009 scheduled maturities, assuming the YTD issuance trend persists into the balance of the year, all else being equal, any new money will go dollar for dollar to match upcoming maturities. The refi rush is not limited to HY - of the other industrial BBB-rated deals done last month, all 8 listed refinancing as a use of proceeds (as well as the generic general corporate purposes).

While credit markets are still marginally open to only the highest quality and least risky corporates, it seems that virtually everyone who still has capital markets access is only focusing on balance sheet clean up. The other two major needs for new capital: M&A activity and CapEx are virtually at a standstill. This implies that the economic downturn is likely to get even worse as capital is drastically redirected not into investment opportunities and economic growth but merely band aiding against potential restructurings. This last point is further confirmed by the Fed senior loan officer survey, which indicates that over 60% of banks saw a drop in bank credit demand. So much for the Treasury's cheap credit being used to flow back into the economy: the major beneficiaries from any loosening in credit conditions seem to be banks themselves who manage to offload their existing loan exposure in risky names to new investors. This is a phenomenon we have seen recently with none other than the REIT space, where instead of HY bonds, outright equity has been issued to repay banks' credit facilities.

Two other items to be pointed out are that if the recent rally collapses and credit capital markets shut down (not to mention REIT equity refi opportunities), then the massive upcoming 2009 maturities have no chance of being addressed and the default wave will likely end up even worse than Moody's and S&P's estimates of 2009 full year defaults of over 20%. A logical follow through question is with all the upcoming bankruptcies and the resulting mass lay offs, how can any pundits (let alone economists) say we will soon see an abatement in unemployment trends? If 20% of all HY companies indeed file for bankruptcy, the additional numbers of unemployed (by some estimates around 3 million upcoming pink slips) will represent another huge shock to the U.S. economic system. And this number excludes the newly unemployed from the upcoming fallout of a GM bankruptcy.

The other item to point out is that the limited demand for new issues as HY investors are not stupid and would rather not funnel their money into banks' loan repayment, but would rather see some economic use of their capital, even if the rate is exorbitant: a 15% interest rate bond bought at par that goes to 40 in one year is still a loss of 45%. This has manifested itself in higher secondary market prices for older vintage deals, the result being an outperformance of older vintage HY deals. As the technical considerations eventually dissipate it is likely that we will see a substantial sell off of the lower rated HY bonds, to parallel the upcoming sell off in the "crap" stocks that have driven the last month's equity rally.

Interview with William Black

link to video

Interview with Simon Johnson

link to video

SIMON JOHNSON: I called up one of my friends on Capitol Hill after that testimony, and that session. I said, "What happened? This was your moment. Why did they pull their punches like that?" And my friend said, "They, the Committee members, know the bankers too well."

Wolf sees no "green shoots" of recovery:

From the FT:

What I find most disturbing of all is the reluctance to admit the nature of the challenge. In its policy advice, even the OECD seems to believe this is largely a financial crisis and one that may be overcome in quite short order. Even the latter looks ever more implausible: in its latest Global Financial Stability Report , the International Monetary Fund now estimates overall losses in the financial sector at $4,100bn (€3,200bn, £2,800bn). The next estimate will presumably be higher.

Above all, the financial crisis is itself a symptom of a balance-sheet disorder. That, in turn, is partly the consequence of structural current account imbalances. Thus, neither short-term macroeconomic stimulus nor restructuring of balance sheets of financial institutions will generate sustained and healthy global growth.

Consider the salient example of the US, on whose final demand so much has for so long depended. Total private sector debt rose from 112 per cent of GDP in 1976 to 295 per cent at the end of 2008. Financial sector debt alone jumped from 16 per cent to 121 per cent of GDP over this period. How much of a reduction in these measures of leverage occurred in the crisis year of 2008? None. On the contrary, leverage rose still further.

The danger is that a turnround, however shallow, will convince the world things are soon going to be the way they were before. They will not be. It will merely show that collapse does not last for ever once substantial stimulus is applied. The brutal truth is that the financial system is still far from healthy, the deleveraging of the private sectors of highly indebted countries has not begun, the needed rebalancing of global demand has barely even started and, for all these reasons, a return to sustained, private-sector-led growth probably remains a long way in the future.

The world economy cannot go back to where it was before the crisis, because that was demonstrably unsustainable. It is at the early stages of a long and painful deleveraging and restructuring. Fortunately, policymakers have eliminated the worst possible outcomes. But there is much more yet to be done before fragile shoots become healthy plants.

