Private, national & common wealth in the post-socialism/capitalism era
Bewildered by what's been happening, both nationally and globally, in the wake of the fall of the Berlin Wall?
I.e. where the unwittingly weakened nation-state - formerly a bulwark against plain-levelling & globalization -
no longer tempers the social, economic & other pitfalls foreseen by Marx, Gramsci, Minsky, McCulley,etc.
Where - as the Laffer & Rider Curves illustrate in the tax & the social fields - excessive poor/rich gradients
upset the social fabric, wash away fertility factors with uncontrolled erosive powers & contribute to famine.
Where indeed, as Patrick Martin pointed out, monopolistic capitalism and the associated reckless greed
are no longer kept in check by Adam Smith' invisible hand, i.e. by the balance of contradictory interests.
And where the capacity for self-correction is increasingly inhibited by loss of freedom, mooring & orientation
which led to market frenzies & false alpha birds feeding on hype & bubbles, reminiscent of the Roaring 20s.
IMF & FATF estimate black funds (drugs, tax evasion etc) to be 2-5% of world's GDP (2006: $960-2400bn).
An IMF Report indicates these funds to be increasingly chased under anti-terrorism & ever flimsier pretexts.
Courtesy by the IV Reich's Secret Service, the world has indeed been made hostage of ill-considered rules
which impede more legitimate business than crime. For big time money laundering, the US Treasury set the
standard in 2001 with its 31% confiscatory backup withholding tax on unidentified investors in US securities,
turning foreign bankers from trustees of clients into IRS agents (qualified intermediaries) subject to US laws.
Private equity & hedge funds thus found a government-sponsored access to black funds, while the latters'
entry into subprime markets was also eased by the Internet. Results: predatory lending & systemic risks.
Society's organization needs re-thinking with Plato, G.Duttweiler, M,Yunus, J.M.Arizmendiarrieta etc.
For man's evolution may only be stressed by technological leaps but not accelerated beyond natural limits.
Also: return on investment rates above productivity gains & organic growth are predatory & not sustainable.
If driven by managers, lawyers & funds on the back of other stakeholders, M&As are thus Ponzi schemes
where shareholder value adepts can maraud with stacked Monopoly cards, helped by micro-economic laws.
Like compulsory social insurance systems whose doom is delayed or obscured only by inflation, war, etc.
And where the cunniest operators are state-supported by myopic magistrates hood-winked into fiscal deals.
Gary J. Aguirre's US Senate testimony details fraud & market mechanics which were at work before 1929,
e.g. Ponzi structures, unregulated pools of money, siphoning from unsuspecting mutual fund investors, and
abuse-prone market dominance: hedge funds' $1.5 trillion drive half of the $28 trillion NYSE's daily trading.
Tongue-in-cheek, Warren Buffet famously opined: "derivatives are financial weapons of mass destruction";
yet, under increasing performance & compliance pressures, some bankers still see a future in fee hunting.
Society wised up against churning of accounts by undelicate trustees, but not yet against macro-parasitism
which feasts on ignorance, sucks & devours a firm's life-preserving substance, & weakens society's pillars.
Which turns economic rat races into societal tailspins with early burn-outs & senior citizens being wasted,
& instills values causing youth to be educated out of sync, resulting in drug, violence & €1000 generations.
With profit-driven quarterly thinking & cost-cuttings also eroding due infrastructure maintenance & renewal,
& democracy's promises ridiculed by Fatf, EU & UN bureaucratic lawmaking as if Berlin Wall fell eastwards.
So why not thinking things over & Revisiting Das Kapital while some dance on the Titanic”?   Iconoclast

Markets are all about inflicting the maximum pain
on the maximum number of suckers at any given point in time.
Matein Khalid, in The Coming Currency Collapse, Khaleej Times (UEA)
Dreams, bubbles & stampedes

courtesy by: Swiss Investors Protection Association - url:
.../capitalism.html ¦ .../1929.htm ¦ .../buccaneers.htm ¦ ....../caisses.htm ¦ .../hedge.htm ¦ .../goldies.htm ¦ .../GAFI.htm
.../porkbellies.htm ¦ .../swissbanks.htm ¦ .../costbenefit.htm ¦ .../oecdmandate.htm ¦ .../crime.htm ¦ .../glasnost.htm
tks 4 notification of errors, comments & suggestions: +4122-7400362 ¦

The U.S. Gross National Debt
globally floating IOUs tied to US housing: $7.5 trillion
hedge-fund asset growth 2001-06: $0.539 to 1.43 trillion
IRS-protected & FATF-targeted black funds: $1 to 2.4 trillion
M&A totalling in 2006: $3.8 trillion ¦ billion dollar bonus gurus
paycheck devide: food for next revolution

1929 crash mechanism spinning again? ¦ TV's Big Brother Ponzi scam ¦ Gold matters ¦ The €1000 Generation
Le capitalisme est en train de s'autodétruire ¦ Le nouvel âge du capitalisme: Bulles, krachs et rebonds
Switzerland. tax eldorado for failed golden boys, greed gurus, hedge fund managers & other apprentice-sourcerers?
Causes of the Financial Crisis

17.Jan 13    William White: «Die Währungskriege sind sehr gefährlich», NZZ, Christof Leisinger
7.Jan 13   Ponzi-System der enormen Verschuldung, NZZ, Andreas Uhlig
24.Dez 12   Börsen und Märkte auf der Achterbahn:  Untragbare Expansion der Notenbank-Bilanzen, NZZ, Andreas Uhlig
13.Aug 11   Vier Gründe, weshalb diese Krise hartnäckiger sein wird als frühere,, Res Strehle
19 Oct 09   Countdown to the next crisis is already under way, FT, Wolfgang Münchau
19 Oct 09   Mideast investment cuts hit private equity, FT, Robin Wigglesworth et al.
25 Sep 09   A Crisis of Politics, Not Economics, WSJ, JEFFREY FRIEDMAN, comments
14 Sep 09   Same Old Hope: This Bubble Is Different, NYT, CATHERINE RAMPELL
12 Jun 09   The Great Unwinding, NYT, DAVID BROOKS
11 Jun 09   Get Ready for Inflation and Higher Interest Rates, WSJ, ARTHUR B. LAFFER
10 Jun 09   America’s Sea of Red Ink Was Years in the Making, NYT, DAVID LEONHARDT
8 Jun 09   The Coming Currency Collapse, Khaleej Times (UEA), Matein Khalid
7 Jun 09   The storm is not over, not by a long shot!, NYT, SANDY B. LEWIS et al.
6 Jun 09   Poking Holes in the Efficient Market Hypothesis, NYT, JOE NOCERA
29 May 09   The Big Inflation Scare, NYT, PAUL KRUGMAN, comments
27 May 09   Exploding debt threatens not only America, FT, John Taylor
18 May 09   The End Game Draws Nigh -The Future Evolution of the Debt-to-GDP Ratio, Safehaven, John Mauldin
11 May 09   Monsters, Inc. - How banks got big, The New Yorker, James Surowiecki
8 Mar 09   If you liked the US subprimes, you'll love Europe's Collapse, NYT, LIAQUAT AHAMED
8 Mar 09   When Austria's bankers danced on their Titanic, NYT, FREDERIC MORTON
4 Feb 09   Wall Street Bonuses Are an Outrage, WSJ, THOMAS FRANK
4 Feb 09   Mating Season Is Over for Alpha Males of Banking, Bloomberg, Matthew Lynn, commentary
4 Feb 09   SEC’s Madoff Miss Fits Pattern Set With Pequot, Bloomberg, Gary J. Aguirre, commentary
2 Feb 09   Prison for Dummies’ Is a Ponzi Guy’s Must-Read, Bloomberg, Susan Antilla, commentary
2.Feb 09   Majestix und Miraculix auf den Finanzmärkten, DER STANDARD, Johannes M. Lehner
1 Feb 09   Disgorge, Wall Street Fat Cats, NYT, MAUREEN DOWD
30 Jan 09   Obama Calls Wall Street Bonuses ‘Shameful’, NYT, SHERYL GAY STOLBERG et al.
29 Jan 09   What Red Ink? Wall Street Paid Hefty Bonuses, NYT, BEN WHITEh
28 Jan 09   Troubled Times Bring Mini-Madoffs to Light, NYT, LESLIE WAYNE
27 Jan 09   Bonus culture: Money for Nothing, NYT, DAVE KRASNE
26 Jan 09   To save the banks we must stand up to the bankers, FT, Peter Boone et al.
25 Jan 09   Time to herald the Age of Responsibility, FT, Robert Zoellick
23 Jan 09   Giga bubble-in-the-making: The World Won't Buy Unlimited U.S. Debt, WSJ, PETER SCHIFF
23 Jan 09   Investors Want Clarity Before They Take Risks, WSJ, MICHAEL BOSKIN
1 Jan 09   annus horribilis 2008: world's stockmarkets lost $14 trillion, Guardian, Julia Kollewe
19 Oct 08   The Bubble Keeps On Deflating, NYT, editorial
30 Sep 08   Prelude to War? Bernanke Knows What We Have to Fear, WP, Richard Cohen
30 Sep 08   How Voter Fury Stopped Bailout &  Put Plan on the Ropes, WSJ, Stephen Power et al.
30 Sep 08   Too Much Money Is Beyond Legal Reach, WSJ, Robert M. Morgenthau
30 Sep 08   Loose Money And the Roots Of the Crisis, WSJ, Judy Shelton
29 Sep 08   French and German anger misses the fact, FT, Charles Wyplosz
29 Sep 08   Those whom the gods would destroy, they first make mad, FT, Willem H. Buiter
29 Sep 08   J.P.Morgan was more effective than Paulson & Bernanke combined, WSJ, L. Gordon Crovitz
29 Sep 08   What We Can Learn From Chile's Financial Crisis, WSJ, Mary Anastasia O'Grady
29 Sep 08   Shorting Financial Stocks Should Resume, WSJ, Arturo Bris
29 Sep 08   Credit Markets and the Real Economy, WSJ, Michael T. Darda
29 Sep 08   Bankrupt Economics: A Crisis Resists The Usual Remedies, WP, Robert J. Samuelson
29.Sep 08   WEF in China: «Wer rettet den Wall-Street-Retter Uncle Sam?», Neue Zürcher Zeitung
29 Sep 08   A Cure for Greed, NYT, EDUARDO PORTER
29 Sep 08   WaMu’s Lesson for Private Equity, NYT,, ROB COX
29 Sep 08   The Real Costs of the Bailouts, WSJ, SUDEEP REDDY
29 Sep 08   A Bailout Is Just a Start, WP, FT, Lawrence Summers
28 Sep 08    Evolution of US Capitalism: Long Tradition of State Roles, WP, Robert J. Shiller
28 Sep 08    How J.Pierpont Morgan defused the 1907 Wall Street panic, WP, Jean Strouse
28 Sep 08   What’s Free About Free Enterprise?, NYT, PETER L. BERNSTEIN
28 Sep 08   Wall Street, R.I.P.: The End of an Era, Even at Goldman, NYT, Julie Creswell et al.
27 Sep 08   In praise of free markets, FT, editorial
27 Sep 08   An Alternative Way to Save the (Financial) World, NYT,  Joe Nocera, 37 comments
27.Sep 08   Die sieben Mythen zur Finanzkrise der USA, Die Welt, Sebastian Jost
27.Sep 08   Was Hayek erkannt und die experimentelle Forschung bestätigt hat, NZZ, Vernon L. Smith
26 Sep 08   Don't disregard all structured products, Telegraph, Chris Taylor
25 Sep 08   Back to Basics: Responsibility! Accountability! Discipline! Oversight! Rules! WSJ, Daniel Henninger
25 Sep 08   "Keynes wouldn't have wanted to nationalize that casino", WP,. David Ignatius
25 Sep 08   Economists Of The World, Unite!, NYT, Joe Nocera, 24 comments
25 Sep 08   U.S. Losing Finance Superpower Status, Germany Says, Bloomberg, Leon Mangasarian
25 Sep 08   A Bailout We Don't Need, WP, James K. Galbraith
25 Sep 08   The Paulson Plan Will Make Money [also] For Taxpayers, WSJ, ANDY KESSLER
24 Sep 08   Financial rescue models: solutions past and present, FT
24 Sep 08   After Wall Street firms paid out over $100 billion in bonuses: Crash, NYT,Timothy Egan
24 Sep 08   How Main Street Will [also] Profit, WP, William H. Gross
24 Sep 08   Top Executives at Bruised Firms Among Wall Street's Highest Paid, WP, Cecilia Kang
24 Sep 08   Bringing Down Wall Street as Ratings Let Loose Subprime Scourge, Bloomberg, Elliot Blair Smith
24 Sep 08   Bailout Proposal Meets Bipartisan Outrage, WP, Lori Montgomery et al.
24 Sep 08   "I'm sorry": The Words Left Unspoken in the Bailout Debate, WP, Steven Pearlstein
24 Sep 08   Faith-Based $ Mainly Dependent on Alien Constituency: Buck Stopped in 1971, NYT, James Grant
24 Sep 08   Congress wants Wall Street to feel it where it hurts: the wallet, NYT, Steve Lohr
24 Sep 08   Traders Sowing Seeds of Destruction Prompt Crackdown, Bloomberg, Shannon D. Harrington et al.
23 Sep 08   Darling tells regulator to curb City's bonus culture, The Guardian, Jill Treanor
23 Sep 08   Experts See a Need for Punitive Action in Bailout, NYT, PETER S. GOODMAN
23 Sep 08   Countdown to a Meltdown, Washington Post, editorial
23 Sep 08   M3 figures hidden since March 2006: Currency's Dive Points to Further Pain, WP, Anthony Faiola et al.
23 Sep 08   A Bailout or a Bonanza?, WP, Eugene Robinson
23 Sep 08   Hard Landing for the Golden Parachute, WP, Dana Milbank
22 Sep 08John McCain: $400000 executive pay cap for bailed-out firms, CNBC, Reuters
22 Sep 08   The Pain of Deleveraging Will Be Deep and Wide, Barrons, Lawrence C.Strauss, INTERVIEW
19 Sept 08   Bankers and Their Salaries, NYT, Editorial
19 Sept 08   A Bid to Curb Profit Gambit as Banks Fall, NYT. VIKAS BAJAJ et al.
19 Sep 08   Present at the Crash, NYT, SAM G. BARIS
19 Sep 08   Peering Over the Cliff, Saying 'I Told You So', WP, Steven Mufson
18 Sep 08   "Wall Street's investment banks plainly deserve to die", Washington Post, Harold Meyerson
18 Sep 08   Scrambling to Clean Up After A Category 4 Financial Storm, WP, Steven Pearlstein
18 Sep 08   The King Is Dead, NYT, Roger Cohen
15 Sep 08   After Bear Stearns, Lehman, Merrill Lynch, etc.: Jittery Road Ahead, NYT, Floyd Norris et al.
12 Sep 08   Lehman: Short Raiders 1: Regulators Nil, Heinz Geyer
11 Apr 08    The Face of a Prophet (George Soros: “The New Paradigm for Financial Markets"), NYT, Louise Story
1 May 08   Numbers Racket: Why the economy is worse than we know, Harper's Magazine, Kevin Phillips
17 Apr 08   Hedge Fund Manager Reaps $3.7 Billion in Casino on the Titanic, WP, David Cho
9 Apr 08   A Silicon Valley Slowdown, NYT, MATT RICHTEL and BRAD STONE
27 Mar 08   Senators Seek Details About Bear Stearns Deal, NYT, EDMUND L. ANDREWS
20 Feb 08   America’s economy risks mother of all meltdowns, FT, Martin Wolf
18 Jan 08   Don’t Cry for Me, America, NYT, Paul Krugman, Op-Ed Columnist
18 Jan 08   Dire Wall Street Year With Record Bonuses of $39 Billion, WP, Bloomberg, Christine Harper
16 Jan 08   Could subprime crisis trigger credit default swaps (CDS) tsunami?, Chronique Agora, Dan Denning
10 Jan 08   Exchequer Club speech by Fed-Chairman Ben S. Bernanke
10 Jan 08   Defaults Rise at Mortgage Lender Countrywide, WP, David Cho
4 Jan 08   The Next Credit Crisis Will Originate in China, Seeking Alpha, J. Christoph Amberger
1 Jan 08   '07: Buyouts and Bailouts, WP, Allan Sloan
31 Dec 07   Wall Street is about smart guys thinking about ways to make money from dumb ones, NYT, Dash
29 déc 07  Quand le rêve américain tourne au cauchemar planétaire, Le Temps, Marie-Laure Chappatte et al.
26 Dec 07   Mortgage Meltdown, Michael S.Barr, et al., Peter Schiff & Louis Hyman, NYT, Op-Eds
24 Dec 07   Dollar's Fall Is Felt Around The Globe, WP, Anthony Faiola
24 Dec 07   Swiss bank regulator to probe UBS: report, WP - Reuters, Jonathan Lynn
23 Dec 07   This Is the Sound of a Bubble Bursting, NYT, Peter S. Goodman
21 Dec 07   Wall Street to get fatter bonuses while many stakeholders suffered huge losses, CNN, AP
21 Dec 07   Blindly Into the Bubble, NYT, Paul Krugman, Op-Ed Columnist
19 Dec 07   The looming banking crisis behind the credit crunch - a systemic fault line?, Economist, leader
18 Dec 07   Fed Shrugged as Subprime Crisis Spread, NYT, Edmund L. Andrews
2.Dez 07   Hans-Jörg Rudloff: «Ein unglaubliches Desaster», SonntagsZeitung, Victor Weber
28 Nov 07   Why banking remains an accident waiting to happen, Financial Times, Martin Wolf
28 Nov 07   Bankers are in the confidence, not in the storage or even moving business, FT, Peter Thal Larsen
24 Nov 07   At the gates of hell: Now the misery is spreading, Economist
23.Nov 07   UBS: Das angekündigte Debakel; Ospels Abgang im Frühling 08?, BILANZ, Lukas Hässig
23.Nov 07    Ken Moelis: Zur Branchenkrise, Geldgier und Aufspaltung der UBS, BILANZ, Enk Nolmans
26 Sep 07   U.S. Aims to Limit Funds' Risk, Washington Post, Carrie Johnson, comment
21 Aug 07   For Wall Street's Math Brains, Miscalculations, Washington Post, Frank Ahrens
20 Aug 07   Herding Scapegoats: Who's to blame for current lending mess? Barrons, T.G.Donlan, Editorial
20 Aug 07   Easy Credit, Bubbles and Betrayals, NYT/IHT, Roger Cohen, edpage comment
20 Aug 07   Market turmoil and threats to the broader economy, NYT, Editorial
19 Aug 07   Watershed: excesses in lending and derivatives threaten system, NYT, Editorial
18 Aug 07   Hyman Minsky Long Argued Markets Were Crisis Prone, WSJ, Justin Lahart
16 Aug 07   Hold tight: a bumpy credit ride is onlyjust beginning, FT, Avinash Persaud
15 Aug 07   In a world of overconfidence, far makes a welcome return, FT, Martin Wolf
14 Aug 07   No longer dancing: How the music stopped for buy-out buccaneers, FT, James Politi et al.
14 Aug 07   Surviving a credit market meltdown, FT, Martin Arnold
13 Aug 07   Banking bail-out sows seeds of future crises, FT, Paul de Grauwe
13 Aug 07   21st Century Bank Run Version: Why the Blowup May Get Worse, Barrons, Randall W. Forsyth
13 Aug 07   Appropriately, the Bill Lands on Wall Street's Desk, Barrons, Andrew Bary
12 Aug 07   Tight Credit Could Stall Buyout Boom, Washington Post, David Cho and Thomas Heath
11 Aug 07   Bubble and Bust, Washington Post,editorial
11 Aug 07   Central Banks Intervene to Calm Volatile Markets, NYT, VIKAS BAJAJ
11 Aug 07   Subprime Turmoil Catches Funds Off Guard, WSJ, ELEANOR LAISE
11.Aug 07   Zusammenbruch des US-Immobilienmarktes, Deutschlandfunk, Presseschau
11 Aug 07   US$ 1 trillion/y black funds sinking "white economy"?, Iconoclast
11 Aug 07   Payback time: A case from the Californian Front, FT, J.E. Morgan, Letter to the Editor
10 Aug 07   Markets abhor the vacuum left by derivatives, FT, Frank Partnoy
10 Aug 07   New Order Ushers in A World of Instability, Washington Post, Steven Pearlstein
10 Aug 07   Very Scary Things, NYT, Paul Krugman
10 Aug 07   A New Kind of Bank Run Tests Old Safeguards, NYT, FLOYD NORRIS, News Analysis
9 Aug 07   Subprime bites, US investigators look for culprits, FT, Brook Masters et al., ANALYSIS
9.Aug 07   Die Mutter aller Krisen: Der tickende Zusammenbruch, WOZ, Till Hein
1 Aug 07   Rupert Murdoch's WSJ acquisition: Public Good versus Ponzi schemes, edpage draft, Anton Keller
30 Jul 07   Trustees or vulgar fee-hunters? Bankers must relearn their craft, Financial Times, John Gapper
30.Jul 07   Wufflis Abgang: UBS in den USA über den Titsch gezogen, SonntagsZeitung, Arthur Rutishauser
29 juil 07   Union mondiale se dresse contre des éléphants financiers en argile, Le Temps, interview
26 Jul 07   'Locusts' enrich our society: Private Equity and Public Good, WSJE, Wilfried Prewo
25.Jul 07   HEDGE FONDS-Debakel: Spitze der Verluste noch nicht in Sicht, Handelszeitung, Samuel Gerber
20 Jul 07   UBS falls from grace, Economist
19 Jul 07   The fair way to tax private equity, FT, editorial
18. Juil 07  Privatsphäre in Gefahr, NZZ, Kommentar
18.Juli 07   Glaubenssätze in der Vermögensverwaltung, NZZ, Roland Hengartner
17 Jul 07   UBS settles New York InsightOne suit over charging excessive fees, WSJ, Chad Bray et al.
16. Juli 07  Jens Ehrhardt: „Es ist die größte Blase, die es je gab“, FAZ, Catherine Hoffmann, Interview
15 juil 07   Notes de frais des fonds de private equity: $8 mia, Agefi, Alexandre Sonnay
23 Jun 07   $3.2 Billion Move by Bear Stearns to Rescue Fund, NYT, Julie Creswell & Vikas Bajaj
13 Jun 07   The Takeover Boom, About to Go Bust, Washington Post, Steven Pearlstein
18 May 07   A headache awaits when the credit party fizzles out, Financial Times, comment
18 May 07   Beijing to take $3bn gamble on Blackstone, Financial Times, Martin Arnold et al.
18 May 07 U.S. Regulators Examine Risk In Banks' LBO Lending, WSJ, Greg Ip
16 May 07   Investment banker says private equity deals too risky for banks, Guardian, Patrick Collinson
14 May 07  The secret world of hedge funds, Telegraph, Ambrose Evans-Pritchard
Apr 07  In Debt We Trust: America Before the Bubble Burst,, Danny Schechter
11 Apr 07   Private equity collapse on cards, says IMF, Telegraph, Edmund Conway ¦ IMF Report
23 Mar 07   The Subprime Loan Machine, NYT, LYNNLEY BROWNING
22 Feb 07   Mortgage Insecurities, NYT, Editorial
11 Jan 07   Private-Equity growth reached "a momentum of its own", WSJ, Tennille Tracy
27 Dec 06   Of Public Debt and Private Wealth, Washington Post, Steven Pearlstein
25 Dec 06   Wall St. Bonuses: So Much Money, Too Few Ferraris, NYT, JENNY ANDERSON
8 Dec 06   Carlyle founder predicts $100bn buy-out deal, Financial Times, James Politi
3 Oct 06   How to Fix the Global Economy, NYT, JOSEPH E. STIGLITZ
21 Sep 06   The dark side of debt, The Economist
3 Aug 06   Bank of Italy slashes $ holdings in favour of UK £, Telegraph,Ambrose Evans-Pritchard
28 Jun 06   1929 crash mechanism spinning again?, US Senate Judiciary Committee, Gary J. Aguirre
13 June 06   America's scariest addiction is getting even scarier, , Jackson Lears
29 May 06   The Interest Must Be Paid, NYT, Editorial
8 Mar 06   Investor: Beware, International Herald Tribune, Daniel Wagner
19 Feb 06   The Case for Fewer but Stronger Currencies, NYT,  DANIEL GROSS
11 Feb 06   U.S. Trade Deficit Sets Record, With China and Oil the Causes, NYT,VIKAS BAJAJ
18 Jan 06   Gilts bubble savages pensions,, Philip Coggan et al.
17 Jan 06   Foreign Currency Piles Up in China, Washington Post, Peter S. Goodman
24 Oct 05   State-sponsored counterfeit dollars: Pyongyang, IHT, John K. Cooley
1990    Krisengefahren in der Weltwirtschaft, Fredmund Malik et al., Schäffer, Stuttgart

International Herald Tribune    24 October 2005

The rogue money printers of Pyongyang
 By John K. Cooley

    The Bush administration has finally publicly acknowledged what U.S. and international law enforcement agencies suspected for decades: North Korea seeks to finance its impoverished economy, and fund its nuclear and other arms programs, with massive production of counterfeit U.S. dollars.
    Scan Garland, 71, a Veteran of the Irish Republican Army, was arrested in Belfast in September. He awaits extradition to the United States on a federal warrant that alleges that he and others bought, moved and either passed or resold high-quality counterfeit $100 notes.
    The United States further charges that Garland, who denies his guilt and was released on bail pending receipt of U.S. extradition papers, arranged with North Korean agencies "for the purchase of quantities of notes and enlisted other people to disseminate" the bogus money, known as superdollars or supernotes.
    U.S. federal prosecutors broke decades of official silence about North Korea's printing and distribution of top-quality $100 counterfeits and related traffic in cigarettes, drugs and arms last August. In California and several other states, arrests were made of people linked to a major Asian crime ring. Prosecutors named the Asian Delta Bank in Macao, the former Portuguese colony in China, as a "primary money-laundering concern," for helping North Koreans distribute forged currency and other criminal activities.
    The North Korean counterfeiting story begins almost simultaneously with the late Shah of Iran's purchase in 1975 and 1976 of two intaglio-color-8 presses, the type then used by the U.S. Treasury to print genuine dollars, from De La Rue Giori, in Lausanne, Switzerland. These survived the Shah's overthrow by Islamic revolutionaries in 1979 and provided an industrial base for the flood of expertly crafted superdollars. Specimens first appeared in Singapore in 1983, then, a decade later, inundated Europe and the Middle and Far East.
    Kim II Sung's hermetic and desperately poor North Korean dictatorship purchased a similar press from the same Swiss Company, also in the mid-1970s. Several North Korean defectors have described the press's subsequent location as central Pyongyang. Distribution networks were organized that extended into China and later into Southeast Asia and as far as North America.
    After criminal complaints against North Korean diplomats who have been caught distributing supernotes since 1994, Phil Williams, a professor at the University of Pittsburgh, observed: "We've rarely seen a state use organized crime in this way. This is a criminal state, not because it's been captured by criminals but because the state has taken over crime."
    In 1994, an alert teuer in the Hong Kong branch of the New York-based Republic National Bank discovered that currency shipments from the Delta Bank in Macao were larded with supernotes. U.S. Secret Service agents traced them to North Korean businessmen in Macao, but the North Korean ringleader escaped to mainland China and the trail went cold.
    The forged dollars migrated across the Pacific into North America. The Canadian police discovered the main masterminds: a Chinese crime gang called Dai Hien Jai or the Big Circle Boys. During the mid-1990s, they spent and laundered superdollars in casinos in Lake Tahoe, Nevada, in New York's East Broadway Chinatown district and elsewhere.
    The most publicized law enforcement breakthrough was the arrest and conviction in Thailand in 1996 of Yashimi Tanaka, a former Japanese Red Army terrorist who had taken refuge in North Korea in 1970. Tanaka was caught in Cambodia trying to launder into Thai currency supernotes with a face value of $250,000.
    In the summer of 1998, the U.S. Treasury refused comment when the Japanese Navy seized a North Korean ship stuffed with superdollars. The Japanese police, backed by the Tokyo field office of the US, Secret Service, rounded up intended distributors in Japan. Within 48 hours of the ship's seizure, officials in Tokyo and Washington had muffled the affair.
    Washington's tardy but welcome acknowledgment of Pyongyang's role in counterfeiting, and further developments in the Sean Garland case and other related cases, deserve careful scrutiny for links between the now supposedly disarmed IRA and other violent groups, including AI Qaeda, and the rogue money printers in North Korea.

John Cooley is a retired American foreign correspondent. His books include "Unholy Wars: Afghanistan, America and International Terrorism."

Washington Post    January 17, 2006

Reserve Fund Soared to Record in 2005
Foreign Currency Piles Up in China

By  Peter S. Goodman

    SHANGHAI, Jan. 16 -- China's state media on Monday reported that the country's foreign currency reserves swelled by more than one-third last year to a record $819 billion as its factories churned out goods for markets around the world, heightening the likelihood of fresh trade tensions with the United States.
    Coupled with news only days earlier that China's world trade surplus tripled last year, to $102 billion, the country's burgeoning foreign exchange reserves seemed certain to intensify demands that China increase the value of its currency, the yuan, the worth of which is linked to the dollar. U.S. manufacturing groups argue that China's currency is priced too low, making its goods unfairly cheap on world markets. Lawmakers in Congress have pressed a bill that would impose across-the-board punitive tariffs on all Chinese goods unless the country substantially raises the value of its currency.
    "This could give the senators more meat for their argument," said Stephen Green, a senior economist with the bank Standard Chartered PLC in Shanghai.
    Chinese officials braced for further conflicts with the United States, particularly as many economists anticipate that the country's trade surplus will widen. A flood of investment into industries such as steel, automobile manufacturing and electronics has erected too many factories and produced more goods than China can absorb, sending prices falling while encouraging Chinese firms to seek sales abroad. Diminished profits and slowing investment temper China's demand for machinery and raw materials, limiting the need for imports.
    "It's almost certain that China's trade surplus will remain at a high level in 2006," said Mei Xinyu, an economist at the Chinese Academy of International Trade and Cooperation in Beijing, a research institute operated by the country's Ministry of Commerce. "Obviously, there will be further pressure from trade protectionists in the United States."
    China argues that it is being used as a scapegoat in Washington for the decline of U.S. manufacturing: The flow of capital to lower-cost manufacturing areas is a global phenomenon that is transferring jobs not only to China, but also to Latin America, Eastern Europe, India and Southeast Asia. About two-thirds of China's exports are produced in factories that are financed at least in part with foreign investment, undercutting the notion that this country's growing trade is coming at the expense of everybody else.
    Analysts said the stance of China's Communist Party-led government will not change, despite the broadening of its global trade surplus and its buildup of foreign exchange. Beijing will continue to move only gradually to widen a band within which the yuan trades against the dollar, lest it unleash uncertainty in a financial system rife with risks -- not least, the existence of an estimated $500 billion in bad debt choking its banks.
    China is loath to increase the yuan enough to dampen growth in its coastal factories. Exports are a key source of jobs in a country that must find tens of millions of them for poor farmers and workers laid off by bankrupt state factories in the continued transition from communism to capitalism.
    Last July, China bumped up the value of the yuan by 2 percent against the dollar, somewhat diminishing tensions with the United States. But in the months since, the yuan has moved little against the dollar, though it has strengthened considerably against other currencies, such as the euro, as the dollar itself has climbed.
    Still, some economists said China's reserves were now growing so huge as to compel the central bank to deliver a significant revaluation. Otherwise, China risks that its reserves will leak into the banking system and be lent out for speculative investments that will only worsen a feared glut of real estate and factory capacity. "The renminbi [yuan] is fundamentally undervalued," said Ha Jiming, chief economist at China International Capital Corp., a giant state-owned investment bank. "As foreign exchange continues to grow, it will force a revaluation."
    The details disclosed in Monday's state press accounts and reported Sunday on the Central Bank's Web site confirmed that China is on track this year to exceed $1 trillion in foreign exchange reserves. That would probably elevate China to the biggest holder of foreign currency, eclipsing Japan, which has $847 billion.
    In recent weeks, Chinese policymakers have signaled a rethinking of investment priorities as they debate what to do with the reserves. Traditionally, China has sunk three-fourths of its reserves into U.S.-dollar-denominated investments, such as U.S. Treasury bills. Some have called for large purchases of oil to create astrategic petroleum reserve. Others have suggested that China will now devote a larger percentage of reserves to other world currencies such as the euro and the yen to reflect its balance of trade.
    Some analysts say the size of the reserve gives China a tool to manage trade tensions. "The more China possesses U.S. dollars, the more China can invest in the U.S. and buy U.S. bonds and U.S. products like Boeing aircraft," said Shen Dingli, an American relations expert at Fudan University in Shanghai.
    China has consistently harnessed its largesse in this way, timing the announcement of big-ticket purchases from the United States to mollify critics. As Shen acknowledged, however, China's investments have themselves stoked tensions -- not least, last summer when the state-owned oil company Cnooc Ltd. tried and failed to buy Unocal Corp. China and Japan have propped up the value of the dollar and financed U.S. spending by continuing to absorb U.S. debt via the purchase of Treasury bills. Yet these purchases have sown unease, with some in Washington complaining that the United States has relinquished control of its destiny to foreigners. "The U.S. could fear concerns that as China possesses U.S. debt, that could give China the ability to influence the U.S. financial situation," Shen said.
    The huge leap in China's foreign exchange and its trade surplus reflect a basic reordering of global manufacturing. Only a few years ago, laptop computers and televisions, for example, were completed in South Korea, Japan, Taiwan and Malaysia before being loaded onto tankers bound for U.S. ports, to be counted as exports from those countries. Today, much of the final assembly work is completed in Chinese factories, adding to China's trade surplus.
    Still, even as the "Made in China" label grows ubiquitous, many of the most valuable pieces inside these products continue to be manufactured and designed elsewhere -- computer chips in Taiwan and Malaysia, liquid-crystal display panels in South Korea, computer software in Japan. "China's trade surplus is a function of a fundamental imbalance of trade," Green said. "But in fact, these are not China exports: They are really Asian exports."

Special correspondent Eva Woo contributed to this report.
© 2006 The Washington Post Company

    February 11, 2006

U.S. Trade Deficit Sets Record, With China and Oil the Causes

    The United States trade deficit widened to a record $726 billion in 2005, the government reported yesterday, adding more fuel to the increasingly partisan debate between advocates of further globalization and those who contend that free trade is causing the loss of too many American manufacturing jobs.
    Hitting its fourth consecutive annual record, the gap between exports and imports reached almost twice the level of 2001. It was driven by strong consumer demand for foreign goods and soaring energy prices that added tens of billions of dollars to the nation's bill for imported oil. The nation last had a trade surplus, of $12.4 billion, in 1975.
    The continued growth in the trade deficit, particularly with China, is likely to renew a fight in Congress as early as this spring over President Bush's trade policies. Lawmakers have seized on the growing imbalance with China to call on the White House to take a harder line with Beijing over its currency practices. But as long as the American economy is growing faster than most of its trading partners and energy prices stay at elevated levels, economists expect little improvement, and perhaps even a slight widening, in the trade imbalance this year. "You would need a dramatic slowdown in domestic U.S. demand to bring down the U.S. trade deficit, and we think that is unlikely," said Dean Maki, chief United States economist at Barclays Capital in New York.
    That means the nation will go deeper into debt with the rest of the world as Americans continue to rely on the strong flow of foreign money, particularly from central banks in Asia, to finance the trade gap. China, Japan and other foreign governments are some of the biggest holders of government securities, lending money to cover the substantial federal budget deficit and helping to keep interest rates and home mortgage costs here relatively low. As a result, American consumers are able to spend more and save less.
    Many economists say this situation is unsustainable over the long run, arguing that the United States could eventually face a harsh correction that would depress spending, increase the cost of borrowing and sharply lower the value of the dollar. "There are certainly going to be inflows, the question is at what price?" said James O'Sullivan, an economist at UBS, an investment house. "As time goes on, it will become a little more difficult to attract foreign funds. That's another way of saying the dollar will fall."
    But other economists argue that the huge trade gap mostly reflects stronger American growth and that money is flowing into the country at relatively low rates because of the attractiveness of the United States as a place to invest. They see little reason to fear a dollar crisis. "As long as foreigners are willing to put their capital in the United States, we can sustain a trade deficit of 6 percent or more" of overall economic activity, said Phillip L. Swagel, a resident scholar at the American Enterprise Institute in Washington who served as a staff economist for President Bush's Council of Economic Advisers. "It would be better that we saved more on our own," Mr. Swagel added, "but given that we aren't, I would rather have investment go on by foreign capital."
    For its part, the Bush administration urged caution on the deficit. Commerce Secretary Carlos M. Gutierrez, touring an I.B.M. operation in North Carolina, told The Associated Press, "We can't overreact and make tactical choices that will hurt our economy."
    As a share of the gross domestic product, the trade gap increased to 5.8 percent, from 5.3 percent in 2004 and 4.5 percent in 2003. While most economists dismiss the importance of bilateral trade imbalances, it is the deficit with China that has set off the most political fireworks. That nation had the largest gap with the United States of any country, at $201.6 billion for the year, up 24.5 percent from 2004. In December, the deficit with China narrowed nearly 12 percent, to $16.3 billion.
    Following increased pressure from the White House, the Chinese government allowed the yuan to rise by about 2 percent in July and allowed its currency to float in a narrow band. Since then the yuan, also known as the renminbi, has risen by an additional 0.7 percent. One dollar buys about 8.0505 yuan. A stronger Chinese currency would make imports to the United States more expensive and American exports to that country cheaper. Most analysts agree the yuan would rise significantly if it were set free, but many experts also worry that many financial institutions in China are not strong enough to survive the shocks that might accompany a fully convertible currency.
    In the Senate, Charles E. Schumer, Democrat of New York, and Lindsey Graham, Republican of South Carolina, have proposed imposing a 27.5 percent tariff on Chinese imports if the country does not allow its currency to appreciate further against the dollar. Late last year, the senators agreed to hold off on the measure after the Senate voted against stopping a floor vote on it. Mr. Schumer said "there is a very strong likelihood that we will move our bill in March should the Chinese not show further movements." "If you believe in free trade, you play by the rules," he said when asked if a protectionist tariff would hurt the American economy. "The long-term damage of the Chinese pegging their currency far exceeds any immediate benefits and almost every economist would agree with that. They might not agree with our methodology."
    Experts note that a large portion of the deficit with China reflects its growing role as a hub for the assembly of goods as Asian manufacturers have shifted production there to save money. The overall deficit with Asia has changed little in recent years.  Bush administration officials have said they, too, would like to see the yuan appreciate further, but have contended that sanctions like a tariff would be counterproductive and would hurt consumers. This month, the Treasury Department urged the International Monetary Fund to improve its policing of currency manipulations by governments, without directly referring to China.
    Treasury Secretary John W. Snow is expected to bring up the issue of exchange rates at a meeting of the Group of 8 finance ministers in Moscow this weekend.
    But even some longstanding advocates of free trade are growing increasingly frustrated with China's intransigence on the currency front, warning that it may be inviting protectionist legislation by repeatedly deflecting Washington's requests. "The administration," said C. Fred Bergsten of the Institute for International Economics in Washington, "has to let the Chinese know that it may not be able to stop it even though it doesn't want it."
    While China draws most of the attention, perhaps the most important factor behind the swelling deficit last year was the rising cost of importing oil and other energy supplies. Trade in petroleum products accounted for 29 percent of the total deficit, up from 25 percent in 2004. Imports of petroleum goods climbed 39 percent, to $251.6 billion, after rising by 39 percent in 2004.
    Over all, the deficit jumped nearly 18 percent in 2005 compared with the previous year. Excluding oil and other petroleum products, the trade gap grew by 10 percent. After China, the United States' second-biggest deficit was with Japan, at $82.7 billion, up 9.4 percent, followed by Canada, a big supplier of oil and natural gas, at $76.5 billion, up 15.1 percent.
    The deficit with members of the Organization of the Petroleum Exporting Countries increased by 29 percent, to $92.7 billion. For December, the trade deficit grew by 1.5 percent over the previous month, to $65.7 billion, as imports of computers, cars and airplanes rose and exports of planes, which had risen sharply in November, dropped. It was the third-largest monthly trade gap on record. And with oil prices rising again, said Ashraf Laidi, chief currency analyst for the MG Financial Group in New York, "we can expect to see worse numbers to come."