What Obama and the Treasury arn't telling us

It appears even after inject 182 billions dollars (with more probably to come), the US still refuses to negotiate retention bonuses and insert clawback dialogue into contracts with AIG:

So, knowing that the Treasury was under orders to block these payments, it was with some cynicism that I read the eight new agreements filed by A.I.G. at 7:43 p.m on Friday. These agreements document the government’s third reworking of its A.I.G. investment and include a securities purchase agreement for up to $40 billion and an amendment to the now $60 billion credit facility. Since Treasury has put its 77.9 percent share ownership in A.I.G. into a trust, these documents are the only way the government can directly exercise its interest over A.I.G.

My cynicism proved correct. The only thing in these agreements (accessible here, here andhere) that the Treasury did to pursue these retention bonuses is to deduct the $165 million in total payments from the approximately $183.5 billion made available to A.I.G. In addition, the Treasury charged A.I.G. a commitment fee of $165 million to be paid from the operating cash flow of the company. Since money is fungible, and the government has now agreed to support the company anyway, the latter requirement is meaningless.

But there was nothing else. Despite the many grounds contract scholars have put forth to claw back this money, there was no obligation to force A.I.G. to sue to recollect the bonuses and for the government to be able to direct that litigation. No prohibition on further contracts with the financial products subsidiary. No language about the future retention payments that are to be paid. Clearly, the government has passed on over this issue. I wonder when Mr. Obama will let the public know about this?

At least they are preventing golden parachutes:

In fairness, there are some compensation limitations in the agreement. Essentially, golden-parachute and retention payments to senior executives of A.I.G. are now limited to 3.5 times their annual salary and bonus for 2008. In addition, the annual bonus pools payable to the senior executives in 2008 and 2009 shall not exceed the average of the annual bonus pools paid to them in 2006 and 2007.

And apparently the government is paying TWO sets of lawyers because lets face it, any money AIG spends at this point is really taxpayer dollars:

Instead, the government hired Simpson Thacher to represent it. A.I.G. then hired its own lawyers at Sullivan & Cromwell and the two negotiated these intricately documented arrangements for each reworking of the bailout. There are now approaching 20 different agreements between the government and A.I.G. I wonder how much A.I.G. paid Sullivan alone to negotiate these agreements?

But the government is afraid to really do what it should, which is take control of A.I.G. as an owner. Given that the government has more than a $100 billion invested in the company, it is astounding that it should continue to write these agreements. Instead, if we controlled A.I.G. as the government could and should, it could simply monitor these payments. Moreover, it can begin to restructure the company to allow for its dismemberment or bankruptcy without systemic effects.

Defaults sore on student loans

This type of news is never good. From the WSJ:

According to new numbers from the U.S. Department of Education, default rates for federally guaranteed student loans are expected to reach 6.9% for fiscal year 2007. That's up from 4.6% two years earlier and would be the highest rate since 1998.

&

Sarah Kostecki, a 24-year-old sales associate in New York, graduated last year from DePaul University with a major in international studies and $87,000 in debt, translating to monthly payments of $685, the vast majority of which are private loans.

The payments represent more than a third of her take-home pay, and to help her make ends meet, her grandparents are giving her $200 a month toward her debt this year. Beginning in January, she'll be on her own, and she worries about falling behind.

"It feels like I'm being punished for having gone to school," Ms. Kostecki says. She has contemplated some of the options offered by private loan companies, such as temporary interest-only payments. But after two years, her payments would jump by almost $200 a month on top of what she's paying now, she says. "I don't want that."

Sorry Sarah, I don't feel sorry for you. You shouldn't have gone to an expensive private institution like DePaul University and majored in International Studies. Why didn't you choose University of Illinois, Urbana. Cheaper. Better bang-for-your-buck.

I love how this sober stories always choose some retard who went to an expensive private school, loaded up a debt, and then majors in a shit subject that pays shit. Then, surprisingly enough, when they get out of school, with debt payments of 700 a month making 35K a year, its hard to balance their checkbooks. Cry me a river.

Disclosure: I went to a public institution and my dad paid for every single penny of it.

Borrowers having trouble repaying their federally backed loans can call their lender to request that their payments be put on hold until they get back on their feet. Most types of federal loans qualify for "forbearance" -- meaning the borrower can suspend payments temporarily but is still on the hook for the interest that continues to build while payments are on hold, which is then amortized over the life of the loan.

Certain need-based loans qualify for "deferment," which means the government will cover any interest payments for a set period. Deferments and forbearances can each be used for a maximum of three years per loan.

There are fewer options for borrowers with private loans, which have soared in recent years as limits on federal borrowing failed to keep up with rising college costs. Students borrowed $19 billion in private loans in the 2007-2008 school year, six times the amount they borrowed a decade earlier, after factoring in inflation, according to the College Board, a New York-based nonprofit.