    February 19, 2006

The Case for Fewer but Stronger Currencies

    OUTSOURCING isn't just a one-way street on which rich countries shift jobs overseas. In recent years, some developing countries have contracted out the work of setting monetary policy to the United States. Ecuador and El Salvador, in 2000 and 2001, respectively, abandoned their own currencies, adopted the dollar and placed their monetary policy in the capable hands of Alan Greenspan, then the chairman of the Federal Reserve.
    When outsourcing involves manufacturing and software programming it is often endorsed by economists and condemned by populist political leaders. So, too, is the tactic of outsourcing of monetary policy — known as dollarization, or euro-ization. After all, noted Robert E. Litan, senior fellow at the Brookings Institute, "currencies are symbols of national sovereignty, and countries are reluctant to give them up."
    And yet nations can impose enormous costs on their citizens when they take extraordinary efforts to maintain independent currencies. "Devaluations of currencies cost people their savings and bring on rapid inflation," said Benn Steil, a senior fellow at the Council on Foreign Relations and co-author with Mr. Litan of "Financial Statecraft" (Yale University Press, 2006). The two argue that the globe's mélange of 200-plus currencies, backed only by the faith of investors, is inefficient and dangerous. Many emerging economies, they say, would be well advised to swap their currencies for strong, stable, widely used ones like the dollar or euro.
    Steve H. Hanke, professor of applied economics at Johns Hopkins University, has examined economic development in 32 countries that adopted foreign currencies from 1950 and 1993. He found that they had faster rates of G.D.P. growth, lower inflation and greater fiscal discipline than their counterparts who hung onto their sovereign currencies. Professor Hanke has been an adviser to Ecuador, which in 2004 was among the best-performing economies in Latin America, growing at a 6.6 percent rate with inflation at 2.7 percent.
    "Dollarization tends to deliver low inflation, and relatively low and stable interest rates," said Ricardo Hausman, a former chief economist of the Inter-American Development Bank who now teaches at the Kennedy School of Government at Harvard.
    So what's not to like? "It's not like dollarization is a magic drug," Mr. Steil said. It certainly doesn't end the risk that countries will default on dollar-denominated debt. Panama has been using the dollar since 1904 and has repeatedly run into difficulties. And El Salvador's economic performance hasn't outpaced those of its Central American neighbors.
    Some Latin American countries, notably Mexico, have tamed inflation without abandoning their own currencies. "If you have sound economic policies in a country, you don't need dollarization," said Nouriel Roubini, professor of economics at New York University's Stern School of Business. "And if you follow poor policies, I don't think dollarization will solve your problems."
    But economists say that smaller countries can encourage investment by lashing their monetary fortunes to larger regional powers. In Latin America, companies that need to make long-term investments — like utilities — are forced to borrow in dollars while they operate in local currencies, leaving them exposed to currency risk. Now that El Salvador has adopted the dollar, companies there can borrow or engage in hedging transactions in dollars with relative ease.
    And when small monetary boats tie themselves together or link themselves to larger ones, it encourages stability. "European financial markets were able to navigate problems of 9/11 and the Madrid and London bombings without too much instability, because they didn't have the extra layer of exchange-rate problems," said Barry Eichengreen, professor of economics and political science at the University of California, Berkeley.
    But one economist's reassuring stability can be another's troubling rigidity. If the price of coffee plummets or the price for textiles falls because of competition from China, a Latin American country that has dollarized won't have the option of cutting interest rates to stimulate growth. "Dollarization takes away the option of depreciation," Professor Hausman said.
    Dollarization advocates say that this is all to the good. Mr. Steil notes that the Dominican Republic, where a currency crisis in 2004 wiped out the savings of a significant chunk of the population, conducts about 85 percent of its trade with the United States. "Why on earth would they need their own currency?" he asks.
    Large countries like the United States have to tread lightly in advocating that small countries give up their currencies. In 2000, Congress considered — but did not pass — the International Monetary Stability Act, which would have provided financial assistance to countries that adopted the dollar.
    WHAT'S more, moving to unite monetary policies without integrating political and labor systems is problematic. The 12 member nations of the euro zone have solved the political problems created by common currencies by adopting a transnational institution—the European Central Bank — and giving every country a seat at the table, Professor Eichengreen said. "Where is Ecuador's seat on the Federal Reserve Board?" he asked.
    Advocates of dollarization recognize that the trend is also at odds with the prevailing political winds in the Western Hemisphere. "There is a mini-anti-American revolt going on in Latin America as we speak," Mr. Litan said. "Countries that would otherwise be interested, like Bolivia and Venezuela, have elected leftist governments" that are ardently opposed to dollarization.
    But Mr. Litan says he believes that time may be on the side of the dollar: "History has marched toward the euro, and it is slowly marching toward the dollar."

Daniel Gross writes the "Moneybox" column for

International Herald Tribune   8 March 2006

A frenzy of getting and spending
Investor: Beware
The world's economies are vulnerable to collective shock.
By  Daniel Wagner

    Borrow and spend fiscal policies are very much in vogue among governments and consumers, the global housing bubble bas reached unprecedented proportions, and many of the world's stock markets are so hyperinflated that investors seem to have forgotten the basic law of physics — what goes up must corne down.
    India's stock market shot up by 42 percent and Malta's rocketed by 60 percent last year, but investors keep pour-
ing money into the markets. This investor frenzy is occurring on the heels of some of thé largest corporate bankruptcies and fïnancial boondoggles in history and indicates that investors appear not to have learned much in the process.
    Investors appear to believe that for some reason the age of globalization has made the prospect of a global economie meltdown remote, and that the global economy will recover from whatever is thrown its way. Their thinking is that since the world's economies are so closely linked together, they will ail somehow swim, not sink, when the next major shock to the System occurs. The more logical conclusion, however, is that globalization has made all the world's economies more vulnerable to collective shock.
    Unlike the past, those shocks can be more severe because of the economie linkages and because of new threats to the system with unpredictable consequences such as global terrorism, nuclear proliferation among rogue states, and the threat of a global pandemic.
    The price of oil currently hovers between $60 and $70 per barrel — near historie inflation-adjusted highs — without any major disruption in the tight global supply. Any major disruption in supply — from a terrorist attack, an oil worker strike, or a decision to withhold supply by a major oil producing nation — could send the price of oil into the stratosphere. The resuit would be predictable: consumers would stop spending and the economie ripple effects would take their toll.
    If the U.S. consumer stops buying, the U.S. economy and the many economies dependent upon it will be affected. China's export machine would downshift from Overdrive to first gear, the commodity boom would stop in its tracks, and the global production machine would slow down dramatically.
    If a bomb on a container ship were to explode in the port of Los Angeles or Rotterdam, global container traffic would be disrupted for weeks or months. Global imports and exports would be halted temporarily, with incalculable damage to the global shipping business and to the global economy.
    If a chemical, biological, or nuclear weapon were to explode in the financial district of New York or London, financial activity would probably have to be halted in those locations for years, as it would be too dangerous to occupy, much less rebuild. The global implications would be severe.
    Yet the capital markets are humming as if there were no tomorrow and investors seem impervious to the risks that are now ever present in the global economie system. Some governments have made their fiscal quagmire worse by piling more debt on the national books and continuing to spend recklessly, while doing little or nothing meaningful to increase national revenues.
    Some home financiers have reacted to the housing bubble by adding fuel to the fire, creating no-down-payment schemes, encouraging more speculation and continued high-stakes risk taking. Many banks have continued to offer consumers new
credit cards, and consumers have responded in kind, spending until their credit cards are maxed out and borrowing
from the banks until they can take out no more home equity loans. How can this possibly continue?
    Governments, investors and lenders continue to build the house of cards, with little apparent regard for the long-term consequences or the many risks that could cause its collapse at any time.
    Al Qaeda's recent attempt to bomb a major oil facility in Saudi Arabia was a wake-up call. Just one major supply disruption could resuit in a super spike in the price of oil. As was the case with 9/11 and with SARS, a terrorist attack or bird flu pandemic could cripple the travel industry, with severe economie consequences. And one action by a rogue nation could send the markets into a tailspin.
    Nothing but a bunch of gloom and doom you think? World War I, remember, started with a single gunshot.

Daniel Wagner is apolitical risk analyst based in Manila.

    May 29, 2006
The Interest Must Be Paid

    Recent stock market turmoil has been a plus for United States Treasury securities. Over the last couple of weeks, investor demand for safety has generally pushed up the price of the benchmark 10-year Treasury bond, making it cheaper for the government to borrow. But there is still plenty of reason to worry about the United States' borrowing binge.
    By definition, federal borrowing eventually results in a transfer of income from American taxpayers, whose taxes go to pay the interest on the debt, to the investors who hold the Treasury bonds. As long as the bonds are owned by Americans, the transfer is simply from one group of citizens to another. Bond holders may get richer, while taxpayers who don't own bonds get poorer, which could add to troubling disparities in personal wealth. But shuffling the income between the two groups doesn't reduce America's overall wealth.
    Today, however, 43 percent of the United States' publicly held debt of $4.8 trillion is held abroad, mainly by central banks in Japan, China and Britain and by offshore hedge funds. That's up from a 30 percent share in 2001, an extraordinary increase. Indeed, during the Bush years, 73 percent of new government borrowing has been from abroad.
    Paying the interest on the foreign-owned portion of the debt will be a burden on future Americans, draining their wallets and siphoning off the nation's wealth.
    Reliance on foreign lenders poses current dangers, as well. A shift in investor sentiment, away from dollar-based investments and into other countries' assets, could be very destabilizing, forcing a drop in the dollar, higher interest rates and higher prices. Such shifts can be sudden, as in the Asian financial crisis in 1998.
    Of course, no one knows the future. But we can size up our present reality: America is living beyond its means, and foreigners are increasingly supporting the excess — in exchange for a government guarantee that a chunk of America's future collective income will benefit them, not the Americans who earn it.    13 June 2006

America's scariest addiction is getting even scarier

Jackson Lears

But as the history of debt in America shows, condemnations of extravagance can obscure more than they illuminate. The equation of debt and decline assumes that once upon a time Americans lived within their means and saved for what they bought. This is fantasy: there never was a golden age of thrift. Debt has always played an important role in Americans' lives — not merely as a means of instant gratification but also as a strategy for survival and a tool for economic advance.

Yet our moral traditions have concealed this complexity. "Owe no man anything," St. Paul warned, and from the New England Puritans forward, legions of Protestant ministers made this their text. Indebtedness signified a sin against the Protestant ethic of self-control; it also threatened the ideal of independent manhood that underwrote the founders' vision of a virtuous republic. The indebted man "must smile on those he hates, he must extend his hand where he would strike, he must speak pleasantly with a curse in his throat," a Harper's contributor wrote in 1894. "He wears dependence like a yoke."

Benjamin Franklin coined similar lessons in aphorisms later memorized by generations of Victorian-era schoolchildren: "The Borrower Is a Slave to the Lender." "Be frugal and free." The link with lost freedom was more than metaphorical: you could still be imprisoned for debt in many places (including New York City) down to the early 1900's.

Still, the case against debt was more principled than practical. Every generation of moralists imagined the same fall from financial rectitude. In their novel "The Gilded Age" (1873), Mark Twain and Charles Dudley Warner mourned the disappearance of the antebellum "horror of debt" amid the speculative borrowing of the post-Civil War years.

In 1924, the editor of The Saturday Evening Post complained that "the firmly rooted aversion to debt in any form which prevailed a generation ago has almost completely evaporated." In 1958, John Kenneth Galbraith noticed that "there has been an inexplicable but very real retreat from the Puritan canon that required an individual to save first and enjoy later."

In fact, debt is as American as cherry pie. For George Washington and Thomas Jefferson, debt was the price they paid to participate in the world of big-spending Southern planters. Among plainer rural folk, through most of the 19th century, cash was scarce, and country-store ledgers carried local peoples' debts for years, sometimes forever.

Factory workers and laborers used debt to make ends meet, resorting to pawnshops, loan sharks, relatives and friends. Even moralists admitted distinctions between good ("productive") debt and bad ("consumptive") debt. The other side of debt, after all, was credit — "Beautiful credit! The foundation of modern society," as Twain and Warner called it in "The Gilded Age." They had a point. The root of credit was credo — "I believe" — and faith was a necessary component of most transactions in an expanding economy. Borrowing money was "getting trusted," in the argot of Victorian commerce. Among businessmen, indebtedness was a sign that you were "a man of importance in the community," as a euphoric young John D. Rockefeller said after he was "trusted" by a Cleveland bank for $2,000. Not financial obligations but the failure to meet them was what made you "good for nothing."

Among the failures in the late 19th century were farmers, whose crop prices fell while they struggled to pay for threshers and combines. Desperate for relief from creditors, they demanded an expansion of the money supply through the free coinage of silver. The "money question" peaked in the election of 1896, when the Northeastern creditors' candidate, William McKinley, defeated William Jennings Bryan, the spokesman of the agrarian South and West. Those last two regions, a writer for The Atlantic Monthly observed, had "nothing in common but a lack of thrift." Imprudent borrowers took on debt "with only a speculative opportunity to pay" — and this, the magazine charged, violated the trust required to maintain the credit system. This rhetoric of "sound money" concealed a clash of interests between bankers and farmers, Wall Street and Main Street. It would not be the last time that moralism would mask class conflict in debates over monetary policy.

After 1900, the proliferation of mass-marketed products encouraged a more open tolerance for consumer debt. By the 1920's, millions of middle-class Americans bought durable goods on time payments — sewing machines, washing machines, radios, automobiles, houses. Lenders acquired legitimacy, reinforced by reassuring names like Household Finance Corporation or General Motors Acceptance Corporation. "Acceptance" implied membership in a national community of responsible borrowers.

Indebtedness could discipline workers, keeping them at routinized jobs in factories and offices, graying but in harness, meeting payments regularly. Good consumers would be good producers. The economist who proposed this idea was Simon Nelson Patten, in "The New Basis of Civilization" (1907). By providing new sanctions for spending, Patten helped create a cultural landscape where consumer debt could find a decent suburban home. He predicted that workers' desires for things would not undermine their capacity for disciplined achievement, as generations of moralists had claimed; rather, the multiplication of wants would become part of the civilizing process, as workingmen and their wives would broaden their horizons and take pride in their accumulating possessions.

Patten's New Basis began the project that E.R.A. Seligman would complete in "The Economics of Installment Selling" (1927) — the abolition of the distinction between "productive" and "consumptive" debt. Patten was onto something. The disciplining power of debt was undeniable. Even during the Depression, while Americans cut back on new borrowing, they also denied themselves food and clothing to avoid repossession of refrigerators or real estate. "Oh, the tension in the house," one of Studs Terkel's informants recalled in "Hard Times," "when Pa used to scramble around trying to get enough money to pay that installment loan. That was the one degrading thing I remember." In 1932, a Harper's contributor observed that the middle-class homeowner "no longer has possessions but only obligations." This homeowner did not exactly represent an ethos of self-gratification.

The true fulfillment of Patten's vision depended on an economically secure working population. These conditions awaited the rise of strong industrial unions and the comparative prosperity of the post-World War II era. The acquisition of appliances, cars and houses was often financed on the installment plan or with the assistance of government agencies like the Federal Housing Administration. Thanks largely to union power, more fortunate workers could depend on steady wages that allowed them to pay off big-ticket items over time. Patten would have been pleased.

The upward spiral of earning and spending survived until the 1970's, when the midcentury ideal of corporate citizenship evaporated in the harsher climate of renewed international competition. Fearing foreign rivals, American business ended its implicit social contract with unions by seeking cheap labor in overseas markets. During the 1980's, while real income continued to stagnate for most Americans, the ascendancy of Ronald Reagan gave government sanction to unprecedented consumer spending.

Reagan's rhetorical refusal of limits combined with the deregulation of the lending industry to detach dreams of luxury from previous constraints. As money worship mounted, job security disappeared and inequalities widened, pundits spoke of a new Gilded Age. By the 1990's, bloated icons of affluence proliferated: the gargantuan pseudo-military vehicle, the 10,000-square-foot hacienda. A bigger standard package of household goods demanded deeper debt and accelerated the pace of the consumer treadmill. No one wanted to look like a "loser."

But for many borrowers, debt has not been just about keeping up appearances. Less-affluent Americans have resorted to borrowing for groceries as well as cars. Public policies have intensified their plight. The freezing of the minimum wage, the tightening of unemployment insurance and workmen's compensation programs, the shifting of the tax burden from the rich to the rest — these changes have starved public services while leaving ordinary Americans more dependent than ever on debt. One of the most consistent statistical findings of recent years is that about half of all personal bankruptcies have been caused by medical bills. Whatever else our current indebtedness may signify, it is hardly a riot of hedonism.

Jackson Lears, editor of Raritan: A Quarterly Review, is the author, most recently, of "Something for
Nothing: Luck in America."    03/08/2006

Bank of Italy slashes dollar holdings in favour of UK pound
By Ambrose Evans-Pritchard

    Italy's central bank has switched a quarter of its foreign currency reserves into sterling, dumping billions in US Treasury bonds, in the most dramatic move to date by a G7 country to slash exposure to the dollar. The Bank of Italy, now under new governor Mario Draghi, said in its half-year report that it had raised the sterling share of its reserves to 24pc, up from zero in 2004.
    Dollar holdings were cut from 84pc to 63pc, a shift that is certain to be analysed closely by traders as a gauge of sentiment among the 12 central banks of the eurozone system. The yen share fell from 14pc to 10pc. Sterling closed yesterday at $1.8787 against the euro, near its peak for the year.
    Italy's huge purchase of pounds is the latest vote of confidence in Britain's economic management, a sign that sterling is regaining its historic role as a benchmark of stability, even if it is too small a player to serve as the anchor of the global system.
An Italian official said the Banca d'Italia was taking action in advance of a dollar slide, widely expected as the US interest rate cycle peaks this summer and investors focus once again on the US's $800bn (£425bn) current account deficit. The official said: "There are not many places to go once you decide to get out of the dollar.
    Japan is always a question mark. "At least the British economy is humming along OK and UK bonds offer a decent yield [4.63pc]. At the end of the day, Britain is still the biggest single trading partner for the eurozone."
    The Banca d'Italia is viewed as one of the world's most market-savvy central banks, holding onto every ounce of its gold reserves when others, including the Bank of England, under Treasury orders, sold much of their bullion at the bottom of the market.
    However, it co-ordinates policy closely with both the European Central Bank and its peers in the euro system, led by the German Bundesbank and the Banque de France. Tony Norfield, chief currency analyst at ABN Amro, said it was likely that other euro-zone banks were also selling dollars, although most of the rest do not reveal the exact breakdown of their foreign currency holdings. Mr Norfield said: "The Italians have been quite sneaky, but I wouldn't be surprised if others are doing the same thing. The Bank of France is worth watching."
    Dollar flight has been gathering pace at smaller central banks. In Sweden the Riksbank announced in April that it had cut its dollar holdings from 37pc to 20pc, while the United Arab Emirates and the gas sheikhdom of Qatar have both signalled plans to move into euros.
    The Swiss National Bank switched 10pc of its holdings into pounds in 2004, and Russia is now following suit. Russia's central bank said it had cut the dollar share of its surging reserves from around two thirds to 40pc, a weighting that matters more and more as Russia vaults up the foreign reserve league. At last count, Moscow was poised to move into third place with $251bn.
    However, for China and Japan, the two giants, with combined reserves of some $1,800bn, it is much harder to diversify smoothly out of the dollar. Any sign that they are liquidating their holdings of US bonds could trigger a global stampede, causing a dollar crash and a broader financial crisis. The two countries would be left with sharply devalued holdings.
    The fashion for sterling is a stark contrast to the grim days of the 1960s and 1970s when the UK pound was invariably the sick currency of the rich club. The silent accumulation of sterling by the heavy brigades would help explain the strength of sterling, the star performer on the currency markets this year.
    The International Monetary Fund said the UK pound had overtaken the yen to become the world's third biggest reserves currency, after the dollar and the euro. Known global reserves of pounds have risen from £55bn to £111.5bn over two years.

The Economist    Sep 21st 2006

Public markets for raising and investing capital are plunging into the shadows
The dark side of debt

    LENDING is a sober business punctuated by odd moments of lunacy. Genoese lenders' indulgence of Philip II of Spain's expensive taste for warfare caused not only the world's first sovereign bankruptcy in 1557, but the second, third and fourth as well. Lenders recycled petrodollars to third-world countries in the 1970s in the wilfully naive belief that countries, because they cannot go bust, will not default.
    The world is once again in the grip of a spree of lending, but this time to companies rather than countries. What is striking is that much of this lending is happening not through public share and bond markets, nor exclusively through banks (see article). The issuance of syndicated loans vaulted to $3.5 trillion last year, from $2.3 trillion in 2000.
    Thanks to the low cost of debt, private lenders, such as hedge funds, are extending vast amounts of credit to leveraged buy-out firms and other private borrowers. Forsaking the sunlit uplands of global finance, the market for capital is plunging into the shadows.
    For the financiers, that is an irresistibly lucrative place to be. In thinly traded, lightly regulated and untransparent markets, the bold can make an awful lot of money—and they can lose it on an even more extravagant scale. A bunch of investors is $6 billion or so poorer this week, after it emerged that Amaranth Advisors, a hedge fund that had some $9 billion under management, suffered catastrophic losses in a few weeks on the back of falling natural-gas prices (see article).
    There is every chance that the markets can cope with a wilting Amaranth, or worse. Moreover, business people have perfectly good reasons for wanting to operate out of the public gaze. The trouble is that the vulnerabilities of debt's dark side have not yet been fully tested by the next act of collective lunacy. The shadows are scary because nobody quite knows what secrets they hold. That has got regulators worried—and rightly so.

Dark matter
    Back in the days of claret-filled city lunches, life was so simple. Company pension funds and mutual funds put money into the securities of states and listed firms and hoped that they did well. Things are a great deal more complicated now. Even as the private world has eclipsed public markets, finance has been convulsed by a computer-enhanced frenzy of creativity. In today's caffeine-fuelled dealing rooms, a barely regulated private-equity group could very well borrow money from syndicates of private lenders, including hedge funds, to spend on taking public companies private. At each stage, risks can be converted into securities, sliced up, repackaged, sold on and sliced up again. The endless opportunities to write contracts on underlying debt instruments explains why the outstanding value of credit-derivatives contracts has rocketed to $26 trillion—$9 trillion more than six months ago, and seven times as much as in 2003.
    In many ways, these complex derivatives are good for economies. Because they allow investors to lay off the risk of borrowers' defaults, they free lenders to lend more. Because risk is dispersed to those who have an appetite for it, the system should be more robust. Because derivatives are traded in liquid markets, they rapidly transmit information about the creditworthiness of borrowers. The benefits of this hyperactive shuffling of money spread well beyond financial markets. If companies are borrowing more cheaply and sensibly to make acquisitions, pay dividends and buy back their own shares, businesses everywhere should run more efficiently.
    That is the theory, at least. And so far, it has broadly been borne out. The markets struggled to cope with financial crises in Asia and Russia in the late 1990s and with the implosion of Long-Term Capital Management, a hedge fund, in 1998. By contrast, there were never serious fears that the dotcom bubble burst, September 11th 2001, or, more recently, the collapse of General Motors' bonds and investors' flight from risky investments, would lead the system to collapse.
    Regulators understand very well how much the world stands to gain from this revolution in finance, but they are nevertheless nervous. Because of the lack of transparency, they cannot see whether these volatile new debt instruments are in safe hands or how they will behave in a crisis when everyone is heading for the exits. As Donald Rumsfeld might have put it, they have left a world of known unknowns for a twilight landscape of unknown unknowns.
    Last week Timothy Geithner, the Federal Reserve's man on Wall Street, gave warning that all this might make financial crises less common, but more severe. Britain's Financial Services Authority complained this week that investment banks and hedge funds were sloppy and prone to conflicts of interest. In a panic, incomplete paperwork could cause the whole system to collapse amid disputes about who owns which liabilities. Worryingly, firms had wildly different estimates for the risks of similar portfolios of investments.

Someone somewhere is investing on flawed assumptions.
    Sensible things can be done. Mr Geithner and the New York Fed have with some success been demanding that the derivatives markets sort out their bureaucracy. He wants banks to increase the cushion of collateral they require from highly leveraged clients, in case trades go bad. Banks, which routinely play computerised war games simulating the risks in their trading strategies, are being asked to be harder-nosed about assessing which hedge funds they deal with. Because the great fear is ignorance, regulators are commendably seeking unobtrusive ways to keep tabs on the markets.
    Regulators also hint that it might eventually be necessary to supervise credit hedge funds, now monitored via their brokers. Here the markets' desire for obscurity contains a lesson as well as a threat. The rush into the shadows is also partly a flight from regulation, to be free of the costs and the burdens of compliance and to preserve the "cover" that helps an outfit keep a profitable trade to itself. When the next recession reveals the next act of lunacy and the urge to re-regulate finance takes hold, remember that today's successes were founded partly on those freedoms.

October 3, 2006

How to Fix the Global Economy


THE International Monetary Fund meeting in Singapore last month came at a time of increasing worry about the sustainability of global financial imbalances: For how long can the global economy endure America’s enormous trade deficits — the United States borrows close to $3 billion a day — or China’s growing trade surplus of almost $500 million a day?

These imbalances simply can’t go on forever. The good news is that there is a growing consensus to this effect. The bad news is that no country believes its policies are to blame. The United States points its finger at China’s undervalued currency, while the rest of the world singles out the huge American fiscal and trade deficits.

To its credit, the International Monetary Fund has started to focus on this issue after 15 years of preoccupation with development and transition. Regrettably, however, the fund’s approach has been to monitor every country’s economic policies, a strategy that risks addressing symptoms without confronting the larger systemic problem.

Treating the symptoms could actually make matters worse, at least in the short run. Take, for instance, the question of China’s undervalued exchange rate and the country’s resulting surplus, which the United States Treasury suggests is at the core of the problem. Even if China strengthened its yuan relative to the dollar and eliminated its $114 billion a year trade surplus with the United States, and even if that immediately translated into a reduction in the American multilateral trade deficit, the United States would still be borrowing more than $2 billion a day: an improvement, but hardly a solution.

Of course, it is even more likely that there would be no significant change in America’s multilateral trade deficit at all. The United States would simply buy fewer textiles from China and more from Bangladesh, Cambodia and other developing countries.

Meanwhile, because a stronger yuan would make imported American food cheaper in China, the poorest Chinese — the farmers — would see their incomes fall as domestic prices for agriculture dipped. China might choose to counter the depressing effect of America’s huge agricultural subsidies by diverting money badly needed for industrial development into subsidies for its farmers. China’s growth might accordingly be slowed, which would slow growth globally.

As it is, however, China knows well the terms of its hidden “deal” with the United States: China helps finance the American deficits by buying treasury bonds with the money it gets from its exports. If it doesn’t, the dollar will weaken further, which will lower the value of China’s dollar reserves (by the end of the year, these will exceed $1 trillion). Any country that might benefit from China’s loss of export market share would put its money into a strong currency, like the euro, rather than the unstable and weakening dollar — or it might choose to invest the money at home, rather than holding more reserves. In short, the United States would find it increasingly difficult to finance its deficits, and the world as a whole might face greater, not less, instability.

Nothing significant can be done about these global imbalances unless the United States attacks its own problems. No one seriously proposes that businesses save money instead of investing in expanding production simply to correct the problem of the trade deficit; and while there may be sermons aplenty about why Americans should save more — certainly more than the negative amount households saved last year — no one in either political party has devised a fail-proof way of ensuring that they do so. The Bush tax cuts didn’t do it. Expanded incentives for saving didn’t do it.

Indeed, most calculations show that these actually reduce national savings, since the cost to the government in lost revenue is greater than the increased household savings. The common wisdom is that there is but one alternative: reducing the government’s deficit.

Imagine that the Bush administration suddenly got religion (at least, the religion of fiscal responsibility) and cut expenditures. Assume that raising taxes is unlikely for an administration that has been arguing for further tax cuts. The expenditure cuts by themselves would lead to a weakening of the American and global economy. The Federal Reserve might try to offset this by lowering interest rates, and this might protect the American economy — by encouraging debt-ridden American households to try to take even more money out of their home-equity loans to pay for spending. But that would make America’s future even more precarious.

There is one way out of this seeming impasse: expenditure cuts combined with an increase in taxes on upper-income Americans and a reduction in taxes on lower-income Americans. The expenditure cuts would, of course, by themselves reduce spending, but because poor individuals consume a larger fraction of their income than the rich, the “switch” in taxes would, by itself, increase spending. If appropriately designed, such a combination could simultaneously sustain the American economy and reduce the deficit.

Not surprisingly, these recommendations did not emerge from the International Monetary Fund meetings in Singapore. The United States retains a veto there, making it unlikely that the fund will recommend policies that aren’t to the liking of the American administration.

Underlying the current imbalances are fundamental structural problems with the global reserve system. John Maynard Keynes called attention to these problems three-quarters of a century ago. His ideas on how to reform the global monetary system, including creating a new reserve system based on a new international currency, can, with a little work, be adapted to today’s economy. Until we attack the structural problems, the world is likely to continue to be plagued by imbalances that threaten the financial stability and economic well-being of us all.

Joseph E. Stiglitz, a professor of economics at Columbia and the author, most recently, of “Making Globalization Work,” was awarded the Nobel in economic science in 2001.

December 25, 2006

Wall St. Bonuses: So Much Money, Too Few Ferraris

It’s a brisk Wednesday morning in the windy caverns of Wall Street and Sarah Clark’s toes are cold. Dressed in a purple flight attendant outfit, Ms. Clark, a 26-year-old model, is trying to entice recent bonus recipients at Goldman Sachs into using a charter plane service, handing out $1,000 discount coupons to people in front of the investment bank’s Broad Street headquarters.

“Where am I going?” asks one man, heading toward the Goldman building. “It’s your own private jet,” says Ms. Clark with a smile. “You can go wherever you like.” For Wall Street’s elite, the sky may well be the limit.

In recent weeks, immense riches have been rained upon the top bankers and traders. After a year of record profits, investment houses like Goldman Sachs, Lehman Brothers and Morgan Stanley are awarding bonuses as high as $60 million. And a select group of hedge fund managers and private equity executives may be taking home even more.

That is serious money. And the serious luxury goods markets are feeling the impact. Miller Motorcars, in Greenwich, Conn., is fielding more requests for the $250,000 Ferrari 599 GTB Fiorano than it can possibly fill. One real estate broker laments a dearth of listings for two clients trying to spend $20 million on Manhattan properties. Financiers already comfortably settled in multimillion-dollar apartments and town houses are buying $5 million apartments for their children. Vacation homes, usually bought and sold in the spring, are now hot this winter, including ones in private resorts like the Yellowstone Club in Montana near Yellowstone National Park.

“Last year, everybody bought Ducatis,” said one investment banker, referring to the Italian motorcycle. “This year it’s vacations. I’m on my way to St. Barts,” he said, en route to the airport. Like most bankers, he spoke on the condition that he not be identified, because he was not authorized to talk to a reporter by his company.

The 2006 bonus gold rush has re-energized some luxury markets. The Manhattan real estate market, for example, had softened; sales of apartments fell 17 percent in the third quarter this year compared with a year ago, according to the Corcoran Group.

Then came bonus day. Last week, Michele Kleier, president of Gumley Haft Kleier, received a call from a hedge fund manager in his late 30s. He had spent $6 million on an apartment two years ago and, with his bonus, wanted to upgrade. His new price range? “Not more than $20 million.” Ed Petrie, a broker at Sotheby’s in East Hampton, N.Y., is now fielding two bids for $8 million to $10 million properties in exclusive Georgica Pond — properties that have been on the market since the spring. “The fall was relatively slow and then suddenly, with news on bonuses, there has been quite a bit of activity,” he said.

Many brokers noticed not just the bonus effect, but the bonus-anticipation effect. Buyers who sat on the sidelines in 2006, waiting for real estate prices to come down, saw news of outsized bonuses and started signing deals to pre-empt any price increase driven by new Wall Street payouts. “Part of our recent increase in sales activity has been buyers not in financial services trying to beat the bonus rush,” said James Lansill, senior managing director at the Corcoran Sunshine Marketing Group. Once the bonus rush started, Mr. Lansill witnessed a trend he had never seen in his 14 years in the business: people who had signed contracts for apartments under construction 5 to 6 months ago were doubling the size of the properties they were purchasing.

In the last three weeks, the Corcoran Sunshine Marketing group sold the last four apartments in the Richard Meier apartments at 165 Charles Street in Greenwich Village. The last one to go: a two-bedroom, two-bathroom apartment with 2,350 square feet that sold for just under $7 million.

Patricia Warburg Cliff, senior vice president and director for European sales at the Corcoran Group, said that until recently, 2006 had been characterized by calmer, more informed buyers. “Now there’s a feeling, ‘I need to sign because I don’t want it snatched away,’ ” she said.

Adding to the spending spree is a rash of young hedge fund analysts, first big bonus checks in hand, scooping up the $2 million to $3 million starter apartments (most popular features: glass walls, marble bathrooms and kitchens — likely to go unused — with top-flight appliances). “We love hedge funds, they are our favorite people” Ms. Kleier said. “They don’t feel like the money is real and they don’t mind spending it — they don’t mind going up by $500,000 or $1 million increments.”

Hedge fund analysts are not the only ones celebrating bonus season. Private equity firms like the Blackstone Group and Kohlberg Kravis & Roberts helped fuel a record deal-making year. Private equity’s deal-making has trickled down to Wall Street in two ways. For one, the banks served as advisers on the deals and financed them, raking in enormous fees. (Kohlberg Kravis is said to pay more than $700 million a year in fees to the Street.) But bankers also see a pay effect: top executives insist they must pay up because of the danger that their best dealmakers could leave for higher-paying private equity firms or other hedge funds considered more flexible and fun.

Those young, single hedge fund managers are bringing holiday cheer to car dealerships as well. This year, drama surrounds the very limited production of the Ferrari 599 GTB Fiorano, a car with 612 horsepower that can go from zero to 60 miles an hour in 3.6 seconds. “It is the most sought-after car ever made,” said Richard Koppelman, president of Miller Motorcars. With a waiting list of 50, Mr. Koppelman expects to get only one. Who will be the lucky customer? “It’s very difficult,” he said. “We try to take care of our best clients.”

Private planes, or shares of them, are also on the rise, with demand for charter planes at one company up 40 percent to 50 percent among financial services executives. “There is a noticeable difference this year compared to the past, especially in the financial sector,” said Jeffrey Menaged, founder and head of Chief Executive Air, the company that hired Ms. Clark for the day. A typical price for a charter flight is $30,000. Sales of “jet cards,” a sort of debit card for private flying, increase during bonus season, Mr. Menaged said, as executives lock in last year’s gains with guaranteed comfort for the new year.

Exotic destinations are also being pitched to the Wall Street ultrarich. Unlimited Speed started Victory Lane in November, a 3,000-acre development in Georgia for motor racing aficionados. Along with a 4.5 mile racetrack, the development also has a 1,600-acre nature preserve, equestrian facilities, a golf course and spa. It already has 27 reservations, a quarter of them coming from Wall Street, said Andrew Goggin, president of Unlimited Speed.

Not everyone on Wall Street is getting multimillion-dollar bonuses. The average managing director — who stands at the top of Wall Street’s hierarchical food chain, but far from rock-star status — will be getting $1 million to $3 million, which will likely be stashed in savings as memories of the 2001 bear market remain fresh. “I’m putting it in the bank because I know next year I could be out of a job,” said one managing director at a leading bank.

For hedge fund traders and managers, markets were rough in the spring and summer, and some did not make gains until stocks rallied this fall. “It was a terrible year,” said one young hedge fund professional. “I am going to the movies with my bonus. By myself."

At cocktail parties, comparisons to 1999 abound. That year marked the height of the technology boom and the eve of a painful crash. “It feels a little bit like the top,” said another banker.

The morning Goldman Sachs announced record fourth-quarter and 2006 earnings, Lloyd C. Blankfein, chairman and chief executive, implored his employees — many whom would directly benefit from the bountiful earnings — to avoid excess. “As stewards of the firm’s reputation, I ask each of you to remember that our actions — inside and outside of the office — reflect on Goldman Sachs. Even a perception of arrogance hurts all of us,” he said in a voice mail sent to the entire firm.

Back handing out vouchers in front of Goldman, Ms. Clark wondered why there weren’t more people coming to work during the early hours. Then, at 7:30 a.m., a black Mercedes pulled up, depositing Mr. Blankfein in front of Ms. Clark. The night before, he had been awarded a $53.4 million bonus. She offered him a voucher. “How are you?” he said, smiling quickly but refusing the voucher. “I guess he didn’t want it,” she lamented.


February 22, 2007

Mortgage Insecurities

If the bankers, investors and regulators who populate the global financial markets are not already anxious, they should be. The easy money that has buoyed the global economy for much of this decade is getting harder to come by.

At a similar point a decade ago, Russia defaulted on its foreign debt and Asia came unglued, weakening global growth. This time, the trigger could be the rapid erosion in the quality of American home mortgages — reflected in surging delinquencies and rising defaults.

Two economists, Mark Zandi and Juan Manuel Licari of Moody’s, detailed the dangers recently. In 2005 and 2006, lenders wrote an estimated $3.2 trillion in new home mortgages, which was a record — and lowered their credit standards considerably to do it. In 2005 alone, 20 percent of the mortgages taken out were “subprime” — made to borrowers with poor credit — and many more had worrisome features like interest-only payments.

Not surprisingly, as interest rates rose last year, mortgage delinquencies soared. Delinquency rates are expected to peak in 2008 at over 3 percent, well above the level of the last recession. Many of these risky mortgages were sold to investment banks, who carved them up into complex i.o.u.’s that they sold to investors worldwide. More than 20 percent of global private debt securities is now tied to housing in the United States. That works out to $7.5 trillion — far larger than the market for United States Treasuries. So if America’s mortgage market heads south, the losses could be widespread.

The odds of a global financial crisis are still low, according to Mr. Zandi and Mr. Licari, but they are rising. There is not a lot now that can be done about the risks in the mortgage market. But the growing possibility of hard times ahead is another argument for rolling back many of the recent excessive tax cuts, so the government will have more resources available to respond if a crisis comes.

March 23, 2007

The Subprime Loan Machine

Edward N. Jones, a former NASA engineer for the Apollo and Skylab missions, looked at low-income home buyers nearly a decade ago and saw an unexplored frontier.

Through his private software company in Austin, Tex., Mr. Jones and his son, Michael, designed a program that used the Internet to screen borrowers with weak credit histories in seconds. The software was among the first of its kind. By early 1999, his company, Arc Systems, had its first big customer: First Franklin Financial, one of the biggest lenders to home buyers with weak, or subprime, credit.

The old way of processing mortgages involved a loan officer or broker collecting reams of income statements and ordering credit histories, typically over several weeks. But by retrieving real-time credit reports online, then using algorithms to gauge the risks of default, Mr. Jones’s software allowed subprime lenders like First Franklin to grow at warp speed.

By 2005, at the height of the housing boom, First Franklin had increased the number of subprime loan applications it processed sevenfold, to 50,000 every month. Since 1999, Mr. Jones’s software has been used to produce $450 billion in subprime loans.

The rise and fall of the subprime market has been told as a story of a flood of Wall Street money and the desire of Americans desperate to be part of a housing boom. But it was the little-noticed tool of automated underwriting software that made that boom possible.

Automated underwriting software spawned an array of subprime mortgages, like those that required no down payment or interest-only payments. The software effectively helped move what was a niche product only a decade ago into the mainstream.

Automated underwriting “replaced the ways we used to extend credit,” said Prof. Nicolas P. Retsinas, director of the Joint Center for Housing Studies at Harvard.

Automated underwriting is now used to generate as much as 40 percent of all subprime loans, according to Pat McCoy, a law professor at the University of Connecticut who has written on real estate lending.

The software itself, of course, cannot be blamed for lowered lending standards or lax controls. But critics say the push for speed influenced some lenders to take shortcuts, ignore warning signs or focus entirely on credit scores.

“Used properly, automated underwriting is a wonderful thing,” Professor McCoy said. The problem, she said, comes when lenders customize it to approve the wrong borrowers.

During the housing boom, speed became something of an arms race, as software makers and subprime lenders boasted of how fast they could process and generate a loan. New Century Financial, second to HSBC in subprime lending last year and now on the brink of bankruptcy, promised mortgage brokers on its Web site that with its FastQual automated underwriting system, “We’ll give you loan answers in just 12 seconds!”

Dozens of little-known software companies compete with Arc Systems. They include MindBox of Greenbrae, Calif.; Metavante, in Milwaukee; Mortgage Cadence of Greenwood Village, Colo.; and Overture Technologies in Bethesda, Md.

With small staffs, the companies typically sell their software to home lenders with vast networks of call centers employing hundreds of thousands of loan officers. Some big Wall Street banks and housing lenders bought the software, then developed their own systems. First Franklin, which has been acquired by Merrill Lynch, said that it stopped using Arc Systems’ software last year to create its own proprietary system.

Subprime lenders like automated underwriting because it is cheap and fast. A 2001 Fannie Mae survey found that automated underwriting reduced the average cost to lenders of closing a loan by $916. The software quickly weeds out the very riskiest of applicants and automatically approves the rest. “You don’t have to chase every lead — just greenlight ’em,” Mr. Jones of Arc Systems said in an interview. And greenlight them they did.

By mid-2004, Countrywide Financial, a major subprime lender, had used MindBox’s automated underwriting system to double the number of loans it made, to 150,000 monthly. “Without the technology, there is no way we would have been able to do the amount of business that we did and continue to do,” Scott Berry, executive vice president for artificial intelligence at Countrywide Financial, told a trade publication, Bank Systems & Technology, in the summer of 2004. Countrywide now uses a proprietary system.

Early forms of automated underwriting were first developed and used in the 1970s to process car loans and credit card applications.  By the mid-1990s, software for home buyers with good credit had gone mainstream at Fannie Mae and Freddie Mac, the large government-sponsored mortgage finance companies, and big traditional lenders. But none had been developed for subprime lending, then a niche market.

There are no estimates of the sales volumes for this software niche, but companies like Arc Systems often have annual revenues in the tens of millions of dollars. Arc Systems, whose name is something of a pun — Mr. Jones’s middle name is Noah — earns $10 to $30 each time a borrower submits a loan application.

Proponents say the software makes things fairer and more objective for risky borrowers. “It takes the subjectivity out of the good ol’ boy system in which Martha knows Joe, who approves the loan — then you end up with a bad decision,” Mr. Jones said.

Samir Rohatgi, a vice president at MindBox, said that old system of manual underwriting actually encouraged loan officers working on commission to grant bad loans. “Those people were feeling pressure because of the way their company’s performing, so the decisions are sometimes biased,” he said.

Mr. Jones said that because his program, LendTech, could parse credit reports for more than 3,000 risk variables, “we had better analytics than the trading desks” on Wall Street. But some question whether such analysis gave comfort where it was not deserved.

“Automated underwriting put the credit score on such a pedestal that it obscured the other important things, like is the income actually there,” said Professor Retsinas of Harvard. “Before there was A.U., down payment mattered a lot. Where we’ve crossed the line in recent years is to say, we don’t need down payment.” Michael Perna, Arc Systems’ marketing director, said that income “is supposed to be verified by a person.”

Mr. Jones founded Arc Systems in 1984 to produce software for Suwannee County, Fla., which used it to track when policemen issued parking tickets and when jail wardens fed inmates. Then in 1992, a local subprime lender called Home Inc. asked Mr. Jones to develop a program to screen risky borrowers. In 1997, amid the adoption of the Internet, “we ditched that software and went Web-based,” Mr. Jones said.

Since 1999, his software has been used by major subprime lenders including HSBC and its former Household subsidiary, Deutsche Bank and the Virginia Housing Development Authority. Lehman Brothers and the Ellington Management Group, a big seller of mortgage-backed securities, have used LendTech to analyze pools of billions of dollars of subprime loans that they sold to big institutional investors. “We’ve had clients all along the food chain,” Mr. Jones, who is 66, said.

An electrical engineer by training who worked at NASA in the 1960s and then Unisys, Mr. Jones keeps his NASA patches on a wall in his office. He likes to clear cedar and juniper brush on his 100-acre property near Austin. His wife, Gayle, a nurse by training, is the company’s executive vice president. Arc Systems has 52 employees and at one point employed seven married couples. “We like to have picnics and play softball,” Mr. Jones said.

Since the subprime housing market began falling apart late last year, Arc Systems’ sales have dropped 30 percent. Still, Mr. Jones sees a sparkling future for automated underwriting. “The smart money on Wall Street is now looking for the gems — and they’ll use A.U. to find them.”

Then he added, “You know that old symbol of the snake eating its own tail? Well, we’ve always thought the industry was that. And that’s kind of where we’re at right now.”

Daily Telegraph   14 May 2007

The secret world of hedge funds
Ambrose Evans-Pritchard

    The world's top 25 hedge fund managers earned an average of $570m each last year, despite the crush of 8,000 funds all competing for a smidgeon of extra yield in the global marketplace. That much we know. Dr James Simons, a maths PhD and former cryptanalyst for the Pentagon, netted $1.7bn at Renaissance Technologies Corp, followed by Citadel's Kenneth Griffin on $1.4bn.
    Less known is how the stars operate, and how they view the world. For a glimpse into their clandestine affairs, try Steven Drobny's book, Inside The House Of Money, based on long lunches with 13 American, British and European fund managers, each a legend in their own sector, and each replete with tales of how they nearly "blew up" - hedge fund parlance for going bust.
    Such funds are not new. John Maynard Keynes ran his "Syndicate" for a group of friends, and another for King's College, Cambridge. The "College Chest" made a 13.2pc annual return from 1928 to 1945, through the Great Depression. Keynes learned the hard way like everyone else, sage though he was. His personal account was wiped out by a margin call in the commodity slide of 1929.
    Hedge fund man is by nature a contrarian. He - rarely she - bucks consensus as a way of life, profiting whenever the price of any asset, derivative, or country, looks out of whack. No surprise that so many view the current blow-off rally in junk bonds and Chinese stocks with deep suspicion, a sign that the cycle is nearing a top.
    More unnerving is the number who fear something worse, afraid that governments may have upset the workings of capitalism by holding interest rates too low for too long - that is, by mispricing credit. The villain of this book is former Fed chief Alan "Easy Al" Greenspan.
    "My gut feeling is that there will be a lot of pain because we still have to pay for the 1990s, and that worries me," said Christian Siva-Jothy, founder of SemperMacro. His ordeal by fire came as a cocky trader for Goldman Sachs when he bet $1bn that sterling would rise against the yen in 1994. Politics intruded, a recurrent theme.
    President Clinton threatened Japan with car tariffs over alleged currency manipulation (sound familiar? China?). The yen soared. "If that wasn't bad enough, five days later UK inflation numbers were simply awful. Sterling went into a free-fall. It was classic - the market found me," he said.
    "On day eight of this episode, when I lost about $40m in one day, I felt this overwhelming desire to walk out and pretend it wasn't happening. Instead I took a deep breath and liquidated everything. Confidence is a very dangerous thing," he said.
    His top trade is to buy eurodollar futures whenever the Fed starts cutting US rates. It worked like a charm after the Russian crisis in 1998, and again after the dotcom bust in 2001. "It's the most obvious trade in the most liquid market in the world. It's not brain surgery," he said.
    Dr Sushil Wadhwani, best known for his stint on the Bank of England's Monetary Policy Committee, also came unstuck on the yen when at Paul Tudor Jones, this time in 1998 as China was threatening devaluation (ironically). "I got seduced by stories that said dollar/yen was going to 180. I remember one or two people saying they thought the US would intervene because of China's complaints, but I'm afraid I didn't pay enough attention," he said. "In June, the Fed intervened, along with the Bank of Japan, and the dollar dropped like a stone. When something is going up or down in a straight line and you start getting political resistance, you had better pay attention," he said.
    Dr Wadhwani politely accused the Fed and old MPC colleagues of fatally ignoring property and asset inflation. "If you take your eye off the ball vis-à-vis asset price misalignments, then you are storing up trouble. What you've got now is huge asset market distortions and one of these days the chickens will come home to roost," he said. "Alan Greenspan has always argued that it's better to deal with a bubble after it has burst than to worry about pre-empting the bubble. I take a different view," he said.
    As for Britain, Mr Wadhwani said that the MPC should have tightened interest rates earlier to cool house prices, even if inflation fell below target. Like others, Jim Leitner from Falcon Management is waiting pensively for the denouement. "Right now there are a lot of bad things lurking, but I'm just not sure when we're going to fall on the knife," he said.
    Or take Scott Bessent, from Bessent Capital: "At some point, we will have the Big One. It's out there. I don't know whether it's financial asset depression, or a real depression. Financial assets can't keep doing what they're doing, with so many people rewarded for being imprudent," he said.
    Or the anonymous currency guru in the last chapter: "When you look at the whole world and see what it's built on, it is totally, clearly not sustainable. I get so bearish that I think about buying a castle in Scotland and moving up there with a couple of loaded shotguns and a truckload of canned food," he said.
    Regulators are now fretting, afraid that the funds have grown too big. They warn that speculators clustered on the same trades might lurch en masse across deck, capsizing the boat. That is a self-serving critique. Hedge funds have multiplied in a sea of credit, and who is ultimately responsible for that excess credit? Central banks, of course.

The Guardian    May 16, 2007

'King maker' breaks ranks to condemn private equity
· Investment banker says deals too risky for banks
· Bull run is four years old and 'correction inevitable'

Patrick Collinson

Britain's leading "star" investment manager, Anthony Bolton of Fidelity, yesterday broke ranks with City colleagues to condemn multi-billion pound private equity deals for exposing banks to a default risk on a scale not seen since the stock market crash of the late 1980s.
Mr Bolton has sold nearly all his bank and financial stocks and is using new powers to "short" stocks in the belief that many, particular smaller and mid-cap shares, are over-valued. He said the bull market in equities is four years old, which is a longer lifespan than most bull runs, and that a correction is inevitable.

Just a day after the CBI said private equity firms should be applauded for rejuvenating companies, Mr Bolton warned that unchecked lending to finance the current rash of merger and acquisition deals is leaving Britain's banks seriously exposed to the risk of a major default.
Mr Bolton is himself best known as a "king maker" in several big City deals. He shot to fame in 2003 when he orchestrated the sacking of Michael Green, then chief executive of Carlton Communications, earning him a title he loathes: the Quiet Assassin.

But yesterday he warned that the quality of lending by banks to private equity firms is deteriorating. Much of the lending is, he said, "covenant-lite" meaning if a firm goes bust, the bank will have little ability to reclaim the money lent. "Covenant-lite, as far as I'm concerned, means there is no covenant at all."

He added that the flood of private equity deals has similarities to the spate of mergers and acquisitions financed by easy lending in the late 1980s. The stock market, he said, is in the latter stages of a bull run and the behaviour of many of the participants in Wall Street and in London is a cause for worry.

"The head of a major New York investment bank told me in private that because the scale of the private equity deals are so big, the bank can't afford not to take part in them. There's a feeling that if they don't participate, then someone else will."

Mr Bolton has spent 27 years at Fidelity, running many of its biggest funds, including Fidelity European and Special Situations, a £6bn behemoth which he split into two funds last year. He handed one half of the fund to be managed by a relatively unknown Fidelity manager, Jorma Korhonen, and yesterday he paved the way for the remaining £3.2bn to be handed to another Fidelity insider, Sanjeev Shah.

Mr Shah's appointment was favourably received by financial advisers yesterday, who have been impressed by his track record in managing UK equities in a style akin to Mr Bolton.

But Mr Bolton's imminent departure - he formally stands down on December 31 - comes at probably the toughest time in Fidelity's history in the UK. The Boston-based family-controlled firm is the world's biggest investment company, but over the past year has seen its performance record flounder. In Britain it has £30bn under management, £4bn more than its nearest competitor, but many of its funds are languishing in fourth-quartile position. Fidelity European, Fidelity American and Fidelity Japan Special Situations are all sitting towards the bottom of the performance tables over one year.

Fidelity's new chief UK and Europe chief investment officer, Nicky Richards, brought in from Schroders last year to stem Fidelty's decline, said: "The first green shoots are now flowering" but she accepted that the company still has a long way to go to convince nervous investors that it has turned around.

Wall Street Journal    May 18, 2007

Fed, Other Regulators Turn Attention
to Risk In Banks' LBO Lending

    The Federal Reserve and other regulators are taking a closer look at the risks banks may be taking on in financing the boom in leveraged buyouts.    Banks have been major players in the surge of takeovers, both as lenders to and investors in buyout targets. As yet, there is little sign that this activity poses a threat to the banks' health. They have strong capital bases thanks to years of strong profits.    But a buoyant financing environment has led investors and lenders to accept declining returns on all sorts of risky assets. Regulators see signs of that in LBO lending, particularly in what is known as "bridge" financing, or the temporary credit that serves as a stopgap between the buyout and longer-term financing.    LBO loan volume hit $121 billion last year, compared with $31 billion in 1998, the peak of the previous cycle, according to Standard & Poor's Leveraged Commentary & Data. Volume this year has reached $88 billion, more than double the year-earlier period. Meanwhile, interest-rate spreads have fallen to their lowest levels ever, and loan restrictions have been loosened.    "There are some significant risks associated with the financing of private equity, including bridge loans, [and] we are looking at that," Federal Reserve Chairman Ben Bernanke said in response to questions at a Chicago conference yesterday. "I urge banks to closely evaluate the risk that they're taking not only in the context of a highly liquid, benign financial environment, but in one that might conceivably be less liquid and benign."    And speaking Tuesday in Sea Island, Ga., Federal Reserve Bank of New York President Timothy Geithner said, "We are...looking carefully at...the management of the bridge exposures institutions run in leveraged lending, leveraged buyout and merger-and-acquisition financing."    Mr. Geithner characterized this as part of a broader look at how the financial system is dealing with risk. As yet, there is no sign regulators plan formal guidance such as they issued on commercial bank lending last year. However, the Office of the Comptroller of the Currency, which regulates nationally chartered banks, has launched a special study of leveraged lending, or loans to heavily indebted companies, including private-equity buyouts, "to look specifically at what changes in underwriting practices we're seeing," said Kathy Dick, deputy comptroller. She said she expects results by August.    The leading arrangers of such loans are J.P. Morgan Chase & Co., Bank of America Corp., and Citigroup Inc. Their exposure is far smaller than the total because they typically "syndicate" the loans, that is parcel out pieces to other banks, institutional investors, and special-purpose entities called "collateralized debt obligations." What they keep, they often hedge with credit-default swaps.    But banks are still exposed to default in the period before they have syndicated or hedged a loan. Even a short-term bridge loan exposes the lender to the risk that the borrower won't be able to find longer-term financing, or will default. One worry for regulators is that an abrupt deterioration in the markets could suddenly leave many banks with long-term exposure they hadn't counted on.    In a famous event dubbed the "Burning Bed," First Boston Corp. in 1989 made a $457 million bridge loan to the purchasers of Ohio Mattress. When the junk-bond market collapsed soon afterward, First Boston couldn't refinance the loan and ended up owning most of Ohio Mattress. Credit Suisse had to inject additional capital into First Boston, culminating in a full takeover.Private-equity financing has been lucrative for banks, but even they are on the lookout for excess.    In a speech to the Swiss-American Chamber of Commerce in Zurich last week, Kenneth Lewis, the chief executive of Bank of America, which participated in seven of last year's 15 largest LBOs, said, "There is tremendous value in being able to provide a strong balance sheet to arrange large, complex financial transactions."    But in answer to a question about private equity afterward, he said, according to Bloomberg News: "We are close to a time when we'll look back and say we did some stupid things....We need a little more sanity in a period in which everyone feels invincible and thinks this is different."

Valerie Bauerlein contributed to this article. Write to Greg Ip at

Financial Times    18 May 2007

Beijing to take $3bn gamble on Blackstone
By Martin Arnold in London, Richard McGregor in Beijing,
Francesco Guerrera in New York and Joanna Chung in London

     China has agreed to place $3bn of its massive foreign exchange reserves with Blackstone, US-based private equity group, signalling Beijing is starting to switch investments from US treasuries into more risky equity holdings.    The decision suggests China is testing the water for a much bigger investment in private equity. It could open the floodgates to a tide of money flowing into the sector at the precise moment regulators are becoming concerned it may be overheating. The placement would come from a state investment agency founded last month to manage part of China's $1,200bn-plus foreign reserves; part of plans for a more active management policy. Granting a $3bn mandate to Blackstone suggests a more aggressive approach to management of the reserves, and also a sense of urgency. Blackstone declined to comment on Friday.    Private equity has been one of the best-performing asset classes in recent years, attracting record investments. But the industry's increasingly prominent role in the economy and its ownership of companies employing tens of thousands has drawn scrutiny from politicians, regulators, unions and the media. Stephen Jen, strategist at Morgan Stanley said China's decision clearly signifies a willingness to take risk.    Economists perceived the news as China's response to pressure to raise the value of its currency against the dollar, before next month's G8 summit where the renminbi's level is set to be discussed. China has announced some monetary tightening measures, to include an interest rate rise and widening of the daily trading band with the dollar. They are really up against a wall, trying to find ways to release the pressure and make [better] use of their foreign exchange reserves, said Diana Choyleva, economist at Lombard Street Research.    For Blackstone, which has filed for an initial public offering, China's action is a notable coup. A big investor in Blackstone told the F inancial Times a rush of funds from China could cause private equity returns to suffer as they focused more on asset gathering than on performance of their assets.

Copyright The Financial Times Limited 2007

Financial Times    18 May 2007

A headache awaits when the credit party fizzles out

    A few days ago in London, a senior banker made a striking admission to me: in his long career, he had almost never seen such bubble-like conditions in the credit markets as exist now. Perhaps back in the 1980s  just before the collapse, he muttered, with a despairing chuckle, over an elegant (and expensive) lunch.
   That is alarming stuff. But worse is to follow: this very same banker m akes a living by arranging loans and bonds to risky companies and he freely admits there is little chance that his institution is about to switch off this financial tap. On the contrary, last week his bank, like its peers, arranged even more finance for buy-out funds, which will enable them to conduct ever bigger de als, thus driving an acquisition frenzy that is helping to keep equity prices high.    Welcome to the fin-de-siècle mood that is gripping high finance. In recent weeks, high-profile figures have started publicly warning that markets are looking overstretched. Anthony Bolton, Britain's most feted fund manager, for example, warned this week as he prepares to stand down from his post at Fidelity at the end of the year that the four-year bull market in shares might be near its end. He also complained of a relaxation of standards in lending to private equity firms.
   Other senior financiers are privately echoing these concerns, sometimes even more forcefully. But right now, nobody appears ready to take away the punchbowl from the credit party. On the contrary, as Mr Bolton noted, the standards used to lend money to the private equity world are becoming weaker by the day, as new innovations keep appearing such as cov-lite loans (instruments on which the normal covenants protecting investors have been stripped away).
   Why? One factor is what the Bank of England coyly calls strong incentives [at banks] to match performance by competitors perhaps better described as the banking rat race. When times are good, bankers make large bonuses by arranging deals. But they rarely get paid for pulling them. While some financiers and investors have tried to argue that credit conditions looked over-exuberant in recent years, the credit cycle has stubbornly refused to turn. As a result, most bankers are now terrified of refusing deals, particularly at a time when the European economy is picking up. No one gets rewarded for taking the risk of crying wolf yet again.
   But there is another important reason why the credit party powers on: the changing face of the financial world. A decade ago, banks in Europe (and, to a lesser extent, the US) were expected to assume all the risk that their loans would go bad. But they have recently been distributing this so-called credit risk to other investors, such as hedge funds, on a massive scale. They do this either by selling loans or writing derivatives contracts that insure against default.
   In many ways, this is a marvellous development. If banks and hedge funds take out insurance against credit risk, they will be less vulnerable if a big crisis hits. That should make the financial system safer, with fewer spectacular collapses. But there are two catches. First, the financial world has started spreading credit risk around on this scale only recently which means that no one knows exactly how markets might behave if (or when) the world goes into a major downturn. Thus far, the existingevidence looks good: so far this decade, the financial world has absorbed several mini-blows, such as the Enron crisis, very smoothly, apparently because financial innovation has spread risk. But whether derivatives would keep playing a benign role if a mega-shock erupted remains an open bet.
   The very fact that institutions now believe that financial innovation has made them safer might actually be making them more cavalier about lending risk. After all, as Robert Merton, the Nobel Prize-winning economist recently observed to me, if you invent an advanced braking system for a car, it can reduce road accidents but it only works if drivers do not react by driving faster.    Similarly, derivatives usage should reduce risk but not if banks respond to their perceived new-found safety by arranging even more risky finance and investors keep gobbling this up. That, however, is precisely what now seems to be under way: financiers furtively mutter that the markets look overstretched, but then reassure themselves that financial innovation has made life safer  and rush to book their bonuses.
   Perhaps all this faith in the powers of financial innovation will turn out to be correct. I certainly hope so. But history suggests that whenever pundits proclaim the start of a brave new world, in which the old financial rules no longer apply, you should look for a bubble. Remember those arguments about the way that the internet had permanently altered the pattern of the business cycle that were advanced back in 1999?
   So, for my money, I would suggest that this credit party can probably continue for a little longer, given all the incentives that are still supporting it. Moreover, this frenzy will probably continue to support equity prices particularly since there does not appear to be anything in the real economy that is sufficiently alarming to trigger panic. But the balance between greed and fear is becoming finely balanced. After all, it is a cast-iron rule of the City, or Wall Street, that the longer any party lasts and the wilder it becomes, the greater the risk of a future hangover.

Copyright The Financial Times Limited 2007

Washington Post    June 13, 2007

The Takeover Boom, About to Go Bust
By Steven Pearlstein

To understand why there's a credit bubble, how it's inflating the price of stocks and what it will mean for you when it bursts, let's consider the acquisition of Avaya, a large telecommunications equipment maker, announced last week by two private-equity firms, Texas Pacific Group and Silver Lake Partners.

Avaya is expected to post revenue of about $5.4 billion this year. It has virtually no debt and has $825 million in the bank. Operating earnings -- profit before counting things like interest payments, taxes, depreciation and amortization -- are expected to reach $700 million. And if that's correct, it means the price being paid for Avaya, $8.2 billion, is 12 times operating profit, making it one of this season's richest deals.

What's driving such high valuations is cheap debt, and plenty of it. We don't know yet how the all-cash purchase of Avaya will be financed, but if it follows the pattern of other recent buyouts, the new owners will take on at least $6 billion in debt. Given the junk-bond rating that has already been assigned to the deal, that is likely to work out to an average interest rate of about 8 percent, along with the obligation to pay back 1 percent of principal every year. Add it all together, and the new, improved Avaya will have to pay about $540 million more a year in debt service than it does now.

Can the company handle that? Well, consider that only three years ago, Standard & Poor's calculated that operating profits for companies involved in leveraged buyouts were typically 3.4 times debt service. Last year, the number fell to 2.4. So far this year, it is 1.7.

And the Avaya deal? It's 1.3 to 1, which, if you think about it, isn't much of a cushion if revenue suddenly falls or expenses rise more than expected. Nor would there be much cash left over for the company to increase its investment in research or pay for new plant and equipment.

In other words, a deal like this would never get financed in normal times. Bank lenders and bondholders would demand that the new owners use more of their own money and take on less debt. Or they would demand interest rates so high that the company, as presently configured, wouldn't be able to generate enough cash to cover debt service. Either way, the buyers would never have agreed to pay $8.2 billion.

But these are not normal times, and overpriced and over-leveraged deals like Avaya have been getting financed in record numbers. Back in 2004, about $275 billion in loans were issued for such highly leveraged transactions. By last year, that had risen to $490 billion. And in just the first five months of 2007, that record was broken.

At some point sanity will be restored, triggered by any number of events. A high-profile acquisition could collapse because the new owners could not secure financing. Or a deal could blow up after it is discovered that there's really not enough cash to meet the debt payments. Or interest rates could suddenly rise from their current low level, threatening the viability of recently acquired companies and making it unlikely that the new owners will be able to sell for anything close to what they paid.

In fact, over the past several weeks, all those things have begun to happen.

On the bond market, yields on the benchmark 10-year Treasury bill have increased from just under 4.5 percent to more than 5.25 percent -- a three-quarters-of-a-point jump without any action by the Federal Reserve.

And just last week, William Gross, one of the country's leading bond investors, recanted on his prediction that interest rates were headed down, warning instead that yields on 10-year Treasurys could reach 6.5 percent over the next several years.

Syndicated loans used to finance the recent purchases of the Minneapolis Star Tribune, Linens 'n Things and Freescale, a semiconductor maker, are trading at significant discounts only months after the deals were closed, after the companies reported disappointing earnings or cash flow.

Meanwhile, the Wall Street Journal reported that after a period in which lenders were throwing money at leveraged buyouts with few if any conditions, several private-equity buyers are having more trouble financing their deals. Those include KKR's $26 billion acquisition of First Data and Texas Pacific's purchase of JVC, the struggling consumer electronics giant.

It is impossible to predict when the magic moment will be reached and everyone finally realizes that the prices being paid for these companies, and the debt taken on to support the acquisitions, are unsustainable. When that happens, it won't be pretty. Across the board, stock prices and company valuations will fall. Banks will announce painful write-offs, some hedge funds will close their doors, and private-equity funds will report disappointing returns. Some companies will be forced into bankruptcy or restructuring.

But the damage won't be limited to Wall Street and its investors. For if we've learned one thing in the past 20 years, it is that what happens on financial markets, in booms and in busts, can have a big impact on the rest of the economy.

Without the billions of dollars flowing each year to financiers and corporate executives, there will be less money to trickle down to car salesmen, yacht makers, real estate agents, third-home builders and busboys at luxury resorts.

Falling stock prices will cause companies to reduce their hiring and capital spending while governments will be forced to raise taxes or reduce services, as revenue from capital gains taxes declines.

And the combination of reduced wealth and higher interest rates will finally cause consumers to pull back on their debt-financed consumption.

It happened after the junk-bond and savings-and-loan collapses of the late 1980s. It happened after the tech and telecom bust of the late '90s. And it will happen this time.

The recent decline in home prices and the meltdown in the market for subprime mortgages are the first signs that the air is coming out of the credit bubble. Already, those factors have shaved half a percentage point off the economic growth rate. And you can be sure that there will be a much larger impact on jobs and incomes from a broad decline in stock and bond prices, a sharp tightening of credit and the turmoil that both of those will create in the murky derivatives markets.

Steven Pearlstein will host a Web discussion today at 11 a.m. at He can be reached at

The asset plunderers and money churners have found yet another low-debt company to exploit. They will distribute false profits to investors and shareholders, using the loans to cover them. When the company is a mere shell of its former self or goes belly-up, they will just re-organize under a different name and start over. Who can blame them? They are following the US government's example, using empty, debt-backed currency to support the illusion of prosperity. That's why the US government is imploding. You can't promise another person's future earnings, then make it as hard as possible for him to work, pay him to lose money or not work, and expect to pay back the debt.

The future of America--if we don't get ourselves nuked first--is the independent contractor and small business owner. Public policy and tax law favors the group over the individual, yet it's the individual who is expected to support the group, to his own detriment.

6/13/2007 3:31:17 PM

June 23, 2007

$3.2 Billion Move by Bear Stearns to Rescue Fund

Bear Stearns Companies, the investment bank, pledged up to $3.2 billion in loans yesterday to bail out one of its hedge funds that was collapsing because of bad bets on subprime mortgages.

It is the biggest rescue of a hedge fund since 1998 when more than a dozen lenders provided $3.6 billion to save Long-Term Capital Management.

The crisis this week from the near collapse of two hedge funds managed by Bear Stearns stems directly from the slumping housing market and the fallout from loose lending practices that showered money on people with weak, or subprime, credit, leaving many of them struggling to stay in their homes.

Bear Stearns averted a meltdown this time, but if delinquencies and defaults on subprime loans surge, Wall Street firms, hedge funds and pension funds could be left holding billions of dollars in bonds and securities backed by loans that are quickly losing their value.

Bear Stearns acted yesterday after the hedge fund and a related fund had suffered millions in losses and after shocked investors had begun asking for their money back. The firm agreed to buy out several Wall Street banks that had lent the fund money, which managers hoped would avoid a broader sell-off without causing a meltdown in the once-booming market for mortgage securities.

The firm is, meanwhile, negotiating with banks to rescue the second, larger fund started last August, which has more than $6 billion in loans and reportedly holds far riskier investments. Those negotiations were continuing yesterday, and it was unclear whether they would be successful.

“We don’t think it is over,” said Girish V. Reddy, managing director of Prisma Capital Partners, which invests in other hedge funds. “More funds will feel the pain, but not many are as leveraged as the Bear fund.”

Nervousness about the souring subprime loans and rising oil prices sent the stock market plummeting. Already down almost 60 points, the Dow Jones industrial average fell sharply after the announcement of the bailout and closed down 185.58 points.

Shares of Bear Stearns closed down $2.06, to $143.75; the stock was down more than 4 percent for the week.

For Bear Stearns, the drama surrounding its two troubled hedge funds has given it and its prestigious mortgage business a black eye. The bailout was a major departure for the firm, which has long resisted putting too much of its own capital at risk.

But in this case, the stakes were too high. If lenders had seized the assets of the funds and tried to sell billions of dollars in mortgage-related securities at fire-sale prices, it could have exposed Bear Stearns and the market to substantial losses.

While the board of Bear Stearns board never met over the funds, all of its top executives, including the chief executive, James E. Cayne; its presidents, Alan D. Schwartz and Warren J. Spector; and the chief financial officer, Samuel L. Molinaro Jr., huddled in meetings over the last few days looking to find a way to contain the crisis, according to people briefed on the discussions who could not speak for attribution.

Even Alan C. Greenberg, the 79-year-old former chairman, who spends less time these days on the firm’s matters but remains an active board member, became involved.

Yet, as Bear Stearns worked to manage the crisis, many on Wall Street speculated about how the firm could let the funds get in such a precarious position.

In fact, executives at Bear Stearns Asset Management had debated last summer whether to start the second hedge fund.

The first fund, the Bear Stearns High-Grade Structured Credit Fund — the one bailed out yesterday — was started in 2004 and had done well, posting 41 months of positive returns of about 1 percent to 1.5 percent a month. But investors were clamoring for even higher yields, which would require more aggressive bets on riskier mortgage-related securities and significantly higher levels of borrowed money, or leverage, to bolster returns.

The firm clearly had the expertise — it was a leader in underwriting and trading bonds and esoteric securities backed by mortgages. In addition, Ralph R. Cioffi, who ran the funds, had played a major role in building the Bear Stearns mortgage business.

So, in August, the Bear Stearns High-Grade Structured Credit Enhanced Leveraged Fund — the second fund that eventually had huge losses — was started with $600 million in investments, mostly from wealthy individual clients of Bear Stearns, and at least $6 billion in money borrowed from banks and brokerage firms. Bear Stearns and a handful of its top executives invested a mere $40 million in both funds.

The timing could not have been worse.

By the end of last year, housing prices in many areas were cresting and beginning to fall. The decline began to expose lax lending standards in the subprime market. Soon borrowers started falling behind on payments just months after they closed on their loans, forcing several large lenders into bankruptcy protection.

The Bear Stearns funds, like so many others, had invested in collateralized debt obligations, or CDOs, which invest in bonds backed by hundreds of loans and other financial instruments. Wall Street sells CDOs in slices to investors. Some of those pieces have low yields but they are easily traded and carry less risk; others are more susceptible to defaults and trade infrequently, which makes them difficult to value.

Last year, $316.4 billion in mortgage-related CDOs were issued, about 77 percent more than the year before, the Securities Industry and Financial Markets Association said.

At first, the Bear Stearns hedge funds appeared to weather the storm. But in March, the older fund registered its first loss. One investor, who asked not to be identified because he was trying to recover his investment, said that when he moved to get his money out, he was told investors had tried to redeem 10 percent of the fund.

By April, the older fund was down by 5 percent for the year, and the newer fund had fallen 10 percent.

Managers tried to protect the fund by hedging potential losses in lower-rated securities they held, but did not do so for higher-rated bonds, which also fell in value.

“They didn’t realize this was Katrina,” the investor said. “They thought it was just another storm.”

In May, however, more significant problems began to emerge. The Swiss investment bank UBS shut its hedge fund arm, Dillon Read Capital Management, after bad subprime bets led to a $124 million loss.

Also that month, Bear Stearns Asset Management filed plans to start a public offering of a financial services firm called Everquest Financial, which, to some, appeared to be little more than a place to park the riskiest securities Bear Stearns had invested in. (The firm has no plans for now to move forward with the offering, according to a person briefed on the firm’s plans.)

Perhaps the most startling development was a sharp restatement in April of the second fund. The firm revalued some securities and told investors that the fund was down 23 percent, not 10 percent as it had said earlier.

Shocked investors began contacting Bear Stearns, demanding to pull their money out. In May, the firm froze all redemption requests. This month, at least three Wall Street firms — JPMorgan Chase, Citigroup and Merrill Lynch — began demanding more cash as collateral for the loans they had made.

Fighting to save the funds, Bear Stearns sold $3.6 billion in high-grade securities. Meanwhile, its adviser, Blackstone, scrambled to line up a deal in which Bear Stearns would put up $1.5 billion in new loans and a consortium of banks led by Citigroup and Barclays would put in $500 million.

In return, the lenders would have their exposure to the funds reduced but could not make further margin calls for 12 months.

Some lenders, including Merrill Lynch and Deutsche Bank, balked and moved to sell assets. At one point Wednesday, nearly $2 billion in securities were listed for sale, although some banks, including JPMorgan, eventually canceled scheduled auctions.

By the end of the day, out of the $850 million in securities that Merrill had put up for sale, only a small portion actually sold.

In the wake of the weak auctions, several other lenders, including JPMorgan, Citigroup, Goldman Sachs and Bank of America, reached deals with Bear Stearns. At least some of the deals involved the lenders selling the securities back to Bear Stearns for cash, although the prices were not disclosed.

Bear Stearns is bailing one of the funds out because it is worried about the damage to its reputation if it stuck investors and lenders with big losses, said Dick Bove, an analyst with Punk Ziegel & Company.

“If they walked away from it, investors would have lost all their money and lenders would have lost all of the money,” Mr. Bove said. But “if they did that to everyone in the financial community, the financial community would have shut them down.”

Gretchen Morgenson and Landon Thomas contributed reporting.

Frankfurter Allgemeine Zeitung    16. Juli 2007

Vermögensverwalter Dr. Jens Ehrhardt
„Es ist die größte Blase, die es je gab“

Catherine Hoffmann

Die internationalen Finanzmärkte boomen, aber nicht nur sie. Denn auch die Preise vieler anderer Güter und so genannter Vermögenswerte laufen nach oben - und  zwar weltweit. Diese Entwicklung ist unter anderem auf die reichlich vorhandene Liquidität zurückzuführen, erklärt Vermögensverwalter Jens Erhardt im Interview.
Solange genügend Geld da ist und die Zinsen vergleichweise tief sind, steigen die Aktienkurse weiter, erläutert er. Die Anleger müssten jedoch höllisch aufpassen, wann  die Liquiditätsquellen versiegten. Denn „die Hausse selbst sät die Saat für ihre Zerstörung“.

Herr Ehrhardt, der Dax ist auf Rekordjagd. Stimmt es, dass eine gigantische Liquiditätswelle die Aktienkurse immer höher treibt?
Die Finanzmärkte boomen schon seit Jahren. Kaum eine Börse auf der Welt, die in diesem Jahr nicht kräftig gewonnen hätte. Für Fusionen und Übernahmen ist jede  Menge Geld da. Alles wird teurer, von der Kunst über Aktien bis hin zum Gold. Und wenn es mal eine Korrektur an den Märkten gibt, ist die Scharte bald ausgewetzt.  Es ist ungewöhnlich, dass in einer Hausse die Preise praktisch aller Vermögenswerte so glatt und ohne große Pause steigen. Das gab es noch nie. Und es ist der beste  Beweis dafür, dass eine gewaltige Liquiditätswelle die Hausse treibt.

Ist das gefährlich?
Vorläufig nicht. Solange genügend Geld da ist, steigen die Aktienkurse weiter. Und die Zinsen dümpeln weiter nahe ihren historischen Tiefstständen herum. In einer  solchen Welt sind die Anleger aber gerne bereit, immer höhere Risiken einzugehen, um sich hohe Renditen zu sichern.

Wo kommt das viele Geld her?
Die Notenbanken haben die Welt so aggressiv alimentiert wie noch nie in der Geschichte. Der frühere amerikanische Notenbankchef Alan Greenspan hat nach dem  Platzen der Blase 2001 und 2002 die Gefahr der Deflation mit Ein-Prozent-Zinsen bekämpft. Damit provozierte er einen Immobilien- und Aktienboom. Andere  Notenbanken zogen mit. Die Welt profitiert noch immer von der lockeren Geldpolitik. Auch wenn die nominalen Zinsen seither kräftig geklettert sind, real sind sie noch immer niedrig. Es ist die größte Blase, die wir je hatten.

Was hat die Liquidität mit dem Aktienmarkt zu schaffen?
Wenn die Liquidität steigt, vergeben die Banken freizügiger Kredite, die Unternehmen investieren mehr, und die Konsumenten kaufen mehr. Das ist gut für den  Aktienmarkt. Die Kurse steigen stark mit der Ausweitung der Geldmenge - und umgekehrt. Es ist ein System kommunizierender Röhren.

Lässt sich die Liquiditätsschwemme messen?
Obwohl der Liquidität eine entscheidende Rolle für die Rally der Aktienbörsen zufällt, ist das Phänomen schwer zu fassen. Liquidität hat viele Gesichter. Die expansive  Geldpolitik der Vereinigten Staaten, Europas und Japans steht nur am Anfang der Kette. Sie hat dazu geführt, dass überschüssige Liquidität entsteht: Es ist mehr Geld  vorhanden, als zur Finanzierung des nominalen Wirtschaftswachstums notwendig wäre.

Wo zeigt der Überschuss an Geld sonst noch sein Gesicht?
Die hohen Devisenreserven, vor allem der Schwellenländer, sind eine Form der Liquidität. Viele asiatische Währungshüter, zum Beispiel in China, Taiwan und Südkorea,  intervenieren massiv am Devisenmarkt, um den Außenwert ihrer Währung künstlich niedrig zu halten. Infolge der gewaltigen Außenhandelsüberschüsse werden  stattliche Fremdwährungsreserven angehäuft. Allein China sitzt heute auf 1,3 Billionen Dollar, welche die globale Liquidität aufblähen. Hinzu kommen die reichlich  vorhandenen Petro-Dollar der Golfstaaten und Russlands, die zunehmend auf die westlichen Finanzmärkte gepumpt werden.

Welche Rolle spielt Japan?
Die nahezu Null-Zins-Politik der Bank von Japan ist zweifellos eine bedeutende Quelle der Liquidität. In ihrem verzweifelten Versuch, das Land aus dem deflationären  Sumpf zu steuern, haben die Notenbanker Geld praktisch umsonst verliehen. So entstanden die lukrativen Carry-Trades: Hedge-Fonds und andere Spekulanten  verschulden sich zinsgünstig in Yen und investieren das Geld in höher rentierliche Anlagen im Rest der Welt.

Das viele Geld treibt die Kurse der Aktien rund um den Globus?
Die hohen Kursgewinne an der Börse sind zwar wesentlich der Liquidität zu verdanken, aber nicht nur: Entscheidend waren auch das hohe Wachstum der  Unternehmensgewinne und die starken Bilanzen. Beides hat allerdings auch mit den monetären Bedingungen zu tun. Trotz des fortgeschrittenen Konjunktur- und  Börsenzyklus gibt es fast keine Inflation, und die Notenbanken müssen nicht so scharf auf die Bremse treten, wie das sonst der Fall wäre. Die Globalisierung hilft, die  Inflation im Zaum und das Liquiditätsspiel am Laufen zu halten. Den Notenbankpräsidenten kommt das entgegen, schließlich will keiner die Konjunktur ins Verderben  schicken.

Was machen die Unternehmen, die so blendend verdienen, mit dem vielen Geld?
Die Unternehmen haben ausgesprochen wenig investiert. Dadurch bleiben die Gewinnmargen und Aktienkurse hoch. Anders als Ende der neunziger Jahre sind die  Manager nicht dem Kaufrausch verfallen. Deshalb sind die Bilanzen heute in bester Verfassung. Allerdings wächst der Druck, einen Teil des Geldes an die Aktionäre  weiterzureichen - in Form von höheren Dividenden oder Aktienrückkäufen. Das treibt die Aktienkurse. Die starken Bilanzen machen die Unternehmen auch zu einem  interessanten Ziel für Beteiligungsgesellschaften - und Konkurrenten. Hier kommen wieder die niedrigen Zinsen ins Spiel, die einen Übernahmeboom induziert haben.  Der ist so lange nicht zu Ende, wie die Unternehmen mehr verdienen, als die Schuldzinsen kosten. Und weil das so ist, finanzieren die Unternehmen Zukäufe auch mit  Krediten und nicht mit eigenen Aktien, was übrigens neue Liquidität schafft.

Ist Liquidität nur eine Frage von viel Geld oder auch eine von großem Vertrauen, dass das große Börsenspiel weitergeht?
Liquidität ist mehr als alles andere eine Funktion des Vertrauens. Die Börsianer sagen, eine Aktie ist liquide, wenn sie munter gehandelt wird und die Anleger  offenkundig bereit sind, Risiken zu schultern. Die Bereitschaft ist derzeit groß. Das zeigen die hohen Börsenumsätze und die niedrige Schwankungsbreite der  Aktienkurse.

Entscheidend ist doch: Wie nachhaltig ist der Liquiditätsstrom?
Die Notenbanken sind nicht glücklich über die Risikofreude der Anleger. Aber sie können wenig tun, solange die Inflation der Verbraucherpreise niedrig bleibt.

Signalisieren die plötzlichen Einbrüche an den Börsen nicht, dass die Zeiten schwieriger werden?
Anleger müssen höllisch aufpassen, wann die Liquiditätsquellen versiegen. Noch ist es aber nicht fünf vor zwölf. Die amerikanische Notenbank kann die Zinsen wegen  der Immobilienkrise nicht erhöhen, und dem EZB-Chef Jean-Claude Trichet sitzt der französische Präsident Nicolas Sarkozy im Nacken. Außerdem haben die  Notenbankchefs eine Riesenangst, dass die Liquiditätsblase platzen könnte. Deshalb werden die günstigen Liquiditätskonditionen in all ihren verschiedenen  Erscheinungsformen wohl noch eine Weile bestehen. Anleger sollten nicht vergessen, dass die Realzinsen mit zwei Prozent noch immer halb so hoch sind wie im  Durchschnitt der Nachkriegszeit. Das macht risikobehaftete Anlagen interessant. Ich ziehe Aktien den Anleihen und Immobilien noch immer deutlich vor.

Wann ist der Boom vorbei?
Die Hausse selbst sät die Saat für ihre Zerstörung. Steigen die Kurse weiter, werden Aktien irgendwann unhaltbar teuer sein. So weit ist es aber noch lange nicht. Es ist  zu früh, sich darüber Sorgen zu machen, denn in den meisten Ländern sind Aktien noch immer maßvoll bewertet. Kritisch wird es, wenn die Unternehmensgewinne  kippen und die Gewinnspannen schrumpfen, die ein Nachkriegshoch erreicht haben. Dann werden sich viele der gerade noch gefeierten Übernahmen als zu teuer  erweisen. So manches Unternehmen wird seine Schulden nicht bedienen können. Dann platzt die Blase.

August 11, 2007

Central Banks Intervene to Calm Volatile Markets

Central banks around the world acted in unison yesterday to calm nervous financial markets by providing an infusion of cash to the system. But stocks still fell sharply in Asia and Europe, and in early trading in New York, before they recovered and closed essentially flat for the day on Wall Street.

As in recent weeks, the markets moved in wild swings — sharp drops were followed by steep gains and vice versa — underscoring the uncertainty. Investors weighed concerns that losses in the American mortgage market would deepen and spread against their faith in the ability of a strong global economy to withstand additional shocks.

Hoping to provide some comfort that there is ample cash available, the Federal Reserve made its largest intervention since the markets reopened Sept. 19, 2001, in the wake of the terrorist attacks. The central bank injected $38 billion into the financial system on top of the $24 billion it put in on Thursday.

The intervention steadied the markets — at least for the day. The Standard & Poor’s 500-stock index closed at 1,453.64, a gain of 0.55 point, and the Dow Jones industrial average closed down 31.14 points, to 13,239.54. For the week, the Dow was up 0.4 percent, the S.& P. 500 rose 1.4 percent and the Nasdaq was up 1.3 percent.

The question that remains is just how exposed the financial system and the economy are to losses in the credit markets and the increase in borrowing costs. The answer will set the agenda at the Federal Reserve, which finds itself confronting its first major financial crisis under the leadership of Ben S. Bernanke, who took over last year.

The Fed will be guided by its assessment of how much do banks, hedge funds, pension funds and others stand to lose and whether consumers and businesses will be able to stomach higher interest rates and stricter loan underwriting.

“There are a lot of risks in front of us,” said Liz Ann Sonders, chief investment strategist at Charles Schwab. “Financial crises, in the past, when not accompanied with a recession have been good for the markets.” But, she added, “if the economic landscape deteriorates much from here, then we are going to have to suffer through a more difficult market period.” That debate, Ms. Sonders and others agree, will not be resolved anytime soon, which suggests that markets will remain choppy as information about failing hedge funds and mortgage companies dribbles out.

Investor anxiety has been so heightened in recent weeks that days of stability have been shattered by the first sign of trouble tied to the debt markets.

Volatility, as measured by one popular index of options trading, has surged to its highest levels in more than four years, though it remains far lower than it was early this decade and in the late 1990s.

The financial sector has been among the most volatile — stocks there fell by as much as 1.7 percent during the day, only to climb as much as 1.1 percent before closing little changed. Shares of Countrywide Financial, the nation’s largest mortgage lender, and Washington Mutual, the sixth-biggest lender, opened sharply lower after both companies said they were facing a harder time selling loans and could potentially have problems raising money. While those stocks recovered much of their losses for the day, they are both down significantly for the year.

A common pattern has been a surge in trading late in the afternoon, around 3 p.m., that has often sent stocks higher, as it did yesterday — though on some days, like Thursday, the move has been just as sharp on the downside.

Richard X. Bove, an analyst at Punk Ziegel & Company, noted the trend in a recent note to investors and suggested that the reason was strong buying from portfolios that use computer models to buy and sell quickly, a practice known as program trading, or a foreign source like the investment arm of the Chinese government. “We are talking about such a sizable amount of buying and volume goes up and stocks react strongly one way or the other,” Mr. Bove said. “What I have trouble with is trying to figure out where it’s coming from.” But he acknowledges that the pattern will probably not last long, because as sophisticated traders figure it out they will jump in on the other side to profit from the trades.

Using data from the New York Stock Exchange, Ms. Sonders of Charles Schwab estimates that program trading accounted for about 40 percent of all trades on the Big Board in recent days, up from the 30 percent range earlier this year. “That’s why we are getting these swings, this is professional- to-professional trading,” she said. “This is money that has a time horizon measured in minutes.”

Indeed, there is evidence that the average individual investor has not been a big player in recent days. Flows into mutual funds that specialize in American stocks were essentially flat for the week that ended on Wednesday, according to AMG Data Services. But investors put $36.2 billion into money market accounts, the largest weekly inflow this year. Investors often put cash into money market funds, which earn more than savings accounts, that they eventually plan to invest in the market.

It is not surprising that individuals are sitting on the sidelines, given the sharp moves in the market. Yesterday, for instance, all three major American indexes fell immediately after the opening bell, and at one point the Dow Jones industrial average was down 212 points. By noon, stocks were on the rebound and the indexes were briefly in positive territory, then declined. The Nasdaq finished at 2,544.89, down 11.60, or 0.4 percent. “You can’t invest into a market that does that,” Mr. Bove said. “You have a better chance at making money on the craps table than in this market.”

Treasury prices were little changed yesterday. The 10-year note fell 9/32, to 99 18/32 and the yield, which moves in the opposite direction from the price, rose to 4.81 percent, from 4.77 percent on Thursday.

Earlier, stocks in Japan, Hong Kong and Australia dropped by more than 2.5 percent. The benchmark Kospi in South Korea fell 4.3 percent, the biggest decline since June 2004. Most major European indexes plunged by 3 percent or more. In both Asia and Europe, fears about the American housing market prompted investors to sell assets and forced commercial banks to reel in credit lines.

Central banks around the work stepped up efforts to slow the losses. The Bank of Japan added liquidity for the first time since the market problems began. The European Central Bank injected money into the system for a second day, adding another 61 billion euros ($84 billion), after providing 95 billion euros the day before. The Federal Reserve yesterday added $19 billion to the system through the purchase of mortgage-backed securities, then another $19 billion in three-day repurchase agreements.

In Washington, Treasury Secretary Henry M. Paulson Jr. spent the day in what his aides said was hourly contact with the Fed, other officials in the administration, finance ministries and regulators overseas and people on Wall Street — where until last year he had worked as an executive at Goldman Sachs. “We’ve been in touch with our colleagues in other agencies and among the financial regulators and are monitoring the situation carefully,” said Michele Davis, the Treasury Department spokeswoman. “Beyond that, we are not commenting.”

As investors in Asia sold off assets considered relatively risky, like Philippine stocks, they bought those considered safer, like Japanese government bonds. Asian currencies like the Thai baht also retreated against the dollar and more liquid and stable currencies like the yen. “Everyone’s been talking about a credit crunch, and not surprisingly it turned into one,” said Jan Lambregts, head of Asia research at Rabobank. While Asian banks did not seem to be directly affected, he said, “the main problem is we don’t know who is bearing the losses, and that kind of uncertainty is creating the situation that we’re in right now.”

Wayne Arnold, Steve Weisman and Jeremy W. Peters contributed reporting.

Wall Street Journal    August 11, 2007

Subprime Turmoil Catches Funds Off Guard

Some of the most highly regarded mutual funds are getting beaten up by the mortgage meltdown -- and investors are yanking money out of U.S. stock funds.

Still, a few fund categories are holding up well this year, despite the recent turmoil. In fact, in what should come as little surprise, the only stock-fund category to post  gains recently is bear-market funds: They're up 6.7% for the month ended Aug. 9, according to Morningstar Inc.

Some top stock funds haven't fared so well, largely because of heavy investments in housing-related stocks. For instance, Weitz Value and Legg Mason Value Trust,  which have stellar long-term track records, also have hefty positions in stocks like home lender Countrywide Financial Corp., according to fund filings.

Countrywide's stock has fallen roughly 34% this year. It took a hit Friday after it said its financial condition could be hurt by "unprecedented disruptions" in debt and  mortgage-finance markets. Weitz Value is down 3.8% this year and lost about 8.9% over the past month, while Legg Mason Value Trust is down 2.3% so far this year and lost 8.5% in the past  month, according to Morningstar data through Aug. 9.

Both funds are lagging behind most of their category rivals so far this year, according to Morningstar. Troubles in such funds illustrate that even some of the savviest  stock-pickers may have been caught off guard by the extent of the housing slowdown and mortgage-market woes.

For fund investors, the risk is making investment decisions based on short-term swings. Advisers say investors should view the volatility as a reminder to stay  diversified. Alternative investments like commodities tend to behave differently than stocks and bonds, reducing the risk of the overall portfolio. Indeed, many  commodities-related funds have weathered the recent storm, given their distance from the mortgage debacle.

Overall, the average losses at U.S. stock funds in the past month range from 1.7% in health-sector funds to 10.7% in small value-oriented funds, according to  Morningstar. Overseas diversification didn't necessarily help: Emerging-markets funds are down 5.5% and Europe stock funds lost 6.7% in that period.

The market turmoil is driving investors to pull money out of domestic stock funds at a rapid clip. Investors pulled nearly $300 million out of stock funds in the week ended Aug. 8, according to AMG Data Services. That is a reversal from July, when money poured in as the Dow Jones Industrial Average climbed toward 14000.

A number of fund managers whose holdings have been hit by housing-related woes say they'd like to buy more of these stocks as their prices fall -- but they don't have the cash to do it because investors are withdrawing money from their funds. "I've had pretty steady redemptions and haven't had a chance to come up for air," says David Ellison, manager of FBR Small Cap Financial fund.

In recent weeks, mortgage-related holdings have seen steep declines. American Home Mortgage Investment Corp. said earlier this month that it had stopped taking  mortgage applications amid the deteriorating market conditions and in recent days filed for bankruptcy-court protection. The stock sank to under $1 from over $20 in  little more than a month.

Also seeing declines are home builders, building-materials companies, and big banks like Washington Mutual Inc., down about 15% over the past month.

The housing and mortgage jitters are reflected in the worst-performing domestic-stock-fund categories this year: Real-estate funds are down 7.1% for the year through  Aug. 9, and financial-stock funds are down 6.1%. Natural resources and communications have been the top-performing domestic stock-fund categories this year, up  15.6% and 10.6%, respectively.

American Home's troubles are likely the main cause of a sudden reversal of fortune for at least one highly respected value-fund manager. The Schneider Small Cap Value Fund, the top-performing small-company value fund over the past five years, is the worst-performing fund in that category in the month through Aug. 9, with a  20.9% decline, according to Morningstar.

Its major holdings as of May 31 included American Home as well as Luminent Mortgage Capital Inc., which recently suspended payment of its second-quarter dividend. Arnold C. Schneider III, manager of the Schneider Small Cap Value Fund, declined to comment.

A number of managers say they didn't anticipate the housing troubles would be so severe or widespread. "We have been surprised by the extent of this," says John  Buckingham, manager of Al Frank Fund, which holds home builders like Beazer Homes USA Inc., down nearly 70% this year, and KB Home, down about 31%, as well as  other housing-related stocks. The fund is down more than 9% over the past month but still up 3.9% this year through Aug. 9.

Many managers firmly defend their housing-related holdings and say their long-term prospects are still bright. "We think the good companies will do very well long term," says Ron Muhlenkamp, who holds stocks like Countrywide Financial, Washington Mutual, and home builder  NVR Inc. in his Muhlenkamp Fund. The fund's 10-year returns place it near the top of its large-company value category, according to Morningstar. But it falls near the  bottom of the category so far this year and over the past month, when it dropped 9.6%.

Some of the managers have been defending their housing-related holdings in recent communications to shareholders. In a July 19 letter to shareholders, managers  Wally Weitz and Brad Hinton, who devoted nearly 18% of their Weitz Value fund's assets to mortgage-services stocks as of June 30, noted that such stocks have  dragged down performance but wrote that "we feel very good about our mortgage-related holdings."

In an interview, Messrs. Weitz and Hinton say they still like holdings like Countrywide but are scrutinizing them. "As questions arise out in the marketplace and fears  blossom and hedge funds go broke and so on, we recheck our assumptions," Mr. Weitz says.

Bill Miller, the Legg Mason Value Trust manager, also defended his housing stocks in a July 30 letter to shareholders. "If we did not own housing or housing-related stocks (such as Countrywide Financial) we would be buying them now, amidst the panic selling currently underway," he  wrote.

A number of managers feel their stocks are being unfairly punished. Anton Schutz, manager of Burnham Financial Services Fund, says holdings like People's United  Financial Inc., a bank stock down 23% this year, have suffered even though they don't have big problems with subprime mortgages. "If someone would give me some more money, I would love to buy more," Mr. Schutz says. Burnham Financial Services fund is down about 13% this year through  Thursday.

Write to Eleanor Laise at

Washington Post    August 11, 2007

Bubble and Bust
As the subprime mortgage market tanks, policymakers must keep their nerve

BY THE HEIGHT of the 17th-century Dutch tulip mania, bulbs were selling for the equivalent of up to $76,000 apiece, and tulip options were trading on markets across Europe. The ensuing crash crippled the Dutch economy for years, establishing a cautionary model of speculative excess that investors have learned from, and ignored, in a seemingly endless cycle of bubble and bust ever since.

Today's tulip bulb is the subprime mortgage: a loan to a not terribly creditworthy person in the United States to buy a house that he or she really can't afford. Hundreds of billions of dollars worth of these paper commitments have be en made, gathered together and resold as bonds to hedge funds and banks all over the world -- which in turn have used them as collateral to obtain more loans, so they can buy more bonds, and so on. Now that home prices are falling and many unhappy U.S. homeowners are, foreseeably, defaulting, the whole business is unraveling. Some holders of subprime-backed securities, such as hedge funds belonging to the giant French bank BNP Paribas, literally can't give their bonds away. The world is in the grip of a liquidity crisis.

The Federal Reserve Board and central banks in Japan, the European Union and elsewhere wisely stepped in to provide enough money to get banks through the last few days of this scary week. It was a sound intervention because, in a financial panic, investors who once wildly overvalued assets can undervalue them just as wildly once the speculative fever breaks. A short-term cash infusion can help keep financial institutions going while they gather the information needed to reach calmer, more economically rational assessments of the risks they face. If all goes well, the credit crunch will stop spreading into the ranks of better-qualified borrowers, thus containing what has so far been minimal damage to the "real" economy from the subprime mess.

Another feature of the boom-bust cycle is that the bust is usually accompanied by well-intentioned but questionable policy prescriptions. Washington should look at ways to help those subprime borrowers who could service restructured loans to work out new terms with their lenders, so that they don't lose their homes.

But one unconvincing proposal is to let Fannie Mae and Freddie Mac, the two government-sponsored enterprises that already dominate the mortgage-backed securities market, buy up more loans. A bill to do that passed the House in May, and, in the past few days, Sens. Charles E. Schumer (D-N.Y.) and Christopher J. Dodd (D-Conn.), the latter a presidential candidate, have echoed the idea. The Office of Federal Housing Enterprise Oversight has capped Fannie Mae's portfolio at $727.2 billion (the level of Dec. 31, 2005), while Freddie Mac's $712.1 billion portfolio may grow only by 2 percent annually. The regulators imposed these conditions because of accounting scandals at Fannie and Freddie -- and it seems unwise to tap them for a bailout now, especially when such an action would leave them holding billions of dollars in new assets of ambiguous value.

Financial Times    August 9, 2007

Payback time as subprime bites
US investigators look for culprits


 At the height of the US subprime lending boom, taking out a mortgage could not have been easier. Low credit score and history of bankruptcy? No problem. Income  too low to qualify for a mortgage? Inflate what you earn on a "stated income" loan. Nervous that your lender might check up on your "stated income"?

For a Dollars 55 fee, the operators of this small California company will help you get a loan by employing you as an "independent contractor". They provide payslips as  "proof" of income and, for an additional Dollars 25, they also man the telephones to give you a glowing reference should your lender need it.

But perhaps the most absurd aspect of the US subprime mortgage market in recent years is that lenders became so generous with credit provision for out-of-pocket  borrowers that very few checks were ever made.

That left the system extraordinarily vulnerable to widespread fraud, a possibility that federal and state prosecutors across the US have begun to look into. With the  subprime crisis expected to cost investors between Dollars 50bn (Pounds 24bn, Euros 36bn) and Dollars 100bn, according to the US Federal Reserve, these  investigations could transform it from a market correction to a full-blown national scandal.

At the root of the subprime problem was easy credit: lenders and their brokers were often rewarded for generating new mortgages on the basis of volume, without  being directly exposed to the consequences of borrowers defaulting. During several years of strong capital markets and strong investor appetite for high-yielding  securities, lenders became accustomed to easily selling the risky home loans they made to Wall Street banks. The banks in turn packaged them into securities and sold  them to investors around the globe.

Such ease of mortgage funding allowed thousands of borrowers to get away with fraudulently mis-stating their incomes, often with the encouragement of their brokers.  More ambitious fraudsters appear to have taken out multiple mortgages and walked away with the cash.

Karen Gelernt, a partner at law firm Cadwalader, Wickersham & Taft, says: "The difficulty is getting a handle on the size of the problem, because there is no real  mechanism for reporting fraud for most originators in this market. In fact, they had every incentive not to report."

Fraud has been detected up and down the financing chain: just as borrowers have lied to get better rates and larger loans, mortgage brokers and loan officers have lied  to borrowers about the terms of their loans and may also have lied to the banks about the qualifications of the borrowers. Appraisers, likewise, have lied about the  value of the properties involved.

"The recent rapid expansion of the subprime market was clearly accompanied by deterioration in underwriting standards and, in some cases, by abusive lending  practices and outright fraud," Ben Bernanke, Fed chairman, recently told lawmakers. With mortgage rates rising and house prices falling, subprime borrowers have been  defaulting at record rates.

The fallout is working its way up from the retail level - forcing people out of their homes and lenders into bankruptcy. Investment banks have lost revenue as investors  back away from mortgage securities and a handful of high-profile hedge funds have collapsed - most notably two highly leveraged funds managed by Bear Stearns. The  crisis has contributed to turmoil in financial markets in recent weeks and could threaten the health of the US economy as lenders tighten access to credit, putting a  drag on consumer spending.

For some, this rapid and dramatic unravelling of the subprime lending industry has echoes of the costly savings and loans crisis of the early 1980s - a meltdown that also  had its origins in financial market innovation and inadequate oversight, and which many cite as a contributing factor in the 1990-91 economic recession. That crisis  ended with a federal bail-out of Dollars 150bn and a handful of high-profile convictions for fraud.

This time around, the major losers have been hedge funds, which in theory are limited to wealthy investors. But some analysts believe the pain could spread - many  pension funds and college endowments have turned to hedge funds to heat up their returns and some, including Harvard University, are starting to get their fingers  burned. Harvard is estimated to have lost Dollars 350m of the Dollars 550m it invested in a hedge fund run by Jeffrey Larson, a former Harvard money manager, that  collapsed recently as a result of positions related to the subprime market.

If the losses trickle down and end up hurting small investors, pressure may grow for a public bail-out. Rumours swept the market earlier this week that Fannie Mae and  Freddie Mac, the government-backed mortgage agencies, might get the authority to make sweeping purchases of underpriced mortgage securities.

"The US mortgage landscape has become a top-of-mind political talking point, and we would not be surprised to see the usual 'flow like mud' legislative process  fast-tracked with respect to items offering relief to the -troubled mortgage market," says Louise Purtle, strategist at -CreditSights, a research firm.

Most fraud in subprime lending appears to have been so-called "fraud for purchase" - lying about income so as to win a mortgage approval. In reviewing a sample of "no  doc" loans that relied on borrowers' statements, the Mortgage Asset Research Institute recently found that almost all would-be home owners had exaggerated their  income, with almost 60 per cent inflating it by more than 50 per cent.

These fraudulent borrowers are often difficult to uncover, says Ms Gelernt, because they often stretch to meet their minimum payments for some time before they  eventually default. The time lag between initial fraud and default also makes a conviction hard to obtain, she adds, while mortgage investors also have little chance of  recovering their losses from individual borrowers in these circumstances.

Many of the originators to blame for poor quality control standards may not be held to account either - with several such lenders already in bankruptcy. "There's a real  problem in finding fraud after the fact because the money is already out the door and you won't get the recovery," says Ms Gelernt.

Loose lending standards also facilitated fraud for profit. US prosecutors around the country have broken up at least a dozen mortgage fraud rings and more cases are  expected.

In one New York case, the FBI charged 26 people who used stolen identities, invented purchasers and inflated appraisals to obtain subprime loans on more than  Dollars 200m of property. In an Ohio case, 49 per cent of the mortgages processed by a -single broker never made even a first payment.

The fate of a series of North Carolina neighbourhoods built by Beazer Homes may offer a foretaste of the looming problem. Low income home-buyers around  Charlotte have sued the builder alleging that its lending arm steered them into mortgages they could not afford, leading to widespread foreclosures.

The homeowners allege that sales agents misrepresented their personal data, including assets and income, to help them qualify for government-insured mortgages  starting in 2002. By the beginning of this year, 10 Beazer subdivisions in Charlotte had foreclosure rates of 20 per cent or higher, compared with 3 per cent state-wide,  according to a local newspaper analysis.

The FBI is probing Beazer for possible fraud and the US Housing and Urban Development is examining whether its sales practices violated government-insured  mortgage rules. Beazer has defended its sales practices and says it has a "commitment to managing and conducting business in an honest, ethical and lawful manner". In  June it announced that it had fired its chief accounting officer for allegedly attempting to destroy documents. The company's shares have lost 75 per cent of their value  since the probes began.

Several state attorneys-general are also on the trail. Andrew Cuomo of New York state made headlines this spring with a series of subpoenas to property appraisal  companies and has said publicly that he is probing the entire industry. Sources familiar with the office's work say the investigation is still at a relatively early stage.

Marc Dann, the Ohio attorney- general, is looking further up the funding chain. He has been outspoken in his criticism of the role the financial services industry may  have played in the large numbers of foreclosures in his state. "There's a whole series of people that knew or should have known that there was fraud in the acquisition  of these mortgages," Mr Dann told the Financial Times. "We're looking at ways to hold everybody who aided and abetted that fraud."

Mr Dann's office is looking at brokers, appraisers, rating agencies and securitisers and plans to use several legal methods to hold bad actors accountable. The Ohio  attorney-general not only has criminal enforcement powers, but also represents the third-largest set of public pensions in the country and can thus file civil lawsuits on  behalf of investors.

"But for the mechanism of packaging these loans, the fraud never would have existed," Mr Dann says. "We're following this trail from homeowner to bondholder." He  says his investigation could take six months to a year to bear fruit.

The Securities and Exchange Commission, for its part, is investigating whether Bear Stearns and other hedge fund managers were forthright about disclosing the rapidly  declining value of their holdings.

Many of the mortgage-related securities bought by the hedge funds are rarely traded and difficult to value accurately. They are often valued in portfolios according to  complex mathematical models because real market prices are not available, making it possible to disguise underperformance if models are not updated.

The SEC has not brought a case in the area so far, but current and former regulators note that it has previously won settlements from several mutual funds and banks  that failed to revise the prices of illiquid assets during a falling market.

Private securities lawyers are also starting to file securities fraud lawsuits on behalf of investors who have lost out because of the subprime meltdown.

Jake Zamansky, a lawyer who negotiated an early settlement from Merrill Lynch in the scandal over skewed investment bank research, has filed an arbitration claim  against Bear Stearns alleging the firm misled investors about its exposure to the mortgage-backed securities market.

The class action law firm of Bernstein Litowitz is also preparing a claim against Bear Stearns, alleging the firm made material mis-statements in the offering documents  for its now defunct hedge funds.

"This was simply about a hedge fund strategy that failed," said a Bear Stearns spokesman. "We plan on defending ourselves vigorously against the allegations in these  complaints."

Other hedge funds may also come under political or legal pressure over their role in the loan crisis.

Richard Carnell, a professor at Fordham law school, says it may be possible to hold the investment banks that securitised the mortgages at least partially responsible in  the case of a major collapse of the market. "There are two things you can object to in the securitisers' conduct: failing to disclose material facts about the credit quality  of the mortgages; and you can also criticise them for acting as an enabler for someone they know is a bad actor," he says.

But putting together a case will not be easy because the hedge funds and other investors who bought such securities are presumed to be sophisticated about financial  matters. This means it will be harder for them to prove they were not properly warned about the risks involved.

In the case of the Bear Stearns funds, investors may face new hurdles to recovering any money through US lawsuits. Though the funds operated mostly in New York,  they were incorporated in the Cayman Islands and that is where they have filed for bankruptcy. In what could be a test case for international bankruptcy laws, the  liquidators have applied to the US courts asking them to block US lawsuits during the liquidation process.

Bear Stearns said in a statement: "Because the two funds are incorporated in the Cayman Islands, the funds' boards filed for liquidation there . . . The return to  creditors and investors will be based on the underlying assets and liabilities of the funds not on the location of the filing."

Even if the US lawsuits do go forward, a case pending before the Supreme Court could also prove crucial to investors who hope to make a case that hedge funds and  rating agencies enabled widespread fraud.

In Stoneridge Investment Partners v Scientific Atlanta, the court is considering whether investors can recover from firms - including accountants, lawyers and bankers -  that help a public company commit fraud by participating in a "scheme to defraud". If the high court rules against "scheme liability", investors who lost money in the  subprime market will have very few places to turn to try to get some of it back.

William Poole of the Federal Reserve Bank of St. Louis thinks that this may be what investors who lose money on subprime-linked securities deserve for not looking at  them closely enough.

Criticising Wall Street underwriting standards recently, he said: "The punishment has been meted out to those who have done misdeeds and made bad judgments. We  are getting good evidence that the companies and hedge funds that are being hit are the ones who deserve it.''

Letter to the Editor
Financial Times    11 Aug 07

Payback time: A case from the Californian Front
From Dr. J.E. Morgan

Sir, "Payback Time" (August 9) was a great article on the US subprime fraud and inadequate credit checks. The blindness of the companies involved is baffling, because  by 2006 everyone in southern California knew that "financing" meant free money.

Having just moved west, I was chief of plastic surgery in a cosmetic surgery centre, most of whose working-class patients financed their operations via a company  owned by the doctors (I was not one of them). Women with incomes of $18,000 a year were being given $10,000 loans.

But at least the doctors' finance company did stricter checks than the local mortgage companies and car dealerships - perhaps because you can't repossess cosmetic  surgery.

For example, I saw two women friends who wanted cosmetic surgery, but the routine computer finance credit checks showed their social security cards and drivers'  licences were forged.

They objected to this being detected, saying the documents were newly bought - $45 each - from street vendors. In the past week using these documents they had  financed two new cars and a home.

They were refused financing by the surgical centre but were so sure there had been a mistake that they returned the next day with two new sets of forged documents. They were not only surprised but outraged that financing was still declined.

The surgery centre, where I no longer work, could not pay its bills by January 2007. I was just surprised that the mortgage companies lasted as long as they did.

J.E. Morgan
Los Angeles, CA 90048, USA

December 23, 2007

This Is the Sound of a Bubble Bursting
By PETER S. GOODMAN, Cape Coral, Fla.

TWO years ago, when Eric Feichthaler was elected mayor of this palm-fringed, middle-class city, he figured on spending a lot of time at ribbon-cuttings. Tens of thousands of people had moved here in recent years, turning musty flatlands into a grid of ranch homes painted in vibrant Sun Belt hues: lime green, apricot and canary yellow.

Mr. Feichthaler was keen to build a new high school. He hoped to widen roads and extend the reach of the sewage system, limiting pollution from leaky septic tanks. He wanted to add parks. Now, most of his visions have shrunk. The real estate frenzy that once filled public coffers with property taxes has over the last two years given way to a devastating bust. Rather than christening new facilities, the mayor finds himself picking through the wreckage of speculative excess and broken dreams.

Last month, the city eliminated 18 building inspector jobs and 20 other positions within its Department of Community Development. They were no longer needed because construction has all but ceased. The city recently hired a landscaping company to cut overgrown lawns surrounding hundreds of abandoned homes. “People are underwater on their houses, and they have just left,” Mr. Feichthaler says. “That road widening may have to wait. It will be difficult to construct the high school. We know there are needs, but we are going to have to wait a little bit.”

Waiting, scrimping, taking stock: This is the vernacular of the moment for a nation reckoning with the leftovers of a real estate boom gone sour. From the dense suburbs of northern Virginia to communities arrayed across former farmland in California, these are the days of pullback: with real estate values falling, local governments are cutting services, eliminating staff and shelving projects.

Families seemingly disconnected from real estate bust are finding themselves sucked into its orbit, as neighbors lose their homes and the economy absorbs the strains of so much paper wealth wiped out so swiftly.

Southwestern Florida is in the midst of this gathering storm. It was here that housing prices multiplied first and most exuberantly, and here that the deterioration has unfolded most rapidly. As troubles spill from real estate and construction into other areas of life, this region offers what may be a foretaste of the economic pain awaiting other parts of the country.

Cape Coral is in Lee County, across the Caloosahatchee River from Fort Myers. In the county, a tidal wave of foreclosures is turning some neighborhoods into veritable ghost towns. The county school district recently scrapped plans to build seven new schools over the next two years. Real estate agents and construction workers are scrambling for other lines of work, and abandoning the area. As houses are relinquished to red ink and the elements, break-ins are skyrocketing, yet law enforcement is resigned to making do with existing staff.

“We’re all going to have to tighten the belt somehow,” says Robert Petrovich, Cape Coral’s chief of police.

FLORIDA real estate has long been synonymous with boom and bust, but the recent cycle has packed an unusual intensity. The Internet made it possible for people ensconced in snowy Minnesota to type “cheap waterfront property” into search engines and scroll through hundreds of ads for properties here. Cape Coral beckoned speculators, retirees and snowbirds with thousands of lots, all beyond winter’s reach.

Creative finance lubricated the developing boom, making it easy for buyers to take on more mortgage debt than they could otherwise handle, driving prices skyward. Each upward burst brought more investors — some from as far as California and Europe, real estate agents say.

Joe Carey was part of the speculative influx. An owner of rental property in Ohio, he visited Cape Coral in 2002 and found that he could buy undeveloped quarter-acre lots for as little as $10,000. Nearby, there were beaches, golf courses and access to the Caloosahatchee River, which empties into the Gulf of Mexico.

Builders were happy to arrange construction loans, then erect houses in as little as six months. Real estate agents promised to find buyers before the houses were even finished. “All you needed was a pulse,” Mr. Carey said. “The price of dirt was going up. We took that leap of faith and put down $10,000.”

Backed by easily acquired construction loans, Mr. Carey’s investment allowed him to buy three lots and top off each with a new home. He flipped them immediately for about $175,000 each, he recalls. Then he bought more lots, confident that Cape Coral and Fort Myers — the county seat across the river — would continue to blossom. From 2000 to 2003, the population of the Cape Coral-Fort Myers metropolitan area grew to nearly 500,000 from 444,000, according to Moody’s “Jobs were very plentiful,” Mr. Carey said. “The construction trade was up, stores were opening up, and doctors were coming in. It kind of built its own economy.”

In 2003, Mr. Carey became a real estate agent. The next year, he opened a title company. Then he teamed up with seven others to open a local office for Keller Williams Realty, the national realty chain. They hired 40 agents. By 2004, the median house price in Cape Coral and Fort Myers had shot up to $192,100, according to the Florida Association of Realtors — a jump of 70 percent from $112,300 just four years earlier. In 2005, the median price climbed an additional 45 percent, to more than $278,000.

Lots that Mr. Carey once bought for $10,000 were now going for 10 times that. During the best times back in Ohio, he once earned about $100,000 in a year. At the height of the Florida boom, in 2005, he says he raked in $800,000. “If you just got up and went to work,” he says, “pretty much anybody could become an overnight millionaire.”

National home builders poured in, along with construction workers, roofers and electricians. But as a kingdom of real estate materialized, growth ultimately exceeded demand: investors were selling to one another, inflating prices. When the market figured this out in late 2005, it retreated with punishing speed. “It was as if someone turned off the faucet,” Mr. Carey said. “It just came to a screeching halt. When it stopped, people started dumping property.”

By October this year, the median house price was down to $239,000, some 14 percent below the peak. That same month, he and his partners shuttered his real estate office. In November, he closed the title company. On a recent afternoon, he went to his old office in a now-quiet strip mall to take home the remaining furniture. He was preparing to move to the suburbs of Atlanta.

While speculators may find it easy enough to pack up and move on, they are leaving behind an empire of vacant houses that will not be easily sold. More than 19,000 single-family homes and condos are now listed on the market in Lee County. Fewer than 500 sold in November, meaning that at the current rate it would take three years for the market to absorb all the houses.

“Confusion abounds because nobody knows where the bottom is,” says Gerard Marino, a commercial Realtor at the Re/Max Realty Group in Fort Myers. Commercial builders are unloading properties at sharply reduced prices, sometimes even below construction costs, which further adds to the glut.

“It’s our goal to clear out the inventory,” James P. Dietz, the chief financial officer of WCI Communities, a Florida-based home builder, said in an interview two weeks ago. “We have to generate cash to make payroll.” Last week, Mr. Dietz announced he would leave WCI at the end of this year to pursue a career in the vacation resort business.

AT Pelican Preserve, a gated community set around a 27-hole golf course in Fort Myers, WCI has halted building, leaving some residents staring at mounds of earth where they expected to see manicured lawns. Half-built condos sit isolated in a patch of dirt, cut off from the road.

“It bugs the hell out of my wife,” says Paul Bliss, 61, whose three-bedroom town house is next to a half-built home site. “She looks out and sees that concrete slab.”

But the builder makes no apologies. “There was such a falloff in demand that it made no sense to build new units,” says Mr. Dietz, adding that the pause in construction “doesn’t in any way detract from the property.”

Throughout Lee County, a sense of desperation has seized the market as speculators try to unload property or lure renters. On many lawns, a fierce battle is under way for the attention of passers-by, with “for rent” signs narrowly edging out “for sale.”

In Cape Coral, foreclosure filings in the first 10 months of the year reached 4,874, more than a fourfold increase over the same period the previous year, according to RealtyTrac, an online provider of foreclosure information. Elaine Pellegrino and her daughter, Charlene, see no way to avoid joining that list.

Seven years ago, Ms. Pellegrino and her husband bought their three-bedroom house in northwestern Cape Coral for $97,000, without having to make a down payment.

The land was mostly empty then. But as construction crews descended and a thicket of new homes took shape, values more than doubled. The Pellegrinos’ mailbox brimmed with offers to convert that good fortune into cash by refinancing their mortgage. They bit, borrowing against the inflated value of their home to buy two businesses: an auto repair shop and a lawn service. “We were thinking we were on the way up,” Ms. Pellegrino says.

But last December, Ms. Pellegrino’s husband died unexpectedly, leaving her with the two businesses, both deeply in debt, and $207,000 she owed against her home, which is now worth about $130,000, she says.

Disabled and 53 years old, Ms. Pellegrino does not work. She says she lives on a $1,259 monthly Social Security check. Her daughter, a college student, receives $325 a month for child support for one child. Charlene Pellegrino has been looking on the Web for office work for months, but with so many people being laid off, she has come up empty, she says. They have not paid their mortgage in four months.

“What can we do?” Charlene Pellegrino asks, as dusk nears and her driveway lights glow into a void. The rest of the block lies in shadows, with little light emanating from surrounding homes. “We’re probably going to lose the house,” she says.

But not anytime soon. The Pellegrinos have joined a new cohort offered up by the real estate unraveling: they are among those waiting in their own homes for the seemingly inevitable. The courts are so stuffed with foreclosures that they assume they can stay for a while. “We figure we have at least six months,” Elaine Pellegrino says. “We haven’t heard a thing from the bank for a long time.”

AS construction and real estate spiral downward, the unemployment rate in Lee County has jumped to 5.3 percent from 2.8 percent in the last year. With more than one-fourth of all homes vacant, residential burglaries throughout the county have surged by more than one-third.

“People that might not normally resort to crime see no other option,” says Mike Scott, the county sheriff. “People have to have money to feed their families.”

Darkened homes exert a magnetic pull. “When you have a house that’s vacant, that’s out in the middle of nowhere, that’s a place where vagrants, transients, dopers break a back window and come in,” the sheriff adds.

The county’s Department of Human Services has seen a substantial increase in applications for a program that helps pay rent and utility bills for those in need. Half the applicants say they have lost jobs or seen their work hours reduced, said Kim Hustad, program manager.

At Grace United Methodist Church in Cape Coral, Pastor Jorge Acevedo normally starts aid drives this time of year for health clinics in places like India and Africa. This year, the church is buying Christmas presents for about 50 children in the congregation, many who are are in families suffering through job losses.

At Selling Paradise Realty, a sign seeks customers with a free list of properties facing foreclosure and “short sales,” meaning the price is less than the owner owes the bank. Inside, Eileen Rodriguez, the receptionist, said the firm could no longer hand out the list. “We can’t print it anymore,” she says. “It’s too long.”

In late November, more than 2,600 of the 5,500 properties for sale in Cape Coral were short sales, says Bobby Mahan, the firm’s owner and broker. Most people who bought in 2004 and 2005 owe more than they paid, he says. “Greed and speculation created the monster.”

As much as anything, the short sales are responsible for the market logjam. To complete a deal, the lender holding the mortgage must be persuaded to share in the loss and write off some of what is due. “A short sale is a long and arduous process,” Mr. Mahan says. “Battling the banks is horrendous.”

Kevin Jarrett is stuck in that quagmire. In 1995, freshly arrived from Illinois, he put down $1,000 to buy a house in Lehigh Acres, in eastern Lee County.

Three years later, Mr. Jarrett left his mental health-counseling job and began selling real estate. He bought progressively nicer homes, keeping the older ones to rent, while borrowing against the rising value of one to finance the next.

Mr. Jarrett acquired a taste for $100 dinners. He bought a powerboat and a yellow Corvette convertible. (In a photograph on his business card, Mr. Jarrett sits behind the wheel, the top down, offering a friendly wave.) Last summer, he paid $730,000 for a 2,500-square-foot home in Cape Coral with a pool and picture windows looking out on a canal.

But Mr. Jarrett hasn’t closed a deal in three months. He is on track to earn about $50,000 for the year, he said. Yet he needs $17,000 a month just to pay the mortgages, insurance, taxes and utility bills on his four properties — all worth less than half what he owes. Rental income brings in only about $3,500 a month.

Mr. Jarrett has not paid the mortgage on two of his properties in six months and is behind on the others as well, he says. His goal is to sell everything, move into a rental and start over.

He is supplementing his income by selling MonaVie, a nutritional juice that retails for $45 a bottle. He recently dropped health insurance for his family, saving about $680 a month. He is applying for a state-subsidized health plan that would cover his 9-year-old daughter. “I’m in survival mode,” he says.

Many others are in similar straits, and the situation has had a ripple effect on the local economy. Scanlon Auto Group, a luxury car dealer, says it has seen its sales dip significantly — the first time that’s happened in 25 years. Rumrunners, a popular Cape Coral restaurant with tables gazing out on a marina, says its business is down by a third, compared with last year.

Furniture dealers are folding. Hardware stores are suffering. At Taco Ardiente in Lehigh Acres, business is down by more than three-fourths, complains the owner, Hugo Lopez. His tables were once full of the Hispanic immigrants who filled the ranks of the construction trade. The work is gone, and so are the workers.

At the state level, Florida’s sales tax receipts have slipped by nearly one-tenth this year, and by 14 percent in Lee County. That is a clear sign of a broad economic slowdown, said Ray T. Kest, a business professor at Hodges University in Fort Myers. “It started with housing, the loss of construction jobs, mortgage companies, title companies, but now it’s spread through the entire economy,” Mr. Kest says as he walks a strip of mostly empty condo towers on the riverside in downtown Fort Myers. “It now has permeated everything.”

In recent years, Bishop Verot Catholic High School in Fort Myers had raised as much as $200,000 by selling goods at a dinner auction. Michael Pfaff, a Cape Coral mortgage broker, used to donate a weekend cruise on his 40-foot catamaran. But Mr. Pfaff’s business has all but disappeared, and he recently sold the boat. This year, the school canceled the auction and is deferring building maintenance.

The county school district’s decision to cancel construction of new public schools reflects a broader diminishing of resources. Developers have to pay so-called impact fees to the district to help fund new facilities. Two years ago, the district took in $56 million in such fees. Next year, it expects only $25 million.

New schools are no longer needed anyway, says the schools superintendent, James W. Browder. Many families connected to construction and real estate have moved away, so school enrollments are growing more slowly than expected. This could generate a snowball effect all its own: the new schools were to cost as much as $60 million each to build, so canceling them could mean further job cuts for the already reeling building industry.

Mr. Browder points out an upside of the housing downturn: Hiring people has become easy. In recent years, the school system struggled to find bus drivers, given the abundance of jobs at twice the pay driving dump trucks in home construction. “Now, we get 14 applicants for every job,” he says.

The county government depends on property taxes for a third of its general funding. Since taxes are assessed based on the previous year’s real estate values, it has yet to feel a dent. But agencies are under significant pressure to pare back in anticipation of a dip in next year’s funds.

Tax-cutting advocates cheer this prospect. Governments have gotten fat on the boom, they say. A constitutional amendment facing Florida voters in January would expand tax caps for many residences statewide.

“All the local governments were drunk with money,” says Mr. Kest, the finance professor. “Now, they’re going to have to cut back and learn how to manage.”

But local officials counter that they are already being forced to contemplate significant changes that could affect everyday life. The county’s public safety division, which operates ambulance services, says it could be obliged to cut staff. The county’s Natural Resources Department recently delayed a $2.1 million project to filter polluted runoff spilling into the Lakes Regional Park — a former quarry turned into a waterway dotted by islands and frequented by native waterfowl.

People who were priced out of the earlier boom here could wind up the winners. “We had an affordable-housing crisis,” says Tammy Hall, a Lee County commissioner. “The people who were here for a fast buck are gone. You’re going to see normal people go back into that housing.”

When Andrea Drewyor, 24, moved to Cape Coral from Ohio this year to take a teaching job, she found a brand-new two-bedroom waterfront duplex in a gated community with a fitness center, a swimming pool and a Jacuzzi — all for $875 a month in rent.

At night, most of the units around her are dark. The developer can moan.

Not Ms. Drewyor. “I like not having a lot of people living here,” she said. “This place is awesome.”

Washington Post - Associated Press    December 24, 2007

Analysis: Gov't Tries to Contain Crisis


WASHINGTON -- After a slow and stumbling start, official Washington is scrambling to try to prevent the unfolding mortgage crisis from pushing the country into recession during an election year. There is a strong feeling, though, that the government will need to do more to avert a financial disaster.

One former Treasury secretary advocates temporary tax cuts and emergency spending on the order of $50 billion to $75 billion. Such action could help the U.S. from slipping into what Lawrence Summers, who served under President Clinton, fears could become the worst downturn since the steep 1981-82 recession.

Some Republicans are worried, too.

From both Martin Feldstein, who was President Reagan's top economic adviser, and former Federal Reserve Chairman Alan Greenspan have come calls for deeper government intervention to deal with the threat.

Before it is all over, the government may have to resort to measures last used in the savings and loan crisis of the 1990s. Back then, it was a new agency to take over failing thrifts sunk by bad loans. Today, it could mean a government agency to buy up billions of dollars of mortgage-backed securities that investors are shunning.

The Bush administration thus far has opted for less dramatic measures. In fact, the administration came reluctantly to the biggest step taken to date _ the "teaser freezer" announced two weeks ago.

A deal with the mortgage industry will freeze the low introductory "teaser" rates for five years on some subprime mortgages _ loans to people with spotty credit histories. The rates were to climb much higher, making the mortgages unaffordable for many people and putting their homes at risk of foreclosure.

The hope is that this agreement will buy time for the housing market to rebound. That would make it easier for these homeowners to refinance to more affordable fixed-rate loans.

But estimates are that only about 250,000 people will end up getting a rate freeze _ a fraction of the 3.5 million home loans that could go into default over the next 2 1/2 years.

The administration also is working with Congress to increase the $417,000 cap on the size of loans that the big mortgage companies Fannie Mae and Freddie Mac can handle. This step could help in high-cost housing areas such as California.

In addition, the administration is supporting legislation that would boost aid to lower-income homeowners by increasing the scope of mortgage insurance programs handled by the Federal Housing Administration.

These efforts may help at the margins. They do not, however, address one of the biggest threats to the economy: a spreading credit crisis triggered by the soaring defaults on subprime mortgages.

Some of the biggest names in finance have suffered multibillion-dollar losses as a result, and critical segments of the credit markets have frozen up. Banks and investors fear making further loans or buying securities backed by debt because they do not know how many more loans might go into default.

Ben Bernanke, facing his first major test as Fed chairman, is getting mixed reviews. The Fed was embarrassed when the credit crisis hit in August. That happened only two days after the central bank had decided to keep interest rates unchanged and declared that inflation was a bigger risk than weak economic growth.

The Fed has cut interest rates by a full percentage point since that time. But only the September cut _ a bigger-than-expected one-half of a percentage point _ elicited cheers on Wall Street. The two quarter-point moves brought about market declines as investors worried the Fed did not recognize the severity of the problem.

The trouble is that the credit crisis is occurring at the same time that a run-up in energy prices is increasing inflationary pressures.

And that is the dilemma.

If the Fed cuts interest rates to keep the economy out of a recession, it could sow the seeds for higher inflation and perhaps give the country the worst of both worlds, bringing back that 1970s bugaboo, "stagflation," in which growth is stagnant and inflation is getting worse.

In a novel approach, the Fed is auctioning off money to the banks in an attempt to get them to open up their loan spigots. The first two auctions, for a total of $40 billion last week, went well. But the amount of the cash provided to the banks paled in comparison with the $500 billion from the European Central Bank.

Many economists believe the Fed will have to cut its federal funds rate, the interest that banks charge each other, at least three more times and strengthen the wording of its statements. In that way, the markets would know the Fed will do whatever is needed to fight economic weakness in spite of its lingering worries about inflation.

"The difference between a soft economy and a recession is confidence. If the Fed appears reticent to do what is needed, like they did at their last meeting, that does not help confidence," says Mark Zandi, chief economist at Moody's

As for the administration and Congress, a tax cut possibly in the form of a rebate probably will be debated in the coming year. President Bush told reporters at the White House on Thursday that "we're constantly analyzing options available to us." He insisted that the economy's underlying fundamentals remained strong.

Summers, however, in a speech last week, urged bolder action. "For the last year, the economic consensus, and the policy actions that have flowed from it, has been consistently behind the curve," he said.

Gaining some currency is the idea of a government agency modeled after the Resolution Trust Corp. of the S&L days that would buy up mortgage-backed securities as a way of dealing with bad loans. About $100 billion in such loans have surfaced and an additional $200 billion are likely, according to market estimates.

If the government spent $150 billion to $200 billion to purchase mortgage-backed securities, the thinking goes, it would prevent a fire-sale that would drive prices of these securities even lower.

When the housing market stabilizes, the price of the government-held securities would begin to rise, allowing the government to sell them back to investors.

Whatever approach the government decides to take, economists said it will take time for the current problems to resolve themselves. They expect this housing downturn, which followed a five-year boom, to last through most of next year even under a best-case scenario in which the country avoids a full-blown recession.

"We have the fundamental problem that we built too many houses and we charged too high a price for them," says David Wyss, chief economist at Standard & Poor's in New York. "We have to stop building houses for a while and the prices have to come down. We are trying to make sure that process doesn't derail the rest of the economy."
EDITOR'S NOTE _ Martin Crutsinger has covered economic issues for The Associated Press in Washington since 1984. © 2007 The Associated Press

Op-Ed Contributors

December 26, 2007

Mortgage Meltdown
By Michael S.Barr, Sendhil Mullainathan, Eldar Shafir, Peter Schiff & Louis Hyman

A One-Size-Fits-All Solution

WHILE the causes of the mortgage crisis are myriad, a central problem was that many borrowers took out loans that they did not understand and could not afford. Brokers and lenders offered loans that looked much less expensive than they really were, because of low initial monthly payments and hidden, costly features.

Families commonly make mistakes in taking out home mortgages because they are misled by broker sales tactics, misunderstand the complicated terms and financial tradeoffs in mortgages, wrongly forecast their own behavior and misperceive their risks of borrowing. How many homeowners really understand how the teaser rate, introductory rate and reset rate relate to the London interbank offered rate plus some specified margin, or can judge whether the prepayment penalty will offset the gains from the teaser rate?

While disclosure alone is unlikely to help, there’s another option. In retirement policy, behavioral research has led Congress to promote “opt out” plans under which employers sign workers up for retirement benefits unless the worker chooses not to participate. This policy has significantly improved people’s retirement savings.

Why not have an opt-out home mortgage plan, based, for example, on a 30-year, fixed-rate loan, with sound underwriting and straightforward terms?

Eligible borrowers would be offered a standard mortgage (or set of mortgages) and that’s the mortgage they would get — unless they choose to opt out in favor of another option, after honest and comprehensible disclosures from brokers or lenders about the risks of the alternative mortgages. An opt-out mortgage system would mean borrowers would be more likely to get straightforward loans they could understand.

But given lender incentives to hide true costs from borrowers, we need to give the opt-out plan some bite. Under our plan, lenders would have stronger incentives to provide meaningful disclosures to those whom they convince to opt out, because if default occurs when a borrower opts out, the borrower could raise the lack of reasonable disclosure as a defense to bankruptcy or foreclosure. If the court determined that the disclosure would not effectively communicate the key terms and risks of the mortgage to the typical borrower, the court could modify or rescind the loan contract.

This approach would allow lenders to continue to develop new kinds of mortgages, but only when they can explain them clearly to borrowers. To avoid the next mortgage crisis, we should use behavioral insights to make it harder for lenders to put borrowers where they will make predictable and consequential mistakes.

Michael S. Barr is a professor of law at the University of Michigan. Sendhil Mullainathan is a professor of economics at Harvard. Eldar Shafir is a professor of psychology at Princeton.

Frozen Rates, Falling Prices
By PETER SCHIFF, Darien, Conn.

THE Bush administration’s mortgage rescue plan will worsen, not alleviate, the problems in the housing market.

We are suffering from a home value crisis, not simply a credit crisis. If home prices were still rising, defaults would be low, investment returns would be high, borrowers would still be cashing out equity, and lenders would be showering credit on home buyers.

Falling prices reverse this dynamic. A recent study by the Federal Reserve Bank of Boston found that most foreclosures result from falling home prices, not from the resetting of mortgage rates.

And if rates are frozen for some subprime mortgages, standards for most new loans will become increasingly strict. Lenders will have to factor in the added risk of having their contracts rewritten when borrowers default. Higher down payments, mortgage rates and required credit scores — along with lower loan-to-income ratios and perhaps the death of adjustable-rate loans altogether — will further push down home prices.

Whether or not their payment levels are frozen, borrowers with loans that are greater than the values of their homes will have few incentives to keep paying their mortgages or to maintain their properties. Why spend more on a home in which they have no equity and which they may lose to foreclosure anyway?

Having put nothing down or having extracted equity in previous refinances, most subprime borrowers will lose nothing financially from foreclosure. In some cases the low teaser rates allowed them to pay less than what they might otherwise have paid in rent. The real losses are borne by the lenders.

Proponents suggest that a rate freeze will buttress home prices by keeping foreclosed homes off the market. But that is a stay of execution, not a pardon. Most homes temporarily saved from foreclosure will continue to depreciate as new buyers fail to qualify for loans. Lenders will be on the hook for even more losses than if the foreclosures had taken place sooner.

Everyone seems to agree that a return to traditional lending standards is a good idea, but no one seems willing to accept a return to rational prices as a consequence.

While the bubble was inflating, self-serving explanations were offered for why traditional formulas of home valuation no longer applied. As it turns out, the laws are still in effect. These traditional measures, like the relationship between home prices, rents and income, indicate that prices need to fall at least 30 percent more nationally. The sooner this balance is achieved, the sooner lenders will again commit capital.

Peter Schiff is the president of a Connecticut-based brokerage company and the author of “Crash Proof: How to Profit From the Coming Economic Collapse.”

The Original Subprime Crisis
By LOUIS HYMAN, Cambridge, Mass.

WHILE critics of today’s mortgage crisis call for government intervention to suppress subprime lending, few are aware that government intervention created subprime mortgages in the first place.

The National Housing Act of 1968, part of President Lyndon Johnson’s Great Society, provided government-subsidized loans to expand home ownership for poor Americans. Liberal policymakers hoped that these loans, called Section 235 loans, would enable poor Americans — urban blacks in particular — to buy their own homes.

Under the program, a poor family could obtain a mortgage from a lender for as little as $200 down and pay only a small portion of the interest. If the borrower defaulted, the government paid the balance of the loan. If the borrower made payments on time, the government covered all of the loan’s interest above 1 percent. Homebuyers could borrow up to $24,000, as long as Federal Housing Administration inspectors declared the property to be in sound condition.

By 1971, Congressional and press investigations found the program riddled with fraud. Section 235 accelerated existing white flight by providing poor African-Americans with money to buy out their anxious white neighbors, who in turn accepted below-market prices for their houses. Real estate agents frightened white homeowners with visions of all-black neighborhoods financed by government money, and then pocketed the proceeds from the resulting high home turnover.

Existing homeowners lost their equity, but a canny alliance of brokers, lenders and federal housing inspectors inserted themselves as middlemen between the buyers and the sellers to reap profits. White speculators, often real estate agents themselves, bought houses cheaply from fleeing white homeowners, did superficial renovations and then sold the houses at steep prices to black first-time homeowners.

As the properties changed hands, the speculators profited and the government paid the tab. When the Federal Housing Administration was not paying interest on inflated mortgages, it was left holding properties in inner-city neighborhoods that could not be sold.

But corrupt opportunists were not the only reason Section 235 failed. Structurally the program could not work because it tried to solve a problem of wealth creation through debt creation.

Homeowners cannot build equity in an overvalued house, no matter what the terms of the mortgage. Whether that inflated value comes from corrupt inspectors or frenzied markets is immaterial. The crisis, now as then, is a symptom of inequality — not its cause.

Louis Hyman teaches history at Harvard.

Washington Post      January 10, 2008

Foreclosures Surge, Countrywide Says
Defaults Rise at Mortgage Lender

By David Cho

Countrywide Financial, the nation's largest home loan lender, reported yesterday that foreclosures and late payments on mortgages in December soared to their highest levels in five years.

The large number of the bad loans alarmed mortgage analysts who follow the company. Several said the Countrywide report showed that housing market conditions were unraveling at an unexpectedly rapid pace.

Lehman Brothers analyst Bruce W. Harting wrote in a report yesterday that "the extent of the deterioration is a surprise." Steven Persky, chief executive of Dalton Investments, a Los Angeles investment adviser, said: "People are recognizing that foreclosures are skyrocketing beyond expectations."

The turmoil in the housing market is prompting more talk of a recession by some of Wall Street's biggest names. Goldman Sachs, the world's largest brokerage, wrote in a note to investors yesterday that it is expecting a recession this year and advised them to buy defensive investments, such as consumer staples and utilities. Investors were cautioned against buying the stocks of financial firms that are exposed to the mortgage crisis and have declined drastically.

Shares of large mortgage lenders dropped yesterday, with Washington Mutual falling 3.5 percent and IndyMac declining 16.5 percent. Countrywide hit a 13-year low at midday before recovering to close down 6 percent. On Tuesday, Countrywide shares plummeted 28.4 percent and prompted a broader sell-off in the stock markets as analysts worried about the lender's long-term survival.

Countrywide, with a $1.5 trillion portfolio of loans, is so large that its failure may cause a crisis on Wall Street, which over the past few years has tied its fate to the mortgage industry by buying so many of the mortgage-backed securities these lenders produce, said Stuart Plesser, an equity analyst at Standard & Poor's.

The housing market would suffer as well, he added. "There are major implications if Countrywide fails," Plesser said. "A customer's ability get a mortgage would be significantly impaired."

In yesterday's monthly operating report, Countrywide said that among the 9 million mortgages for which it processes payments, the foreclosure rate doubled in December, to 1.44 percent from 0.7 percent a year earlier. Defaults rose to 7.2 percent from 4.6 percent in the same period.

Foreclosures and rising defaults, which occur when homeowners are more than 30 days late on monthly payments, deal a double blow to Countrywide: The firm suffers losses on the loans themselves, and its mortgage securities, which are backed by its loans, drop in value and become difficult to sell.

Without a robust mortgage-backed security business, the firm would face a severe cash shortage. Company officials have admitted that they face a challenging environment but have repeatedly said they are not considering a bankruptcy filing.

Some analysts doubt such statements. Egan Jones, a ratings company, wrote in a report Tuesday that Countrywide is "severely challenged and might falter if it does not receive an infusion of at least $4 billion within the next couple of weeks."

To this point, Countrywide has heavily relied on the Federal Home Loan Bank in Atlanta, which has loaned $51.1 billion to the troubled mortgage company. But Countrywide appears to lack the collateral to borrow more from that bank.

Some analysts say Countrywide may be too big to fail. "The government would have to pick up a big tab if Countrywide failed," said Plesser, the equity analyst at Standard & Poor's. "So it would seem to me it's in the government interests to step in before the mess, before it failed rather than later."

A major problem for Countrywide, based in Calabasas, Calif., is that housing prices continue to decline around the country, with some areas experiencing double-digit drops in value. House-price declines are the driving force behind defaults and foreclosures because homeowners are more likely to stop their monthly payments on properties that are worth less than what they paid for them.

The worst may be ahead for home prices. Treasury Secretary Henry M. Paulson Jr. said yesterday that the housing market has not bottomed out. "There's no evidence that is improving or bottoming, and as a matter of fact, I think the evidence would indicate that it is going to have further to run," Paulson said on CNBC.

Countrywide's president and chief operating officer, David Sambol, said the firm is headed in the right direction despite such challenges.

The lender had a slight increase in the number of mortgages it sold in December compared with the previous month, and deposits jumped to $113 billion in December from $83 billion in the previous year at the bank Countrywide owns, which is insured by the Federal Deposit Insurance Corp.

"Our fourth quarter ended with a number of positive operational trends," Sambol said in a statement. "Management is pleased with the progress we have made in positioning the company to navigate the current challenging environment."

La Chronique Agora 16 Janvier 2008

La crise du subprime aura-t-elle une influence sur le monde réel?
par Dan Denning

** Les investisseurs américains compteraient-ils trop sur les résultats positifs d'IBM ? Le Dow a gagné trois points sur la séance de lundi. Il ne faut jamais contredire le marché. Mais nous avons la nette impression que les résultats positifs d'IBM sont une belle mascarade (et nous en avons eu la confirmation hier, avec la chute des indices US).

- IBM a annoncé que ses bénéfices du quatrième trimestre allaient augmenter de 10%, principalement grâce à une importante progression des ventes en Asie et sur les marchés émergents. La bourse peut désormais se raccrocher à un leitmotiv, quelque chose comme : les multinationales qui diversifient leur base de clients vont survivre à la tempête de la crise de l'immobilier et du crédit, et pourront faire tourner la machine. Très bien.

- C'est possible. Mais la base de ce leitmotiv, c'est que le marché baissier du crédit n'aura pas d'effet sur l'économie réelle, du moins pas au-delà du secteur financier et des 24 000 licenciements annoncés par Citigroup (selon les articles de presse). Après tout, il existe des précédents d'éclatement de bulles de capitaux sans effet notable sur le monde réel.

- La crise du peso mexicain en 1994... les problèmes de LTCM et leur propagation en Asie en 1998... et même l'éclatement de la bulle technologique en 2000... Toutes ces bulles ont apparu et disparu, et le monde n'a pas cessé de tourner. Les rouages de l'industrie et les mécanismes du commerce ont continué à tourner eux aussi. Pourquoi est-ce que ce serait différent cette fois-ci ? Nous avons posé la question à Wolfgang Munchaun, qui écrivait lundi dans le Financial Times :

- "Si cela n'avait été qu'une crise du subprime, ce serait déjà terminé. Mais ce n'est pas le cas, et la fin est encore loin. La raison, c'est que plusieurs autres 'poches' du marché du crédit sont également vulnérables. Les cartes de crédit en sont une partie, et ont la même importance que le marché du subprime".

- Quoi ? Vous voulez dire qu'il y a plein d'autres risques qui se cachent sur les bilans des entreprises en se faisant passer pour des capitaux ? Et donc davantage de capitaux dont la valeur dépend de la capacité des consommateurs américains à rembourser leurs cartes de crédit à temps ? Combien ?

- Une enquête réalisée en décembre par l'Associated Press annonce que la valeur des comptes ayant au moins 30 jours de retard de paiement a augmenté de 26% et a atteint les 17 milliards de dollars à la fin de l'année dernière.

- Une autre enquête de la société de conseil en crédit RiskMetrics affirme que les défauts de paiement augmentent encore plus rapidement. De plus en plus d'emprunteurs ne peuvent plus payer à temps. Certains ne peuvent d'ailleurs plus payer du tout ; ils sont ruinés.

- Ce que nous pensons ? Ce marché baissier du crédit est différent des autres parce qu'il touche au cœur de l'économie mondiale : les dépenses de consommation. Les consommateurs sont déjà couverts de dettes et sans le sou. Ils découvrent maintenant en masse que l'on peut devenir riche en dépensant plus que ce qu'on gagne et en payant la différence avec une carte en plastique.

** Le marché a semblé tout excité par les revenus d'IBM. Mais restons objectifs. Le plus important, c'est que pendant que le marché brade les nouvelles de l'année dernière, 2008 nous réserve des choses qui auront un impact négatif sur les revenus des entreprises, le consommateur américain et l'économie mondiale. Par exemple, les credit default swaps (CDS).

- Munchaun écrit que "le marché des CDS vaut près de 45 000 milliards de dollars (30 500 milliards d'euros). Un chiffre difficile à visualiser. C'est plus de trois fois le PIB des Etats-Unis. D'un point de vue économique, les CDS sont une assurance. Mais légalement, ça n'en est pas une, c'est la raison pour laquelle ce marché n'est quasiment pas réglementé".

- "Il n'est pas difficile de voir que le marché des CDS a le potentiel de provoquer une grave contagion financière. La crise du subprime a faillit déstabiliser le système financier mondial. Une crise des CDS, si on imagine un scénario pessimiste, pourrait entraîner un effondrement de l'économie mondiale. Ce n'est pas une prédiction de ce qui va se passer, plutôt un scénario contingent. Mais ce scénario dépend d'un évènement -- une crise longue et grave -- qui n'est pas totalement improbable".

Op-Ed Columnist

January 18, 2008

Mexico. Brazil. Argentina. Mexico, again. Thailand. Indonesia. Argentina, again.
And now, the United States.
Don’t Cry for Me, America


The story has played itself out time and time again over the past 30 years. Global investors, disappointed with the returns they’re getting, search for alternatives. They think they’ve found what they’re looking for in some country or other, and money rushes in.

But eventually it becomes clear that the investment opportunity wasn’t all it seemed to be, and the money rushes out again, with nasty consequences for the former financial favorite. That’s the story of multiple financial crises in Latin America and Asia. And it’s also the story of the U.S. combined housing and credit bubble. These days, we’re playing the role usually assigned to third-world economies.

For reasons I’ll explain later, it’s unlikely that America will experience a recession as severe as that in, say, Argentina. But the origins of our problem are pretty much the same. And understanding those origins also helps us understand where U.S. economic policy went wrong.

The global origins of our current mess were actually laid out by none other than Ben Bernanke, in an influential speech he gave early in 2005, before he was named chairman of the Federal Reserve. Mr. Bernanke asked a good question: “Why is the United States, with the world’s largest economy, borrowing heavily on international capital markets — rather than lending, as would seem more natural?”

His answer was that the main explanation lay not here in America, but abroad. In particular, third world economies, which had been investor favorites for much of the 1990s, were shaken by a series of financial crises beginning in 1997. As a result, they abruptly switched from being destinations for capital to sources of capital, as their governments began accumulating huge precautionary hoards of overseas assets.

The result, said Mr. Bernanke, was a “global saving glut”: lots of money, all dressed up with nowhere to go.

In the end, most of that money went to the United States. Why? Because, said Mr. Bernanke, of the “depth and sophistication of the country’s financial markets.”

All of this was right, except for one thing: U.S. financial markets, it turns out, were characterized less by sophistication than by sophistry, which my dictionary defines as “a deliberately invalid argument displaying ingenuity in reasoning in the hope of deceiving someone.” E.g., “Repackaging dubious loans into collateralized debt obligations creates a lot of perfectly safe, AAA assets that will never go bad.”

In other words, the United States was not, in fact, uniquely well-suited to make use of the world’s surplus funds. It was, instead, a place where large sums could be and were invested very badly. Directly or indirectly, capital flowing into America from global investors ended up financing a housing-and-credit bubble that has now burst, with painful consequences.

As I said, these consequences probably won’t be as bad as the devastating recessions that racked third-world victims of the same syndrome. The saving grace of America’s situation is that our foreign debts are in our own currency. This means that we won’t have the kind of financial death spiral Argentina experienced, in which a falling peso caused the country’s debts, which were in dollars, to balloon in value relative to domestic assets.

But even without those currency effects, the next year or two could be quite unpleasant.

What should have been done differently? Some critics say that the Fed helped inflate the housing bubble with low interest rates. But those rates were low for a good reason: although the last recession officially ended in November 2001, it was another two years before the U.S. economy began delivering convincing job growth, and the Fed was rightly concerned about the possibility of Japanese-style prolonged economic stagnation.

The real sin, both of the Fed and of the Bush administration, was the failure to exercise adult supervision over markets running wild.

It wasn’t just Alan Greenspan’s unwillingness to admit that there was anything more than a bit of “froth” in housing markets, or his refusal to do anything about subprime abuses. The fact is that as America’s financial system has grown ever more complex, it has also outgrown the framework of banking regulations that used to protect us — yet instead of an attempt to update that framework, all we got were paeans to the wonders of free markets.

Right now, Mr. Bernanke is in crisis-management mode, trying to deal with the mess his predecessor left behind. I don’t have any problems with his testimony yesterday, although I suspect that it’s already too late to prevent a recession.

But let’s hope that when the dust settles a bit, Mr. Bernanke takes the lead in talking about what needs to be done to fix a financial system gone very, very wrong.

Financial Times    February 20 2008

America’s economy risks mother of all meltdowns
By Martin Wolf

“I would tell audiences that we were facing not a bubble but a froth – lots of small, local bubbles that never grew to a scale that could threaten the health of the overall economy.” Alan Greenspan, The Age of Turbulence.

That used to be Mr Greenspan’s view of the US housing bubble. He was wrong, alas. So how bad might this downturn get? To answer this question we should ask a true bear. My favourite one is Nouriel Roubini of New York University’s Stern School of Business, founder of RGE monitor.

Recently, Professor Roubini’s scenarios have been dire enough to make the flesh creep. But his thinking deserves to be taken seriously. He first predicted a US recession in July 2006*. At that time, his view was extremely controversial. It is so no longer. Now he states that there is “a rising probability of a ‘catastrophic’ financial and economic outcome”**. The characteristics of this scenario are, he argues: “A vicious circle where a deep recession makes the financial losses more severe and where, in turn, large and growing financial losses and a financial meltdown make the recession even more severe.”

Prof Roubini is even fonder of lists than I am. Here are his 12 – yes, 12 – steps to financial disaster.

Step one is the worst housing recession in US history. House prices will, he says, fall by 20 to 30 per cent from their peak, which would wipe out between $4,000bn and $6,000bn in household wealth. Ten million households will end up with negative equity and so with a huge incentive to put the house keys in the post and depart for greener fields. Many more home-builders will be bankrupted.

Step two would be further losses, beyond the $250bn-$300bn now estimated, for subprime mortgages. About 60 per cent of all mortgage origination between 2005 and 2007 had “reckless or toxic features”, argues Prof Roubini. Goldman Sachs estimates mortgage losses at $400bn. But if home prices fell by more than 20 per cent, losses would be bigger. That would further impair the banks’ ability to offer credit.

Step three would be big losses on unsecured consumer debt: credit cards, auto loans, student loans and so forth. The “credit crunch” would then spread from mortgages to a wide range of consumer credit.

Step four would be the downgrading of the monoline insurers, which do not deserve the AAA rating on which their business depends. A further $150bn writedown of asset-backed securities would then ensue.

Step five would be the meltdown of the commercial property market, while step six would be bankruptcy of a large regional or national bank.

Step seven would be big losses on reckless leveraged buy-outs. Hundreds of billions of dollars of such loans are now stuck on the balance sheets of financial institutions.

Step eight would be a wave of corporate defaults. On average, US companies are in decent shape, but a “fat tail” of companies has low profitability and heavy debt. Such defaults would spread losses in “credit default swaps”, which insure such debt. The losses could be $250bn. Some insurers might go bankrupt.

Step nine would be a meltdown in the “shadow financial system”. Dealing with the distress of hedge funds, special investment vehicles and so forth will be made more difficult by the fact that they have no direct access to lending from central banks.

Step 10 would be a further collapse in stock prices. Failures of hedge funds, margin calls and shorting could lead to cascading falls in prices.

Step 11 would be a drying-up of liquidity in a range of financial markets, including interbank and money markets. Behind this would be a jump in concerns about solvency.

Step 12 would be “a vicious circle of losses, capital reduction, credit contraction, forced liquidation and fire sales of assets at below fundamental prices”.

These, then, are 12 steps to meltdown. In all, argues Prof Roubini: “Total losses in the financial system will add up to more than $1,000bn and the economic recession will become deeper more protracted and severe.” This, he suggests, is the “nightmare scenario” keeping Ben Bernanke and colleagues at the US Federal Reserve awake. It explains why, having failed to appreciate the dangers for so long, the Fed has lowered rates by 200 basis points this year. This is insurance against a financial meltdown.

Is this kind of scenario at least plausible? It is. Furthermore, we can be confident that it would, if it came to pass, end all stories about “decoupling”. If it lasts six quarters, as Prof Roubini warns, offsetting policy action in the rest of the world would be too little, too late.

Can the Fed head this danger off? In a subsequent piece, Prof Roubini gives eight reasons why it cannot***. (He really loves lists!) These are, in brief: US monetary easing is constrained by risks to the dollar and inflation; aggressive easing deals only with illiquidity, not insolvency; the monoline insurers will lose their credit ratings, with dire consequences; overall losses will be too large for sovereign wealth funds to deal with; public intervention is too small to stabilise housing losses; the Fed cannot address the problems of the shadow financial system; regulators cannot find a good middle way between transparency over losses and regulatory forbearance, both of which are needed; and, finally, the transactions-oriented financial system is itself in deep crisis.

The risks are indeed high and the ability of the authorities to deal with them more limited than most people hope. This is not to suggest that there are no ways out. Unfortunately, they are poisonous ones. In the last resort, governments resolve financial crises. This is an iron law. Rescues can occur via overt government assumption of bad debt, inflation, or both. Japan chose the first, much to the distaste of its ministry of finance. But Japan is a creditor country whose savers have complete confidence in the solvency of their government. The US, however, is a debtor. It must keep the trust of foreigners. Should it fail to do so, the inflationary solution becomes probable. This is quite enough to explain why gold costs $920 an ounce.

The connection between the bursting of the housing bubble and the fragility of the financial system has created huge dangers, for the US and the rest of the world. The US public sector is now coming to the rescue, led by the Fed. In the end, they will succeed. But the journey is likely to be wretchedly uncomfortable.

*A Coming Recession in the US Economy? July 17 2006,; **The Rising Risk of a Systemic Financial Meltdown, February 5 2008; ***Can the Fed and Policy Makers Avoid a Systemic Financial Meltdown? Most Likely Not, February 8 2008

March 27, 2008

Senators Seek Details About Bear Stearns Deal

WASHINGTON — Senior senators signaled their unease on Wednesday with the Federal Reserve’s shotgun marriage of JPMorgan Chase and Bear Stearns, demanding detailed information by next week about how the $30 billion deal was reached.

The challenge from Capitol Hill is the most striking shot in a rising political battle about whether the Fed’s decision to provide emergency loans to major Wall Street investment banks should be accompanied by stricter regulation over their activities — as is already the case for commercial banks.

Treasury Secretary Henry M. Paulson Jr. defended the Fed’s rescue of Bear Stearns in a speech on Wednesday and resisted calls by some Democrats for greater regulation of Wall Street.

“Recent market conditions are an exception from the norm,” Mr. Paulson said in a speech at the Chamber of Commerce of the United States. “The Federal Reserve’s recent action should be viewed as a precedent only for unusual periods of turmoil.”

Though Mr. Paulson said that Wall Street firms should provide more information about their financial condition if they borrow money from the Fed, he said that investment banks were still fundamentally different from commercial banks and did not endorse any proposals for tighter regulation.

But in the Senate, the two leading members of the Finance Committee raised questions about policies being pursued by the Fed and the Bush administration in dealing with the credit crisis.

“Americans are being asked to back a brand-new kind of transaction, to the tune of tens of billions of dollars,” wrote Senator Max Baucus, Democrat of Montana and chairman of the Senate Finance Committee, and Senator Charles E. Grassley of Iowa, the senior Republican on the committee. “Congress has a responsibility to look at whether the taxpayers will lose money here.”

Senator Chris Dodd, chairman of the Senate Banking Committee, also announced a hearing for next Thursday on the Bear Stearns deal and summoned Mr. Paulson, along with Ben S. Bernanke, chairman of the Fed, and Timothy F. Geithner, president of the Federal Reserve Bank of New York.

The senators did not mention any specific suspicions about the deal, but the range of their requests suggested concerns about the motives of the various negotiations, the soundness of the deal and the potential precedent for future bailouts. Lawmakers made it clear they also had questions about the government’s broader response to the widening financial crisis and the soaring rate of home foreclosures.

In the deal announced on Monday, the Fed agreed to lend JPMorgan Chase $29 billion and to hold as collateral what Fed officials estimated were $30 billion worth of mortgage-related assets owned by Bear Stearns. Working together, Fed and Treasury officials were convinced that Bear Stearns was about to go bankrupt and set off a systemic breakdown in financial markets.

But scores of questions remain unanswered. No one knows the real value of the assets formerly owned by Bear Stearns that the Fed agreed to take as collateral. Fed officials have said they greatly discounted the value of those assets before agreeing to the $29 billion loan, but they have offered no detail of what those assets actually look like.

Mr. Baucus and Mr. Grassley, on the Senate Finance Committee, demanded that the Treasury and Fed provide a detailed list of Bear Stearns assets, as well as a memorandum on the sequence of events leading up to the deal, the names of every participant in the discussions, including those of lawyers, accountants and other advisers.

Mr. Dodd said the agreement “raises serious public policy questions” about the role of the Fed, the Treasury and the Securities and Exchange Commission as the deal’s “facilitators.”

The broader question for lawmakers is whether the Fed’s rescue, and its simultaneous decision to let the nation’s biggest investment banks borrow from its discount window, mean that the Fed should subject Wall Street firms to the same scrutiny and regulation as it now imposes on commercial banks.

For the first time since the Depression, the Fed announced on March 16 that big investment firms would be allowed to borrow billions of dollars from the Fed’s so-called discount window.

The discount window is normally reserved only for commercial banks and other depository institutions, which in exchange subject themselves to closer scrutiny and stricter capital reserve requirements.

Several leading Democrats in Congress are now calling for tighter regulation of Wall Street firms, saying that they are getting some of the same protection as commercial banks without the same kind of regulation.

Mr. Paulson acknowledged that the Fed’s decision had created a contradiction between how commercial and investment banks are treated. He said that investment banks should be subjected to “the same type of regulation” if they were to have “regular” access to the Fed’s discount window.

But Mr. Paulson quickly added that the Fed’s offer to the investment banks should be seen as the exception to the rule.

Mr. Paulson also took a swipe at Democratic proposals to have the government refinance millions of troubled mortgages to reduce what is expected to be a tidal wave of home foreclosures.

“I know members of Congress have outlined other ideas,” he said, “but most are not ready for the starting gate.”

April 9, 2008

A Silicon Valley Slowdown

SAN FRANCISCO — Housing prices in Silicon Valley remain defiantly high. New BMWs and Saabs cruise Highway 101. But for the first time there are signs that the current economic downturn is taking its toll on the country’s cradle of technology and innovation.

Job growth has slowed, start-up companies are hiring and spending more cautiously, and early-stage investors who nurture the start-ups with money and expertise are growing more frugal.

Most of the investors, entrepreneurs and innovators who build companies in the Valley do so with the hope of taking them public or selling them — the rainmaking opportunities that people here call exits. But with gloom pervading the financial markets and the business climate, the exits are hard to find.

During the first three months of the year, only five companies backed by venture capital investors went public on Wall Street, the National Venture Capital Association said last week. That is down from 31 in the fourth quarter of last year, and is roughly the same level as at the nadir of the dot-com bust.

There was also a sharp falloff in the acquisition of start-up companies by bigger corporations. Microsoft is making noise with its effort to take over Yahoo, but elsewhere things are quieting down. There were only 56 acquisitions in the first three months of the year, down from 83 in the fourth quarter.

With those options increasingly off the table, investors must spend money and time nurturing — or altogether salvaging — existing companies rather than building new ones.

“We are holding expenses very tight,” said Jim Breyer, managing partner at Accel Partners, a venture capital firm. The firm is an investor in Model N, a software company that recently withdrew its registration to go public because of the inhospitable market conditions. Mr. Breyer said the company would wait until the fall, at the earliest, to try again.

“It’s anybody’s guess how long the downturn will last,” Mr. Breyer said.

If it lasts through this year, he said, “it will be far more than an inconvenience for all companies.” The dried-up market for public offerings and acquisitions is affecting not just the atmosphere of innovation but also the lifestyle of its participants.

“Less cash coming into the Valley means less cash to purchase homes, and go out to nice dinners, spend on consumer products and go on vacations,” said Hans Swildens, founder and principal of Industry Ventures, an investment firm that buys stakes in start-up companies that need infusions of cash.

“The general sentiment in Silicon Valley is that we’re not yet there, but the reality is that we are,” Mr. Swildens said. “It’s already started.”

The region feels as if it is on the cusp of a mood shift. On the one hand, its denizens say they feel fortunate to be working in a segment of the economy and living in a region that has been hurt far less than other parts of the country. They also express stubborn confidence in the inexorable shift to the Internet and the role that Valley technology companies will play in that transition.

And they assert that they are not feeling anything like the pain that followed the collapse of the dot-com bubble, which led to big job losses, an exodus of talent, a plunging commercial real estate market and a significant drop in investment in start-up companies.

But having assiduously clawed its way back from the dot-com bust, the Valley is again facing some tough conditions. At the area’s blue chip companies, stock performance has turned grim as growth has slowed. Google’s stock has fallen around 31 percent this year; Apple is down 21 percent. The Nasdaq composite, an index with a major technology focus, is down 11.4 percent this year.

Among the shares of venture-backed companies that went public in the last year, only 28 percent are above the offering price. That compares with around 50 percent in a typical year and 70 percent in strong market conditions, according to the National Venture Capital Association.

New companies are hitting roadblocks on their way to the capital markets. Upek, a company in Emeryville, Calif., that makes computer chips and software used for fingerprint recognition, registered to go public last May. It then began trying to drum up investor enthusiasm, and was making progress. But on March 4, it withdrew its registration.

On Wall Street “there was suddenly no more appetite for growth companies,” said Eric Buatois, a general partner in Sofinnova Ventures, an early-stage investment firm that backed the start-up.

Upek is profitable already, but without the cash infusion from the offering, Mr. Buatois said, it will delay new products, limit the number of projects it takes on and hire less aggressively.

“You shrink your expansion plans,” Mr. Buatois said.

Upek has 30 employees in California and another 80 or so worldwide; it has manufacturing in Singapore, hardware development in Italy and software development in Prague. It also does 80 percent of its sales overseas.

Upek’s global nature, which is shared by a growing number of start-ups in Silicon Valley, is cutting both ways in the economic downturn. On the positive side, the overseas sales are insulating the company from some of the tough economic conditions in the United States.

However, because it has workers outside the country, it is paying a hefty and unexpected price as a result of the dollar’s decline.

“The biggest impact is the free fall of the dollar,” Mr. Buatois said. He said costs to the company have risen 10 percent to 20 percent in the last three quarters. “But the price of the product is not going up.”

The withering national economy also appears to be having an impact on the amount of money that early-stage investors are putting into start-ups.

In 2007, very early-stage investors — so-called angels — put $26 billion into start-ups, according to the Center for Venture Research at the University of New Hampshire. That figure represents no increase from the year before, after large increases every year since 2003, when the Valley emerged from the bust.

“Since the climb back, this is the first flat year,” said Jeffrey Sohl, the center’s director. He said the money was being spread over more start-up companies, which means the average amount going into individual start-ups from angels has fallen to $450,000, from around $500,000.

“It’s not a crisis in confidence, but it is a more cautious approach,” Mr. Sohl said of the perspective of investors, whom he said may also have less to invest in new companies because the market’s decline has diminished their capital.

The caution is likely to hinder job growth. The Center for the Continuing Study of the California Economy projects there will be 10,000 new jobs in the region this year, down from 17,700 last year, and 25,000 in 2006

Another seemingly unrelated but potentially crucial financing issue has come from the paralysis in the market for so-called auction-rate securities. These are investments that individuals and companies have used to park money for short periods, with the knowledge that they could quickly retrieve the funds. Many venture capitalists have relied on such investments but are finding they are unable to get their money out, which in turn is threatening their ability to pay bills at their start-ups.

But the most troubling specter for the tech economy has been the stalled stock market and the impact it has had on the ability of investors and entrepreneurs to go public for personal profit and to raise money to continue to build their businesses.

At the end of the fourth quarter, there were 60 venture capital-backed companies registered to go public. By the end of the first quarter, 38 were registered. And some of those have since withdrawn their registrations, said Mark G. Heesen, president of the National Venture Capital Association.

“That’s how quickly it turned,” Mr. Heesen said, adding: “It is not good news, and we are not trying to sugarcoat it at all.”

There is a trickle-down impact, he said. “For Silicon Valley, it means fewer start-ups funded, fewer entrepreneurs funded, fewer employers that you hope to be the next major employer.”


October 19, 2008

The Bubble Keeps On Deflating

By now everyone knows that reckless and even predatory mortgage lending provoked the financial meltdown. But bad lending did not stop there. The easy money also fed a corporate buyout binge, with private equity firms borrowing huge sums to buy up public companies and pay themselves big dividends.

The process was much like a homeowner who borrowed big for a house and then refinanced to pull out cash. In corporate buyouts, however, the newly private company was left with the fat loan, while the private equity partners got the cash.

In keeping with the mania of the era, banks lowered their lending standards as they competed fiercely to make buyout loans. Lenders also did not worry much about being repaid, because they made money by slicing and dicing the buyout loans and selling them off in pieces to investors.

All of this means that the country needs to brace for yet another round of trouble: a potentially sharp increase in corporate bankruptcies. This time, government officials and Congress must not be taken by surprise.

So far relatively few companies have gone bust. But that is not necessarily a hopeful sign. Instead, loose lending has very likely allowed many troubled companies to postpone a day of reckoning — but not forever.

Under the lax terms of many buyout loans (deemed “covenant lite”), borrowers could delay payments, say, by issuing i.o.u.’s in lieu of payment or adding the interest to the loan balance rather than paying it. But when the loans come due and need to be repaid or refinanced, terms will no longer be so easy. The likely result will be defaults and bankruptcies.

A rash of corporate bankruptcies would obviously be very bad news for employees and lenders, and for stockholders at troubled public companies, like the carmakers. It could also rock the financial system anew.

As with mortgages, huge side bets have been placed on the performance of corporate debt via derivative securities, like credit default swaps. Derivatives are unregulated, so no one can be sure how widely a big or unexpected default would reverberate through the system.

Various measures indicate elevated default risk at a range of businesses, including retailers, media companies, restaurants and manufacturers. A survey released this month by the Federal Reserve and other regulators is especially sobering.

It looked at $2.8 trillion in large syndicated corporate loans held by American banks at the end of June. Compared with a year earlier, the share of loans rated as problematic had risen from 5 percent to 13.4 percent.

Regulators must continue to monitor possible bankruptcies. Even if they cannot prevent a failure, they can soften its impact by ensuring that it does not come as a shock, further spooking investors.

Congress must prepare to deal with higher unemployment from corporate failures. In the coming lame duck session, lawmakers must extend jobless benefits for people who have exhausted their previous allotment. The next Congress and the next president need to upgrade the nation’s outmoded system of unemployment compensation to cover more Americans.

Congress must also be prepared to investigate large or particularly disruptive bankruptcies to identify both possible unlawful activity and regulatory lapses.

So far, inquiries into the collapses of Bear Stearns, Lehman Brothers and American International Group have been little more than public hazings of corporate executives. What is needed is a serious effort to determine accountability and figure out what reforms are needed to make sure these disasters don’t happen again.

The Guardian    January 1, 2009

annus horribilis 2008: FTSE 100 has lost 31%, Russia's down 72% and China's off 65%
Stockmarkets around world suffer worst year on record
Julia Kollewe

A record $14 trillion (£9.7tn) has been wiped off world share values in 2008 as many stockmarkets around the world suffered their worst 12 months on record.

Turmoil in the financial system and the worst global recession since the 1970s have sent shares reeling. Global stocks, as measured by the MSCI index, have fallen by a record 44% over the year.

A trader reacts to the falling FTSE 100 at CMC Markets in London. Photograph: Alastair Grant/AP

In London, the FTSE 100 index lost 31.3% in 2008, its worst annual decline since it was created in 1984, and following a 3.8% gain in 2007. It edged up 0.94% to 4434.17 on the last trading day of the year, a gain of 41.49 points. Banks, at the centre of the financial storm, were among the biggest losers  ranging from HBOS, Royal Bank of Scotland and Lloyds TSB to Barclays. Mining companies Kazakhmys, Xstrata and Rio Tinto also fared badly as the economy worsened.

Drugmakers AstraZeneca and GlaxoSmithKline were among the best-performing stocks on the FTSE. British Energy was another big gainer, up more than 40% in a year in which the government secured the sale of its stake in the nuclear power firm to French energy giant EDF.

David Buik at BGC Partners talked of an "annus horribilis by any standards".

It started with the Northern Rock nationalisation, and got progressively worse. In March, US investment house Bear Stearns became the first major bank to be rescued from collapse and by the autumn scores of banks around the world had gone under – notably Lehman Brothers – or been bailed out.  Lending between banks ground to a halt, triggering more government interventions, and most major economies slid into recession.

Sterling has also had its worst year against the euro since the single currency started life almost a decade ago. The pound staged a rally on the last day of the year, rising 2% to 95.44p versus the euro. But analysts say there was nothing to prevent further losses that could take the pair to parity, with UK  interest rates set to fall close to zero in the new year from 2% now – far below rates in the eurozone, currently at 2.5%.

Against the dollar, the pound has lost nearly 27% over the year, the sharpest drop since the gold standard monetary system was abolished in 1971. It traded around $1.4605 today.

Oil dropped to $37 a barrel, heading for its worst year ever with a slump of more than 60%.

Last night, Wall Street took heart from Washington's expanded bail-out of the embattled auto sector, with the Dow Jones industrial average closing up 2.2%. The Dow is off nearly 35% so far this year.

The mainland European bourses that opened for a half day drifted marginally upwards but still registered their worst yearly losses for decades. The CAC-40 in Paris notched up a decline of 43%, the worst run in its 20-year history. Germany's Dax-30 closed down 40.4% yesterday while Italy's MIB-30 was  off 48.5% and Spain's Ibex-35 down 47.5%.

The worst-performing stockmarket over the year was Russia's, where the benchmark RTS index plunged by 72%. Second worst hit was China's benchmark Shanghai composite index, which plummeted 65% – its largest-ever annual drop – after soaring more than 300% over 2006 and 2007.

"China's economy is obviously at a turning point. There are too many uncertainties, and past huge losses have made investors increasingly cautious," said Cheng Weiqing, an analyst at Citic Securities in Beijing.

Many investors are hoping for a better year in 2009, taking heart from the stock gains seen during December. "If there's any optimism, it's on the basis that stockmarkets recover in recessions," said Justin Urquhart Stewart of Seven Investment Management. "Now we have the real recession, rather than  the phoney recession. Last year we were so optimistic that we were fooling ourselves. It's gone too far the other way."

Buik said the outlook for the UK was mixed. "With the dole queue likely to increase to 2.5 million by the end of May 2009, and with corporate profits in the next quarter likely to fall by 15% and with the housing market continuing to retrench, the immediate outlook for equities is unappetising," he said.  "However, with many companies still paying reasonable dividends, the UK stockmarket should rally strongly in the second half of the year with the FTSE ending at 5000, as the UK attempts to dig itself out of recession."

Across Asia, stocks suffered record falls over the year, a painful change from its once-booming markets. In Tokyo, the benchmark Nikkei closed for the year yesterday having recorded the biggest annual percentage loss in its 58-year history. Modest gains in December – the first since May – did little to  mitigate a yearly loss of 42% after the world's second-largest economy sank into recession.

In Hong Kong, also in recession, the Hang Seng index ended the year 48% lower, its worst annual drop since the global oil shock of the early 1970s. India's main index in Mumbai plummeted by 52%.

The South African stock exchange lost 27% this year and the rand slipped almost 30%.

Wall Street Journal    JANUARY 23, 2009

Investors Want Clarity Before They Take Risks
Obama could calm markets with some swift policy moves and reassuring words.

With the U.S. (and global) economy contracting at the steepest pace since 1982, we need a clear and coherent policy response rooted in a sound analysis of how we got to this dreadful place. Washington's changing explanations, ad hoc bailouts, massive special-interest spending, and references to the once-in-a-lifetime nature of this event convey a sense that policy makers do not have one.

Martin Kozlowski

The current situation was created by a perfect storm of mutually reinforcing trends and major policy mistakes: loose monetary policy (years of negative real interest rates in a growing economy); socially engineered housing policy; poorly implemented regulation; the rapid growth of leverage, opaque and technically deficient derivatives, and the shadow banking system; lax investor diligence and bank supervision; poor governance and misaligned incentives; and outright fraud. The low interest rates subsidized massive short-term borrowing, led investors to reach for yield, increased demand for allegedly safe securitized mortgages, drove up housing prices, and reinforced the ever-looser lending standards championed by government.

Loans for subprime mortgages, credit cards, autos, commercial real estate, and private-equity financings were made on the projection or hope by banks, businesses and households that strong economic growth, rising housing prices and easy short-term credit would continue forever. Credit-market debt soared relative to GDP. Subprime loans tripled. Home prices rose 45% more than rent or income. Private equity and asset-backed-securities issuance quadrupled.

We now have a giant margin call and painful deleveraging following the mother of all credit cycles. The resulting widespread insolvency in financial institutions was magnified by the over-the-counter derivatives subject to counterparty risk creating uncertainty about who was or might quickly become insolvent. The tardy Treasury and Fed recognition, ad hoc bailouts, and letting Lehman fail added confusion. Private capital fled and even interbank lending froze.

What needs to be done to ease the economic and financial crisis? The first order of business is still to recapitalize the banking system, with equity injections and a Resolution Trust-like, toxic-asset removal program. The first $350 billion was not enough to repair the balance sheets of financial institutions that needed to raise $1 trillion before the height of the financial crisis (although former Treasury Secretary Henry Paulson is correct that it prevented a worse contraction of lending).

More rapid, transparent, efficient triage -- closing insolvent, nonsystemically important institutions and merging marginal ones with healthy ones -- is required. That's what eventually made our Resolution Trust Corporation solution to the savings-and-loan crisis work, along with selling the acquired assets off in large blocks. Exhorting the banks to lend -- when examiners are in their offices telling them not to -- cannot work. Hammer out an approach consistent with FDIC resolution procedures. Include a sensible circuit breaker for the procyclical interaction of bank capital rules and mark-to-market accounting. But beware the law of unintended consequences, such as restrictions on banks causing private capital flight or foreclosure relief creating millions more delinquencies.

While we have legitimate infrastructure needs, public-works spending historically has been too slow, has delayed private and local government spending, and created few jobs for the unemployed. The programs are not labor-intensive and require skills few unemployed have. Public works did not end the Great Depression. Even FDR's treasury secretary, Henry Morgenthau, said in 1939, "We have tried spending money . . . and it does not work . . . we have just as much unemployment . . . and an enormous debt to boot." Nor did a decade of infrastructure spending help the Japanese escape three recessions and a decade of stagnation. It did, however, saddle Japan with a national debt burden four times ours.

President Barack Obama has wisely pressed for legislation free of Congressional earmarks. But what about the local officials with incentives to build if someone else pays for it? Who guarantees the national benefits exceed the costs? Worse yet, once started, it will be difficult to stop this flow of easy money from Washington. A year or two from now we'll have many partly finished projects over-budget and behind-schedule, in need of their own continuing bailout. For these reasons we need to focus on projects of proven national benefit, such as speeding up the re-equipping and refurbishing of the military and expanding and upgrading the electrical grid.

The one-time tax rebates last year were mostly saved, not spent; Mr. Obama's planned rebates will do no better. Permanent reductions, especially in rates, would be much more stimulative. If temporary tax cuts are necessary, at least provide some incentives to reduce layoffs and/or spend now, with temporary payroll-tax or sales-tax rate reductions (via funds to states).

With the federal-funds rate close to zero, the Fed is trying to affect credit and spending via expectations of future monetary policy lowering long rates, and by use of its balance sheet. Fed Chairman Ben Bernanke is right to emphasize the asset side of the Fed's balance sheet, and he should also buy longer-term non-Treasury securities. It is vital that the Fed finish the long-delayed project of a well-capitalized derivatives clearinghouse, in order to reduce the risk of another financial crisis emanating from the derivatives markets.

But there is still more that can be done. With Treasury in control of Fannie and Freddie, it can lower conforming mortgage rates by explicitly stating the implicit guarantee. With many small importers unable to get normal letters of credit, national export-import banks might provide them (unsubsidized). With hundreds of billions of dollars of American companies' earnings overseas due to heavy taxes on repatriation, a low-tax repatriation holiday would add substantial deposits to our banking system.

These policies, those already in the pipeline, and the natural adaptation of the economy have the best chance to reduce the length and severity of the recession. But they still leave an economy and financial system on government lifelines. We need a glide-path back to normalcy.

First, the Fed must forestall future inflation by withdrawing its immense liquidity injections in favor of private extension of credit as soon and predictably as feasible. Its failure to do so earlier in the decade helped create this mess.

Second, the various guarantees and insurance will need to be unwound without causing another panic. As their expiration dates approach, (e.g., April for money-market funds), pressure will be intense to extend them to prevent a mass exodus of capital. While they may have to be extended briefly, predictable ending dates should be enforced, if necessary with declining percentages to zero (insure 95%, then 90%, etc.).

Equally important, the new administration needs to be clearer on its long-run goals and policies. Mr. Obama deserves time to lay out his longer-term agenda, but he must reassure those who would put capital at risk that we are not headed toward a European-style social welfare state. Will he push for financial reform with better intelligence, the centerpiece being that any firm that is or could quickly become too big to fail must be subject to real-time capital adequacy and risk disclosure and monitoring? Or will he just push for more punitive regulation?

Mr. Obama has pledged to go through the budget and shut down ineffective programs, but how much shorter is his list than mine or yours? Is he capable of a "Nixon goes to China" on Social Security, as President Bill Clinton once hoped to do? Or will he push for tax reform and simplification with a broader base and lower rates?

One thing is certain: Investors, workers and employers need to have a sense of where tax, spending and regulatory policy are headed, or they will postpone decisions and further weaken the economy.

Mr. Boskin is a professor of economics at Stanford University and a senior fellow at the Hoover Institution. He chaired the Council of Economic Advisers under President George H.W. Bush.

Wall Street Journal    JANUARY 23, 2009, 11:32 A.M. ET

We're asking others to sacrifice for our 'stimulus.'
The World Won't Buy Unlimited U.S. Debt

Barack Obama has spoken often of sacrifice. And as recently as a week ago, he said that to stave off the deepening recession Americans should be prepared to face "trillion dollar deficits for years to come."

But apart from a stirring call for volunteerism in his inaugural address, the only specific sacrifices the president has outlined thus far include lower taxes, millions of federally funded jobs, expanded corporate bailouts, and direct stimulus checks to consumers. Could this be described as sacrificial?

What he might have said was that the nations funding the majority of America's public debt -- most notably the Chinese, Japanese and the Saudis -- need to be prepared to sacrifice. They have to fund America's annual trillion-dollar deficits for the foreseeable future. These creditor nations, who already own trillions of dollars of U.S. government debt, are the only entities capable of underwriting the spending that Mr. Obama envisions and that U.S. citizens demand.

These nations, in other words, must never use the money to buy other assets or fund domestic spending initiatives for their own people. When the old Treasury bills mature, they can do nothing with the money except buy new ones. To do otherwise would implode the market for U.S. Treasurys (sending U.S. interest rates much higher) and start a run on the dollar. (If foreign central banks become net sellers of Treasurys, the demand for dollars needed to buy them would plummet.)

In sum, our creditors must give up all hope of accessing the principal, and may be compensated only by the paltry 2%-3% yield our bonds currently deliver.

As absurd as this may appear on the surface, it seems inconceivable to President Obama, or any respected economist for that matter, that our creditors may decline to sign on. Their confidence is derived from the fact that the arrangement has gone on for some time, and that our creditors would be unwilling to face the economic turbulence that would result from an interruption of the status quo.

But just because the game has lasted thus far does not mean that they will continue playing it indefinitely. Thanks to projected huge deficits, the U.S. government is severely raising the stakes. At the same time, the global economic contraction will make larger Treasury purchases by foreign central banks both economically and politically more difficult.

The root problem is not that America may have difficulty borrowing enough from abroad to maintain our GDP, but that our economy was too large in the first place. America's GDP is composed of more than 70% consumer spending. For many years, much of that spending has been a function of voracious consumer borrowing through home equity extractions (averaging more than $850 billion annually in 2005 and 2006, according to the Federal Reserve) and rapid expansion of credit card and other consumer debt. Now that credit is scarce, it is inevitable that GDP will fall.

Neither the left nor the right of the American political spectrum has shown any willingness to tolerate such a contraction. Recently, for example, Nobel Prize-winning economist Paul Krugman estimated that a 6.8% contraction in GDP will result in $2.1 trillion in "lost output," which the government should redeem through fiscal stimulation. In his view, the $775 billion announced in Mr. Obama's plan is two-thirds too small.

Although Mr. Krugman may not get all that he wishes, it is clear that Mr. Obama's opening bid will likely move north considerably before any legislation is passed. It is also clear from the political chatter that the policies most favored will be those that encourage rapid consumer spending, not lasting or sustainable economic change. So when the effects of this stimulus dissipate, the same unbalanced economy will remain -- only now with a far higher debt load.

If any other country were to face these conditions, unpalatable measures such as severe government austerity or currency devaluation would be the only options. But with our currency's reserve status, we have much more attractive alternatives. We are planning to spend as much as we like, for as long as we like, and we will let the rest of the world pick up the tab.

Currently, U.S. citizens comprise less than 5% of world population, but account for more than 25% of global GDP. Given our debts and weakening economy, this disproportionate advantage should narrow. Yet the U.S. is asking much poorer foreign nations to maintain the status quo, and incredibly, they are complying. At least for now.

You can't blame the Obama administration for choosing to go down this path. If these other nations are giving, it becomes very easy to take. However, given his supposedly post-ideological pragmatic gifts, one would hope that Mr. Obama can see that, just like all other bubbles in world history, the U.S. debt bubble will end badly. Taking on more debt to maintain spending is neither sacrificial nor beneficial.

Mr. Schiff is president of Euro Pacific Capital and author of "The Little Book of Bull Moves in Bear Markets" (Wiley, 2008).

March 8, 2009

Subprime Europe

THE 1931 collapse of the Austrian bank Creditanstalt provoked financial panic across Europe and almost single-handedly turned a bad downturn into the Great Depression. Last week, when I read about the brewing European banking crisis, I suddenly began to dread that history might be repeating itself.

You might think that my worries are a bit late. After all, losses on subprime mortgages in the United States have already caused a Depression-like banking collapse. Well, believe it or not, Europe’s current crisis is scarier. For while losses on Eastern European debts may be only a small fraction of those on subprime mortgages, the continent’s problems are politically harder to solve, and their consequences may prove to be much worse.

Much as in our subprime mess, Eastern Europe’s problems began with easy credit. From 2004 to 2008 Eastern Europe had its own bubble, fueled by the ready availability of international credit. In recent years countries like Bulgaria and Latvia borrowed annually the equivalent of more than 20 percent of their gross domestic product from abroad. By 2008, 13 countries that were once part of the Soviet empire had accumulated a collective debt to foreign banks or in foreign currencies of more than $1 trillion. Some of the money went into investment, much of it into consumption or real estate.

When the music stopped last year and banks retrenched, the flow of new capital to Eastern Europe came to an abrupt halt, and then reversed direction. This credit crunch hit the region just as its main export markets in Western Europe were going into free fall. Moreover, with so much of the debt denominated in foreign currencies, everyone in Eastern Europe has been scrambling to get their hands on foreign exchange and local currencies have collapsed.

Most of the Eastern European debt is held by Western European banks. It also turned out that some of the biggest lenders to Eastern Europe were Austrian and Italian banks — for example, loans by Austrian banks to Eastern European countries are almost equivalent to 70 percent of Austria’s G.D.P. Now, Italy and Austria can’t afford to bail out even their own banks.

The debt crisis in Eastern Europe is much more than an economic problem. The wrenching decline in the standard of living caused by this crisis is provoking social unrest. American subprime borrowers who have had their houses foreclosed on are not — at least not yet — rioting in the streets. Workers in Eastern Europe are. The roots of democracy in the region are not deep and the specter of right-wing nationalism remains a threat.

So what is to be done? The potential approaches essentially mirror those that have been attempted in response to America’s subprime problem.

The first approach is to deal with the short-run liquidity problem. In the same way that the Federal Reserve expanded its own lending last year to compensate for the collapse in private lending, the International Monetary Fund is providing funds to Eastern Europe, and Hungary has proposed that the European Central Bank lend to borrowers who use non-euro assets as collateral. But given the state of the rest of the world, Eastern Europe will not be able to export its way out of its troubles in the immediate future.

The debts of many Eastern European countries and some banks will have to be written off. Ultimately, as in the case of the American subprime debts, taxpayers will have to foot the bill. But which taxpayers? The taxpayers of Austria and Italy certainly can’t. So the burden will have to fall on the rich countries of Europe, especially Germany and France.

There are two approaches to taxpayer-financed bailouts. The first is to go case by case. This is being proposed by the Germans. The problem here, as we discovered after the Bear Stearns rescue last March, is that the case-by-case approach does nothing to establish confidence in the system and prevent contagion.

The best choice would be a fund that provides bailout money and a protective umbrella to banks and countries, even those that don’t seem to need it now. Hungary has proposed the creation of such a fund with roughly $240 billion at its disposal. Though the proposal has already been rejected by stronger European economies, the American experience of last year in which the Treasury finally had to ask Congress for $700 billion for a similar fund suggests that this is where Europe will end up.

The response of the American government to the financial crisis has been criticized for being too slow and inadequate. But at least we have a federal budget, the national cohesion and the political machinery to get New Yorkers and Midwesterners to pay for the mistakes of homeowners in California and Florida, or to bail out a bank based in North Carolina. There is no such mechanism in Europe. It is going to require leadership of the highest order from officials in Germany and France to persuade their thrifty and prudent taxpayers to bail out foolhardy Austrian banks or Hungarian homeowners.

The Great Depression was largely caused by a failure of intellectual will. In other words, the men in charge simply did not understand how the economy worked. Now, it is the failure of political will that could lead to economic cataclysm. Nowhere is this danger more real than in Europe.

Liaquat Ahamed is the author of “Lords of Finance: The Bankers Who Broke the World.”

March 8, 2009

The Armageddon Waltz

IN the depth of winter of 1913, at the height of pre-Lenten carnival, the Vienna Bankers Club gave a Bankruptcy Ball at the opulent Blumensaal hall. Some ladies appeared as balance sheets, displaying voluptuous debits curving from slender credits. Others came as inflated collateral: faux enhancements amplified the bust or upholstered the posterior. As for the gentlemen, thin ones were costumed as deposits, fat ones as withdrawals. Sooner or later everybody repaired to the debtor’s prison — the restaurant of the Blumensaal.

Here mortgage certificates made pretty doilies for Sachertortes. Ornamented with the bailiff’s seal, eviction and foreclosure notices were colorful centerpieces, each topped by a bowl of whipped cream. If you wrote your waiter an I.O.U., he would pour you a flute of Champagne. Dancing and merriment continued until 5 a.m., when, suddenly, the orchestra leader stopped his men in the middle of the “Emperor Waltz.” He announced that since the musicians hadn’t been paid, there would be no more music, good morning, good luck, goodbye.

Great laughter, but only the ladies went home. The gentlemen changed to business suits, breakfasted in nearby coffeehouses, proceeded straight to their offices. And there, as they bent over their ledgers, confetti would drop from their hair on many a grim tally.

During Vienna’s carnival season red ink seemed to be just another festive color. Though Habsburg economics were growing as ramshackle as its politics, Old Vienna maintained its flair for frolicking through gloom. The city’s stock exchange, the only one in the world with a ballroom, prospered by renting out that space for Mardi Gras jollities.

Of course there were, even during the merry season, some awkward encounters with reality. At the time of the Bankruptcy Ball, for example, Austria’s Parliament had to deal with Vienna’s housing problem, one of the worst in Europe. A bill intended to moderate the egregious contrast between princely mansions and paupers’ hovels was coming up for a vote. Lawmakers had to decide whether to back an enormous state bond issue that would finance decent shelter in the proliferating slums.

This effort to salvage a dire real estate situation through very expensive government support was transpiring at an unfortunate juncture; the empire’s finances were strained by a costly military commitment in a remote and clan-riven territory. Fractious tribes in Albania, mostly Muslim, had broken away from Ottoman rule. In 1913 Vienna was about to invest its money, military presence and prestige in a bid to establish a client state in Albania under a puppet king.

The very week of the Bankruptcy Ball, Archduke Franz Ferdinand, successor to the throne, met with Emperor Franz Josef to urge disengagement from Albania. This, he pleaded, would help facilitate a rational dialogue with Albania’s neighbor — militant, Austria-hating Serbia. The hater-in-chief there was Col. Dragutin Dimitrijevic, the head of Serbian military intelligence, who was organizing a secret terrorist squad to be loosed against the Habsburg realm.

At the same time, Vienna was incubating in its own streets some of the century’s prime virtuosos of violence. One of them was active close to the imperial palace, Schloss Schönbrunn, where the emperor had received his heir. An elegant building on Schönbrunner Schlossstrasse housed young Josef Stalin, dispatched by Lenin to explore the empire’s explosive nationalities situation. It was during Stalin’s weeks in Vienna that he initiated his lethal feud with young Leon Trotsky, who, a few streetcar stops away, was publishing the original Pravda. All this while on the other side of town young Adolf Hitler was seething obscurely, painting postcards for a living.

What those three did the day after the Bankruptcy Ball history does not record. We do know that the Austrian Parliament voted against appropriating money for the housing bill. We also know that the emperor turned down the archduke’s plea for negotiation rather than confrontation with Serbia. Franz Ferdinand walked out of the palace defeated — to die 16 months later of a Serb nationalist’s bullet, igniting World War I.

His killer, Gavrilo Princip, was not a Muslim, but his buddies in his guerrilla band called him “hadzija,” after the Muslim pilgrims who make the hajj to Mecca. Why? Because the penniless zealot had walked from Sarajevo to Belgrade to receive the military training that would help him discharge his pistol at the archduke.

“Austria,” said Karl Kraus, who was Habsburg Austria’s H. L. Mencken, “is the laboratory for the apocalypse.” What would he say about America today?

Frederic Morton is the author of “Thunder of Twilight: Vienna 1913-1914.”

The New Yorker       May 11, 2009

How banks got big
Monsters, Inc.
by James Surowiecki

Amid the blizzard of economic data that the government puts out every week, last Tuesday’s report analyzing G.D.P. industry by industry got little notice. But it contained one very interesting piece of data: in 2008, for the first time in sixteen years, the finance and insurance industry shrank. Since 1980, this sector’s share of the economy has grown by almost half. Now, apparently, the worm has turned.

For many, this comes as a welcome development: the size of the banking industry has become a symbol of the much lamented “financialization” of the U.S. economy over the past thirty years, and of what the M.I.T. economist Simon Johnson has called a “quiet coup” by Wall Street. But, while banking has become a hypertrophied monster, we still need to understand how the industry got so big in the first place in order to right-size it. And although bad policy and regulatory somnambulism have something to do with it, much of the industry’s growth has been driven by major changes in the economy as a whole, rather than vice versa.

The desire to bring back the boring, small banking industry of the nineteen-fifties is understandable. Unfortunately, the only way to do that would be to bring back the economy of the fifties, too. Banking was boring then because the economy was boring. The financial sector’s most important job is channelling money from investors to businesses that need capital for worthwhile investment. But in the postwar era there wasn’t much need for this. The economy, while remarkably strong, was dominated by huge companies that faced little competition, and could finance investments out of their profits. And entrepreneurship was restrained: there were many fewer start-ups then than in the period after 1980. So the financial sector didn’t have much to do.

Two things changed this. First, in the seventies those huge companies started tottering, while the U.S. economy fell apart. Second, the corporate world was transformed by revolutionary developments in information technology and by the emergence of new industries like cable television, wireless, and biotechnology. This meant that the economy became, and has remained, far more competitive, while corporate performance became far more volatile. In the nineteen-eighties, companies moved in and out of the Fortune 500 twice as fast as they had in the fifties and sixties. Suddenly, there were lots of new companies with big appetites for outside capital, which they needed in order to keep growing. And it was Wall Street that helped them get it. Companies like Turner Broadcasting, M.C.I., and McCaw Cellular used junk bonds to turn themselves into major businesses. Venture-capital investing took off, and so did the I.P.O. market; there were twice as many I.P.O.s between 1980 and 1999 as there were between 1960 and 1979. To be sure, deregulation was also a factor, but Thomas Philippon, an economist at N.Y.U., has shown that most of the increase in the size of the financial sector in this period can be accounted for by companies’ need for new capital.

This wasn’t the first time that something like this had happened. There have been three big banking booms in modern U.S. history. The first began in the late nineteenth century, during the Second Industrial Revolution, when bankers like J. P. Morgan funded the creation of industrial giants like U.S. Steel and International Harvester. The second wave came in the twenties, as electrification transformed manufacturing, and the modern consumer economy took hold. The third wave accompanied the information-technology revolution. Each wave, Philippon shows, was propelled by the need to fund new businesses, and each left finance significantly bigger than before. In all these cases, it wasn’t so much that the bankers had changed; the world had.

The same can’t be said, though, of the boom of the past decade. The housing bubble was unique, and uniquely awful. Each of the previous waves had come in response to a profound shift in the real economy. With the housing bubble, by contrast, there was no meaningful development in the real economy that could explain why homes were suddenly so much more attractive or valuable. The only thing that had changed, really, was that banks were flinging cheap money at would-be homeowners, essentially conjuring up profits out of nowhere. And while previous booms (at least, those of the twenties and the nineties) did end in tears, along the way they made the economy more productive and more innovative in a lasting way. That’s not true of the past decade. Banking grew bigger and more profitable. But all we got in exchange was acres of empty houses in Phoenix.

There’s no doubt that the financial sector needs to be smaller; Philippon suggests that, given the demands of businesses for capital, a normal financial sector would be about the size it was in 1996. Besides just shrinking the industry, though, we have the harder task of making credit bubbles like the one we just lived through less likely. That will require limiting the ability of banks to rely on vast amounts of leverage, which clearly increases risk without adding social value. Many financial innovations also seem to be overrated; it’s not clear that they actually help finance do its core job of channelling capital to businesses. The most important change, though, may be something harder to legislate: Wall Street needs to recognize that its proper role is, as it has been in the past, to follow the real economy, rather than trying to drive it. During the housing bubble, the financial sector essentially tried to create reality. Now’s the time for it to respond to reality instead.

Financial Times    May 27, 2009

Exploding debt threatens America
John Taylor

Standard and Poor’s decision to downgrade its outlook for British sovereign debt from “stable” to “negative” should be a wake-up call for the US Congress and administration. Let us hope they wake up.

Under President Barack Obama’s budget plan, the federal debt is exploding. To be precise, it is rising – and will continue to rise – much faster than gross domestic product, a measure of America’s ability to service it. The federal debt was equivalent to 41 per cent of GDP at the end of 2008; the Congressional Budget Office projects it will increase to 82 per cent of GDP in 10 years. With no change in policy, it could hit 100 per cent of GDP in just another five years.

A government debt burden of that [100 per cent] level, if sustained, would in Standard & Poor’s view be incompatible with a triple A rating,” as the risk rating agency stated last week.

I believe the risk posed by this debt is systemic and could do more damage to the economy than the recent financial crisis. To understand the size of the risk, take a look at the numbers that Standard and Poor’s considers. The deficit in 2019 is expected by the CBO to be $1,200bn (€859bn, £754bn). Income tax revenues are expected to be about $2,000bn that year, so a permanent 60 per cent across-the-board tax increase would be required to balance the budget. Clearly this will not and should not happen. So how else can debt service payments be brought down as a share of GDP?

Inflation will do it. But how much? To bring the debt-to-GDP ratio down to the same level as at the end of 2008 would take a doubling of prices. That 100 per cent increase would make nominal GDP twice as high and thus cut the debt-to-GDP ratio in half, back to 41 from 82 per cent. A 100 per cent increase in the price level means about 10 per cent inflation for 10 years. But it would not be that smooth – probably more like the great inflation of the late 1960s and 1970s with boom followed by bust and recession every three or four years, and a successively higher inflation rate after each recession.

The fact that the Federal Reserve is now buying longer-term Treasuries in an effort to keep Treasury yields low adds credibility to this scary story, because it suggests that the debt will be monetised. That the Fed may have a difficult task reducing its own ballooning balance sheet to prevent inflation increases the risks considerably. And 100 per cent inflation would, of course, mean a 100 per cent depreciation of the dollar. Americans would have to pay $2.80 for a euro; the Japanese could buy a dollar for Y50; and gold would be $2,000 per ounce. This is not a forecast, because policy can change; rather it is an indication of how much systemic risk the government is now creating.

Why might Washington sleep through this wake-up call? You can already hear the excuses. “We have an unprecedented financial crisis and we must run unprecedented deficits.” While there is debate about whether a large deficit today provides economic stimulus, there is no economic theory or evidence that shows that deficits in five or 10 years will help to get us out of this recession. Such thinking is irresponsible. If you believe deficits are good in bad times, then the responsible policy is to try to balance the budget in good times. The CBO projects that the economy will be back to delivering on its potential growth by 2014. A responsible budget would lay out proposals for balancing the budget by then rather than aim for trillion-dollar deficits.

“But we will cut the deficit in half.” CBO analysts project that the deficit will be the same in 2019 as the administration estimates for 2010, a zero per cent cut. “We inherited this mess.” The debt was 41 per cent of GDP at the end of 1988, President Ronald Reagan’s last year in office, the same as at the end of 2008, President George W. Bush’s last year in office. If one thinks policies from Reagan to Bush were mistakes does it make any sense to double down on those mistakes, as with the 80 per cent debt-to-GDP level projected when Mr Obama leaves office?

The time for such excuses is over. They paint a picture of a government that is not working, one that creates risks rather than reduces them. Good government should be a nonpartisan issue. I have written that government actions and interventions in the past several years caused, prolonged and worsened the financial crisis. The problem is that policy is getting worse not better. Top government officials, including the heads of the US Treasury, the Fed, the Federal Deposit Insurance Corporation and the Securities and Exchange Commission are calling for the creation of a powerful systemic risk regulator to reign in systemic risk in the private sector. But their government is now the most serious source of systemic risk.

The good news is that it is not too late. There is time to wake up, to make a mid-course correction, to get back on track. Many blame the rating agencies for not telling us about systemic risks in the private sector that lead to this crisis. Let us not ignore them when they try to tell us about the risks in the government sector that will lead to the next one.

The writer, a professor of economics at Stanford and a senior fellow at the Hoover Institution, is the author of ‘Getting Off Track: How Government Actions and Interventions Caused, Prolonged, and Worsened the Financial Crisis’

May 29, 2009

The Big Inflation Scare

Suddenly it seems as if everyone is talking about inflation. Stern opinion pieces warn that hyperinflation is just around the corner. And markets may be heeding these warnings: Interest rates on long-term government bonds are up, with fear of future inflation one possible reason for the interest-rate spike.

But does the big inflation scare make any sense? Basically, no — with one caveat I’ll get to later. And I suspect that the scare is at least partly about politics rather than economics.

First things first. It’s important to realize that there’s no hint of inflationary pressures in the economy right now. Consumer prices are lower now than they were a year ago, and wage increases have stalled in the face of high unemployment. Deflation, not inflation, is the clear and present danger.

So if prices aren’t rising, why the inflation worries? Some claim that the Federal Reserve is printing lots of money, which must be inflationary, while others claim that budget deficits will eventually force the U.S. government to inflate away its debt.

The first story is just wrong. The second could be right, but isn’t.

Now, it’s true that the Fed has taken unprecedented actions lately. More specifically, it has been buying lots of debt both from the government and from the private sector, and paying for these purchases by crediting banks with extra reserves. And in ordinary times, this would be highly inflationary: banks, flush with reserves, would increase loans, which would drive up demand, which would push up prices.

But these aren’t ordinary times. Banks aren’t lending out their extra reserves. They’re just sitting on them — in effect, they’re sending the money right back to the Fed. So the Fed isn’t really printing money after all.

Still, don’t such actions have to be inflationary sooner or later? No. The Bank of Japan, faced with economic difficulties not too different from those we face today, purchased debt on a huge scale between 1997 and 2003. What happened to consumer prices? They fell.

All in all, much of the current inflation discussion calls to mind what happened during the early years of the Great Depression when many influential people were warning about inflation even as prices plunged. As the British economist Ralph Hawtrey wrote, “Fantastic fears of inflation were expressed. That was to cry, Fire, Fire in Noah’s Flood.” And he went on, “It is after depression and unemployment have subsided that inflation becomes dangerous.”

Is there a risk that we’ll have inflation after the economy recovers? That’s the claim of those who look at projections that federal debt may rise to more than 100 percent of G.D.P. and say that America will eventually have to inflate away that debt — that is, drive up prices so that the real value of the debt is reduced.

Such things have happened in the past. For example, France ultimately inflated away much of the debt it incurred while fighting World War I.

But more modern examples are lacking. Over the past two decades, Belgium, Canada and, of course, Japan have all gone through episodes when debt exceeded 100 percent of G.D.P. And the United States itself emerged from World War II with debt exceeding 120 percent of G.D.P. In none of these cases did governments resort to inflation to resolve their problems.

So is there any reason to think that inflation is coming? Some economists have argued for moderate inflation as a deliberate policy, as a way to encourage lending and reduce private debt burdens. I’m sympathetic to these arguments and made a similar case for Japan in the 1990s. But the case for inflation never made headway with Japanese policy makers then, and there’s no sign it’s getting traction with U.S. policy makers now.

All of this raises the question: If inflation isn’t a real risk, why all the claims that it is?

Well, as you may have noticed, economists sometimes disagree. And big disagreements are especially likely in weird times like the present, when many of the normal rules no longer apply.

But it’s hard to escape the sense that the current inflation fear-mongering is partly political, coming largely from economists who had no problem with deficits caused by tax cuts but suddenly became fiscal scolds when the government started spending money to rescue the economy. And their goal seems to be to bully the Obama administration into abandoning those rescue efforts.

Needless to say, the president should not let himself be bullied. The economy is still in deep trouble and needs continuing help.

Yes, we have a long-run budget problem, and we need to start laying the groundwork for a long-run solution. But when it comes to inflation, the only thing we have to fear is inflation fear itself.


24    May 29, 2009 7:02 am
Clifford, WA

I believe that the "long run budget problems," are going to be really long, and no one, especially no one in the Government, knows just how long those problems will be or/and how many problems are yet to arise.

This so-called biggest bankruptcy in history that is just about to unfold with GMC could throw a monkey-wrench into the prognastications of all of the economists, and the Europe-wide ramifications of that bankruptcy could severely impact already severely impacted countries in Europe, namely Germany.

Germany's failures will drag all of Europe down with them, and that action will reverberate back across the Atlantic to the deepening Depression in the United States.

The auto industry implosion is only one of the factors. Admittedly, that is the biggest one, but the housing market is not far behind, and the steadily rising unemployment, in the US and in Europe and Aisa, is not far behind either of those two factors.

Hobo-camps will soon begin to sprout-up along RR grades across the United States as those many unfortunates who are out of work and homes begin to take to the rails as they did in the 1930s.

How can anyone measure the costs to life and liberty and the pursuit of happiness in terms of inflation or deflation?

A barter system will take the place of cash and carry and credit will be non-existent. Survival will depend on those who know how to survive and are quick to learn, the remainder will have a very long row to hoe.

Some might say that this idea is next to black-marketeering, but that is what Wall Street, the banks, and the corporate world have been doing for decades. Now everyone else is suffering because of their 8 years of the bush administration wealthy-first economic policies.

The down-and-out Wall Streeters, bankers, and corporates types would be well-advised not to ride the rails or to pay visits to the hobo-camp system. That system operates on an honor and trust factor, and none of the three mentioned know anything about honor or trust.

That system also doesn't have grave-yards for proper burials.

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25    May 29, 2009 7:02 am
John MacCormak, Athens, Georgia

Dr. Krugman's argument is worth considering: it's not just the "printing" of money, but also how it circulates that is importance in determining the inflationary potential of monetary policy. However, his argument is also 1. ahistorical and 2. apolitical, and that's a weakness.

1. He notes the overwhelming-debt experience of the US after WWII. However, that was then. The US emerged from the war in a unique position: it was stronger than any other nation had ever been in history, giving it the clout to impose stable conditions for capitalism on the non-communist world; the physical destruction of capital in Germany and Japan during the war literally paved the way for the start of a period of growth based on investment in the "real" economy; and the experience of the Depression and war had crushed any labor reistance to the expansion plans of the capitalists after the war. Those were the ingredients of the very real (as opposed to asset-generated) post-war boom.

Those conditions do not exist today. With the luxury of hindsight, we can actually see that the post-war boom petered out in the 1970s and that since then the Western economies and Japan have been staving off economic stagnation through state spending and the inflation of various asset bubbles.

What's new in this crisis is that it has struck at the heart of the global power that generated and maintained the political and social conditions for the post-war boom around the globe. It is silly to compare the experiences of Japan, Canada or any other country in recent decades to the predicament of the US today. The huge difference is that those crises were local or regional and not global-systemic.

2. Dr. Krugman may be right that the quantitative easing in itself may not be inflationary in these circumstances, but that is only reassuring if we take a rather narrow, fetishistic view of what money is. Money is not a thing, it is a social relationship. The weight of a currency - it's buying power - is inherently social. The credibility of the US economy has been shattered over the past seven months or so. That can only have an effect on the dollar, which, as it says on the bills, is based on "trust".

A final point: I'm not convinced that we have to have either inflation or deflation exclusively. For example, we have falling car prices and rising interest rates on mortgage loans right now.

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26    May 29, 2009 7:02 am
Christopher Nunneley, Alabama

I doubt that talk about inflation is due to "politics." People worry about so much new government debt. That's a legitimate concern.

But so much credit and wealth have both been destroyed, and so little new money is being loaned out, that a case can be made for Japanese-style deflation today in the U.S.

That viewpoint isn't political, either.

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27    May 29, 2009 7:02 am
— lulugirl765, Wisconsin

No inflation and prices are falling? I'm not so sure about that. What I'm seeing around here is the same price on the package as a year ago, but less in the package. And believe it or not, the size of the box is still the same, but there is less in that box. Toilet paper rolls are smaller, paper towels are smaller, there is far less cereal in a cereal box, the aluminum foil roll is smaller, fewer socks in a package, it's across the board. The consumer is just being fooled into thinking prices are the same but you're getting less for your money these days.

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31    May 29, 2009 7:02 am
Robin Foor, California

Very good editorial. It is correct that the money supply has dramatically decreased with falling asset prices, disappearing bank reserves, falling stock market values and global commodity price decreases. Merely providing some offset to this global money supply reduction is not inflationary.

However, it is not 1929. It is different this time.

The multinational corporation has come of age in the past 80 years. Many of these multinationals hold billions in their treasuries. These companies are like a shadow banking system. Indeed, they have positive net worth that is quite substantial while the banking system does not.

It is different this time because the government rescued the banking system. So the economy can rebuild with credit much more rapidly.

The world is much bigger today than in the 1930's. Vast economies engage in world trade today on a scale unknown in the 30's. There are 6 billion people in the world. They all use energy, consume food and need medical care. The demand side of the equation is much bigger than 70 years ago.

Inflation really is the least of our problems. We need a team effort to build the world economy including the developing world. This effort should address global warming while it seeks to end poverty.

Last time it was war that brought about the end of a depression. It is different this time. It should be peace and cooperation that bring about an end to this recession.

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37    May 29, 2009 7:02 am
LAS, Redmond, WA

Looking at it from the standpoint of Working America, there could be inflation and deflation at the same time, two different trends in parallel. The gap between the wealthy and everyone else is only widening. As workers are laid off and lose their homes, wealthy investors are buying them up at lowered prices as investments. One high tech employment agency has predicted on the blogs that 50% of the workforce will have contract employment rather than full time employment. Contract (i.e. temporary) workers will not have the stability to take on a mortgage. So there will be a class of the super rich and those with permanent jobs competing for real estate and a class of temporary workers who cannot become homeowners. Deflation can exist for the underclass while the extremely wealthy compete to purchase large estates and luxuries at inflated prices. Women can already experience this in the fashion industry, because a skirt costs $140 in a high end store, but less than $15 at a discount chain store. Similarly, the prices of the most expensive furniture will stay the same, but the temporary contract workers often have to relocate, so their furniture is passed from one worker to another at low prices via craigslist or the Goodwill Store. It is as if there are two completely different subcultures operating at the same time.

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42    May 29, 2009 7:02 am
Jason, Buffalo, NY

Paul - the inflation fears (at least for me) stem from my mistrust of the Fed's political ability to unwind this current balance sheet/interest rate structure in time to avoid inflation taking hold. If this were a video game, or an academic case study, Bernanke may be able to read the data correctly and soak up the excess reserves in time...but he's got a lot of heat on him to save the world and keep money cheap at all costs. Is it possible that we almost need a 'double dip' recession where the Fed causes a tight money "normal" slowdown on the heals of this one to safely soft launch the economy with a stable currency?

Please don't mock my intelligence or others who fear the unprecedented Fed risk that's on the table right now. No one can bail out the dollar except the printer.

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46    May 29, 2009 8:05 am
NickLaudani, Boston,Ma.

According to you "the Fed is just buying debt from the government and private sector". But buying these items from themselves or others must have a cost which also will need to be payed back in some manner. The more stuff the Fed buys while hugely in debt can only mean at the very least higher interest rates! Perhaps inflation is the wrong word. How about the real danger of a devalued dollar or more specifically significant reduction in our buying power. O how bout the factual discussions from other huge countries that the Dollar is starting to look risky. Which will further de-value our Dollar.IT might by definition be inflation but it will sure feel like that. Further more I find a flaw in your reasoning that we should not worry about going into 100 % debt of GDP as we have done so in the past.Things are different now. Back in world war II we had the biggest industrial or production based economies in the world. What do we produce now? Other than articles like this, that attempt smoke and mirrors. No this government binge will not bring property. We need to stop borrowing and starting producing. Otherwise it makes perfect sense to be concerned Nick Laudani

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47    May 29, 2009 8:05 am
Michael, South Florida

If inflation is caused by more money in circulation relative to available goods and services, wouldn't the recent crash of the stock market, popping of the real estate bubble, a glut of foreclosures, bank loans gone bad and the bankruptcy of car companies, numerous banks and other financial institutions have had the opposite impact, since an enormous amount of wealth was just wiped off the books? After all, the dollar value of my home plummeted from the $250K I paid for it in 2006 to $100K now, and the supposed value of the stocks in my 403(b) suddenly went from $30K to $17K in two quarters. That's nearly $165K that simply evaporated from my possession into space within a very brief period of time. I can no longer utilise that money to purchase goods and services. I have to continue paying that mortgage in the full amount, rather than on what the house is worth. So, in effect, I get to enjoy a monsterous cut in my retirement income (about 40%) each month simply based on the date of purchase. Loads of other Americans also have much less cash now for the essentials of life, mainly for the same reasons. Isn't that a powerful anti-inflationary force at work? All I know about economics is what I read in the paper. Please explain.

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48    May 29, 2009 8:05 am
Paul Katz, Vienna, Austria

If all the money thrown into the market by governments now were used only to buy out banks which in return deposit the money again, I would agree with Mr. Krugman (at some time in the future the avalanche would break loose though). But at least in Europe the governments are throwing money into many markets ("stimulus packages") and unprecedented amounts at that. That´s money they simply do not have and therefore either has to be borrowed or "printed". A bigger and bigger money supply facing a stable or even shrinking amount of goods and services - where does that lead to?

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50    May 29, 2009 8:05 am
Michael Wolfe, Henderson, Texas

What about this article in which Mr. Krugman is quoted as saying that he "... also opposed regional monetary policies that continue to peg local currencies to the dollar, citing the expected decline in the value of the dollar by the end of the year..."?

Unless Mr. Krugman was misquoted, he seems to be predicting the imminent collapse of the dollar at a conference in Abu Dhabi, while promising its continuing strength to Times readers.

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51    May 29, 2009 8:05 am
ras, chicago, il

your interpretation is so far off base, i dont even know where to start. people are not worried about immediate inflation, theyre worried about future inflation. the fear is that they the Fed has primed the pump too much and when the time comes they wont be able to control things. they are indeed printing money, the fact that it is going back to them as reserves is irrelevant. as soon as confidence returns, the money multiplier will kick in, loan demand will improve, banks will lend and inflation will kick in. and what mechanisms will the fed employ to withdraw that liquidity? it wont be an easy fix

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54    May 29, 2009 8:05 am
advaita, eugene

...but what will happen when more workers are jobless? More credits, more foreclosures, and the US can't convince investors to buy treasury bonds to get loans for two wars?
One solar eclipse, maybe July 21, will be enough and bond holders in Asia start panicking and selling depreciating dollars.
This system is based on trust and when doubt comes up the House of Cards will just collapse.

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55    May 29, 2009 8:05 am
Mike Strike, Boston

In a perfectly rational and certain world, there would be no disagreement about the future even between economists. However, in the real world that we find ourselves in, the opinions of economists are at best no better than those forthcoming from sorcerers. When those opinions are coloured with political biases and emanate from the closed mindset of flawed ideology, they are worst than useless and are in fact destructive.

Placing any credence in the utterances of economists is akin to paying attention to the ranting of the village idiot of yore.

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61    May 29, 2009 8:05 am
R. Munves, New York

If credit created by the Fed out of thin air is not finding its way into the market causing inflation, then why create it at all? It risk causing inflation if it is spent and provides fodder for those who are worried that there will be more money chasing the same goods and services either today or after the economy bottoms out, the banks lend and people are less reluctant to spend?

Is it just to prop up banks that made bad decision? That is a bad idea in a market economy. I suspect that the purpose of the policy isto prevent the FDIC from having its reserves wiped out were the government to throw the banks into conservatorship and be unable to sell their assets for enough to cover deposits as has happened on a number of occasions already for smaller banks. But the government is paying one way or another. It is paying by injecting hundreds of billions into parts of the banking system that failed due to bad business decisions. I'd rather see those banks liquidated and the money go directly to the depositors. It will be cheaper in the long run requiring less printing of money to cover debt. These banks are not too big to fail, they are too big to save.

I think this is very, very bad policy. It favors banks who have been irresponsible over banks that have been responsible which is the wost sort of central planning. It creates the same problem as giving money to some car companies or some insurance companies or to anyone else. It is just not fair. It penalizes responsible economic behavior. It prevents the market from fully readjusting for the unwarranted bubble driven investments int he past. It creates no new value in the economy. It is just credit created out of nothing and hence is inherently inflationary as soon as it finds its way past the banks.

Much of this inflationary government credit will find its way into the economy. You have the bailouts of the car companies, the insurance companies, injection of money into the system via loans on a heads you win, tails the government loses basis to hedge funds buy toxic asset, the government intervening directly in the marketplace to buy up credit card and auto loan backed securities that the market would not touch, making direct loans to students and now proposing to buy up poor quality municipal debt.

All this is inflationary. It's is rational that investors would worry about inflation because all of these actions. It smacks of central government planning which time and again has proven not to work. I see no logical reason why it should work this time and have heard no explanation from Mr. Krugman as to why it would work. At the end of the day, you just can't make something out of nothing.

I like Obama but I think this is very, very bad policy as it just perpetuate distortions created by bad government policy over the past 20 or more years by both parties and will cripple the US economy for years to come. I haven't heard a cogent explanation as to why it won't.

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64    May 29, 2009 8:05 am
John Merryman, Sparks, Maryland

Money functions as both a store of value and a medium of exchange. These work at cross purposes, because as a store of value it is a form of private property, while as a medium of exchange it is a form of public utility, similar to a road system. Most people focus on their own wealth in comparison to others and thus think of it as private property. The reality is that the system belongs to whomever guarantees its value. We do possess the money we hold, in the same way we possess the section of road we are driving on. You own your car, house, business, etc, but not the roads connecting them. Money is a similar medium. It was one thing when money signified some commodity you had stored or traded and its value was entirely based on that underlaying commodity, but now the money supply far exceeds the underlaying value of the real economy and so its value is maintained by the ability of the government to support it through taxation. This means that it has broken away from being an actual store of value and it is now entirely a medium of exchange. While this is potentially catastrophic, it presents an opportunity to change the basic economic equation.

Believing money is private property encourages people to hoard it. The problem is that capital is subject to the laws of supply and demand, with the lender as supply and the borrower as demand. Since the supply of capital must be balanced by demand for it, there must be sufficient borrowers for this notational wealth, or its value will collapse. The problem is that political power is on the side of those with money, rather than those borrowing it and this lack of balance regularly creates situations which swell the supply of money, while depleting the abilities of those borrowing it. This results in periodic credit collapse, as masses of borrowers default. We are at an extreme state of this particular situation, since lenders have persuaded the government to borrow massive amounts of its own money back, lowered loan standards and blown enormous bubbles of excess circulation, essentially pari-mutual wagering, aka, derivatives, to hold this surplus notational wealth. Now that the bubble is collapsing, the powers that be are engaged in even more destructive behavior, by issuing ever more debt and currency to keep the bubble from imploding. Since the money supply already exceeds the value of the general economy, the only way to prevent this additional money from being seriously inflationary is to draw ever more value out of society and the environment in order to support and pay interest on it, to the increasing detriment of world health.

Consider how it would change public perception of monetary wealth, if we were to come to the realization that the monetary system really is now entirely a form of public commons? The practice of hoarding excessive amounts would lack moral, logical and eventually legal justification. If people understood monetary value constituted public property, than they would be far more reluctant to drain value out of their social networks and environment to put in a bank in the first place. We all like having roads, but there in little inclination to pave more than we have to. In this situation, the same would apply to monetizing our lives. Other avenues of trust and reciprocation would have the space to develop.

We made politics a public trust, why not do the same with the banking industry? As the currency is a public utility, so profits from its administration could be public income. A public banking system would not be one huge behemoth, but consist of institutions incorporated at every level of governance, so that individuals could bank with the ones which funded the services they are most likely to use. Different communities would seek to provide the best services with these funds, otherwise they would lose business and citizens to other communities. As it is, banking doesn't need the inventiveness for which private enterprise is most suited, but the stability that is the strength of the public sector.

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72    May 29, 2009 9:59 am
Lisa M, Burlingame, CA

I can't fathom where Mr. Krugman is coming from with this article or really any of the articles he writes. I think it's pretty obvious to anyone with a basic sense of math, and who also happens to be paying attention, that the U.S. economy will not make a real "recovery" any time soon. Probably not in our lifetimes.

As to this "recovery" that people like Krugman speak about--which of the private sectors will be spearheading this I wonder? The auto industry? Where will this powerful economic resurgence originate from? Where is this new sector of production forming in our country?

As Mr. Krugman should know, we can't get out of our present debt in the manner that we got out of the debt held post World War II, because back in '44 we had built up a mighty manufacturing capacity which had us poised to become the world leaders in manufacturing and production. This capacity made us rich, but this has *drastically* changed over the years and the productive jobs continue to bleed out of the country to be replaced by worthless government and service jobs. This trend is not stopping, as Mr. Krugman knows, and he seems never to factor this into his calculations. I don't know what his motives are but he, like most of the people in our media and in our government, are veiwing reality through distorted rose-colored lenses.

Krugman will also be wrong about inflation. Actually he is already wrong to say we are not seeing it. Prices are going up on all kinds of things, and in people's largest expenditures especially = fuel and food. We will have inflation, and it will be severe.

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76    May 29, 2009 10:00 am
Michael, Rochester, NY

Paul, Consistent you are.

First, you write articles supporting vast expansion of debt to help cure an ailing "economy". The administration, having bought in to these articles, has followed with budget deficits that are unheard of in modern or past US History.

Now, with some folks wondering what the consequences to this debt expansion really are, and there will be some that you don't understand, and that all of us don't, one reasonable hypothesis is inflation.

In fact, no government has ever PAID OFF their debt.

So, the most common historical option has been currency destruction at the expense of the standard of living of the people.

In other words, inflation.

Although this is the most common method of gross debt management at the government level, you are not afraid of anything but being afraid.
Are you sure?

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79    May 29, 2009 10:00 am
Michael Caracappa, Charlotte, NC

People notice every time they fill their tank that the price of gasoline has shot up 100 percent from the lows last year. Other commodities like copper, silver, and gold are up 40 to 70 percent in recent months. The U.S. dollar is tumbling against other currencies while the Fed is printing money on an unprecedented scale. Not all the worries over inflation are rooted in politics or irrational fantasies.

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81    May 29, 2009 10:01 am
JMT, Palo Alto CA

In the past few weeks, I've noticed a disturbing trend in consumer prices. The prices on popcorn and soda at our local cineplex increased 15%. A restaurant increased prices by about 10%. Bridge tolls on the Golden Gate are up 20%. Something's going on.

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96    May 29, 2009 10:31 am
David Lentini, North Berwick, ME

I agree, Paul, but I think the political axe being ground here is much bigger. Of course it's insane to worry about inflation now when the official unemployment rate is expected to pass 10%, meaning the real unemployment rate is in the mid-teens at least, and California is on the verge of bankruptcy. And the irony of the same people who kept telling us that tomorrow would take care of itself now telling us to worry about the future is pretty thick.

I think the inflation stories are coming from the GOP, which fears that Obama will succeed in re-establishing many of the policies---but more importantly much of the philosophy---they worked so hard to destroy. For the Republicans and Chicago School, they want to forget the recent past and party like it's 1999 again.

But the real drivers of this baloney are the banks and financial industry. It's hard not to notice how all of a sudden the banks have gone from telling us they are on the verge of collapse and desperately need capital infusions to telling now that everything is fine and they want to return the money right away. And the driver for there insanity is the impending return to sane regulations. Not surprisingly now that they've been bailed out, they want to return to the good old days of wild western finance.

And should we be that surprised. As you pointed out in your books and columns these many years now, the public has repeatedly bailed out the financial industry---the S&L disaster in the 1980s, the hedge fund fiasco in the 1990s, the dot-com bubble in 2000, and now the real estate bubble in 2008---only to let them start the party up again. No wonder they think they're so important that they expect the public to simply give them billions, er, trillions, no questions asked. And, more likely, they've come to think we're even bigger fools than they for letting them get away with this insanity for so long.

Finally, the rich also have another major fear: They'll be taxed at a fair rate once this crisis ends and we have to settle up. Raising taxes on the rich is the most intelligent way to pay down the deficits. But of course, the rich have become accustomed to getting all they want for nothing.

But why is the press being so compliant again. Frankly, this all smells like the prelude to the Iraq War when the press simply parroted every inane claim of the Bush Administration. Now, the same folks who kept telling us that all is well in the markets---don't listen to that Krugman fellow and his lot!---are telling us to worry about the inflation boogeyperson.

We need more spending, not less. The stunted stimulus package is not enough. Here in Maine, the state has made severe cuts in services and education because of the downturn. Those are real problems, here, now. Too many Americans have to live day-to-day. For once, we can worry about tomorrows problems tomorrow.

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June 6, 2009

Poking Holes in a Theory on Markets

For some months now, Jeremy Grantham, a respected market strategist with GMO, an institutional asset management company, has been railing about — of all things — the efficient market hypothesis.

You know what the efficient market hypothesis is, don’t you? It’s a theory that grew out of the University of Chicago’s finance department, and long held sway in academic circles, that the stock market can’t be beaten on any consistent basis because all available information is already built into stock prices. The stock market, in other words, is rational.

In the last decade, the efficient market hypothesis, which had been near dogma since the early 1970s, has taken some serious body blows. First came the rise of the behavioral economists, like Richard H. Thaler at the University of Chicago and Robert J. Shiller at Yale, who convincingly showed that mass psychology, herd behavior and the like can have an enormous effect on stock prices — meaning that perhaps the market isn’t quite so efficient after all. Then came a bit more tangible proof: the dot-com bubble, quickly followed by the housing bubble. Quod erat demonstrandum.

These days, you would be hard-pressed to find anybody, even on the University of Chicago campus, who would claim that the market is perfectly efficient. Yet Mr. Grantham, who was a critic of the efficient market hypothesis long before such criticism was in vogue, has hardly been mollified by its decline. In his view, it did a lot of damage in its heyday — damage that we’re still dealing with. How much damage? In Mr. Grantham’s view, the efficient market hypothesis is more or less directly responsible for the financial crisis.

“In their desire for mathematical order and elegant models,” he wrote in his firm’s quarterly letter to clients earlier this year, “the economic establishment played down the role of bad behavior” — not to mention “flat-out bursts of irrationality.”

He continued: “The incredibly inaccurate efficient market theory was believed in totality by many of our financial leaders, and believed in part by almost all. It left our economic and government establishment sitting by confidently, even as a lethally dangerous combination of asset bubbles, lax controls, pernicious incentives and wickedly complicated instruments led to our current plight. ‘Surely, none of this could be happening in a rational, efficient world,’ they seemed to be thinking. And the absolutely worst part of this belief set was that it led to a chronic underestimation of the dangers of asset bubbles breaking.”

(Mr. Grantham concluded: “Well, it’s nice to get that off my chest again!”)

I couldn’t help thinking about Mr. Grantham’s screed as I was reading Justin Fox’s new book, “The Myth of The Rational Market,” an engaging history of what might be called the rise and fall of the efficient market hypothesis.

Mr. Fox is a business columnist for Time magazine (and a former colleague of mine) who has long been interested in academic finance. His thesis, essentially, is that the efficient marketeers were originally on to a good idea. But sealed off in their academic cocoons — and writing papers in their mathematical jargon — they developed an internal logic quite divorced from market realities. It took a new group of young economists, the behavioralists, to nudge the profession back toward reality.

Mr. Fox argues, echoing Mr. Grantham, that the efficient market hypothesis played an outsize role in shaping how the country thought and acted in the last 30-plus years. But Mr. Fox parts company with him by also arguing that the effect wasn’t necessarily all bad. As for the question of whether an academic theory hatched in Chicago led to the financial crisis, suffice it to say that some questions can never be answered definitively. Which isn’t to say they shouldn’t be asked.

“There are no easy ways to beat the market,” Mr. Fox said when I spoke to him a few days ago. If you want to point to the single best thing the efficient market hypothesis taught us, that is the lesson: we can’t beat the market. Indeed, the vast majority of professional money managers can’t beat the market either, at least not on a regular basis.

As Mr. Fox describes it, much of the early academic work that led to the efficient market theory was aimed at simply showing that most predictive stock charts were glorified voodoo — just because a pattern had developed didn’t mean it would continue, or even that it had any real meaning. Dissertations were written showing how 20 randomly chosen stocks outperformed actively managed mutual funds. (Hence the phrase “random walk,” to connote the near impossibility of beating the market regularly.) Mr. Thaler, the Chicago behavioralist, says that evidence on this point — “the no free lunch principle,” he calls it — is clear and convincing.

In time, this insight led to the rise of passive index funds that simply matched the market instead of trying to beat it. Unless you’re Warren Buffett, an index fund is where you should put your money. Even people who don’t follow that advice know they should.

As it turns out, Mr. Grantham was an early advocate of index funds, mainly for unsophisticated investors who have no hope of beating the market. But he also believes that professionals should do better precisely because, as he puts it, “the market is full of major league inefficiencies.”

“There are incredible aberrations,” he told me over lunch not long ago. “The U.S. housing market in 2007. Japan in the 1980s. Nasdaq. In 2000, growth stocks were three times their fair value. We were quoted in The Economist in 2000 saying that the Nasdaq would drop by 75 percent. In an efficient world, you wouldn’t have that in a lifetime. If the market were truly efficient, it would mean that growth stocks had become permanently more valuable.”

As Mr. Grantham sees it, if professional investors had been willing to acknowledge these aberrations — and trade on the fact that the market was out of whack — they should have been able to beat the market. But thanks to the efficient market hypothesis, no one was willing to call a bubble a bubble — because, after all, stock prices were rational.

“It helped mold the ‘this time it’s different’ mentality,” he said. Indeed, professional money managers who tried to buck the tide wound up losing their jobs — because everybody else was making money by riding the bubble for all it was worth. Meanwhile, government officials, starting with Alan Greenspan, were unwilling to burst the bubble precisely because they were unwilling to even judge that it was a bubble. “Our default reflex is that the world knows what it is doing, and that is extravagant nonsense,” Mr. Grantham said.

But as much as I’ve admired Mr. Grantham’s writings over the years, I think the truth, in this case, is a little more subtle. Given the long history of bubbles, I suspect this crisis would have taken place with or without the aid of the efficient market hypothesis. People thought “it’s different this time” in the 1920s, long before anyone was writing about efficient markets. And over the course of history, professional money managers have been just as fearful of bucking the trend as they were during the Internet bubble.

Mr. Fox sees it somewhat differently. On the one hand, he says, the efficient market theoreticians always assumed that smart market participants would force stock prices to become rational. How? By doing exactly what they don’t do in real life: take the other side of trades if prices get out of whack. Their ivory tower view reflected an idealized market that simply doesn’t exist.

On the other hand, Mr. Fox says, what was truly pernicious about the efficient market hypothesis is the way it allowed us to put asset prices on a pedestal that they never deserved. Stock options — supposedly based on a rational price — became prevalent in part because higher stock prices were supposed to be the rational reward for good performance.

Or take the modern emphasis on market capitalization. “At some point in the early 1990s (or maybe it was in the late 1980s), market capitalization became accepted as the best measure of a company’s importance,” Mr. Fox wrote me in an e-mail message. “Before then it was usually profits or revenue. I think that’s a classic example of the way efficient market theory seeped into popular discourse and shaped how we perceived the world. It wasn’t entirely stupid — profits and revenue are flawed, limited measures, and market value does tell you something useful about a company. But it was another one of the ways in which asset prices came to rule the world, which eventually turned out to be a bad thing.”

A few days ago, I called Burton G. Malkiel, the Princeton economist, to ask him what he thought of Mr. Grantham’s theories. Mr. Malkiel is the author of “A Random Walk Down Wall Street,” surely one of the greatest popularizers of any academic theory that’s ever been written.

“It’s ridiculous” to blame the financial crisis on the efficient market hypothesis, Mr. Malkiel said. “If you are leveraged 33-1, and you’re holding long-term securities and using short-term indebtedness, and then there’s a run on the bank — which is what happened to Bear Stearns — how can you blame that on efficient market theory?”

But then we started talking about bubbles. “I do think bubbles exist,” he said. “The problem with bubbles is that you cannot recognize them in advance. We now know that stock prices were crazy in March of 2000. We know that condo prices were nuts.”

I thought to myself: if a smart guy like Burton Malkiel had to wait for the Internet bubble to end to realize we had been in one, then maybe Mr. Grantham has a point after all.

June 7, 2009

The storm is not over, not by a long shot!
The Economy Is Still at the Brink

WHETHER at a fund-raising dinner for wealthy supporters in Beverly Hills, or at an Air Force base in Nevada, or at Charlie Rose’s table in New York City, President Obama is conducting an all-out campaign to try to make us feel a whole lot better about the economy as quickly as possible. “It’s safe to say we have stepped back from the brink, that there is some calm that didn’t exist before,” he told donors at the Beverly Hilton Hotel late last month.

Mr. Obama thinks that the way to revive the economy is to restore confidence in it. If the mood is right, the capital will flow. But this belief is dangerously misguided. We are sympathetic to the extraordinary challenge the president faces, but if we’ve learned anything at all two years into the worst financial crisis of our lifetimes, it is that a capital-markets system this dependent on public confidence is a shockingly inadequate foundation upon which to rest our economy.

We have both spent large chunks of our lives working on Wall Street, absorbing its ethic and mores. We’re concerned that nothing has really been fixed. We’re doubly concerned that people appear to feel the worst of the storm is over — and in this, they are aided and abetted by a hugely popular and charismatic president and by the fact that the Dow has increased by 35 percent or so since Mr. Obama started to lay out his economic plans in March. But wishing for improvement and managing by the Dow’s swings are a fool’s game. (Disclosure: One of us, Mr. Lewis, was convicted on federal charges of stock manipulation in 1989, pardoned by President Bill Clinton in 2001 and had his lifetime trading ban overturned by the Securities and Exchange Commission in 2006; documents relating to the case can be found at

The storm is not over, not by a long shot. Huge structural flaws remain in the architecture of our financial system, and many of the fixes that the Obama administration has proposed will do little to address them and may make them worse. At another fund-raising event, for Senator Harry Reid, President Obama said: “We didn’t ask for the challenges that we face. But we are determined to answer the call to meet those challenges, to cast aside the old arguments and overcome the stubborn divisions and move forward as one people and one nation .... It will take time but I promise you, I promise you, I’ll always tell you the truth about the challenges we face.”

Keeping that statement in mind — as well as an abiding faith in the importance of properly functioning capital markets — we have come up with a set of questions meant to challenge a popular president, with vast majorities in Congress, to find the flaws in the system, to figure out what’s being done to fix them and to get to the truth about the difficulties we face as we set out to restore the proper functioning of our markets and our standing in the world.

Six months ago, nobody believed that our banking system was well designed, functioning smoothly or properly regulated — so why then are we so desperately anxious to restore that model as the status quo? Nearly every new program emanating these days from the Treasury Department — the Term Asset-Backed Securities Loan Facility, the Public Private Investment Program, the “stress tests” of major banks — appears to have been designed to either paper over or to prop up a system that has clearly failed.

Instead of hauling out the new drywall to cover up the existing studs, let’s seriously consider ripping down the entire structure, dynamiting the foundation and building a new system that rewards taking prudent risks, allocates capital where it is needed, allows all investors to get accurate and timely financial information and increases value to shareholders and creditors.

As a start, the best-compensated executives at the top of these big banks, hedge funds and private-equity firms should be treated like general partners of yore. If a firm takes prudent risks that pay off, this top layer of management should be well compensated. But if the risks these people take are imprudent and the losses grave, they should expect to lose their jobs. Instead of getting guaranteed salaries or huge bonuses, they should have the bulk of their net worth completely at risk for a long stretch of time — 10 years come to mind — for the decisions they make while in charge. This would go a long way toward re-aligning the interests of these firms with those of their shareholders and clients and the American people, who have been saddled with their risks and mistakes.

Why is so much effort being put into propping up those at the top of the economic pyramid — the money-center banks, the insurance companies, the hedge funds and so forth — when during a period of deflation like the one we are in, any recovery will come only by restoring the confidence of the people down at the bottom of the pyramid?

Confidence will return only when jobs can be found and mortgage payments are made. Even if Mr. Obama’s claim is true that his $780 billion stimulus package “saved or created” some 150,000 jobs, we seem a long way away from the point where those struggling to get by will feel like spending again. What happens when people buy a car once every 10 years instead of once every two or three, especially now that we taxpayers own such a big percentage of the American auto industry?

Instead of promising the imminent return of good times, why isn’t Mr. Obama talking more about the importance of living within our means and not spending money we don’t have on things we don’t need? We used to be a frugal nation. The president should be talking about kicking our addictions to easy credit, to quick fixes and to a culture of more is better (and Congress’s new credit-card legislation, while perhaps eliminating some of the worst aspects of that industry, certainly didn’t send the right message about personal finance).

Gas-guzzling S.U.V.’s, cigarette boats, no-income mortgages and private jets should be relegated to the junk heaps of history, or better yet, put in a museum dedicated to never forgetting the greed and avarice that led us so far astray.

Why is the morphine drip still in the veins of the financial system? These trillions in profligate federal spending are intended to make us feel better again even though feeling pain, and dealing with it responsibly, would be healthier in the long run. It is time to stop rescuing the banks that got us into this mess. If that means more bank failures on a grander scale or the dismemberment of Citigroup, so be it. Depositors will be protected — up to $250,000 per account — but shareholders, creditors and, sadly, many employees will, for the long-term health of the system, need to feel the market’s wrath.

Is there to be any limit on bailouts? We have now thrown money at the big banks, any number of regional ones, insurance companies, General Motors, Chrysler and state and local governments. Will we soon be bailing out Dartmouth, which just lost its AAA bond rating? Is there no room left for what the Austrian economist Joseph Schumpeter termed “creative destruction”? And what is the plan to get the American people out of all these equity stakes we now own and don’t want?

Furthermore, for government leaders to decide who shall live and who shall die in an economic sense opens them up to legitimate charges of crony capitalism and favoritism. We will benefit in the long run from a return to market discipline.

Why has Mr. Obama surrounded himself largely with economic advisers who are theoreticians and academics — distinguished though they may be — but not those who have sat on a trading desk, made a market, managed a portfolio or set a spread?

In our view, one of the ways out of this economic conundrum is to have experienced traders — not hothouse flowers — design incentives that will encourage the market to have buyers and sellers meet anew around the proper valuations of assets, not some artificial construct of a market propped up by a pliant Financial Accounting Standards Board or government-sponsored programs that appear to be virtually giving money away to hedge funds and private-equity firms so that they will buy assets they would not ordinarily buy. We’re not talking about putting the fox in charge of the henhouse, just putting people who know how markets function in the real world into the important seats in Washington.

Why isn’t the Obama administration working night and day to give the public a vastly increased amount of detailed information about what happens in financial markets? Ever since traders started disappearing from the floor of the New York Stock Exchange in the last decade of the 20th century, there has been less and less transparency about the price and volume of trades. The New York Stock Exchange really exists in name only, as computers execute a very large percentage of all trades, far away from any exchange.

As a result, there is little flow of information, and small investors are paying the price. The beneficiaries, no surprise, are the remains of the old Wall Street broker-dealers — now bank-holding companies like Goldman Sachs and Morgan Stanley — that can see in advance what their clients are interested in buying, and might trade the same stocks for their own accounts. Incredibly, despite the events of last fall, nearly every one of Wall Street’s proprietary trading desks can still take huge risks and then, if they get into trouble, head to the Federal Reserve for short-term rescue financing.

Here’s something that should change in terms of transparency. The most recent price that any stock traded for should be published online in real time for all to see. And the public should have access to a new type of electronic ticker that provides market information in language that all can understand, not just the insiders.

As for those impossibly complex securities that caused so much of the trouble — among them derivatives, credit-default swaps and asset-backed securities — the S.E.C. should have the power to make public all the documentation surrounding these weapons of mass financial destruction, including all data about the current costs of buying and selling them and the cash flow underlying them. We also need widely accessible, real-time reporting of all trades in the bond market. We bet Mike Bloomberg’s company could help design such a system for our benefit.

Why is the government still complicit in making the system ever less transparent, even when it comes to what should clearly be considered public information? For instance, it took more than a year for the Federal Reserve to disclose that it had agreed to pay BlackRock — the huge money manager that is 45 percent owned by Bank of America — and others $71 million in a no-bid contract to manage the $30 billion of toxic assets that JPMorgan did not want when it bought Bear Stearns in March 2008. And that is only one of the five contracts BlackRock has with the government as a result of this crisis — the nature of the other contracts remains secret.

Treasury Secretary Timothy Geithner has made much of, the Treasury’s new Web site dedicated to “transparency, oversight and accountability.” But look it over and try to find, for example, just one record of a bona fide credit-default swap, or the names of the hedge-fund and private-equity investors who have participated in the Term Asset-Backed Securities Loan Facility bonanza. It was only a lawsuit filed by a watchdog group that convinced the Treasury to divulge details of former Secretary Henry Paulson’s October meeting with the chief executives of the 10 largest Wall Street firms to force them to take money from the Troubled Asset Relief Program. A lawsuit filed last November by Bloomberg News to force the Federal Reserve to reveal the details on more than $2 trillion in loans that went to banks including Citigroup and Goldman Sachs is still pending in federal court.

And what has become of the S.E.C.’s year-old investigation into who made short-dated, out-of-the-money bets in March 2008 hoping Bear Stearns would fail — bets that were suddenly worth millions of dollars when the company did collapse later that month?

Why do we still not know why Mr. Paulson, Mr. Geithner and the Federal Reserve chairman, Ben Bernanke, allowed Lehman Brothers to file bankruptcy last Sept. 15 but then, a day later, saved A.I.G.? Or why last November this trio decided to absorb potential losses on $301 billion of Citigroup’s shaky assets, when conventional wisdom among insiders held that they were worth only $150 billion at best?

Also, before Dick Fuld, Lehman Brothers’ chief executive, appeared before the House Committee on Oversight and Government Reform last October, it demanded from company executives boxes of documents about what happened at Lehman and why. Where are those documents?

Why hasn’t President Obama insisted on public hearings over what happened during this financial crisis?

Not a single top executive of a Wall Street securities firm responsible for causing the financial crisis has had the courage or the decency to step forward in front of the cameras and explain to the American people in his own words exactly how and why he allowed his firm to cause the crisis. Both Mr. Fuld and Alan Schwartz, the chief executive of Bear Stearns at the end, in their Congressional testimony blamed the proverbial once-in-a-century financial tsunami. Do they or any of their peers really think this is true?

There may be a way to find out. There is much talk nowadays coming from top bankers — Lloyd Blankfein of Goldman Sachs, Jamie Dimon of JPMorganChase, John Mack of Morgan Stanley and even Ken Lewis of Bank of America — about seeing how quickly they can repay to the Treasury the TARP money Mr. Paulson forced on them. One precondition of their being allowed to repay the funds should be a requirement that each gives a public deposition and explains, under oath, what truly happened and why.

Such a public hearing would be meant only to offer a truthful assessment of the errors in judgment made at each firm and to promote understanding, so that we — somehow — can avoid repeating the same mistakes again. It would not be about indictments. These men should be offered use immunity from prosecution for their honest testimony, but only with a clear understanding that the failure to tell the truth at any point would result in serious legal consequences. The hearing could be complemented by a truth-seeking commission established to hear the accounts of several people who have departed the scene, including, among others, Mr. Paulson, former Treasury Secretary Robert Rubin and former Wall Street chiefs like Mr. Fuld, Hank Greenberg of A.I.G., Sanford Weill of Citigroup, Jimmy Cayne of Bear Stearns and Stan O’Neal of Merrill Lynch. While far removed from their positions of authority, these men have tales to tell about how this crisis got started and why.

Why are we not looking to change our current civil and criminal racketeering statutes, which are playing a perverse role in investigations of the crisis? Statutes meant to give prosecutors extraordinary powers of seizure before an indictment is handed up, or to impose treble damages, are appropriately used to break up rings of criminal behavior like the Mafia or drug cartels.

But a few clever prosecutors could use such laws to bring charges against people or firms in the financial services industry whose pattern of bad behavior played important roles in the collapse. Such outright seizure of capital or assets through use of the racketeering statutes can do much harm by giving prosecutors an unnecessarily powerful role in our capital markets. There must be a way to keep what is good about the statutes and to make sure they are not used for ill in trying to get to the bottom of the financial meltdown.

We are in one of those “generational revolutions” that Jefferson said were as important as anything else to the proper functioning of our democracy. We can no longer pretend that our collective behavior as a nation for the past 25 years has been worthy of us as a people. Many of us hoped that Barack Obama’s election would redress the dire decline in our collective ethic. We are 139 days into his presidency, and while there is still plenty of hope that Mr. Obama will fulfill his mandate, his record on searching out the causes of the financial crisis has not been reassuring. He must do what is necessary to restore the American people’s — and the world’s — faith in American capitalism and in our nation. Answering our questions may help us get back on track. But time is wasting.

Sandy B. Lewis, an organic farmer, founded S B Lewis & Co., a brokerage house. William D. Cohan, a contributing editor at Fortune and former Wall Street banker, is the author of “House of Cards: A Tale of Hubris and Wretched Excess on Wall Street.”

Khaleej Times (UEA)     8 June 2009

The Coming Currency Collapse
Matein Khalid

I WAS inundated with calls from my friends and valued readers to explain the cryptic allusion to the Bummer Down Under, my gut feeling that something nasty was about to happen to the Aussie dollar.

Well, the Aussie did plunge from 0.8265 on Wednesday to a tad below 79 cents on Thursday. So is the Aussie and sterling toast in the next fortnight? After all, both currencies are the ultimate FX proxies for risk appetites run amok and risk is fast becoming a four letter word, as is flip and skip in Gulf mortgage banking! So let us gaze lovingly into the crystal ball and play the role of Nostradamus and imagine a scenario where risk becomes leprosy and the bulls get gored in the derriere as convincingly as their human groupies do in the streets of Pamplona.

Latvia becomes the first EU state to declare sovereign debt bankruptcy. The world suddenly realises that Easter Europe’s financial constellation is as kaput as Latin America in the 1980s or Indonesia/Russia/Thailand/South Korea in 1998. Contagion has been the Achilles heel of international banking ever since the failure of the Medici and Fuggar bank in Renaissance Florence to the fatal run on Creditanstalt Vienna in the opening moments of the Great Depression, from the Japanese zobie banks in the lost decade to the death (murder?) of Lehman brothers and Bear Stearns last year. Panic spreads across the world at the speed of light as investors liquidate their holdings of Swedish banks who have lent untold billions to the deadbeat Baltic States. Currency pegs fall like dominoes on an international scale and the maligned, unloved greenback (the Chinese students actually laughed when Babyface Timmy solemnly assured the crème de la crème of Beijing University that “Chinese assets are safe in the dollar”.

The laughter in Beijing, not the polite applause in Cairo to another speech, had a decibel count that will echo in the secret history of our times, once again becomes the safe haven money of a world gone mad. With the S&P500 flirting with its trend resistance below 1000, world equities get creamed. The Dow Jones loses 500 points, the Sensex opens 2000 points lower, the VIX spikes to 40. The sovereign credit default swap market goes ballistic on the Latvian bombshell and the green shoot gunslingers (hedge funds? momentum traders? leveraged cowboys?) scramble to sell what they can, not what they must. The El Grizzly Grande returns with a vengeance to haunt the subliminal subconscious of the global financial village. Its Bye Bye Miss American Pie, drove my Chevy to the levee… got a margin call and this will be the day I die. What happens to sterling when Latvia goes bust, as Gordon and Her Majesty’s Cabinet did this week? Where does sterling go? 1.60? 1.50? Where does the Aussie go? 80? 75? 70? The US dollar is the wild card in the carnival/fiesta/party of risk. The game is all about psychology and the pendulum of risk between greed and fear. Well, greed is priced into the markets. Armageddon is not. Markets are all about inflicting the maximum pain on the maximum number of suckers at any given point in time. So if Armageddon is under-priced, I have to go long with a vengeance, exactly as when this column predicted the global financial crisis in January 2007 light years ago. Rastamon vibrations are definitely not positive, baby! Something rotten is brewing in the kingdom of Denmark and risk is a tale told by an idiot, full of sound and fury, signifying nothing. Yes, the Sterling Bull of Dubai is now a diehard sterling/Aussie bear, O maestro of the strategic flip flop!

Devaluations, to misquote Dr Samuel Johnson, are like hangings. They tend to concentrate the mind — and a Latvian devaluation is coming. The euphoria, froth and bovine bullishness in the markets are simply not consistent with the financial werewolf I believe will soon gut Latvia’s currency. This will be the tequila crisis that followed the Mexican peso devaluation in 1994 or the contagion triggered by the devaluation of the Thai baht in July 2007. Note that S&P500 rated the Kingdom of Thailand AAA just before it went bust, a feat the venerable credit raters repeated just before Kenny Boy and Jailbird Skilling (Harvard MBA ha ha ) sank Enron. I believe in credit ratings with the same passion as I believe in Santa Claus and the Tooth fairy. Contagion is implied by high global market correlations. Too much dumb money is sloshing in the equities bandwagon. Oil at $68 when 100 million barrels of black gold are stored in supertankers? Copper at $5000 when the Chinese reserve managers rigged the bulls? The Latvian hard peg is a joke, as was the sterling —ERM bet on September 16, 1992. Not all the IMF’s horses nor all the IMF’s men will put the Latvian Humpty Dumpty together again, though I notice Riga is under an IMF standby agreement. The Romanian leu is a disaster waiting to happen, as is the Hungarian florint and the Serbian Slobodan (actually dinar, the lineal currency descendant of the Roman Empire’s dinari, the reserve currency of humankind two millennia ago).

There are other risks on the horizon. Commercial property will skewer bank earnings. Until last week, I did not know the name of Latvia’s currency. Now I do. The Latvian lats (appropriate name for Hindi/Urdu speakers. Lats means kicks) forwards predict a 50 per cent devaluation against the euro. The Latvian peg to the euro is history. The GDP shrank 18 per cent, the worst since the fall of the Soviet Union, the deepest economic cataclysm in the history of the EU. Why did Latvia go bust? Take a guess. Property speculation on borrowed money run amok. The IMF witch doctors are doing their spin but I do not believe government statements (eg China on the Tiananmen Square massacre. Never happened, duckies). I believe markets and the market tells me that Latvian CDS is now 730. This is the danger zone, this is the twilight netherworld before the Big Bad Wolf of world finance comes to gobble naughty (over leveraged and bankrupt) sovereign kiddos. Yes, this time the wolf is really here. Fasten your seat belt for $50 oil (Goldman prediction is $85. Is Blankfein nuts?), 1.50 sterling and 72 cents on the Aussie. Grizzly time again, amigos!

June 10, 2009

America’s Sea of Red Ink Was Years in the Making

There are two basic truths about the enormous deficits that the federal government will run in the coming years. The first is that President Obama’s agenda, ambitious as it may be, is responsible for only a sliver of the deficits, despite what many of his Republican critics are saying. The second is that Mr. Obama does not have a realistic plan for eliminating the deficit, despite what his advisers have suggested.

The New York Times analyzed Congressional Budget Office reports going back almost a decade, with the aim of understanding how the federal government came to be far deeper in debt than it has been since the years just after World War II. This debt will constrain the country’s choices for years and could end up doing serious economic damage if foreign lenders become unwilling to finance it.

Mr. Obama — responding to recent signs of skittishness among those lenders — met with 40 members of Congress at the White House on Tuesday and called for the re-enactment of pay-as-you-go rules, requiring Congress to pay for any new programs it passes.

The story of today’s deficits starts in January 2001, as President Bill Clinton was leaving office. The Congressional Budget Office estimated then that the government would run an average annual surplus of more than $800 billion a year from 2009 to 2012. Today, the government is expected to run a $1.2 trillion annual deficit in those years.

You can think of that roughly $2 trillion swing as coming from four broad categories: the business cycle, President George W. Bush’s policies, policies from the Bush years that are scheduled to expire but that Mr. Obama has chosen to extend, and new policies proposed by Mr. Obama.

The first category — the business cycle — accounts for 37 percent of the $2 trillion swing. It’s a reflection of the fact that both the 2001 recession and the current one reduced tax revenue, required more spending on safety-net programs and changed economists’ assumptions about how much in taxes the government would collect in future years.

About 33 percent of the swing stems from new legislation signed by Mr. Bush. That legislation, like his tax cuts and the Medicare prescription drug benefit, not only continue to cost the government but have also increased interest payments on the national debt.

Mr. Obama’s main contribution to the deficit is his extension of several Bush policies, like the Iraq war and tax cuts for households making less than $250,000. Such policies — together with the Wall Street bailout, which was signed by Mr. Bush and supported by Mr. Obama — account for 20 percent of the swing.

About 7 percent comes from the stimulus bill that Mr. Obama signed in February. And only 3 percent comes from Mr. Obama’s agenda on health care, education, energy and other areas.

If the analysis is extended further into the future, well beyond 2012, the Obama agenda accounts for only a slightly higher share of the projected deficits.

How can that be? Some of his proposals, like a plan to put a price on carbon emissions, don’t cost the government any money. Others would be partly offset by proposed tax increases on the affluent and spending cuts. Congressional and White House aides agree that no large new programs, like an expansion of health insurance, are likely to pass unless they are paid for.

Alan Auerbach, an economist at the University of California, Berkeley, and an author of a widely cited study on the dangers of the current deficits, describes the situation like so: “Bush behaved incredibly irresponsibly for eight years. On the one hand, it might seem unfair for people to blame Obama for not fixing it. On the other hand, he’s not fixing it.”

“And,” he added, “not fixing it is, in a sense, making it worse.”

When challenged about the deficit, Mr. Obama and his advisers generally start talking about health care. “There is no way you can put the nation on a sound fiscal course without wringing inefficiencies out of health care,” Peter Orszag, the White House budget director, told me.

Outside economists agree. The Medicare budget really is the linchpin of deficit reduction. But there are two problems with leaving the discussion there.

First, even if a health overhaul does pass, it may not include the tough measures needed to bring down spending. Ultimately, the only way to do so is to take money from doctors, drug makers and insurers, and it isn’t clear whether Mr. Obama and Congress have the stomach for that fight. So far, they have focused on ideas like preventive care that would do little to cut costs.

Second, even serious health care reform won’t be enough. Obama advisers acknowledge as much. They say that changes to the system would probably have a big effect on health spending starting in five or 10 years. The national debt, however, will grow dangerously large much sooner.

Mr. Orszag says the president is committed to a deficit equal to no more than 3 percent of gross domestic product within five to 10 years. The Congressional Budget Office projects a deficit of at least 4 percent for most of the next decade. Even that may turn out to be optimistic, since the government usually ends up spending more than it says it will. So Mr. Obama isn’t on course to meet his target.

But Congressional Republicans aren’t, either. Judd Gregg recently held up a chart on the Senate floor showing that Mr. Obama would increase the deficit — but failed to mention that much of the increase stemmed from extending Bush policies. In fact, unlike Mr. Obama, Republicans favor extending all the Bush tax cuts, which will send the deficit higher.

Republican leaders in the House, meanwhile, announced a plan last week to cut spending by $75 billion a year. But they made specific suggestions adding up to meager $5 billion. The remaining $70 billion was left vague. “The G.O.P. is not serious about cutting down spending,” the conservative Cato Institute concluded.

What, then, will happen?

“Things will get worse gradually,” Mr. Auerbach predicts, “unless they get worse quickly.” Either a solution will be put off, or foreign lenders, spooked by the rising debt, will send interest rates higher and create a crisis.

The solution, though, is no mystery. It will involve some combination of tax increases and spending cuts. And it won’t be limited to pay-as-you-go rules, tax increases on somebody else, or a crackdown on waste, fraud and abuse. Your taxes will probably go up, and some government programs you favor will become less generous.

That is the legacy of our trillion-dollar deficits. Erasing them will be one of the great political issues of the coming decade.


JUNE 11, 2009

Get Ready for Inflation and Higher Interest Rates
The unprecedented expansion of the money supply could make the '70s look benign.

Rahm Emanuel was only giving voice to widespread political wisdom when he said that a crisis should never be "wasted." Crises enable vastly accelerated political agendas and initiatives scarcely conceivable under calmer circumstances. So it goes now.

Here we stand more than a year into a grave economic crisis with a projected budget deficit of 13% of GDP. That's more than twice the size of the next largest deficit since World War II. And this projected deficit is the culmination of a year when the federal government, at taxpayers' expense, acquired enormous stakes in the banking, auto, mortgage, health-care and insurance industries.

With the crisis, the ill-conceived government reactions, and the ensuing economic downturn, the unfunded liabilities of federal programs -- such as Social Security, civil-service and military pensions, the Pension Benefit Guarantee Corporation, Medicare and Medicaid -- are over the $100 trillion mark. With U.S. GDP and federal tax receipts at about $14 trillion and $2.4 trillion respectively, such a debt all but guarantees higher interest rates, massive tax increases, and partial default on government promises.

But as bad as the fiscal picture is, panic-driven monetary policies portend to have even more dire consequences. We can expect rapidly rising prices and much, much higher interest rates over the next four or five years, and a concomitant deleterious impact on output and employment not unlike the late 1970s.

About eight months ago, starting in early September 2008, the Bernanke Fed did an abrupt about-face and radically increased the monetary base -- which is comprised of currency in circulation, member bank reserves held at the Fed, and vault cash -- by a little less than $1 trillion. The Fed controls the monetary base 100% and does so by purchasing and selling assets in the open market. By such a radical move, the Fed signaled a 180-degree shift in its focus from an anti-inflation position to an anti-deflation position.

The percentage increase in the monetary base is the largest increase in the past 50 years by a factor of 10 (see chart nearby). It is so far outside the realm of our prior experiential base that historical comparisons are rendered difficult if not meaningless. The currency-in-circulation component of the monetary base -- which prior to the expansion had comprised 95% of the monetary base -- has risen by a little less than 10%, while bank reserves have increased almost 20-fold. Now the currency-in-circulation component of the monetary base is a smidgen less than 50% of the monetary base. Yikes!

Bank reserves are crucially important because they are the foundation upon which banks are able to expand their liabilities and thereby increase the quantity of money.

Banks are required to hold a certain fraction of their liabilities -- demand deposits and other checkable deposits -- in reserves held at the Fed or in vault cash. Prior to the huge increase in bank reserves, banks had been constrained from expanding loans by their reserve positions. They weren't able to inject liquidity into the economy, which had been so desperately needed in response to the liquidity crisis that began in 2007 and continued into 2008. But since last September, all of that has changed. Banks now have huge amounts of excess reserves, enabling them to make lots of net new loans.

The way a bank or the banking system makes new loans is conceptually pretty simple. Banks find an entity that they believe to be credit-worthy that also wants a loan, and in exchange for the new company's IOU (i.e., loan) the bank opens up a checking account for the customer. For the bank's sake, the hope is that the interest paid by the borrower more than makes up for the cost and risk of the loan. The recently ballyhooed "stress tests" on banks are nothing more than checking how well a bank can weather differing levels of default risk.

What's important for the overall economy, however, is how fast these loans are made and how rapidly the quantity of money increases. For our purposes, money is the sum total of all currency in circulation, bank demand deposits, other checkable deposits, and travelers checks (economists call this M1). When reserve constraints on banks are removed, it does take the banks time to make new loans. But given sufficient time, they will make enough new loans until they are once again reserve constrained. The expansion of money, given an increase in the monetary base, is inevitable, and will ultimately result in higher inflation and interest rates. In shorter time frames, the expansion of money can also result in higher stock prices, a weaker currency, and increases in commodity prices such as oil and gold.

At present, banks are doing just what we would expect them to do. They are making new loans and increasing overall bank liabilities (i.e., money). The 12-month growth rate of M1 is now in the 15% range, and close to its highest level in the past half century.

With an increased trust in the overall banking system, the panic demand for money has begun to and should continue to recede. The dramatic drop in output and employment in the U.S. economy will also reduce the demand for money. Reduced demand for money combined with rapid growth in money is a surefire recipe for inflation and higher interest rates. The higher interest rates themselves will also further reduce the demand for money, thereby exacerbating inflationary pressures. It's a catch-22.

It's difficult to estimate the magnitude of the inflationary and interest-rate consequences of the Fed's actions because, frankly, we haven't ever seen anything like this in the U.S. To date what's happened is potentially far more inflationary than were the monetary policies of the 1970s, when the prime interest rate peaked at 21.5% and inflation peaked in the low double digits. Gold prices went from $35 per ounce to $850 per ounce, and the dollar collapsed on the foreign exchanges. It wasn't a pretty picture.

Now the Fed can, and I believe should, do what it must to mitigate the inevitable consequences of its unwarranted increase in the monetary base. It should contract the monetary base back to where it otherwise would have been, plus a slight increase geared toward economic expansion. Absent this major contraction in the monetary base, the Fed should increase reserve requirements on member banks to absorb the excess reserves. Given that banks are now paid interest on their reserves and short-term rates are very low, raising reserve requirements should not exact too much of a penalty on the banking system, and the long-term gains of the lessened inflation would many times over warrant whatever short-term costs there might be.

Alas, I doubt very much that the Fed will do what is necessary to guard against future inflation and higher interest rates. If the Fed were to reduce the monetary base by $1 trillion, it would need to sell a net $1 trillion in bonds. This would put the Fed in direct competition with Treasury's planned issuance of about $2 trillion worth of bonds over the coming 12 months. Failed auctions would become the norm and bond prices would tumble, reflecting a massive oversupply of government bonds.

In addition, a rapid contraction of the monetary base as I propose would cause a contraction in bank lending, or at best limited expansion. This is exactly what happened in 2000 and 2001 when the Fed contracted the monetary base the last time. The economy quickly dipped into recession. While the short-term pain of a deepened recession is quite sharp, the long-term consequences of double-digit inflation are devastating. For Fed Chairman Ben Bernanke it's a Hobson's choice. For me the issue is how to protect assets for my grandchildren.

Mr. Laffer is the chairman of Laffer Associates and co-author of "The End of Prosperity: How Higher Taxes Will Doom the Economy -- If We Let It Happen" (Threshold, 2008).

June 12, 2009

The Great Unwinding

Here’s one way to look at the politics of our era: We’ve moved from The Age of Leverage to The Great Unwinding.

For about a generation, the U.S. surfed on a growing wave of debt. The ratio of debt-to-personal-disposable income was 55 percent in 1960. Since then, it has more than doubled, reaching 133 percent in 2007. Total credit market debt — throwing in corporate, financial and other borrowing — has risen apace, surging from 143 percent of G.D.P. in 1951 to 350 percent of G.D.P. last year.

Charts that mark these trends are truly horrifying. There is a steady level of debt through most of the 20th century, until the mid-1980s. Then there is a steep accelerating rise to today’s epic levels.

This rise in debt fueled a consumption binge. Consumption as a share of G.D.P. stood at around 62 percent in the mid-1960s, and rose to about 73 percent by 2008. The baby boomers enjoyed an incredible spending binge. Meanwhile the Chinese, Japanese and European economies became reliant on the overextended U.S. consumer. It couldn’t last.

The leverage wave crashed last fall. Facing the possibility of systemic collapse, the government stepped in and replaced private borrowing with public borrowing. The Federal Reserve printed money at incredible rates, and federal spending ballooned. In 2007, the federal deficit was 1.2 percent of G.D.P. Two years later, it’s at 13 percent.

The crisis response more or less worked. Historians will argue about the Paulson-Geithner-Bernanke reaction, but the economy seems to be stabilizing. And now attention turns to the task of the next decade: slowly unwinding the debt that has built up over the past generation.

Americans aren’t borrowing the way they used to, but the accumulated debt is still there. Over the next many years, Americans will have to save more and borrow less. The American economy will have to transition from an economy based on consumption and imports to an economy with a greater balance of business investment and production. A country that has become accustomed to reasonably fast growth and frothy affluence will probably have to adjust to slower growth and less retail fizz.

The economic challenges will be hard. Reuven Glick and Kevin J. Lansing of the San Francisco Fed estimate that Americans will have to increase their household savings rate from 4 percent to 10 percent by 2018 to restore balance. That, they write, will produce “a near-term drag on overall economic activity.” Meanwhile, capital and labor will have to flow from sectors that depend on discretionary consumption to sectors based on research and investment.

But it’s the political challenges that will be most hellacious. Basically, everything that a politician might do to make voters happier in the near term will have horrible long-term consequences. Stimulate the economy too much now and you wind up with ruinous inflation down the road. Preserve failing companies and you wind up with Japanese stagnation. Cushion the decline in living standards with easy money now and you just move from a housing bubble to a commodities bubble.

The members of the political class face a set of monumental tasks. First, they have to persuade a country to postpone gratification for the sake of rebuilding the country. This country hasn’t accepted sacrifice in 50 years.

Second, political leaders will have to raise taxes and cut spending to get the federal fiscal house in order, and they will have to do it at a time when voters are already scaling back their lifestyles.

Third, they will have to refrain from doing anything that might further damage America’s fiscal position, which is extremely fragile. That means not passing a health care reform package unless it is really and truly paid for. That means forming a Social Security commission next year to tackle that entitlement problem.

Fourth, the political class is going to attempt the politically unthinkable. The U.S. is going to have to move toward a consumption tax, to discourage spending and encourage savings. There’s also a crying need for tax reform. As economist Douglas Holtz-Eakin points out, the tax code is rife with provisions that encourage leverage and discourage investment. The government will have to spend less on transfer payments and more on investments in science and infrastructure.

The members of the Obama administration fully understand this and are brimming with good ideas about how to move from a bubble economy to an investment economy. Finding a political strategy to accomplish this, however, is proving to be very difficult. And getting Congress to move in this direction might be impossible.

Congressional leaders have been fixated on short-term conventional priorities throughout this entire episode. There is no evidence that the power brokers understand the fundamental transition ahead. They are practicing the same self-indulgence that got us into this mess.

September 14, 2009

Same Old Hope: This Bubble Is Different

That’s what people argue every time a bubble inflates, and what they think every time they are chastened by its popping. But century after century, decade after decade and year after year, human beings irrationally exuberate all over again.

Not long ago, the housing bubble burst and brought the global economy to a standstill. Now economists, recognizing that bubbles tend to come in bunches, are on the lookout for the next market to fizzle. They say that governments, central banks and international bodies should scrutinize a few markets that look likely to froth over in the next few years, like capital markets in China, commodities like gold and oil, and government bonds in heavily indebted countries like the United States.

“Globally, a lot of money is now seeking higher returns once again,” said Rachel Ziemba, senior analyst at RGE Monitor. The steadying of the economy, liquidity injections by governments and big returns reaped early this year by investment banks are encouraging more traders to dip their toes back in the water in search of the next big thing.

“As long as compensation and bonuses are based on short-term performance in the market,” she said, “that’s going to encourage risk-seeking behavior.”

Bubbles are episodes of collective human madness — euphoria over investments whose skyrocketing values are unsustainable.

They tend to arise from perceptions of pending shortages (as happened last year, with the oil bubble); from glamorized new technologies or investment frontiers (like the dot-com bubble of the 1990s, the radio bubble of the 1920s or the multiple railroad bubbles of the 19th century); or from faddish cultural obsessions (like the Dutch tulip bubble of the 17th century, or the more recent Beanie Babies bubble).

Often they are based on legitimate expectations of high growth that are “extrapolated into the stratosphere,” as the economist Daniel Yergin, chairman of IHS-Cambridge Energy Research Associates, put it. Such is the fear over investment in emerging markets like China.

“I’m a long-term bull on Asia, but right now it’s premature to be celebrating the ‘Asian Century,’ like some investors seem to be doing,” said Stephen Roach, chairman of Morgan Stanley Asia.

The Shanghai Stock Exchange Composite Index, for example, nearly doubled from November to July before pulling back last month. “People seem to believe the baton of global economic leadership is being seamlessly passed from the West to the East. That’s going to happen, but not for another 5 to 10 years at least.”

Similarly premature excitement inflated what became known as the South Sea bubble, a 18th century mania over British trade with emerging Latin American markets. (Aside: Even the brilliant Sir Isaac Newton, seduced by the mirage of infinitely rising stock prices, lost a lot in the South Sea bubble — which is somewhat ironic, given his famous recognition that what goes up must come down.)

Economists also worry that commodity bubbles, which tend to be more cyclical, may strike again. Oil and gold prices are rising, and though both of those commodities have boomed and busted many times in the last century, investors may bet on unrealistically high growth once more. Gold prices, for example, have risen more than 30 percent from a year ago.

“With every commodity bubble, you see a whole new set of rationalizations,” Mr. Yergin said. “People find ways to shut out the reality of economic processes. If oil prices shoot up, investors are always surprised to see demand go down again.”

In each of these markets, the inflation and deflation of prices would be painful to investors but may not have as far-reaching consequences as the recent housing and credit collapses.

But a sovereign debt bubble — which many argue is driving the acceleration in gold prices — could prove far more dangerous.

So many countries, like the United States, are running up such large national debts as a percentage of their overall economies that they could risk eventual default. Even without outright default on their obligations, the value of government bonds sold to finance these deficits could plunge, costing investors a lot.

“Talk about a big bubble that really affects the global economy,” said Kenneth Rogoff, an economics professor at Harvard whose new book, “This Time Is Different,” chronicles 800 years of debt-driven financial crises.

“The huge run-up in government debt has led to patently unsustainable fiscal policies across a number of major countries,” he said. “So far, the rest of the world’s been willing to finance it, primarily with savings from China and elsewhere, but if investors’ confidence is shaken, we might see the interest rates on long-term debt rising, and rising very sharply.”

Debt crises are usually associated with developing countries, like Brazil, Argentina or Zimbabwe. But they can affect big, rich economies too, where the scale of global damage can be much greater.

“Look at California,” Mr. Rogoff said. “It’s incredibly rich, but Californians want a lot of services but don’t feel like taxing themselves to pay for them. You can be incredibly rich and still go bankrupt.”

The depth and breadth of the pain unleashed by the recent housing bust have led political leaders and central bankers to reconsider their duties to pre-empt, rather than just respond to, potential bubbles, and the same is true with the potential bubbles that economists foresee today.

China has started to tighten monetary policy to rein in the hype surrounding its equities. Politicians in the United States, while torn over the means, are discussing ways to bring the deficit until control.

The Group of 20, at its coming meeting in Pittsburgh, is expected to address ways to calm financial frenzies. The solution may involve additional regulation, guidelines for financial compensation and possibly requirements for more market transparency so that, at least in theory, investors can better judge what they are taking on.

But however stringent such new regulations may be, economists say, they cannot completely defeat human nature. Investors will continue to be hypnotized by get-rich-quick deals, seeking investments that magically double, double without toil or trouble.

“Ultimately, bubbles are a human phenomenon,” said Robert Shiller, a Yale economics professor and Cassandra of the current crisis. “People just get a little crazy.”

SEPTEMBER 25, 2009

G-20 accounting rules, not bank bonuses, put the system at risk.
Bank Pay and the Financial Crisis

The developed world's financial regulators and political leaders have, as one, decided what caused the financial crisis: the compensation systems used by banks to reward their employees. So the only question to be discussed at the G-20 summit that begins today in Pittsburgh is how draconian the restrictions on banker compensation should be.

The compensation theory is a familiar greed narrative: Bank employees, from CEOs to traders, knowingly risked the destruction of their companies because their pay rewarded them for short-term profits, regardless of long-term risks. It's conceivable this theory is true. But thus far there is no evidence for it—and much evidence against it.

For one thing, according to Rene Stulz of Ohio State, bank CEOs held about 10 times as much of their banks' stock as they were typically paid per year. Deliberately courting risk would have put their own fortunes at risk. Richard Fuld of Lehman Brothers reportedly lost almost $1 billion due to the decline in the value of his holdings, while Sanford Weill of Citigroup reportedly lost half that amount.

In the only scholarly study of the relationship between banker pay and the financial crisis, Mr. Stulz and his colleague Rüdiger Fahlenbrach show that banks whose CEOs held a lot of bank stock did worse than banks whose CEOs held less stock. (The study was published in July on Another study by compensation consultant Watson Wyatt Worldwide in July shows a negative correlation between firms' Z scores—a measure of their risk of bankruptcy—and their use of such widely criticized practices as executive bonuses, variable pay and stock options. These studies suggest that bank executives were simply ignorant of the risks their institutions were taking—not that they were deliberately courting disaster because of their pay packages.

Ignorance of risk is also suggested in a study by Viral V. Acharya and Matthew Richardson of New York University (just published in the journal Critical Review). Their research shows that 81% of the time the mortgage-backed securities purchased by bank employees were rated AAA. AAA securities produced lower returns than the AA and lower-rated tranches that were available. Bankers greedy for high returns and oblivious to risk would have bought BBBs, not AAAs.

Even more relevant to the question of culpability in the financial system's crisis is why banks were buying mortgage-backed securities at all.

Commercial bank capital holdings are governed by the Basel regulations, which are set by the financial regulators of the G-20 nations. In 2001, U.S. regulators enacted the Recourse Rule, amending the Basel I accords of 1988. Under this rule, American banks needed to hold far more of a capital cushion against individual mortgages and commercial loans than against mortgage-backed securities rated AA or AAA. Similar regulations, contained in the Basel II accords, began to be implemented across the other G-20 countries in 2007. The effect of these regulations was to create immense profit opportunities for a bank that shifted its portfolio from mortgages and commercial loans to mortgage-backed securities.

Bankers were of course seeking profits by purchasing mortgage-backed securities, but the evidence is that they thought they were being prudent in doing so. They bought AAA instead of more lucrative AA tranches, and they bought credit-default-swap and other insurance against default. None of this can be explained unless, on balance, the banks' management and risk-control systems kept in check whatever incentives to ignore risk had been created by the banks' compensation systems.

Banks did not behave uniformly. Citigroup bought as many mortgage-backed securities as it could; banks such as J.P. Morgan Chase did not. Were incentives at work? Yes. But all bankers faced the same artificially created incentive to buy mortgage-backed securities. Most bankers seem to have agreed with the regulators that the profit opportunity created by the regulations outweighed any risk in these securities, especially when they were rated AAA. But some bankers, like Morgan's Jamie Dimon, disagreed.

That type of disagreement, otherwise known as "competition," is the beating heart of capitalism. Different enterprises compete with each other by pursuing different strategies. These strategies encompass everything an enterprise does—including how it manages and pays its employees.

At bottom, all the practices of an enterprise are tacit predictions about which procedures will bring the most reward and which ones will avoid excessive risk. Accurate predictions bring profits and survival; mistaken predictions bring losses and bankruptcy. But nobody can know in advance which predictions are right. By allowing different capitalists' fallible predictions to compete, capitalism spreads a society's bets among a variety of different ideas. That, not the pursuit of self-interest, is the secret of capitalism's achievements.

To be sure, capitalists' different ideas are all, in the end, about how to gain profit. That's why incentives matter. But what matters even more are diverse predictions about where profits—and losses—are likely to be found. For this reason, herd behavior is a danger to capitalism, if the herd bets wrong. But herd behavior is imposed on capitalists every time a regulation is enacted—and regulators, being as human as bankers, can be wrong.

Regulations homogenize. The Basel rules imposed on the whole banking system a single idea about what makes for prudent banking. Even when regulations take the form of inducements rather than prohibitions, they skew the risk/reward calculations of all capitalists subject to them. The whole point of regulation is to make those being regulated do what the regulators predict will be beneficial. If the regulators are mistaken, the whole system is at risk.

That was what happened with the G-20's own Basel rules. Now the G-20 has decided to blame the crisis on bank compensation systems, which it proposes to homogenize just as it had previously homogenized bank capital allocation. What has not been explained is why we should trust that the G-20's regulations won't be mistaken once again.

Mr. Friedman is a visiting scholar in the government department at the University of Texas, Austin, and the editor of the journal Critical Review, which has just published a special issue on the causes of the financial crisis.  Causes of the Financial Crisis: A CRISIS OF POLITICS, NOT ECONOMICS


Blogging on Jeffrey Friedman's commendable edpage piece "Bank Pay and the Financial Crisis" (WSJ, Sep.25, 2009), Gerald Gruber wrote:  "This is good. This is really good! 'Herd behavior is a danger to capitalism, if the herd bets wrong. But herd behavior is imposed on capitalists [, socialists and ordinary citizens] every time a regulation is enacted -- and regulators, being as human as bankers, can be wrong.' If ever there was a fact statement that should inform public policy, this is one of them. The clear public policy implication from this (and tens of thousands of other examples pertaining not only to banking, but health care, taxation, and on and on) is that regulations should first of all be about policy. An example of the opposite is the 140,000 pages of Medicare regulations applicable to hospitals [and the some 20000 plain-levelling directives, guidelines and other Ukases the thus no-future European Union has served up on the emasculated citizens of its member countries]!"

Also particularly noteworthy, David Brady wrote: "... Here is an interesting approximate fact: In the 1960s the average CEO made about 60 times minimum wage. Today that multiplier is 820. Since barely a dime’s worth of shareholder value has been created in this country since 1997, it is time to abandon the ”greed-begets-riches-for-the-CEO” comp model in favor of something that better serves folks really taking the risk, the shareholders. Require the risk takers to become owners!" Brady could have added that Mao, reportedly, postulated a ratio of 1 to 30, that the Swiss theologian Hans Küng favored a socially tolerable maximum ratio of 1 to 100, and that the China Daily, earlier this year, reported on social and political backlashes on the background of top bonuses paid at Chinese state enterprises and financial institutions in excess of a 1 to 300 ratio (see:

Financial Times    19 October 2009

Mideast investment cuts hit private equity
By Robin Wigglesworth in Abu Dhabi, Martin Arnold in,London and Simeon Kerr in Dubai

Middle East families and sovereign wealth funds are slashing their investments and demanding more favourable terms from private equity funds following the financial crisis.

The region has been a significant source of capital for the private equity industry in recent years but many investors are still suffering from the collapse in liquidity that followed the collapse of Lehman Brothers.

One private equity executive who recently finished raising a buy-out fund said: "The one area where we have not raised any money is the Middle East. The region shut down 12 months ago."

Private bankers, who are important middlemen for wealthy private investors, said many of their regional clients were loath to make fresh commitments.

"Loans facilitate the fluidity of investments and that has shut a lot of these families down," said another private equity executive. "It is a liquidity crisis ."

Sovereign wealth funds are still willing to invest in private equity, but the amount of capital flowing to private equity is expected to decline.

Many regional institutions are now also demanding more favourable terms in return for new investments.

Previously, large investors in a fund would receive the same terms as others but that is changing, according to David Rubenstein, chief executive of Carlyle Group.

"I think a lot of very large limited partners now realise they have more leverage and they will exercise that by seeking either separate accounts or different terms if they go into a fund," he told the Financial Times.

The third quarter of this year was the worst period for global fundraising since the last three months of 2003, according to Preqin, a data provider.

Abraaj Capital, the region's largest buy-out firm, estimates the Middle East accounts for nearly a tenth of all capital raised globally by the industry.

Chris Ward, Deloitte's chief executive in the Middle East, said it is "almost impossible" for private equity groups to get funds from regional investors these days. "It is easier to get cash for a specific project, but funds are a dirty word," he said.

Most regional investors are secretive, but smaller banks and insurance companies admittheir private equity activities have halted.

Emirates Insurance Company "is planning to gradually reduce its exposure to private equity funds in light of the financial crisis and has no plans to invest in any further private equity funds in the foreseeable future", the company told Preqin.

Omar Lodhi, head of investor relations at Abraaj, said regional companies can still raise capital locally, but the private equity group has said it might lower the size of a planned $4bn fund, citing cheaper asset prices and investor caution.

Financial Times    19 October 2009

Countdown to the next crisis is already under way
By Wolfgang Münchau

We did not need to wait until the Dow Jones Industrial Average hit 10,000. It has been clear for some time that global equity markets are bubbling again. On the surface, this looks like 2003 and 2004 when the previous housing, credit, commodity and equity bubbles started to inflate, helped by low nominal interest rates and a lack of inflation. There is one big difference, though. This bubble will burst sooner.

So how do we know this is a bubble? My two favourite metrics of stock market valuation are Cape, which stands for the cyclically adjusted price/earnings ratio, and Q. Cape was invented by Robert Shiller, professor of economics and finance at Yale University. It measures the 10-year moving average of the inflation-adjusted p/e ratio. Q is a metric of market capitalisation divided by net worth. Andrew Smithers* has collected the data on Q, a concept invented by the economist James Tobin.

Cape and Q measure different things. Yet they both tend to agree on relative market mispricing most of the time. In mid-September both measures concluded that the US stock market was overvalued by some 35 to 40 per cent. The markets have since gone up a lot more than the moving average of earnings. You can do the maths.

The single reason for this renewed bubble is the extremely low level of nominal interest rates, which has induced people to move into all kinds of risky assets. Even house prices are rising again. They never fell to the levels consistent with long-term price-to-rent and price-to-income ratios, which are reliable metrics of the property markets’ relative under- or over-valuation.

But unlike five years ago, central banks now have the dual role of targeting monetary and financial stability. As has been pointed out time and again, those two objectives can easily come into conflict. In Europe, for example, the European Central Bank would under normal circumstances already have started to raise interest rates. The reason it sits tight is to prevent damage to Europe’s chronically under-capitalised banking system, which still depends on the ECB for life support. The same is true, more or less, elsewhere.

Now, I agree there is no prospect of a significant rise in inflation over the next 12 months, but the chances rise significantly after 2010.

Once perceptions of rising inflation return, central banks might be forced to switch towards a much more aggressive monetary policy relatively quickly – much quicker than during the previous cycle. A short inflationary boom could be followed by another recession, another banking crisis, and perhaps deflation. We should not see inflation and deflation as opposite scenarios, but as sequential ones. We could be in for a period of extreme price instability, in both directions, as central banks lose control.

This is exactly what the economist Hyman Minsky predicted in his financial instability hypothesis.** He postulated that a world with a large financial sector and an excessive emphasis on the production of investment goods creates instability both in terms of output and prices.

While, according to Minsky, these are the deep causes of instability, the mechanism through which instability comes about is the way governments and central banks respond to crises. The state has potent means to end a recession, but the policies it uses give rise to the next phase of instability. Minsky made that observation on the basis of data mostly from the 1970s and early 1980s, but his theory describes very well what has been happening to the global economy ever since, especially in the past decade. The world has witnessed a proliferation of financial bubbles and extreme economic instability that cannot be explained by any of the established macroeconomic models. Minsky is about all we have.

His policy conclusions are disturbing, especially if contrasted with what is actually happening. In their crisis response, world leaders have focused on bonuses and other irrelevant side-issues. But they have failed to address the financial sector’s overall size. So if Minsky is right, instability should continue and get worse.

Our present situation can give rise to two scenarios – or some combination of the two. The first is that central banks start exiting at some point in 2010, triggering another fall in the prices of risky assets. In the UK, for example, any return to a normal monetary policy will almost inevitably imply another fall in the housing market, which is currently propped up by ultra-cheap mortgages.

Alternatively, central banks might prioritise financial stability over price stability and keep the monetary floodgates open for as long as possible. This, I believe, would cause the mother of all financial market crises – a bond market crash – to be followed by depression and deflation.

In other words, there is danger no matter how the central banks react. Successful monetary policy could be like walking along a perilous ridge, on either side of which lies a precipice of instability. For all we know, there may not be a safe way down.

*Wall Street Revalued: Imperfect Markets and Inept Central Bankers, Wiley 2009;
** Stabilising an Unstable Economy, McGraw-Hill, 2008    13.08.2011, 06:29 Uhr

Vier Gründe, weshalb diese Krise hartnäckiger sein wird als frühere
Von Res Strehle.

Wer kurz vor der Jahrtausendwende am World Economic Forum (WEF) in Davos  war, wird sich an den Auftritt des damaligen US-Finanzministers Robert Rubin  erinnern. Rubin hatte von der Investmentbank Goldman Sachs in die Clinton- Administration gewechselt und versprühte den damaligen Optimismus der  Wallstreet. Er zeigte in einer fulminanten Präsentation, wie der US- Staatshaushalt innert Kürze zu einem positiven Abschluss drehen würde. Bis  2011, rechnete Rubin vor, hätten die USA sämtliche Staatsschulden getilgt und  dank der New Economy fantastische Wachstumsaussichten.

Heute wissen wir, dass Rubins Prognose nicht ganz ins Schwarze traf. Statt 0  haben die USA heute 14'000 Milliarden Dollar Schulden. Die Überschätzung der  New Economy hat der Weltwirtschaft die erste grosse Blase im neuen  Jahrtausend beschert und die auf Rubins Initiative aufgehobene Trennung  zwischen Investment- und Kommerzbanken die grossen Finanzinstitute in der  zweiten Krise dieses Jahrzehnts mit in einen Strudel gerissen, aus dem sie sich  bis heute nicht befreit haben. Vier Gründe lassen vermuten, dass diese Krise  hartnäckiger sein wird als frühere:

1.) Staatliche Finanzspritzen haben ihre Wirkung verloren. Offensichtlich wirken  sowohl Konjunkturprogramme als auch die Erhöhung der Liquidität und die  Tiefzinspolitik diesmal weniger stimulierend. Das hat damit zu tun, dass diese  Mittel in den vergangenen Jahren zu oft eingesetzt wurden. Tiefe Zinsen und  hohe Liquidität schaffen nur die Voraussetzungen – investieren und  konsumieren müsste der Privatsektor. Oder wie es der legendäre britische  Wirtschaftswissenschaftler John M. Keynes einst plakativ formulierte: Man kann  die Pferde zum Brunnen führen, aber trinken müssen sie selber.

2.) Kommt hinzu, um beim Bild zu bleiben, dass der Feuerwehr langsam das  Wasser ausgeht. Mit jeder Krise stieg die staatliche Verschuldung der westlichen  Länder an. 2001 betrug sie in der EU durchschnittlich 70 Prozent des  Bruttoinlandprodukts. Das hatte die EU damals ermutigt, den Mitgliedsländern  ein Ziel von 60 Prozent zu setzen. Spätestens nach der Finanzkrise 2008 war  diese Grenze nicht mehr zu halten und betrug nun 85 Prozent. Mit den neuen  Programmen wird sie einen weiteren Sprung nach oben machen. Werden die  Zinsen dereinst ansteigen, im schlimmeren Fall auf 10 Prozent oder höher, dann  wird in hoch verschuldeten Staaten wie Japan bald gegen ein Viertel der  nationalen Wertschöpfung für den Zinsdienst benötigt. Das wird umso schneller  der Fall sein, wenn sich der Prozess fortsetzen sollte und nun auch ehedem  erstklassige Schuldner wie die USA herabgestuft werden.

3.) Im Unterschied zu früheren Krisen scheinen Regierungen, Zentralbanken  und internationale Organisationen dieses Mal deutlich ratloser. Das gilt auch für  die Schweizerische Nationalbank, die zur Stunde von der Wirkung ihrer neuen  Massnahmen zur Schwächung des Frankens überzeugt ist. Ob dies die  Finanzmärkte auch sind, werden erst die kommenden Wochen zeigen. Der  fehlende Konsens hat damit zu tun, dass es keinen gemeinsamen  Theorierahmen mehr gibt. Einst hatte ihn John M. Keynes geliefert, dann sein  Gegenspieler Milton Friedman. Mit Keynes müsste die Nationalbank  intervenieren, ein Wechselkursziel formulieren und notfalls auch eine Inflation  in Kauf nehmen. Mit Friedman dürfte sie die Hände in den Schoss legen und  zusehen in der Hoffnung darauf, dass die Märkte ihr Gleichgewicht früher oder  später selber finden – die Frage, wie viele Opfer es geben würde, interessiert in  diesem Paradigma weniger. Die Nationalbank schlingert wie auch ihre  grösseren Schwestern EZB und Fed heute dazwischen: Es dominiert eine Art  Intervention light, man setzt auf Placebomedizin – mit ungewisser  Beruhigungswirkung auf den Patienten.

4.) In der aktuellen Krise zeigt sich, dass die politische Akzeptanz von  Sparprogrammen in demokratischen Staaten immer kleiner wird. Das hat mit  den wachsenden gesellschaftlichen Ungleichheiten zu tun, der gestiegenen  Staatsverschuldung und mit der Tatsache, dass viele Verantwortliche die  Krisenschäden nicht mittragen mussten. Der ehemalige US-Finanzminister  Rubin liess sich seine Arbeit an der Spitze der Citigroup ab 2002 mit insgesamt  126 Millionen Dollar entschädigen und berät heute Barack Obama. Das ist mit  ein Grund, dass kaum ein Rezept heute politisch mehrheitsfähig ist. Kommt es  aus Keynes Küche, so erwächst ihm Widerstand von der Tea Party – kommt es  aus Friedmans Küche, so erwächst ihm linker Widerstand. Die Markttheorie ist  ratlos, und den Anhängern staatlicher Programme fehlen die Mittel.  (

Neue Zürcher Zeitung    24.Dezember 2012

Börsen & Märkte Dossier: Börsen und Märkte auf der Achterbahn
Untragbare Expansion der Notenbank-Bilanzen
Andreas Uhlig

Das verbesserte Klima an den Finanzmärkten bedeutet nicht eine Überwindung der Schulden- und Finanzkrise. Gefordert wird ein Kurswechsel der Geldpolitik.
Blickt man auf die vergangenen zwölf Monate zurück, stellt man fest, dass die schlimmsten Befürchtungen der Finanzmärkte nicht eingetreten sind. Die oft als nur noch extrem gering eingeschätzten Überlebenschancen Griechenlands als Mitglied der Euro-Zone haben sich auch in der Sicht von kritisch beobachtenden Marktkommentatoren wie Willem Buiter von der Citigroup deutlich verbessert. Wie sehr sich die Stimmung der Finanzmärkten gehoben hat, zeigen die geschrumpften Rendite-Spreads von Anleihen peripherer Euro-Länder über deutsche Bundesanleihen. Der Aufschlag für zehnjährige griechische Staatspapiere ist sogar unter zehn Prozentpunkte gefallen. Was schlimmere Szenarien befürchtende Beobachter unterschätzt hatten, war der Wille von Politikern und EZB-Chef Mario Draghi, den Euro zu retten – selbst unter Inkaufnahme neuer Risiken.

Trichet schlägt Alarm
Nun aber hat Draghis Vorgänger, Jean-Claude Trichet, Alarm geschlagen. Ihn beunruhigt die seit 2007, dem Ausbruch der Finanzkrise, erfolgte Aufblähung der Bilanzen der Notenbanken der USA, Grossbritanniens, Japans und der Euro-Zone. In einem Interview mit der Fernsehgesellschaft CNBC bezeichnete er diese durch verschiedene Formen der geldpolitischen Lockerung und Käufe von Staatsanleihen eingetretene Situation als zutiefst abnormal. Sie könne nicht ewig so bleiben, sie sei keine neue Normalität, die man akzeptieren könne.

Scott Minerd, der CIO der Finanzfirma Guggenheim Partners, hat sich die Expansion der Notenbank-Bilanzen genauer angesehen. Die Bilanzsumme der EZB beträgt gegenwärtig über 30% des Bruttoinlandprodukts (BIP) der Euro-Zone. Sollte das von Draghi in Aussicht gestellte Programm der unlimitierten Käufe von Staatsanleihen (OMT) tatsächlich umgesetzt werden, würde sich ein entsprechender Anstieg der Bilanzsumme ergeben. Die Bilanz der japanischen Notenbank entspricht ebenfalls rund einem Drittel des BIP des Landes; sie wird durch das 90 Bio. ¥ betragende Kaufprogramm auf über 40% steigen.

In der Grössenordnung eines Viertels des BIP liegt die Bilanz der Bank von England; bestehende Kaufprogramme werden sie weiter aufblähen. Mit den beabsichtigen Käufen von Wertpapieren wird die Bilanz der US-Notenbank 2013 von relativ bescheidenen 17% auf 26% expandieren. Anfang 2008 hatten die Bilanzen der britischen und amerikanischen Notenbanken lediglich rund 7% des BIP entsprochen; die EZB kam bereits auf rund 15%.

Ende des Schuldenzyklus
Eine Entwarnung scheint also trotz jetzt freundlicherem Klima nicht angebracht zu sein. Zunehmend aufmerksam wird an den Finanzmärkten die entstandene und vom künftigen Gouverneur der Bank von England, Mark Carney, an die Öffentlichkeit getragene Debatte über Wünschbarkeit und Notwendigkeit einer Neuausrichtung der Geldpolitik beobachtet. Zu den Befürwortern einer Orientierung der Notenbanken am nominellen BIP gehört auch Jeff Frankel, Professor der Harvard University. Er sieht die Zeit für einen Kurswechsel der Geldpolitik gekommen, damit die Wirtschaftsregionen USA, Grossbritannien, Japan und Euro-Zone zu einem rascheren Wirtschaftswachstum kommen, das einen Abbau der Schulden erleichtert. Das nominelle BIP wäre ein glaubwürdiger Anker für diese Notenbanken.

Wachstum alleine dürfte allerdings zum Abbau der hohen Verschuldung nicht ausreichen. Kyle Bass, Managing Partner des grossen Hedge Fonds Hayman Capital hat vor kurzem darauf hingewiesen, dass das Verhältnis der gesamten Kapitalmarktschuld zum globalen BIP 350% beträgt: Dem BIP von 62 Bio. $ stehen Kredite und Schulden von 200 Bio. $ gegenüber. Er spricht von einem Super-Schuldenzyklus, der seit Jahrzehnten laufe, nun aber am Ende angekommen sei, und er ist überzeugt, dass gewisse Länder eine Restrukturierung ihrer Schulden nicht auf Dauer vermeiden werden können.

Schon seit einiger Zeit vertritt auch der bekannte Marktkommentator John Mauldin die These vom Ende dieses Superzyklus. Der in der Weltwirtschaft. ablaufende vielschichtige Deleveraging-Prozess werde zwar vorerst weiter für Deflationstendenzen sorgen. Doch wegen der vorgenommenen enormen Expansion der Bilanzen der Notenbanken werde anschliessend eine Inflationsphase unvermeidbar sein.

Neue Zürcher Zeitung    7.Januar 2013

Blick auf die Finanzmärkte
Ponzi-System der enormen Verschuldung
Andreas Uhlig

Aus oberflächlicher Sicht hat die Finanzkrise an Kraft verloren. Doch Investoren und Analytiker befürchten weiterhin ein Platzen der riesigen Schuldenblase.
Investoren und Analytiker befürchten ein Platzen der Schuldenblase. (Bild: Keystone / AP / Daniel Ochoa de Olza)

Die Beruhigung an den globalen Finanzmärkten hat einige Politiker wie den Chef der EU-Kommission, Barroso, und den Präsidenten des Europäischen Rates, Van Rompuy, zum Schluss verleitet, dass zumindest in der Euro-Zone die Schuldenkrise überwunden sei. Diesen offiziellen Optimismus teilen aber nicht alle Marktteilnehmer. Unter Investoren herrsche ein wachsendes Unbehagen, meint beispielsweise der global vernetzte Marktkommentator John Mauldin. Es dominiere die Ansicht, die gegebenen ökonomischen Strukturen seien nicht von dauerhafter Natur. Man habe es mit der grössten Blase der Geschichte zu tun, einer von unbezahlbaren Staatsschulden und uneinlösbaren Versprechen. Diese Blase werde platzen, auch wenn der Zeitpunkt unklar sei.

In die Zukunft verschoben
Ein Ausdruck des Unbehagens ist die Warnung der Investmentbank Goldman Sachs vor einem Trendwechsel an den Kapitalmärkten. Nachdem vergangene Woche die Rendite von Treasuries auf den höchsten Stand seit acht Monaten gestiegen war, wies der Analytiker Robert Boroujerdi auf die Gefahr von hohen Verlusten hin, sollten sich die Risikoprämien in Richtung des historischen Durchschnitts bewegen. Aus einer viel umfassenderen Sicht hat sich die Boston Consulting Group (BCG) mit dem Krisenpotenzial der Industrieländer befasst. Auch sie sieht eine in ihrem Ausmass einzigartige Blase und spricht vom grössten Ponzi-System, das die Welt je gesehen habe: Mit immer neuen Schulden würden alte beglichen.

Entscheidungsträger seien nachlässig und selbstzufrieden, befindet Daniel Stelter in der neuen Studie der BCG. Sie würden weiterhin eine Politik betreiben, welche die Lösung von Problemen in die Zukunft verschiebe, und es vermeiden, gegenüber der Öffentlichkeit die Wahrheit einzugestehen: Ein grosser Teil der angehäuften Schulden werde niemals in ordentlicher Weise zurückbezahlt werden. Ohne Überwindung der Schulden- und Strukturprobleme drohe den Industrieländern aber eine säkulare Krise mit wachsender sozialer Unruhe und steigenden Risiken für Demokratie und Marktwirtschaft.

Defektes Wachstumsmodell
Dieses einzigartige Ponzi-System habe sich durch die rekordhohen öffentlichen und privaten Schulden ergeben. Seit 1980 sei die reale Verschuldung von Regierungen um über das Vierfache, die der privaten Haushalte um über das Sechsfache und die der Unternehmen um das Dreifache gestiegen. Zwar sei Verschuldung, betont Stelter, nicht an sich falsch, aber in den vergangenen Jahrzehnten sei der grosse Teil neuer Schulden nicht produktiv zur Erhöhung zukünftiger Einkommen, sondern für Konsum, Spekulation in Finanzanlagen und Immobilien und Schuldenfinanzierung eingesetzt worden. Ein beunruhigender Trend sei, dass das Verhältnis von neuer Schuld zu damit erzeugtem Sozialprodukt immer schlechter werde.

Unter der Annahme, dass eine vertretbare Verschuldung von Staat, Privathaushalten und Nicht-Finanzunternehmen je 60% des zugehörigen Bruttoinlandproduktes (BIP) beträgt, sind die USA mit 11 Bio. $ und die Euro-Zone mit über 7 Bio. € überschuldet. Allerdings müssen zur Gesamtverschuldung auch die riesigen verborgenen Verpflichtungen der staatlichen und privaten Sektoren in Altersvorsorge und Gesundheitssystem addiert werden.

Aus Sicht der BCG ist das Wachstumsmodell der Industrieländer zerbrochen. Hohe Verschuldung bremse wirtschaftliches Wachstum. Gleiches gelte für den überdimensionierten, zumeist 40% des BIP übersteigenden Staatssektor. Stelter beklagt die systematische Vernachlässigung von Investitionen der öffentlichen und privaten Sektoren in ihren Kapitalstock. Die Industriestaaten investierten zu wenig in Infrastruktur und in Quantität und Qualität von Erziehung und Ausbildung. Unternehmen hätten, berichtet Goldman Sachs, schon vor der Finanzkrise ein hohes Investitionsdefizit gehabt. Lähmend wirke auch die hohe Unsicherheit, wann dieses Ponzi-System kollabieren werde.

Ein Katalog von Massnahmen
Zur Vermeidung eines Kollapses empfiehlt BCG einen Abbau des Schuldenüberhangs durch Abschreibungen, Restrukturierungen, Ausgabenkürzungen, Steuererhöhungen und Inflation. Auch die verborgenen Schulden müssten reduziert werden. Die Effizienz von Staat und Wohlfahrtssystem sei zu verbessern, und Staat und Privatsektor müssten mit Zukunftsinvestitionen ihre Kapitalausstattung stärken. Die Akzeptanz von Innovationen müsse gestärkt werden.