This article seems to fulfill the new mindset in America: "when you in financial trouble, plead ignorance and blame it on someone else".

Interesting article on high-frequency trading

From the author of Demons our own Design:

In terms of chips, I gave a talk at an Intel conference a few years ago, when they were launching their newest chip, dubbed the Tigerton. The various financial firms who had to be as fast as everyone else then shelled out an aggregate of hundreds of millions of dollar to upgrade, so that they could now execute trades in thirty milliseconds rather than forty milliseconds – or whatever, I really can’t remember, except that it is too fast for anyone to care were it not that other people were also doing it. And now there is a new chip, code named Nehalem. So another hundred million dollars all around, and latency will be dropped a few milliseconds more. 

In terms of throughput and latency, the standard tricks are to get your servers as close to the data source as possible, use really big lines, and break data into little bite-sized packets. I was speaking at Reuters last week, and they mentioned to me that they were breaking their news flows into optimized sixty byte packets for their arms race-oriented clients, because that was the fastest way through network. (Anything smaller gets queued by some network algorithms, so sixty bytes seems to be the magic number). 

Milken on Capital Structures

I am always amazed when convicted criminals, who are banned from working in the financial world for their crimes, still have a voice which carries weight. I have noticed Henry Blodget (convicted of pumping up stocks in the dotcom boom and than talking shit about them with his colleagues through email) is the co-host of tech ticker oh yahoo. Now I see convicted criminal Michael Milken writing editorials in the Wall Street Journal. I am in currently reading the book Predator's Ball, so I gave this one a read. And so says the king of the junk bonds:

Issuing new equity can of course depress a stock's value in two ways: It increases the supply, thus lowering the price; and it "signals" that management thinks the stock price is high relative to its true value. Conversely, a company that repurchases some of its own stock signals an undervalued stock. Buying stock back, the theory goes, will reduce the supply and increase the price. Dozens of finance students have earned Ph.D.s by describing such signaling dynamics. But history has shown that both theories about lowering and raising stock prices are wrong with regard to deleveraging by companies that are seen as credit risks.

Two recent examples are Alcoa and Johnson Controls each of which saw its stock price increase sharply after a new equity issue last month. This has happened repeatedly over the past 40 years. When a company uses the proceeds from issuance of stock or an equity-linked security to deleverage by paying off debt, the perception of credit risk declines, and the stock price generally rises.

Milken seems to blaming companies for their stock buybacks (hindsight is fore sight)

The new law is also helpful for companies that made the mistake of buying back their stock with new debt or cash in the years before the market's recent fall. These purchases peaked at more than $700 billion in 2007 near the market top -- and in many cases, the value of the repurchased stock has dropped by more than half and has led to ratings downgrades. Particularly hard hit were some of the world's largest companies (i.e., General Electric, AIG, Merrill Lynch); financial institutions (Hartford Financial, Lincoln National, Washington Mutual); retailers (Macy's, Home Depot); media companies (CBS, Gannett); and industrial manufacturers (Eastman Kodak, Motorola, Xerox).

Without stock buybacks, many such companies would have little debt and would have greater flexibility during this period of increased credit constraints. In other words, their current financial problems are self-imposed. Instead of entering the recession with adequate liquidity and less debt with long maturities, they had the wrong capital structure for the time.

And his opinion on financial history:

History isn't a sine wave of endlessly repeated patterns. It's more like a helix that brings similar events around in a different orbit. But what we see today does echo the 1970s, as companies use the capital markets to push out debt maturities and pay off loans. That gives them breathing room and provides hope that history will repeat itself in a strong economic recovery.

It doesn't matter whether a company is big or small. Capital structure matters. It always has and always will.

Interesting Article from ZeroHedge

The old bait-and-switch

Highlights from Johnson's Paper

I have tried to parse out what I thought was interesting from the paper posted below:

There were, of course, some facilitating factors behind the crisis.  Top investment bankers and government officials like to lay the blame on low U.S. interest rates after the dotcom bust, or even better – for them – the flow of savings out of China.  Some on the right of the spectrum like to complain about Fannie Mae or Freddie Mac, or even about longer-standing efforts to promote broader home ownership.  And, of course, it is axiomatic to everyone that the regulators responsible for “safety and soundness” were fast asleep at the wheel. 

But these various policies - lightweight regulation, cheap money, the unwritten Chinese-American economic alliance, the promotion of homeownership - had something in common, even though some are traditionally associated with Democrats and some with Republicans: they all benefited the financial sector. The underlying problem was that policy changes that might have limited the ability of the financial sector to make money - such as Brooksley Born's attempts at the Commodity Futures Trading Commission to regulate over-the-counter derivatives such as credit default swaps - were ignored or swept aside. 

Comparing the US to the corrupt emerging market economies:

And they were captured (or completely persuaded) by exactly the sort of elite that dominates an emerging market.  When a country like Indonesia or Korea or Russia grows, some people become rich and more powerful.  They engage in some activities that are sensible for the broader economy, but they also load up on risk.  They are masters of their mini-universe and they reckon that there is a good chance their political connections will allow them to “put” back to the government any substantial problems that arise. In Thailand, Malaysia, and Indonesia prior to 1997, the business elite was closely interwoven with the government; and for many of the oligarchs, the calculation proved correct – in their time of need, public assistance was forthcoming.  This is a standard way to think about middle income or low income countries.  And there are plenty of Americans who are also comfortable with this as a way of describing how some West European countries operate.  Unfortunately, this is also essentially how the U.S. operates today.

Wallstreet represents the financial oligarchs of the US:

Instead, the American financial industry gained political power by amassing a kind of cultural capital – a belief system. Once, perhaps, what was good for General Motors was good for the United States. In the last decade, the attitude took hold in the U.S. that what was good for Big Finance on Wall Street was good for the United States. The banking and securities industry has become one of the top contributors to political campaigns, but at the peak of its influence it did not have to buy favors the way, for example, the tobacco companies or military contractors might have to. Instead, it benefited from the fact that Washington insiders already believed that large financial institutions and free-flowing capital markets were critical to America's position in the world. 

The revolving door between DC and NYC:

One channel of influence was, of course, the flow of individuals between Wall Street and Washington. Robert Rubin, co-chairman of Goldman Sachs, served in Washington as Treasury Secretary under President Clinton, and later became chairman of the executive committee of Citigroup. Henry Paulson, CEO of Goldman Sachs during the long boom, became Treasury Secretary under President George W. Bush. John Snow, an earlier Bush Treasury Secretary, left to become chairman of Cerberus Capital Management, a large private equity firm that also counts Vice President Dan Quayle among its executives. President George H. W. Bush has been an advisor to the Carlyle Group, another major private equity firm. Alan Greenspan, after the Federal Reserve, became a consultant to PIMCO, perhaps the biggest player on international bond markets. 

Analysis of all of the bailouts:

First, there was the prominent place of policy by deal: when a major financial institution, got into trouble, the Treasury Department and the Federal Reserve would engineer a bailout over the weekend and announce that everything was fine on Monday. In March 2008, there was the sale of Bear Stearns to JPMorgan Chase, which looked to many like a gift to JPMorgan. The deal was brokered by the Federal Reserve Bank of New York - which includes Jamie Dimon, CEO of JPMorgan, on its board of directors. In September, there were the takeover of Fannie Mae and Freddie Mac, the sale of Merrill Lynch to Bank of America, the decision to let Lehman fail, the destructive bailout of AIG, the takeover and immediate sale of Washington Mutual to JPMorgan, and the bidding war between Citigroup and Wells Fargo over the failing Wachovia - all of which were brokered by the government. In October, there was the recapitalization of nine large banks on the same day behind closed doors in Washington. This was followed by additional bailouts for Citigroup, AIG, Bank of America, and Citigroup (again).  

In each case, the Treasury Department and the Fed did not act according to any legislated or even announced principles, but simply worked out a deal and claimed that it was the best that could be done under the circumstances. This was late-night, back-room dealing, pure and simple. What is more telling, though, is the extreme care the government has taken not to upset the interests of the financial institutions themselves, or even to question the basic outlines of the system that got us here. 

On the hidden subsidies given to the banks (to complex for the general public to understand):

As the crisis deepened and financial institutions needed more assistance, the government got more and more creative in figuring out ways to provide subsidies that were too complex for the general public to understand. The first AIG bailout, which was on relatively good terms for the taxpayer, was renegotiated to make it even more friendly to AIG. The second Citigroup and Bank of America bailouts included complex asset guarantees that essentially provided nontransparent insurance to those banks at well below-market rates. The third Citigroup bailout, in late February 2009, converted preferred stock to common stock at a conversion price that was significantly higher than the market price - a subsidy that probably even most Wall Street Journal readers would miss on first reading. And the convertible preferred shares that will be provided under the new Financial Stability Plan give the conversion option to the bank in question, not the government - basically giving the bank a valuable option for free.  

Obama isn't doing shit either:

This continued solicitousness for the financial sector might be surprising coming from the Obama Administration, which has otherwise not been hesitant to take action. The $800 billion fiscal stimulus plan was watered down by the need to bring three Republican senators on board and ended up smaller than many hoped for, yet still counts as a major achievement under our political system. And in other ways, the new administration has pursued a progressive agenda, for example in signing the Lilly Ledbetter law making it easier for women to sue for discrimination in pay and moving to significantly increase the transparency of government in general (but not vis-à-vis its dealings with the financial sector).  

What it shows, however, is that the power of the financial sector goes far beyond a single set of people, a single administration, or a single political party. It is based not on a few personal connections, but on an ideology according to which the interests of Big Finance and the interests of the American people are naturally aligned - an ideology that assumes the private sector is always best, simply because it is the private sector, and hence the government should never tell the private sector what to do, but should only ask nicely, and maybe provide some financial handouts to keep the private sector alive. To those who live outside the Treasury-Wall Street corridor, this ideology is increasingly not only at odds with reality, but actually dangerous to the economy.

How to clean up the balance sheets of these banks:

Cleaning up bank balance sheets cannot be done through negotiation. Everything depends on the price the government pays for those assets, and the banks’ incentive is to hold up the government for as high a price as possible. Instead, the government should thoroughly inspect the banks' balance sheets and determine which cannot survive a severe recession (the current “stress tests” are fine in principle but not tough enough in practice). These banks would then face a choice: write down your assets to their true value and raise private capital within thirty days, or be taken over by the government.  The government would clean them up by writing down the banks' toxic assets - recognizing reality, that is - and transferring those to a separate government entity, which would attempt to salvage whatever value is possible for the taxpayer (as the Resolution Trust Corporation did after the Savings and Loan debacle of the 1980s).

Break up to financial oligarchy: no more too-big-to-fail institutions:

In the U.S., this means breaking up the oversized institutions that have a disproportionate influence on public policy. And it means splitting a single interest group into competing sub-groups with different interests. How do we do this? First, bank recapitalization - if implemented right - can use private equity interests against the powerful large bank insiders.  The banks should be sold as going concerns and desperately need new powerful shareholders.  There is a considerable amount of wealth “on the sidelines” at present, and this can be enticed into what would essentially be reprivatization deals.  And there are plenty of people with experience turning around companies who can be brought in to shake up the banks.  The taxpayer obviously needs to keep considerable upside in these deals, and there are ways to structure this appropriately without undermining the incentives of new controlling shareholders.  But the key is to split the oligarchy and set the private equity part onto sorting out the large banks.  

The second step is somewhat harder. You need to force the new private equity owners of banks to break them up, so they are no longer too big to fail – and making it harder for the new oligarchs to blackmail the government down the road. The major banks we have today draw much of their power from being too big to fail, and they could become even more dangerous when run by competent private equity managers.

Ideally, big banks should be sold in medium-sized pieces, divided regionally or by type of business, to avoid such a concentration of power. If this is practically infeasible – particularly as we want to sell the banks quickly – they could be sold whole, but with the requirement of being broken up within a short period of time. Banks that remain in private hands should also be subject to size limitations. 

This may seem like a crude and arbitrary step, but it is the most direct way to limit the power of individual institutions, especially in a sector that, the last year has taught us, is even more critical to the economy as a whole than anyone had imagined.  Of course, some will complain about “efficiency costs” from breaking up banks, and they may have a point.  But you need to weigh any such costs against the benefits of no longer having banks that are too big to fail.  Anything that is “too big to fail” is now “too big to exist.” 

To back this up, we quickly need to overhaul our anti-trust framework.  Laws that were put in place over 100 years ago, to combat industrial monopolies, need to be reinterpreted (and modernized) to prevent the development of financial concentrations that are too big to fail.  The issue in the financial sector today is not about having enough market share to influence prices, it is about one firm or a small set of interconnected firms being big enough so that their self-destruction can bring down the economy. The Obama Administration’s fiscal stimulus invokes FDR, but we need at least equal weight on Teddy Roosevelt-style trust-busting. 

Put caps on Wall Street's compensation:

Third, to delay or deter the emergence of a new oligarchy, we must go further: caps on executive compensation - for all banks that receive any form of government assistance, including from the Federal Reserve - can play a role in restoring the political balance of power. While some of the current impetus behind these caps comes from old-fashioned populism, it is true that the main attraction of Wall Street - to the people who work there, to the members of the media who spread its glory, and to the politicians and bureaucrats who were only too happy to bask in that reflected glory - was the astounding amount of money that could be made. To some extent, limiting that amount of money would reduce the allure of the financial sector and make it more like any other industry. 

 Everyone should read the whole paper, and also read Johnson's article that came out in the Atlantic the past month on the same topic: